Why I'm Not Long Downey Financial

Downey Financial Corp. (DSL) announced 2007 results last week and shares rallied despite very weak results. The broader financial sector has been oversold in recent months so this rally was not that surprising. The results were clearly terrible, but I think a variety of actions ranging from an active/intervening Federal Reserve Board and overtures of a government led/organized bailout of bond insurers contributed to establishing a sentiment that says the worst is over. From a valuation perspective, certain financials are looking attractive but while DSL has benefited from this rising tide, I'm not sure it qualifies for a life jacket.

There will be much more to analyze when the 10-K is released but the earnings release last week did have some key information such as the increase in non-performing assets ("NPAs") and delinquent loans. As Table I illustrates, DSL is now facing not only considerably percentage increases in these metrics, but also very large absolute values for these metrics. In addition, there has been a massive surge in the 30-59 day class of delinquent loans indicating there's scant evidence that CA-based real estate problems are slowing down anytime soon.

TABLE I: DSL NPAs AND DELINQUENT LOANS 2004-2007

Some that are bullish on DSL may say that the 2007 NPA figures are overstating the bank's troubles, as $321MM of these NPAs related to a "borrower retention program" initiated by DSL in Q3 2007. DSL basically went to customers that were current with their loans and re-cut the mortgages whereby the new interest rate on the mortgage was lower than the original interest rate on the mortgage but not less than rates currently offered to new borrowers.

Interest income from this segment of NPAs is recorded as borrowers make their payments and if the borrowers remain current for six months, the loans will be removed from NPA status. This program is just a cleverly worded workout for some of DSL's customers and I think this move by DSL and the forced accounting change by its auditor KPMG won't be relevant in the coming months, as some of those restructured loans do not perform as expected and thus remain classified as NPAs.

I really think DSL's performance comes down to a few factors in 2008 and those all seem to indicate the bank is still facing huge obstacles. The massive rise of delinquent loans and NPAs shows no sign of abating for DSL, with loans that are basically located at ground zero in terms of the real estate meltdown. As those figures escalate into 2008, the absolute figure for credit loss provisions will rise as well.

I would also not be surprised if KPMG begins to require DSL to recognize a larger percentage of credit loss provisions against bad mortgages which will make that absolute credit loss provision figure even larger than expected in 2008, cutting into book equity.

The reason I expect that credit provisions could be recognized at a higher rate against bad loans is because in the case of DSL's retention program, DSL was able to skirt the typical underwriting requirements which is also why KPMG made DSL classify these set of mortgages as NPAs. I would anticipate that as DSL sees more struggling borrowers and tries to work on those mortgages, it will have to start a full underwriting process to re-cut mortgages. That's where I expect some of the larger negative impacts to arise where the value of these homes may be well below what DSL and its auditor have provisioned for.

Given these problems, I would also expect KPMG to address the carrying value of capitalized interest income from negative amortization ("CINA") on DSL's balance sheet. DSL investors may have pushed shares up because CINA has declined on a progressive basis to 24% in Q4 2007 compared to 26% in Q3 2007 and 29% in Q4 2006 while DSL's assets have been shrinking, with residential one to four units accounting for just 69% of DSL's total assets as opposed to 85% at the end of 2006.

Despite these figures, DSL's CINA balance is still $379MM, up from 2006, and represents 5% of its residential loan balance compared to 2.9% in 2006 and 4.7% in Q3 2007. Given current and impending problems, I don't think current loss provisions include all of the negatives that DSL's mortgage book is facing.

Some investors may feel that the bottom for CA real estate problems has been realized already, which is why DSL and other regional banks have rallied of late. I think that some financials may reflect worst case scenarios or be such strong franchises that it's worth investing in over a five year time horizon, but I feel DSL is not one of those companies. This past Sunday, 60 Minutes ran a pretty interesting story on the subprime problems, using Stockton, CA as an example.

This 60 Minutes story may be similar to the "magazine cover" indicator, signaling a buying opportunity, but I don't think it's necessarily the case with DSL. While DSL is not a subprime originator, the bank's customers will be facing many of the same problems and dilemmas faced by those in this story. Readers should reference the 8:40 mark on this story dealing with a couple that is contemplating walking away from their home. The couple can afford the higher payments but because the value of their home has dropped so much, they see little reason to continue payments, it simply doesn't make sense to them.

The story continues to discuss growing acceptance for disregarding these obligations. This example, where the customer can afford to pay the higher rate but is willing to default on the loan, is something I think could occur with DSL more frequently in 2008 as a large wave of prime option ARMs reset. Recent earnings calls by Wachovia (WB) and Bank of America (BAC) have provided more support to the notion that homeowners are more willing to walk away from their homes.

While subprime problems have been front page news for a while, one person interviewed at time point 14:05 suggests that the U.S. is not even 40% into the problem. Furthermore, I've stated in the past that I think the prime option ARM reset waves are somewhat overlooked at the moment due to the subprime crisis.

Now some DSL investors may say that while these problems are bad, the Fed's actions will greatly benefit DSL and offset some problems. DSL should be less sensitive to these rate cuts because unlike traditional banks that have fixed rate assets and floating rate liabilities, DSL's entire operating strategy has been based on matching floating rate assets against floating rate liabilities.

So while DSL stock has experienced a sharp rebound of late, the market could be over estimating the impact on DSL. While its funding costs will decline, DSL will make much less on its assets which are floating rate. In addition, DSL's asset base has shrunk due to weaker loan originations and bad mortgages which should result in a declining interest rate spread, similar to what was seen in 2007 with an effective interest rate spread of just 2.7%, a decrease from 2006.

One could think that another benefit of the Fed's rate cuts would be that DSL borrowers would face a more accommodative "reset rate" on their option ARMs preventing default. While this may be true, this thinking underestimates the potential for people to do what the couple in the 60 Minutes story are doing. Keep in mind that this couple is located in Stockton, CA which is specifically mentioned as a problem spot for DSL in its earnings release. With home prices rapidly falling in bubble markets, homeowners' equity has been evaporating and there is little incentive for DSL customers to continue paying their mortgage when the mortgage can potentially be worth more than the home.

Another factor I think investors are overlooking is the lack of mortgage originations that DSL will contend with in the coming years. DSL's loan originations including purchases dropped by 54% in 2007. This ties back to my previous write ups regarding DSL's "normal operating income" because I've felt analysts have used the past few years as a benchmark of what "normal" is when the reality is that these were the best times for banks and earnings includes massive origination volumes as well as ancillary streams for securitizations.

The past few years benefited DSL mostly from massive origination volumes which contributed to an overstated interest generating asset base, which will now shrink through impairments, and mortgage sales, although not to the same extent as other banks. Simply stated, DSL will not be originating loans anywhere near the volume or size it has in recent years. This will result in reduced future interest income and earnings.

Referring back to the 60 Minutes story, one interesting data point is that there is a reported two year supply of homes in Stockton, CA. Given DSL's concentrated geographic exposure, it is not a stretch to assume that there is oversupply in many of its markets. This oversupply will pressure home prices and future mortgages will be smaller in size, tying back to reduced future earnings for DSL.

That's another reason why the Fed's rate cuts won't directly impact DSL. The bubble markets are broken with far too much inventory and psychological trauma, which will make it hard for the Fed to reflate home values. Reflating home values is really the only "out" for bubble-focused regional lenders like DSL and I think that's a very difficult proposition in the coming year.

DISCLOSURE: AUTHOR MANAGES A HEDGE FUND THAT OWNS DSL PUTS

Comments

[highalpine]

Excellent analysis! KPMG is forcing Downey to account for the restructured loans as "TDR's". Further attempts to address the increasing delinquencies will only bloat the NAL levels more. While a portion will cure, the rising tide may overwhelm the earnings base. A significant writedown of the portfolio will cause a large erosion in capital, as the allowance for loan losses is now just a fraction of the non-performing levels. While the bank has about 700 million of capital in excess of regulatory minimums, it's not beyond the realm of possibility to see that floor challanged.