Will Downey Financial Go To Zero?

So Downey Financial (DSL) is trading at 45% of book value today - is this warranted? Is DSL going to zero? I'll try to take a relatively balanced view of the fundamentals, using the dispassionate eye, if you will.

So a short recap, all numbers from December 2007, except where noted:

Downey has $11.3 billion in loans held for investment. $7.5 Billion of these include a negative amortization option, and most borrowers are using the neg-am option. When a loan negatively amortizes, it's as if the loan is paying-in-kind: the loan size is increasing and there is no cash inflow. In Q4 07 DSL received 24% of their $194 million in loan interest income from negative amortization, or $46.7 million.

Back in 2006, when DSL forecasted that $1.4 billion of loans subject to negative amortization would recast for the first-time in 2007, $527 million actually did recast while:

• $552 million paid off;
• $162 million were modified during 2007;
• $106 million did not recast during 2007 as borrowers reduced their utilization of negative amortization;
• $17 million were foreclosed upon; and
• $6 million were modified as part of our loan workout program.

In 2008, DSL will have about $3.2 billion neg-am loans recast, more than double 2007. The ability for borrowers to refinance these loans is far less than it was in 2007. Even where a borrower is eligible for a conforming loan, Freddie Mac (FRE) and Fannie Mae (FNM) are tightening guidelines, and in all cases they require documentation regarding the borrowers' income and assets. 82% of DSL's loans were originated under a "reduced documentation program". Some of these are the dreaded "liar loans", and in some cases borrowers simply didn't provide documentation because it was easier and it didn't cost them anything to not show docs.

So in 2007, DSL was left with $607 million of the neg-am loans that recast during the year and that were not refinanced. of those 26.1% were delinquent by more than 30 days. In 2008, the $3.2 billion of neg-am recast loans should generate a higher percentage of delinquency - possibly 30-35%, due to tighter lending. So brace yourself, this means that $3.2 billion x 30% could mean over $1 billion of delinquent, no-documentation, California, jumbo, neg-am loans sitting on their balance sheet. You can guess what the bid is for that pool of whole loans.

So what does this mean for DSL? In 2007 the $607 million of delinquent loans partially contributed to an increase of $283.5 million in provision for credit losses (and $218 million in Q4 alone). I'm thinking that it wouldn't be outrageous for DSL to have to recognize about $250 million per quarter in credit loss provisions in 2008. This is a bit rough and dirty because they have about $4 billion in non neg-am loans, but many of those are subprime.

Does that make any sense? It would be $1 billion of their $11.3 billion portfolio. Keep in mind that their subprime portfolio represented 38.1% of Tier 1 capital at Dec 31 2007, and that another $3.2 billion neg-am loans are recasting during 2008. There isn't much overlap between neg-am and subprime because the neg-am product was generally offered to Alt-A and prime borrowers.

$1 billion in credit losses is $35.90 per share, and current book is $47.91. This will be partially offset by positive net interest income of $12 per share, assuming nothing goes horribly wrong and that there isn't a run on the bank.

The last item that caught my eye was a little line item in the annual report that it cost them $4.5 million in "net operation of real estate acquired in settlement of loans". In their discussion they actually say that taking back properties from people cost them $9.2 million last year. They have 326 properties in their REO portfolio, so that's about $28,000 per property on a static basis (yes I realize that properties came and went during the year, but they mostly came - it takes a long time to dispose of REO properties). If we expect a big uptick in the number of properties that they own, and I do, this line item could balloon to a dollar or two per share for the year.

There are other problems in their servicing business, but they're relatively small. I suppose at the end of the day we all realize that a portfolio of Option ARM loans with Alt-A stated documentation borrowers in California is going to be one of the worst possible risks on the planet. I've looked at many of these Downey loans on a loan level basis (they have a large securitization program in the mortgage market) and I can tell you that the payments do really jump on these borrowers from $1200 or $1500 to $3000 or $3500 once they hit the neg-am cap. Unpleasant.

Make your own conclusions, but I'm not sure that DSL will make it through 2008 and the first part of 2009. There's just too stiff a headwind going against them. Many of the President/Congress/Paulson plans simply don't help these borrowers- those plans are designed to help the guy in Cleveland with a $180k mortgage. Downey's average mortgage size is $550k.

Disclosure: none

Comments

[gaucho]

Downey is already a Zombie. They like most banks try and paint a rosy picture for their balance sheets. If their balance sheet were market to real market they are already a nonviable entity. The worst of the mortgage crisis is just beginning and will last through the middle of next year. After that who knows how long it will continue. As an investor I would not hold Downey in my portfolio. There are investors that think that the fed will step in. This will not happen since Downy is insignificant in the mortgage industry. They think that a white knight will step in. This will not happen since white knights are rare and this damsel in distress is truly ugly in the balance sheets.

[Howard Sun]

In addition, from the technical POV, there was a huge shooting star yesterday. Seems like DSL will take another hit in the ensuing days.

[bill d]

Bastards are getting what they deserve.
Worked for a company they ran out of business in the 70's when "maurice" was running it.

[BetterInvestor]

Excellent article. Remember EVERYTHING about this company is going to be much worse in 2008. NPAs are increasing exponentially, resets are soaring, and California has a rule against deficiency judgments, making "walking away" from a house with an underwater mortgage a much less painful process than, say, Florida.

The perfect time to walk away is right before the reset. If you are living in a house you bought for $700K that is now worth $500K, your 1500 a month mortgage payment is a better deal than renting. But when it resets to $3500 ($42,000 per year!) default is going to be the most common result.

[DMizzy]

I agree with everything posted here and actually I am probably more negative on this pig than most as I think they have until the summer. Properties in foreclosure are up 500% in just 3 months on some of their securitizations. I am also short the company. The thing that scares me as a short is that it seems everyone knows this company is worth zero. What is the bull case? If there is none, then why is this trading in the high teens and not single digits. I cant find anyone that says anything positive about this company. What is the bull case? What are we missing if anything..