The Option Arm Triplets: Dead Banks Walking

by: Greg Weston

I am continually surprised that people are willing to hold, at any price, the common stock of regional Option-ARM mortgage disasters Downey Financial (NYSE:DSL), BankUnited Financial Corporation (BKUNA), and FirstFed Financial (FED).  They are dead banks walking. The big investment banks, money center banks, insurance companies, and even the GSEs have been drastically writing down the value of their toxic mortgage portfolios. Some might argue they have not written them down enough, but clearly management is at least trying to estimate the value of their portfolio. These big institutions, like AIG (NYSE:AIG), Citibank (NYSE:C), and Lehman Bros (LEH), also may benefit from government bailouts and foreign fund white knights who want to buy their name brand to break into the US market.

None of these long-shot saviors exist for the three small banks that I like to call the Option Arm Triplets: Downey Financial; FirstFed Financial and BankUnited. These banks are all loaded to the gills with perhaps the most risky and insane mortgage product ever devised in the recent speculative bubble: The negative-amortization ARMs, more commonly referred to by the more cheerful industry euphemism “Option Arm” or “OA.” For some borrowers, even the risky interest only [IO] mortgages still provided for too high payments. So these mortgages provide them with, in theory, the “option” of making several different payments each month: the full 30-year payment rate, an interest only rate, and lowest of all a minimum payment that doesn’t even equal the loan’s interest. In fact, well over 70% choose to make the minimum payment each and every month, causing loan balances to grow even as property values decline.

And boy are these properties declining! The California Association of Realtors reported that median housing prices in California declined by a whopping 40% between July 07 and July 08. Florida is even worse, though the decline started earlier. And these median declines mask the fact that in large portions of these states housing values have dropped by over 60%.

I am going to focus on DSL in particular. I already wrote an article devoted to FED, and continue to stand by the article. Read that article on FirstFed Financial here, and a shorter follow-up here. Fed’s exposure to OA mortgages is somewhat smaller than BKUNA and DSL as a percentage of assets, but it is still so gigantic, and still has so many other types of toxic loans on its books, that FED has no hope of long term survival, and even its short-term ability to continue operations is questionable.

Nor is much discussion needed for Florida-based BKUNA, the company already seems to be in the final stage of its death spiral. The stock has dropped 31% the past three days, and the following news has appeared in the past two weeks:

  1. NASDAQ has sent the company a letter informing the company that it was not in compliance with the filing requirements for continued stock exchange listing because it did not file its quarterly report on time;
  2. Stifel Nicolaus downgraded the company to “Sell”;
  3. Jim Cramer warned investors to stay away from BKUNA (and DSL) on his CNBC show;
  4. Fitch Downgraded BKUNA’s credit rating even further into junk territory, all the way to “D” for its individual rating;
  5. The Federal Home Loan Bank, one of BKUNA’s main sources of capital, said $736 million of pledged collateral from BankUnited’s real estate investment trust might not be enough to fully cover the money it borrowed, and cut its available credit by 96%, from $627 million to $25 million;
  6. and worst of all, the Office of Thrift Supervision informed the bank that if it did not raise $400 million, that its activities would be substantially curtailed, and further that BKUNA must immediately begin shutting itself down by ceasing to offer new OA and low/no doc “liar loans” and notifying the OTS before it opened any new branches. Jim Cramer also noted on his show that the same action was taken against IndyMac just before its failure, and that DSL and Corus Bankshares (CORS) were in similar positions.

Bank United has been talking about raising $400 million of equity for months now. The problem is, BKUNA’s market cap is about $42 million, so even if BKUNA were to raise that amount at current price, current shareholders would be diluted by about 90%. If it raised that money at a fairly standard discount of 25%, then current shareholders would be diluted by 94%. Of course the idea of BKUNA being able to raise any substantial capital is laughable. I strongly doubt BKUNA will be able to fend off banking regulators and the NASDAQ for more than another month or two. In realty, BKUNA shareholders have two grim futures: a 93%+ dilution that might keep the bank in business for another 6-12 months, and the more likely scenario of their shares becoming worthless by the end of the year. BKUNA is BK-kaput.

DSL has had the following provisions for credit losses: $2.3 million in 2005, $26.6 million in 2006, $310.1 million in 2007. In Q1-08, DSL added a net $237 million provision for loan losses, and took a $24 million loss on homes that it foreclosed and then sold. DSL management was obviously absurdly and recklessly optimistic in 2005 and 2006 by retaining such tiny amounts for loan losses. In Q2 DSL added a another net $259 provision for loan losses, with the total allowance standing at $734 million.

That sounds like a lot of provisions for losses, but DSL has a total loan portfolio of $11.36 billion, of which $1.147 billion is non-performing, and an additional $548 million is “performing troubled debt restructurings.” Further, DSL has as of 6/30/08 $261 million worth of foreclosed property, and some of the loans that DSL classifies as “performing” are currently delinquent. Total delinquent loans are $1.276 billion.

The losses on just these loans and foreclosed properties will more than eat up DSL’s entire allowance for loan losses, but remember its “performing” portfolio consists largely of “ticking time bomb” OA mortgages in California.

Worst of all, DSL’s loan performance is weakest in the parts of California where real estate has fallen the most, meaning that losses on these loans is going to be unprecedented. A shocking 34.2% of DSL’s loans in Sacramento are non-performing or already in foreclosure, and the number in San Diego and Riverside is 24.6%.

Even as the California market continues to deteriorate, Downey’s stockpile of severely depreciated foreclosed loans continues to grow. In Q2 2008, Downey took possession of 522 homes, but only sold 209, so its REO inventory grew from 575 to 808.

The important thing to realize is that Downey (like BKUNA and FED) is already a living-dead zombie bank that is only operating right now (and probably not for long) because our asleep-at-the-wheel banking regulators have not required the bank to take big provisions for loan losses on “performing” OA portfolio in loans whose security is severely underwater, whose borrowers did not verify their incomes (liar loans) and who month after month are only making small payments that do not even cover the interest accumulating each month on the loan. Downey noted that a whopping 39.9% of loans that “recasted for the first time in 2007 or 2008 …. were delinquent 30 days or more” as of 6/30/08. In other words, when the recast bomb explodes, 40% of borrowers soon go delinquent (or worse).

An additional $914 million in loans are projected by DSL to recast in Q3 and Q4 2008, and then $1.496 billion in 2009. Meanwhile even more of the older recast loans will go bad. If the same 39.9% delinquency rate on the loans recast so far applies to DSL’s recast loan projections, that’s another $364 million of new delinquent loans that will go delinquent by year-end and $597 million more in 2009. Meanwhile DSL’s foreclosed “REO” portfolio keeps growing, as the bank refuses to properly discount foreclosed properties fully to market prices, a move that would require it to actually report how much it is losing on foreclosed properties, and increase it provision of currently delinquent loans not yet in foreclosure .

Fortunately the lethargic banking regulators at the OTS are finally taking action against Downey, though their negligence has already allowed the bank to set itself up to cost US taxpayers billions. Downey reported this month that like Bank United, it is in the first stages of shutdown, as the Office of Thrift Supervision:

has also imposed the following limitations on the Holding Company and the Bank: the Bank may not pay dividends to the Holding Company without prior OTS approval, and the Holding Company may not pay dividends without prior non-objection of the OTS; the Bank may not increase its assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities without prior OTS approval; the Holding Company may not issue or renew debt without the prior non-objection of the OTS; the Holding Company and the Bank must provide prior notice to the OTS regarding any additions or changes to directors or senior executive officers (or changes in the responsibilities of senior executive officers); the Holding Company and the Bank may not pay certain kinds of severance and other forms of compensation without regulatory approval; the Bank may not enter into, renew, extend or revise any contract related to compensation or benefits with any director or senior executive officer without prior regulatory approval; the Bank must provide prior notice to the OTS (and not receive any objection) before engaging in transactions with any affiliate or subsidiary. In addition, Downey is subject to higher regulatory assessments and FDIC deposit insurance premiums than those prevailing in prior periods.

(quoted from DSL’s most recent quarterly report)

The official failure of any one of the three Option Arm Triplets will likely cause the other two to plunge in share price, and cause a run on the other two banks among uninsured depositors (the smart ones have already taken their deposits out of the triplets and put their money in a sound bank, like Bank of America (NYSE:BAC).

Disclosure: Author is short DSL, BKUNA, and FED.  No positions are held in the other companies mentioned.