Why Downey Financial is Not IndyMac

The IRA is on the road part of this week in Oslo for our talk on Monday, "Do OTC Credit Derivatives Increase or Reduce Risk?"  But we wanted to comment on Downey Financial (NASDAQ:DSL) before we head to EWR. 

We've been getting lots of "oh no" calls from the print and broadcast media about DSL. Our response is very simple: calm down.

Yes, DSL's loan loss rate is nasty with run-rate defaults above 300bp and an MPL calculated in The IRA Bank Monitor over 400bp. Yes, the bank's very ample capital ratios are under some pressure, with total risk-weighted capital down to "only" 14.5% as of June 30, 2008. Tangible equity to tangible assets was 7.5% as of the same date, according to data from the FDIC.

But the thing we have stressed with members of the "oh no" club is that whereas thrifts such as Countrywide, IndyMac and even the giant lake trout, Washington Mutual (NYSE:WM), have excessive liquidity risk in their dependence upon brokered funds (as manifest by rising advances from the FHLBs), two key red flags in the IRA world view, DSL does not.

DSL has almost 80% core funding for its assets and shows no brokered deposits in its latest report to regulators. Only 10% of total assets are funded off the FHLBs, meaning DSL is below the level considered "excessive" by regulators and has access to ample additional liquidity if needed.

At a market cap of $61 million, DSL is trading at 6% of book. Given the premium being paid for deposits in the market today, at some point we see DSL getting bought. Indeed, it would not be impossible for a fund to take DSL private at current levels. That's a hint, BTW.

Remember that DSL is a lot like the old GoldenWest business, basically a loan portfolio with an in-house origination, servicing and funding operation. Yes, loss rates may remain high through 2008 for the type of exotic CA collateral found on DSL's loan book, but the value of this collateral is not 6% of par, in our humble view.

We have told and are telling our advisory clients that it may not yet be time to pull the trigger but it is certainly time to shop. Evaluating situations like DSL is going to require steel nerves and creative thinking for investors on both sides of the table to extract value. As of friend David Kotok said in our interview earlier this year ("Sleepless in MuniLand: Interview With David Kotok" ), if the act of pulling the trigger makes you sick to your stomach, then there is probably value to be had.

We believe that current market valuations for banks like DSL are silly, even assuming a worst case, 2x 1990 loss rate scenario as we postulated last week. Indeed, even were the bank's capital wiped out by losses of say 2x current default rates, a remote possibility in our view, the loan portfolio would still be worth north of 60-70% of par. Right?

Strategic acquirers are well aware of the value locked-up inside both sides of the balance sheet at strong retail banking franchises such as DSL. While the continued mark-to-market self-immolation still has much of the Street distracted, there is a growing crowd of investors evaluating bank valuations from Reykjavik to DSL's home in Newport Beach, CA, down the road from IRA's HQ.  In both cases, hysteria and media hype may be obscuring value.

As and when more chum hits the water in terms of further confirmation that bank loan loss rates are slowing, the fish will start to feed in earnest. We'll have more to say about that when the FDIC releases the Q2 data the week of August 25th. 

Comments

[Craigla1:]

"At a market cap of $61 million, DSL is trading at 6% of book. "

"...but the value of this collateral is not 6% of par, in our humble view."

It's pretty sloppy journalism when a blogger doesn't recognize the fact a market cap of 6% of book does NOT at all equate to assets being worth 6% of par. Remember a bank is highly leveraged. If assets depreciate 10%, and equity capital is 10% of assets, you basically have an insolvent institution, and market cap should be zero.

You don't need anywhere near a write-down of 94% of assets for insolvency to occur. Just a small fraction of this. And DSL has about the highest levels of non-performing assets of any financial institution in the country.

They are insolvent if proper mark-downs were to occur. And the re-sets of negative am loans is nowhere near done. Not even close. These re-sets continue unabated through 2009.

2008 Aug 17 11:36 AM

[Craigla1:]

One further comment:

"Indeed, even were the bank's capital wiped out by losses of say 2x current default rates, a remote possibility in our view, the loan portfolio would still be worth north of 60-70% of par. Right?"

If the portfolio were worth 70 cents on the dollar, consider this:

70% of $11.363 billion equals $7.954 billion. Or total write-downs of $3.409 billion.

Yet Downey currently has a total provision for loan losses, plus stockholders equity, of only $1.591 billion. In other words, if the loss rate contemplated by Mr. Whalen were to prevail, DSL would have to add over $1.8 billion to their loan loss provision!

Please make an effort to do the math here, Mr. Whalen! There is a very good reason the market puts a nearly insolvent value in DSL's common equity.

2008 Aug 17 11:53 AM

[Reasonable Guy:]

I think it is a very reasonable article. Mr. Whalen has a fair valuation about DSL. Of course, this article will make anyone who short this stock angry!!

2008 Aug 17 04:59 PM

[fred120:]

this poster is inept. DSL is bankrupt.

2008 Aug 18 09:33 AM

[Bonanza36:]

DSL has a Texas Capital ratio of 125%.

2008 Aug 18 02:30 PM

[Big Al45:]

Vineyard National will be the next California bank to fail, followed in short order by DSL. Will be real surprised if DSL lasts to Halloween.

2008 Aug 18 08:54 PM

[Frank P:]

I think the problem with this reasoning is it assumes DSL can burn through customer deposits! I'm sure these people would be happy to find out their account is "worth north of 60-70% of par". Of course, the FDIC will shut them down before they get to that point.

2008 Aug 19 06:19 AM

[warbucks:]

The author of this piece is either not very bright, or he knows better and is intentionally trying to mislead investors. I am flabbergasted that a man with his bio would make such foolish mistakes in analyzing a stock.

That DSL's market value is 6% of their alleged book value, does not mean they could take a 94% write down of assets and still be ok (as the author implies). DSL's book value is less than 10% of assets, so a 10% write off wipes out all value in DSL equity. Most observers believe DSL will have to write down way more than 10% of their toxic loan portfolio when all is said and done, and that is why it is trading at almost zero. DSL already has over 18% non-performing assets and growing.

2008 Aug 19 11:59 AM

[oneshotstop13:]

You can rattle off all the numbers you want....At this time the trend is to knock all the financials. Be my guest....I am one one of the few that thinks Banks are the hot buy. With over a 25% gain in DSL and 30% in Washington Mutual I'm laughing all the way to the banks......(No Pun intended)

2008 Sep 04 02:09 AM

[Reza:]

Warbucks just one thing, the Non-performing assets hav actually been declining and they are now at 14.50%.

I'm with you oneshotestop13, they are hot buys and i'm standing next to you in line.

2008 Sep 25 10:43 AM