Philip Gvinter

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

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.