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.