Credit Fiasco Could Spread To Downey Financial

The worldwide glut of capital has caused low quality debt to be bid up to outrageous levels. Subprime debt has already had a severe correction. I believe this will spread to the "Alt-A" market, which is defined by slightly higher credit scores but similar programs and underwriting.

I think that Downey Financial (DSL), a California savings and loan is another possible play. Downey has branches in CA and AZ, and focuses on residential mortgage lending.

• As of June 2006, 89% of DSL’s approximate $15.4 billion residential real estate portfolio was secured by properties located in southern California
• 78% of the residential mortgages were based on borrower stated income. 10% were underwritten with no verification of borrower income and/or assets.
• This is especially bad because mortgage fraud is so prevalent in southern California.
• 19% of the Company’s loans were originated in 2006 and 40% were originated in 2005
• In 2005, approximately 81% DSL’s one-to-four unit residential real estate loans were originated or purchased through outside mortgage brokers. Of course, this creates severe moral hazard.
• 85% of its residential portfolio consists of adjustable rate mortgages subject to negative amortization with the majority structured as option-ARMs
• They sell the conservative, fixed rate loans and keep the toxic loans as investments.
• They claim to have mortgage insurance for the portions of any loans that exceeded 80% LTV when originated. However, they do not purchase mortgage insurance when negative amortization pushes loan balances above 80% LTV, nor when declining property values increase the LTV. Furthermore, we know how pervasive bad appraisals are. Finally, the mortgage insurers will be able to claim fraud and negligence on Downey's part. Downey's insurers will be able to stall and avoid paying claims when Downey needs liquidity. Also, the mortgage insurers might themselves go bankrupt.
• Property values are set to fall so far in CA that even the uninsured 80% will experience losses.
• For every dollar's worth of assets, the company has $0.91 cents in debt. In itself, this is a reasonable amount of leverage for a bank to have. However, if the assets depreciate by 9%, the company's equity will be wiped out.

Risks to the trade:

• Trades at about 1.3 times book value. Publicly traded S&L's trade at about 2.9x BV and financials at about 3x. (Track these multiples here.) People could look at DSL as a "deal" and so it is a takeover candidate. Of course, there were rumors about a New Century buyout [at a multiple of book value] as recently as December 2006.
• High short interest.
• Hedge fund presence. (I think it's clear by now that some of these managers were out of touch with residential real estate conditions on the ground in the southwestern US.)
• The real estate market might have bottomed. We might be entering a strong selling season.

Downey has fallen only 15.5% from its all time high. I'm short.

Disclosure: Author is short DSL

Related: Downey Financial: Underlying Fundamentals Continue to Deteriorate

DSL 1-yr chart:

Comments

[Sr. Pessimist:]

This is what the capitalists want. They want to deprive workers of any financial power, and only let workers have debt. Without reasonable income opportunities available to any but the few, workers must take on debt just to survive. There is no income available for laborers as of right now. Only debt opportunities. So the capitalists have taken the approach to destroying the financial lives of everybody so that everybody is made to feel as if they are somehow accountable and must make up repairs. From my point of view, if it costs $200 to go to the emergency room in the hospital, and you're better off without any insurance than with insurance, you are responsible for buying your own car and insuring it, it's financially impossible to raise a child, and you pay whatever the stated rate is for things like home ownership, apartment rent, and food, then I don't give a damn if you suffered financial damages. I discredit the credit scoring industry. With no accountability comes no responsibility, and with no responsibility comes no leadership. I think there should be new ways of scoring creditworthiness, including new forms of income that are not in any way related to the US Dollar. Although I hate the US Dollar, I respect it. I believe in what value is behind money, not the money itself. It is no surprise to me that this is happening. Most people just are not in a position to understand things as well.

2007 Mar 31 01:38 PM

[billheurlin749:]

Right on brother! The intent of the money changers is to ruin the average working person in the U.S. so that they can buy back any assets for a nickle on the dollar. The money game to going to get much worse for the average citizen for the next five to ten years. It would be prudent to reduce debt as fully as possible going forward.

2007 Mar 31 07:53 PM

[cohenbarryj:]

You guys sure you have the right website ?

2007 Apr 06 10:37 AM