Downey Financial: Pessimism Begins To Be Vindicated

Downey Announces Third Quarter 2007 Results

Here is a graph of the dollar amount of delinquent loans, which are loans less than 90-days past due. (And, therefore, still considered performing.)

Look how sharply the 30-59 day delinquencies are up this quarter. Expect the 60-89 day delinquency series to snap upward in coming quarters, as they lag the 30-59 day series.This increase in delinquencies has been driving the increase in non-performing assets (NPAs).

The exponential trend appears to be continuing unabated. As I have explained previously, NPAs are calculated as a percentage of total assets. But not all of a bank's assets are loans. So, to make the NPA statistic more easily comparable, you can back out Downey's cash, investment securities, FHLB stock, and other assets that are not loans from the calculation.This graph shows NPAs as a percentage of only loans. It reveals that calculating NPAs as a percentage of total assets has been steadily understating the increase.

In my previous post on Downey, I mentioned my surprise at an analyst who thinks this quarter's loss provision is "being made to avoid having to make other large provisions in future quarters." In other words, he thinks this is a one-time-only increase in the loss provision.But take a look at Downey's loss allowance as a percentage of non-accrual loans:

Their loss allowance is substantially lagging the increases in non-accrual loans. This is in an environment where the Southwestern U.S. real estate markets get worse every month. In other words, I think that Downey will be posting loss allowances at least this big in quarters to come. Two other pieces of bad news:

• an increase of $3.5 million in net operations of real estate acquired in the settlement of loans due to a higher number of foreclosed properties, including 113 single family lots acquired through foreclosure of a land loan during the quarter
• The amount of negative amortization included in loan balances increased $11 million during the current quarter to $388 million or 4.70% of loans subject to negative amortization. During the current quarter, approximately 26% of loan interest income represented negative amortization, down from 29% in the second quarter of 2007 and 28% in the year-ago third quarter.

Disclosure: I continue to be short Downey Financial (DSL).