Shares of Downey Financial Corp. ("DSL" or the "Company") have recently resumed their downward trend. The 10-K was filed last week and included some new information that was helpful in reinforcing a continued negative view on the Company. Since a variety of analysis has been provided on DSL over the past year, I wanted to focus on some interesting components of its 10-K.
I've received some inquiries about DSL's downside because it currently trades for 0.5x FY 2007 book value, ergo the bad news must be priced in. After all, in a previous post I suggested Citigroup ("C") must be getting close to a buy since it is trading for basically book value. C and DSL are not really comparable but more importantly DSL's capital position seems very tenuous given the growth in non-performing assets ("NPAs"), the commensurate loan loss provisions, and its weakening core lending operations.
First, 2007 core operations for DSL were very weak. The Company's total interest income was just $980MM while total interest expense was $556MM resulting in $424MM in net interest income. That would be fine except for the fact that $245MM of that income is non-cash capitalized interest from negative amortization ("CINA") making the cash interest income just $179MM. These figures are before any credit loss provisions which seemed to be relatively light given the rapid acceleration in DSL's NPAs. Heading into 2008, I expect DSL will generate under $900MM in interest income and about $530MM in interest expense resulting in $370MM in interest income. Consistent with recent years, a good portion of DSL's 2008 interest income will include a significant CINA component meaning cash interest income for 2008 will be pretty low. Considering the company has about $250MM in operating expenses, DSL is very likely to have negative cash operating earnings in 2008.
This analysis does not include credit loss provisions which is becoming a figure that allows DSL to manage its earnings and capital ratios. By keeping its loss provisions low, the hit to book equity is minimized and thus book value continues to be overstated making capital ratios look much better than what they really are. I'll revist this issue towards the end of this analysis but I think understanding NPAs and DSL's balance sheet will help address the Company's loss provisions. Table I illustrates DSL's recent monthly NPA's based on its latest 13 Month Financial Data filing and it's clear that NPAs have risen very rapidly.
TABLE I: DSL MONTHLY NPAs (click to enlarge)
The growth in TDRs or "Troubled Debt Restructurings" is also an interesting item. In 2007, DSL's auditor, KPMG, forced the Company to recognize TDRs as NPAs. TDRs are basically quasi-workout loans where DSL recognized certain borrowers were struggling and granted concessions to these customers including a change in repayment terms, reducing the interest rate, principal, or maturity date ahead of any potential loan performance problems. What's important to recognize is that these loans were not re-underwritten and I believe that allows DSL to maintain this illusion that these are not really NPAs but are forced to be classified as such due to an auditor demand. However, I believe if DSL were to re-underwrite these mortgages, the current credit crunch may actually prove that these newly negotiated terms for the TDRs are not in fact "market" loans.
As it stands through January 2008, NPAs are now $1.2B or 9.1% of total assets. What could be a concern is that TDR growth is now outpacing normal NPAs meaning DSL could be aggressively running down troubled customers and trying to stave off having to classify those assets as "real" NPAs. Keep in mind these are monthly figures which makes NPA growth pretty scary. By applying some reduced monthly growth rates for both TDRs and Other NPAs, it becomes apparent that even at these reduced rates, DSL's total level of NPAs could exceed $2B by the mid point of 2008 and reflect 15+% of total assets.
What's also important to note is that DSL is projecting recasts for over $3B, or 30%, of its residential mortgages in 2008. In 2007, DSL forecasted recasts of $1.4B of which $527MM recast while $552MM were paid off. However, $162MM fell under DSL's TDR program, $17MM were foreclosed upon, $6MM were modified, and $106MM were not recast as negam utilization fell below the recast threshold. That was 2007 but heading into 2008 I would expect a lower percentage of loans will be paid off as economic difficulties have increased. I also expect a greater number of borrowers will utilize negam meaning the the overall percentage of loans needed to be recast should increase. This will put DSL in a bind because I suspect many of these loans will end up being part of DSL's TDR program or have greater impairment issues.
Now it's also important to understand how all of these items tie together. DSL has about $13.5B in total assets and when loans recast in 2008, what's likely to happen is that the good borrowers will pay down their mortgages reducing DSL's asset base. DSL's 2007 operating performance shows that there's little demand for mortgage origination, however, so it's not likely a significant number of new interest earning assets will get onto the Company's books. This might sound great as DSL is deleveraging but what this is actually doing is keeping the bad mortgages on DSL's books. The loans that are being recast or modified or classified as NPAs will be "stuck" to DSL.
As it currently stands, the quality of DSL's balance sheet is greatly overstated. Page 47 of DSL's 10-K presents the banks loan to value ("LTV") statistics and it shows that LTVs stand at about 73% as of year-end 2007. This might sound very reasonable until one reads the footnotes and realizes the "current" LTV figures are based only on the current loan balance relative to the sales price or appraisal value at origination. This is not exactly a current LTV but DSL provides enough data where a proxy can be constructed which is what follows in Table II.
TABLE II: DSL ESTIMATED MARKET LTV (click to enlarge)
The Implied Home Value is what I calculated based on DSL's reported LTV figures. What's critical to understand is that DSL underwrote over half of its mortgages during the heaviest bubble years, with 32% of its loans underwritten in 2005. Despite the adverse volatility around the market prices of homes in DSL's key areas of operations (southern California), DSL's "current" LTV ignores the value of the underlying collateral. What I've done in Table II is simply take reported figures of valuation declines in California and apply these against the Implied Home Values which allows me to generate a proxy "market" LTV, which shows that DSL's loans are close to 85% LTVs. I suspect the loans underwritten in 2005, which are likely to have the highest LTVs, are also going to comprise the biggest portion of recasts as the most amont of time has occurred to allow for negam to approach recast thresholds. At 90+% LTV, there could be very little incentive for borrowers to recast loans at onerous terms when they have such a small amount of equity in these homes.
That brings us back to loan loss provisions and allowances. DSL recognized $310MM in credit loss provisions which boosted loan loss allowances to about $350MM for 2007. To put it in perspective, the negam included in loan balances in $379MM so I'd say that DSL's estimates look very low. However, by keeping these provisions and allowances low, DSL can present capital ratios that look fine and avoid regulatory scrutiny. However, as we've covered, DSL's balance sheet greatly overstates its credit quality by ignoring market prices for the homes these mortgages are secured against. Based on Table II, there's about $2B in "extra" collateral value that DSL is implying its loans are secured against when market prices are much lower. NPAs are rapidly accelerating and the bank is facing a very challenging recast schedule. All of these obstacles are stacked against just $1.3B in capital which is why I've maintained my puts against DSL.
Given the problems facing the bank and rapidly deteriorating situation based on the monthly financial data reports, I'm not sure how long the credit provisions can be managed before the market realizes how bad DSL's capital situation really is.
DISCLOSURE: AUTHOR MANAGES A HEDGE FUND THAT OWNS PUTS ON DSL