Downey's Aversion to Home Equity, Construction Lending: Key to Its Survival

Downey Financial (DSL) is a California based savings and loan bank whose stock price has fallen 84% this year on the heels of a worsening California real estate market and larger than expected loan losses in each of the past 3 quarters.

Its stock has been frequently targeted by short sellers for months on end, with short interest substantially increasing. The current 45% short interest has no doubt contributed to the now steep discount to book value which the shares now trade at.

As of June 6th, the stock trades at an unbelievable 15% of tangible book value. The market cap is now just $162 million versus shareholder equity of $1.09 billion.

A look behind the numbers, however, reveals that Downey has miniscule exposure to the high risk loan categories of home equity lines, second mortgages, homebuilding loans, and construction loans.

These categories which are now causing havoc for Downey's peers often have loss severities which approach 100%. For example, when a HELOC goes bad, the bank usually suffers a near 100% loss as the value of the underlying property has declined too much. The fact that Downey avoided HELOC and other risky lending coupled with the fact that it entered the crisis in the Summer of last year with one of the most conservative leverage ratios in the industry has positioned them to be a survivor while so many of its peers have either gone out of business or have been forced to do a fire-sale dilutive capital raise.

The fact that Downey's share price has been pushed to a sharp discount to its peers, even though Downey has a stronger risk profile on many metrics, makes the stock a great buy and is likely a once in a life time buying opportunity in this security if you believe as I do that Downey has the capital to survive. It is a rare opportunity indeed to be able to purchase a bank with $39/share in book value for under $10/share. This is particularly true in the case of Downey as it has already built a war chest of loan loss reserves of $546 million equal to an additional $18 per share.

LOW EXPOSURE TO HOME EQUITY AND CONSTRUCTION LOANS

Total home equity lines outstanding and as percentage of total loans held for investment (3/31/08):

• Downey (DSL) $133 million; 1.2%
• WaMu (WM) $61.2 billion; 25.6%
• Countrywide (CFC) $33.4 billion; 35.1%
• Wells Fargo (WFC) 75.3 billion; 19.6%
• SunTrust (STI) $14.0 billion; 11.6%

Downey has construction and land loans outstanding of only $74 million and $10 million as of 3/31/08 or less than 1% of total loans outstanding. Regional bank investors have grown fearful in recent weeks of a potential tsunami of losses in commercial and construction loans hitting next. Downey is immune to this as it is almost exclusively a 1'st lien mortgage lender.

SIGNIFICANT LOAN LOSS RESERVES ALREADY IN PLACE

Downey has enormous reserves for loan losses already in place and bank equity remains high even after taking large loss provisions in each of the past 3 quarters. Downey's book value is still an astronomical $39 per share relative to its stock price trading under $10/share. Downey is ahead of its competitors in taking loan loss reserves and has reserves in place to cover a nightmare scenario in which 20% of the entire $10.7 billion residential mortgage portfolio were to go bad with 25% loss severity. Loss severity in the last quarter for mortgages that went to foreclosure was just 22%.

Total loan loss reserves and as a percentage of total loans held for investment (3/31/08). The chart below shows that Downey already has double and triple the reserves in place as some of its troubled competitors:

• Downey $547 million; 4.9%
• WaMu $4.71 billion; 1.9%
• Countrywide $3.35 billion; 3.5%
• BankUnited (BKUNA) $202 million ; 1.6%
• SunTrust $1.54 billion; 1.2%

DOWNEY HAS A LARGE REGULATORY CAPITAL CUSHION OF OVER $400 MILLION

At March 31, 2008, Downey Financial Corp.'s primary subsidiary, Downey Savings and Loan Association, F.A., had core and tangible capital ratios of 8.43% and a risk-based capital ratio of 15.04%. These capital levels were well above the "well capitalized" standards of 5% and 10%, respectively, as defined by regulation. With $547 million of loan loss reserves in addition to this $400 million regulatory capital cushion, Downey could conceivably weather in excess of 25% defaults and still maintain “well capitalized” standards.

LOW OPERATING LEVERAGE

Downey's saving grace is that it entered the credit crisis with extremely conservative leverage ratios. This has allowed it to avoid a dilutive capital raise that its peers like Citigroup, WAMU, Country Wide, Indymac, and National City all had to pursue. At June 30, 2007, Downey had core and tangible capital ratios of 10.08% and a risk-based capital ratio of 20.86%. These capital levels were well above the "well capitalized" standards of 5% and 10%, respectively, as defined by regulation. At the dawn of the credit crisis, Downey was utilizing only half the leverage that bank regulators permit. In contrast, peers like WAMU and Country Wide were already close to maxed out with super high leverage as the crisis began. Not to mention their exposure to toxic HELOCs.

June 30th 2007 Tangible equity/total tangible assets. Higher the ratio the lower the leverage:

• Downey 9.80%
• WaMu 6.07%
• Countrywide 6.63%
• BankUnited 5.56%
• SunTrust 5.33%

LOW LOAN TO VALUE RATIOS FOR DOWNEY’S RESIDENTIAL MORTGAGE PORTFOLIO

Downey's mortgage portfolio has extremely conservative loan to values which is keeping loss severities lower than the bears are betting on. Over 30% of the loan portfolio has a LTV less than 70%. The weighted average loan to value was 72% at the end of Q1. This has helped Downey to keep the Q1 average loss severity at a low 22%. Going forward, even if houses are sold for 50 cents on the dollar of original purchase price in foreclosure, loss severities may not be astronomical because of the extremely low initial loan to values of mortgages Downey retained for its own investment portfolio.

Loan to value of the Downey's residential mortgage portfolio:

• 60% or less $1.50 billion
• 61% - 70% $1.97 billion
• 71% - 80% $6.72 billion
• 81%+ $0.51 billion **

** all but 35.8 million of loans greater than 80% LTV carry private mortgage insurance.

Downey's unbelievably low price to book, coupled with its high reserves and conservative operating leverage, make its stock a great value.

Price/Book

• Downey (DSL) 0.15
• Bankunited 0.18
• First Fed (FED) 0.35
• WAMU 0.40
• Country Wide 0.23
• SunTrust 0.96
• Wells Fargo 1.86
• Bank America 1.02

Note: Downey has virtually no intangible assets that overstate its book value while most of its peers have substantial intangible assets accumulated from past mergers.

BANK EQUITY SHOULD REMAIN ABOVE $25/SHARE

I am expecting book value to be written down further over the next 2 years as the California real estate market works through its ongoing disaster. I am modeling for another $300 million in loan losses equal to around $11 per share. But the good news for current investors is that still leaves book value in the high $20's which supports a buy rating for shares in the single digits. If you assume book value will be around $26 in the summer of 2010 at the bottom of the cycle, a discounted present value for shares of Downey using a conservative 0.8 price to book and a 12% ROE gets you to a present value of $16.58 for shares today. That is 176% price appreciation from current levels of around $6/share. If California stabilizes sooner than expected, appreciation could be an extra 100%.

DOWNEY’S VALUE AS A TAKE OVER TARGET

Within the past 24 months CNBC's Jim Cramer has mentioned that he thought Downey was a takeover target at around $100/share. Of course that was before the current real estate bust picked up steam. But as recently as last fall, famed banking investor Gerald Ford bought a 6.8% stake in the company and was thought to be considering a takeover in the $40's before talks broke down. Needless to say a takeover now would occur at far lower prices as real estate prices have worsened and defaults continue to rise. But California banking franchises still are the most valuable in the nation as assets per customer and per branch are still the highest of any state. Downey has over 160 branches and at the current market cap they are only being valued at a surprisingly low $1 million per branch.

Even if the bears' doomsday scenario comes true and bank equity is severely impaired, buyers could emerge for Downey's banking franchise that has spanned many decades and has over $2.2 billion in close to zero interest bearing deposits. In fact, I believe that Downey is currently trading well below even the price that it would have success attracting potential investors to come in and do a secondary stock offering should conditions continue to deteriorate.

Furthermore, in the past two weeks two private equity firms have announced ownership stakes in excess of 5% each.

Disclosure: Author has a long position in DSL

Comments

[silk]

While this article doesn't focus on all of Downey's problem loans, I agree that at $5 share the stock has gone too far and certainly too fast. If Downey goes under, it will not be the first and many others will fail before they do.

[PGvinter]

While this is an excellent analysis of Downey's artificially inflated book value this article has absolutely no connection with the reality of Downey's insolvent financial situation. A majority of Downey's "assets" are Pay Option ARMs in the California market. While these loans are currently performing they continue to do so only during the initial period where negative amortization is available as a payment option for the borrowers. The majority of this loan portfolio was originated using Stated Income or an even lower level of documentation. The majority of the loan portfolio was also originated with Loan-to-Value rations in the 70% to 80% range. These are actually the riskiest loans possible as there is no PMI or other credit enhancement present in the loan. The structure of DSL's Option ARMs allow borrowers to pay the minimum neg-am payment up until the loan balance reaches 115% of the original loan. This would mean that a loan originated in 2006 on a $500k house for $400k would allow the borrower to pay minimum payments until the borrower chose to differ $60k in interest payments. At this point the minimum payment will go away and the borrower will be forced to make fully amortizing payments on the remaining loan term (let's say 27 years on a 30year loan and 37 on a 40 year loan.) This means that a house originally valued at $500k, which after the recent price correction is now worth approximately $450 has a loan balance of $460k. Add to this $50k in foreclosure costs and another 10% to 30% discount to sell the house and suddenly DSL is recovering somewhere around $250k to $350k on it's "asset" of $460k.
Using fundamental analysis which looks only at book value while ignoring the necessity of due diligence on the booked assets which gets investors into DEEP trouble. It is also this line of thinking combined with a reliance on a chain of third parties, each of which absolves themselves of due diligence responsibility (brokers, rating agencies, etc.) which allowed companies like DSL to underwrite and sell garbage sub-prime, ALT-A and other low quality debt which helped create the current financial crisis. While I empathize with the author on the losses incurred by their long DSL position I also advise him and anyone else to cut the losses here and walk away as DSL will follow IMB, BKUNA, IMH, AHM, NFI, NEW and numerous others to a share price of somewhere between $0 and $2.

[dashingdwl]

it's BK guys. End of discussion.

[Timbo]

Have you been to LA? When the pay options go bad it will be all over for Downey. Sad but true. It will be "bought" for less than $1 per share. Deposits can fly out the front door faster that realtors can say now is the best time to buy.

[ViewfromNYC]

Disclosure my fund is short FED, FirstFed CA

Just a few comments on DSL. NPAs are over 13%. LTVs listed are at orgination, so the portfolio would have a much higher current LTV ratio if the V portion was marked to market. Therefore loss severity is poised to increase. Run some scenarios at different severity ratios and determine if the current provision for loan loss is adequate. If not, which I don't think it is, you need to make a reduction in book value. Provision probably needs to more than double to just to cover current NPAs, then make some provision for future deliquencies. There goes some more book value. Then there is the farce of negative amortization. Subtract that accumlated neg. am. interest of $375 million from book value (not to double count with the general provision for loan loss) put this in the specific loan provision bucket rather than the general provision. As soon as these loans recast to fully amortizing, the borrower who couldn't pay even the interest only portion certainly won't be able to cover interest plus amortization of principle. The company is never going to collect that inerest which has been added to book value through earnings. These two adjustments alone get you to a current mid twenties book value. Properly reserved then the book value is is the mid to high teens. Then apply a discount and maybe the stock looks cheap at $4. The problem is pretty soon you run out of regulatory capital and there goes the only "asset" the company has (the deposit base) as the FDIC gets another bank to take over the deposit liability. Finally if you really think this company could survive, look at the on going business, no bank is going to be able to originate exotic products for the foreseeable future so normalized origination volumes will never recover (forget about trough origination volumes). As the performing loans run off so will interest income decline so even if the company could survive a significant discount to book value would be warranted. Cramer missed the complete change in the business model of these formerly conservative lenders, which is why he hasn't said a word about them.

[The Jackal]

If CNBC’s Jim Cramer recommended DSL it is a short. This stock is going to ZERO. I know a few employees at DSL and the moral is at an all time low and going lower (just like the stock).

[kurt walter]

Isn't DSL the king of pay option ARM loans. Those are exotic loans for many people that couldn't afford to buy real estate.

[Snowytrail]

Kurt, you have it exactly right. Downey's current "business model", if you can call it that, is that of landlord for approx 15,000 tenants with below market month to month leases. The tenants have little to no equity and in many cases put nothing down. The tenants can stop paying for 4-5 months before they can be evicted and when they do leave, the owner(Downey) has great difficulty reselling the lower value assets and will now have to pay for any maintenance and property taxes while holding the REO. Not a business I want to invest in.

[anastos]

We're still talking about DSL? This thing had a fork stuck in it months ago....I wouldn't get near it with your money and someone else trading it.

[chief]

Mr. Pelham wrote a somewhat glowing report on DSL's problems. Is he not an employee of DSL????