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Downey Financial Corp. (“DSL” or the “Company”) is a savings and loans holding company for Downey Savings and Loan Association, a regional bank based in Downey, California with just under 100 full-service branches across parts of CA and AZ. As a regional savings and loan association, DSL’s main business is loan origination, focusing primarily on residential real estate mortgages in California and mortgage-backed securities (“MBS”). While the Company focuses on first mortgage loan origination secured by residential properties, it also originates multi-family and commercial property loans, home equity loans (“HELS”), and home equity lines of credit (“HELOC”). DSL also provides construction loan financing for residential and commercial projects.

A key component of DSL’s investment portfolio has been its emphasis on the origination of adjustable rate mortgages (“ARMs”) for single family homes loans, including sub-prime loans. The Company elects to either hold these and other loans for investment in its portfolio or sells them into the secondary market. DSL generally holds its ARMs and sells its fixed-rate mortgages in order to mitigate interest rate risk associated with fixed rate 15-40 year mortgage maturities.

As indicated in the Company’s filings, most of DSL’s ARMS are option ARMs with an interest rate that adjusts monthly and a required minimum monthly loan payment that adjusts annually. The start rate is lower than the fully-indexed rate and is the effective interest rate for the loan only during the first month. After the first month, interest accrues at the fully-indexed rate. The initial start rate, however, is used to calculate the required minimum monthly loan payment for the first twelve months. The borrower is required to make the minimum monthly payment, but retains the option to make a larger payment to reduce loan principal and avoid negative amortization, or the addition to loan principal of accrued interest that exceeds the required monthly loan payment.

The Company’s option ARMs typically limit negative amortization to 110% of the original loan amount,
have a lifetime interest rate cap, and include a payment cap that limits the change in required minimum monthly loan payments to 7.5% per year, unless the loan is recast (i.e., a new monthly loan payment is calculated using the fully-indexed interest rate and provides for amortization of the loan balance over the remaining term of the loan). A loan is recast at the earlier of every five years or when the loan balance reaches the maximum level of negative amortization permitted. The maximum home loan DSL will make is equal to 95% of a property’s appraised value with private mortgage insurance required for loans in excess of 80%.

Investment Rationale
The basis for this short position is the belief that today’s housing and, more importantly, lending bubbles and the subsequent deflation will be far worse than most anticipate. The market has generally priced in downward expectations in many homebuilders and banks that have exposure to real estate lending with some stocks trading for less than book value and low to single digit P/E multiples. As news regarding housing slowdowns has surfaced, a variety of general circulation media have given the real estate market front page coverage. Conventional wisdom would suggest that stocks in affected sectors currently reflect the anticipated slowdown. Nonetheless, the possible fallout from the recent years’ excesses in real estate and lending could be much more deleterious that expected, particularly for lenders. A good portion of the housing bubble was fueled by nontraditional mortgages and lending criteria has considerably relaxed, increasing the beta of any potential hiccup.

Yale Professor Robert Shiller made an interesting presentation entitled “Irrational Exuberance Revisited” at the CFA Risk Symposium in February 2006 which was recently reprinted in CFAI’s latest Conference Proceedings Quarterly. Shiller purports that bubbles are caused by precipitating, amplification, cultural, and psychological factors. Shiller’s research included searching for the number of times that the phrase “housing bubble” was ever mentioned since 1980. The results were that the phrase briefly appeared after the crash of 1987 and then suddenly returned in 2002. He also constructed a historical chart of single family homes based on available data and compared it to conventional wisdom of why home prices have appreciated.

Despite the beliefs held by some that construction/building costs, population growth, employment rates, and interest rates fuel home price appreciation, there is little correlation between these factors and home price appreciation according to Shiller. He went as far back as 1890 to examine interest rates and their potential relationship with housing and found no correlation. He also reminded readers that real interest rates have dropped consistently since 1980 and have demonstrated no relationship with home prices. The main point is that despite all the attempted rationalization by certain analysts and pundits, the housing bubble and commensurate lending bubble have been vastly driven by psychology and emotion, which as witnessed in other manias from Dutch tulips to the dotcom bust can result in violent, adverse six-sigma events. Further, there is really no precedent for the lending and housing bubble that the U.S. witnessed over the past several years.

Exposure to Residential Real Estate in Bubble Markets: The residential real estate market has shown greater signs of difficulty relative to the commercial market, specifically in bubble markets such as Florida, California, and New York. Since DSL’s banking operations primarily focus on residential real estate mortgages in California, the Company has a great degree of concentration in both asset and geographic risk. As of June 2006, 89% of the Company’s approximate $15.4 billion residential real estate portfolio was secured by properties located in southern California, specifically Los Angeles, San Diego, Orange, Santa Clara, and Riverside counties.

Further, while 78% of the residential mortgages were based on borrower stated income, 10% were underwritten with no verification of borrower income and/or assets, known as “no-doc” loans. This can be particularly onerous given the level of mortgage fraud activity in southern California, which tops the list of mortgage fraud reports according to the FBI. As reported in the L.A. Times article “More Home Buyers Stretch Truth, Budgets to Get Loans” on September 29, 2006, a seven-county region from Orange County to San Luis Obispo County has experienced a fourfold increase in suspicious loan activity since 2003.

When real estate values were rising, borrowers who used duplicity to obtain their mortgages could draw down their home equity through refinancing to help in paying off their monthly mortgage payments or sell the property for a profit to repay the entire mortgage. During those boom times, the banks could easily look the other way as the borrower’s cash-out or sale transactions would bring in additional fee income to the bank. Now, with prices flattening/declining, borrowers without sufficient equity may be forced to sell for a loss or even default on payments which could accelerate a market downturn with a glut of foreclosed properties.

Another interesting statistic from the article was the reference to some findings presented by the Mortgage Asset Research Institute (“MARI”) from a lender that conducted a study of 100 non-doc borrowers. According to MARI, the lender found that only 10 of the 100 borrowers it examined were telling the truth about their wages and sixty had overstated their income by over 50%. While these statistics are not representative of a normal distribution sample, applying it to DSL’s approximate $1.4 billion in non-doc loans gives some scale and insight to the potential problems the Company could soon face. Based on the study, 90% of non-doc borrowers lied about their financial status which would imply that nearly $1.4 billion of DSL’s loans could face significant pressure as the real estate market in California flattens/declines.

In addition to its geographic risk, 19% of the Company’s loans were originated in 2006 and 40% were originated in 2005. As a result, a substantial amount of the Company’s loans have not experienced borrowers’ reactions to increasing monthly payments based on the established reset rates. As of June 2006, DSL was reporting just $51.1 million in loan loss allowances for its $15.4 billion in loans held for investment. In comparison, IndyMac Bancorp., Inc. ((NDE) or “IndyMac”), a comparable bank based in southern California recorded a $57 million allowance in loan losses for a loan portfolio of approximately $8.7 billion. In addition, about 71% of NDE’s loans are some form of ARMs which is significantly lower than 90+% ARM exposure of DSL.

Potential for Asset and Earnings Impairment: As of June 2006, DSL’s loan portfolio totals nearly $15.4 billion of which $13.2 billion is invested in residential option ARMs subject to negative amortization. Through the same period, the Company had just $39 million or .23% of total assets classified as non-performing assets (“NPAs”) and its credit loss provision was just $16.7 million. This has increased based on the Company’s latest 8-K (the 10-Q has not been filed yet) to $67 million or 0.39% of total assets. Based on expectations for the housing market, the level of NPAs should continue to increase, adversely impacting the Company’s balance sheet.

The Company’s loan portfolio may also be overstated through its seemingly low loan loss allowance as previously mentioned. DSL also includes $229 million in negative amortization in its loan balance. This is proper accounting but negative amortization likely accrues for people that are struggling financially and as a result, the future carrying value of this $229 million could be suspect. DSL maintains $9.8 billion in prime loans where the current balances are greater than the original loan amount and $593 million in sub-prime loans where current balances are greater than the original amount. These two figures represent nearly 80% of DSL’s prime and sub-prime residential loan portfolios.

Issues related to negative amortization will also impact the Company’s income statement. Table I illustrates the level of capitalized interest from negative amortization compared to the Company’s interest income from loans as well as Earnings before Taxes (“EBT”) over recent years.

negative amort

As Table I clearly illustrates, capitalized interest is becoming a growing part of DSL’s income stream. While the accounting is perfectly legitimate, the key issue is determining how tangible the capitalized interest truly is. To skeptics, a good portion of it could be viewed as phantom earnings. In fact, if one were to assume 50% of capitalized interest from negative amortization was impaired, 2005 EPS would be overstated by over 20%. Given the expected economic climate, borrowers of option ARMs will probably have increasing difficulty in meeting their monthly interest payments which will increase the level of capitalized interest DSL recognizes, further reducing the quality of the Company’s earnings.

Third Party Loan Origination:
In 2005, approximately 91% DSL’s one-to-four unit residential real estate loans were originated or purchased through outside mortgage brokers. While third party loan origination is far from uncommon, the results of utilizing such a substantial outside source for loan origination can result in lax analysis of potential borrowers despite the presences of Company credit committees and controls. The borrowers do not have a relationship with DSL or any in-house loan officers which can add to possible obstacles when borrowers experience difficulty in making mortgage payments.

Valuation: DSL appears richly valued given its exposure to the option ARM market in California. In fact, many S&L/thrifts based focused on California appear to have high valuation metrics if one expects the real estate market and lenders to experience difficulties. The stock currently trades at 9.5x trailing and 9.0x 2007 earnings while its price-to-book (“P/B”) is 1.5x. These may seem like bargain multiples compared to the general market and even certain financial services companies, but the Company has traded at much cheaper valuations during periods when California’s economy and real estate market experienced difficulty. From 1992-early 1995, DSL’s P/B ratio mostly traded below 1.0x book while its trailing P/E ratio oscillated between 5.5-7.0x.

These multiples are more consistent with the current trading values of sub-prime originators such as Fremont General Corp. (FMT) and sub-prime originators structured as REITs such as Saxon Capital (SAX) and Impac Mortgage Holdings, Inc. (IMH). SAX was acquired by Morgan Stanley in August 2006 but prior to the deal announcement was trading for significantly below book value. Both FTM and IMH currently trade for less than 0.8x book value and low to mid single digit P/Es, reflecting the possibility of write-offs related to loans and residual interests from securitizations as well as the expected reduction in gain on sale and securitization income that will be forthcoming as the market slows.

DSL may actually be a riskier investment when compared to sub-prime originators such as FMT and IMH. While the portfolio of sub-prime companies is filled with loans issued to borrowers with average FICO scores below those of DSL’s borrowers, these businesses possess strong mortgage servicing businesses which offer value for potential acquirers and can generate additional income when the real estate market slows. Secondly, FMT and IMH are adept at loan disposition and have a large network of potential buyers for various assets. These aspects have attracted many large financial services companies such as Goldman Sachs, Deutsche Bank, Morgan Stanley, and Barclays who have all purchased sub-prime originators/servicers over the past year.

In contrast, DSL is a regional bank that is holding a large volume of risky, geographically concentrated assets in its portfolio, does not have as strong as mortgage servicing franchise to generate incremental income, and does not have the secondary market connections of a company like FMT. Consequently, if some of these loans begin to go bad, the Company will face the same write-off issues as FMT and IMH but will not be as adept in re-packaging and disposing these loans.

Another way of valuing DSL could be to simply calculate a present value of its investment loan portfolio based on the Cost of Funds Index (“COFI”) + spread, analogous to a basic bond valuation. This could be viable in DSL’s case because it is essentially a one-product bank so the bulk of its value is tied to a fairly homogenous investment loan portfolio. In the case of DSL, this technique could be used to find the implied spread over COFI that is resulting in the Company’s current valuation as well as conduct a sensitivity analysis. If the market becomes risk averse, the spread should widen reducing the value of the Company’s loan portfolio, despite the floating rates of its investment loans.

Dividends: Shorting a stock which pays a dividend always entails more risk as the dividend is paid out of short proceeds. DSL has been a steady dividend payer although payouts have fluctuated based on the Company’s results.

Acquisition Target: The regional bank sector has experienced significant M&A activity in recent years. Generally larger banks have been acquiring smaller firms in attempt to achieve greater scale and in some cases the acquisitions go for 2.0-3.0+x book value. Despite the expected problems DLS could have with its loan portfolio, a large bank could absorb that exposure and the potential losses in exchange for the expanded retail presence and a large loan portfolio. A large bank would have a strong distribution channel and could dispose of the less attractive loans and affect a “clean-up” of DSL’s balance sheet once it is acquired. In return, while taking some possible write downs through losing sales and/or bad loans, the acquirer would receive entrance/expansion into an attractive geography, the Company’s deposit base, and could generate incremental revenue by driving its own products through the 100 chain bank.

Additionally, a significant portion of the Company is owned by Maurice McAlister, Chairman of the Board. Mr. McAlister co-founded DSL with the late Gerald McQuarrie in the 1950s. Insiders collectively own 24.7% of DSL stock based on their latest proxy statement. Given how long McAlister has been with DSL, it is possible that he would be willing to cash out, especially since the stock is trading close its all time highs.

Smart Investor Presence: Nearly 10% of DSL is held by Jeffrey Gendell, managing partner of Tontine Financial Partners L.P. (“Tontine”). Tontine has an impressive reputation and has had success with regional banks in the past such as First Mariner Bancorp (“FMAR”) which Tontine purchased for about $8.00 per share in 2003 and now trades for over $19.00 per share. The logic behind Tontine’s purchase of DSL is probably similar to what has been highlighted in the “Acquisition Target” section above.

Tontine’s investment may also be similar to the long play on Wells Fargo & Co. (“WFC”) made by Bruce Berkowitz, Warren Buffett, Tweedy Browne, and other value investors about 13 years ago when the quality of WFC’s loan portfolio was questioned. At the time, California had been suffering through major economic and real estate malaise and WFC’s exposure to commercial real estate resulted in substantial negative sentiment towards the stock. Of course, the contrarian value investors concluded the sentiment was far worse than reality and established positions in WFC, reaping substantial gains.

While plenty of value investors like to refer to this investment “story,” there are some key distinctions between WFC and DSL. WFC, even in the early to mid 1990’s, had far more diversity in terms of financial services relative to DSL. Secondly, and perhaps the most critical aspect of where these two ideas diverge, was that WFC was being overly conservative with its accounting by establishing huge loan loss provisions and recognizing a large segment of NPAs, despite the fact that many of the NPAs had shown little sign of degradation. In contrast, DSL has still not recognized nearly enough in loan loss provisions and NPAs based on where the California market could be headed.

Safety Sector: DSL is a regional bank and the financial services industry is often viewed as a safety sector, particularly during slowing economic times. Given the potential for a slowing economy, financial services stocks may outperform the general market as more investors rotate into the sector. In this case, DSL may catch a rising tide which could seriously damage an unhedged/unpaired short position.

Short Squeeze: Nearly 17% of the Company’s float is sold short which creates the risk of a short squeeze. One thing to keep in mind, however, is that short interest has consistently increased despite a few valuation corrections over the past year which could indicate that short sellers believe the real correction is yet to come.

Disclosure: Author is short Downey Financial

Source: The Short Case On Downey Financial