================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
For the quarterly period ended SEPTEMBER 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
__________ TO __________
Commission File Number 1-13578
DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0633413
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3501 JAMBOREE ROAD, NEWPORT BEACH, CA 92660
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
------------------- ------------------------
COMMON STOCK, $0.01 PAR VALUE NEW YORK STOCK EXCHANGE
PACIFIC EXCHANGE
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
At September 30, 1998, 28,131,776 shares of the Registrant's Common Stock,
$0.01 par value were outstanding.
================================================================================
DOWNEY FINANCIAL CORP.
SEPTEMBER 30, 1998 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
PART I
FINANCIAL INFORMATION ...................................................... 1
Consolidated Balance Sheets ............................................ 1
Consolidated Statements of Income ...................................... 2
Consolidated Statements of Comprehensive Income ........................ 3
Consolidated Statements of Cash Flows .................................. 4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ................................. 6
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS .................................... 8
PART II
OTHER INFORMATION ...................................................... 29
Item 6 Exhibits and Reports on Form 8-K ............................. 29
i
PART I - FINANCIAL INFORMATION
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30, December 31, September 30,
(Dollars in Thousands, Except Per Share Data) 1998 1997 1997
- --------------------------------------------------------------------------------------------------------------------
ASSETS
Cash .................................................................... $ 43,315 $ 48,823 $ 73,020
Federal funds ........................................................... 54,801 6,095 39,040
- --------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents ........................................... 98,116 54,918 112,060
U.S. Treasury and agency obligations and other investment securities
available for sale, at fair value ................................... 116,629 159,398 143,436
Municipal securities being held to maturity, at amortized cost (estimated
market value of $6,865 at September 30, 1998, and December 31, 1997,
and $6,975 at September 30, 1997) ................................... 6,885 6,885 6,996
Mortgage loans purchased under resale agreements ........................ 40,000 -- --
Loans held for sale, at the lower of cost or market ..................... 272,913 35,100 25,968
Mortgage-backed securities available for sale, at fair value ............ 38,131 49,299 51,931
Loans receivable held for investment .................................... 5,076,799 5,281,997 5,257,870
Investments in real estate and joint ventures ........................... 47,918 41,356 40,865
Real estate acquired in settlement of loans ............................. 5,423 9,626 13,072
Premises and equipment .................................................. 102,030 101,901 98,248
Federal Home Loan Bank stock, at cost ................................... 48,712 44,085 43,384
Other assets ............................................................ 57,023 51,260 60,138
- --------------------------------------------------------------------------------------------------------------------
$ 5,910,579 $ 5,835,825 $ 5,853,968
====================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ................................................................ $ 5,179,380 $ 4,869,978 $ 4,782,794
Government securities sold under agreements to repurchase ............... -- 34,803 --
Federal Home Loan Bank advances ......................................... 197,935 352,458 467,637
Commercial paper ........................................................ -- 83,811 118,635
Other borrowings ........................................................ 12,166 12,663 12,760
Accounts payable and accrued liabilities ................................ 45,062 40,579 45,226
Deferred income taxes ................................................... 5,221 11,187 9,256
- --------------------------------------------------------------------------------------------------------------------
Total liabilities ................................................... 5,439,764 5,405,479 5,436,308
- --------------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY:
Common stock, par value of $0.01 per share; authorized 50,000,000
shares; outstanding 28,131,776 shares at September 30, 1998,
26,755,938 shares at December 31, 1997, and 26,753,970 shares at
September 30, 1997 .................................................. 281 268 268
Additional paid-in capital .............................................. 92,166 45,954 45,926
Accumulated other comprehensive income (loss) - unrealized gains (losses)
on securities available for sale .................................... 1,403 110 (652)
Retained earnings ....................................................... 376,965 384,014 372,118
- --------------------------------------------------------------------------------------------------------------------
Total stockholders' equity .......................................... 470,815 430,346 417,660
- --------------------------------------------------------------------------------------------------------------------
$ 5,910,579 $ 5,835,825 $ 5,853,968
====================================================================================================================
See accompanying notes to consolidated financial statements.
1
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Income
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------
(Dollars in Thousands, Except Per Share Data) 1998 1997 1998 1997
- -----------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME:
Loans receivable ........................................... $ 103,949 $ 105,150 $ 314,877 $ 298,214
U.S. Treasury and agency securities ........................ 1,813 2,023 5,488 6,110
Mortgage-backed securities ................................. 654 884 2,200 2,795
Other investments .......................................... 2,566 1,044 5,937 2,842
- -----------------------------------------------------------------------------------------------------------------------------
Total interest income ................................ 108,982 109,101 328,502 309,961
- -----------------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE:
Deposits ................................................... 64,243 59,476 188,780 166,982
Borrowings ................................................. 1,952 12,071 11,119 30,024
- -----------------------------------------------------------------------------------------------------------------------------
Total interest expense ............................... 66,195 71,547 199,899 197,006
- -----------------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME ........................................ 42,787 37,554 128,603 112,955
PROVISION FOR LOAN LOSSES .................................. 985 1,578 2,719 5,606
- -----------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses .. 41,802 35,976 125,884 107,349
- -----------------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET:
Loan and deposit related fees .............................. 4,163 2,924 11,059 7,842
Real estate and joint ventures held for investment, net:
Net gains on sales of wholly owned real estate ........... -- 1,505 70 1,810
Reduction of losses on real estate and joint ventures .... 139 317 5,082 3,081
Operations, net .......................................... 3,879 973 13,384 6,265
Secondary marketing activities:
Loan servicing fees ...................................... (420) 303 (131) 1,054
Net gains on sales of loans and mortgage-backed securities 1,726 1,559 5,012 2,222
Net gains on sales of investment securities ................ -- -- 68 --
Other ...................................................... 185 437 2,003 2,088
- -----------------------------------------------------------------------------------------------------------------------------
Total other income, net .............................. 9,672 8,018 36,547 24,362
- -----------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE:
Salaries and related costs ................................. 16,171 13,005 46,416 41,043
Premises and equipment costs ............................... 4,343 3,944 12,133 11,245
Advertising expense ........................................ 1,367 1,873 4,502 5,554
Professional fees .......................................... 701 1,528 2,058 3,529
SAIF insurance premiums and regulatory assessments ......... 977 865 2,882 2,520
Other general and administrative expense ................... 5,158 3,666 14,179 10,612
- -----------------------------------------------------------------------------------------------------------------------------
Total general and administrative expense ............. 28,717 24,881 82,170 74,503
- -----------------------------------------------------------------------------------------------------------------------------
Net operation of real estate acquired in settlement of loans 107 463 265 2,031
Amortization of excess of cost over fair value of net assets
acquired ............................................. 125 133 391 399
- -----------------------------------------------------------------------------------------------------------------------------
Total operating expense .............................. 28,949 25,477 82,826 76,933
- -----------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES .................................... 22,525 18,517 79,605 54,778
Income taxes .................................................. 9,757 7,960 34,284 23,581
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME ................................................. $ 12,768 $ 10,557 $ 45,321 $ 31,197
=============================================================================================================================
PER SHARE INFORMATION:
BASIC ......................................................... $ 0.45 $ 0.37 $ 1.61 $ 1.11
=============================================================================================================================
DILUTED ....................................................... $ 0.45 $ 0.37 $ 1.60 $ 1.11
=============================================================================================================================
CASH DIVIDENDS PAID ........................................... $ 0.080 $ 0.076 $ 0.236 $ 0.225
=============================================================================================================================
Weighted average diluted shares outstanding ................... 28,181,313 28,136,044 28,176,326 28,132,799
=============================================================================================================================
See accompanying notes to consolidated financial statements.
2
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------
(In Thousands) 1998 1997 1998 1997
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME ..................................................................... $ 12,768 $ 10,557 $ 45,321 $ 31,197
- -----------------------------------------------------------------------------------------------------------------------------
OTHER COMPREHENSIVE INCOME, NET OF INCOME TAXES:
Unrealized gains on securities available for sale:
U.S. Treasury and agency obligations and other investment securities
available for sale, at fair value ....................................... 309 912 833 843
Less reclassification of realized gains included in income ................ -- -- (39) --
Mortgage-backed securities available for sale, at fair value .............. 674 84 499 64
- -----------------------------------------------------------------------------------------------------------------------------
Other comprehensive income .................................................. 983 996 1,293 907
- -----------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME ........................................................... $ 13,751 $ 11,553 $ 46,614 $ 32,104
=============================================================================================================================
See accompanying notes to consolidated financial statements.
3
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Nine Months Ended
September 30,
--------------------------
(In Thousands) 1998 1997
- ------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ............................................................................. $ 45,321 $ 31,197
Adjustments to reconcile net income to net cash provided by (used for) operating
activities:
Depreciation and amortization ........................................................ 5,666 7,045
Provision (recovery) for losses on loans, real estate acquired in settlement of loans,
investments in real estate and joint ventures and other assets ..................... (2,023) 3,845
Net gains on sales of loans and mortgage-backed securities, investment securities,
real estate and other assets ....................................................... (15,885) (8,174)
Interest capitalized on loans (negative amortization) ................................ (13,817) (10,207)
Federal Home Loan Bank stock dividends ............................................... (2,010) (1,937)
Loans originated for sale .............................................................. (1,421,746) (209,842)
Proceeds from sales of loans originated for sale ....................................... 867,409 137,097
Other, net ............................................................................. 5,896 (1,059)
- ------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities .................................................... (531,189) (52,035)
- ------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from:
Maturities of U.S. Treasury and agency obligations ................................... 10,001 --
Sales of investment securities available for sale .................................... 60,068 --
Sales of loans held for investment ................................................... -- 291,660
Sales of mortgage-backed securities available for sale ............................... 314,265 60,038
Sales of wholly owned real estate and real estate acquired in settlement of loans .... 5,461 12,874
Purchase of:
U.S. Treasury and agency obligations and other investment securities ................. (27,617) --
Securities under resale agreements ................................................... (40,000) --
Loans receivable held for investment ................................................. (6,956) (30,261)
Loans originated for investment (net of refinances of $33,877 and $48,252 at
September 30, 1998 and 1997, respectively) ........................................... (1,132,868) (1,635,729)
Principal payments on loans receivable held for investment and mortgage-backed
securities available for sale ........................................................ 1,342,354 770,533
Net change in undisbursed loan funds ................................................... 24,155 15,759
Investments in real estate held for investment ......................................... 1,391 6,069
Other, net ............................................................................. (5,507) (7,173)
- ------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ...................................... 544,747 (516,230)
- ------------------------------------------------------------------------------------------------------------------------
4
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Continued)
Nine Months Ended
September 30,
----------------------
(In Thousands) 1998 1997
- -------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits .................................................. $ 309,402 $ 609,692
Net decrease in securities sold under agreements to repurchase ............ (34,803) --
Proceeds from Federal Home Loan Bank advances ............................. 179,700 760,100
Repayments of Federal Home Loan Bank advances ............................. (334,223) (679,346)
Net decrease in other borrowings .......................................... (84,308) (77,067)
Proceeds from exercise of stock options ................................... 510 --
Cash dividends ............................................................ (6,638) (6,313)
- -------------------------------------------------------------------------------------------------------
Net cash provided by financing activities .................................... 29,640 607,066
- -------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents .................................... 43,198 38,801
Cash and cash equivalents at beginning of year ............................... 54,918 73,259
- -------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ................................... $ 98,116 $ 112,060
=======================================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest ................................................................ $ 199,529 $ 195,667
Income taxes ............................................................ 38,684 14,831
Supplemental disclosure of non-cash investing:
Loans exchanged for mortgage-backed securities ............................ 316,891 60,956
Real estate acquired in settlement of loans ............................... 12,160 18,766
Loans to facilitate the sale of real estate acquired in settlement of loans 12,280 15,321
=======================================================================================================
See accompanying notes to consolidated financial statements.
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE (1) - BASIS OF PRESENTATION
In the opinion of Downey Financial Corp. and subsidiaries ("Downey"), the
accompanying consolidated financial statements contain all adjustments
(consisting of only normal recurring accruals) necessary for a fair presentation
of Downey's financial condition as of September 30, 1998, December 31, 1997 and
September 30, 1997, and the results of operations for the three months and nine
months ended September 30, 1998 and 1997, and changes in cash flows for the nine
months ended September 30, 1998 and 1997. Certain prior period amounts have been
reclassified to conform to the current period presentation.
The accompanying consolidated financial statements have been prepared in
accordance with generally accepted accounting principles ("GAAP") for interim
financial operations and are in compliance with the instructions for Form 10-Q
and therefore do not include all information and footnotes necessary for a fair
presentation of financial position, results of operations and cash flows. The
following information under the heading Management's Discussion and Analysis of
Financial Condition and Results of Operations is written with the presumption
that the interim consolidated financial statements will be read in conjunction
with Downey's Annual Report on Form 10-K for the year ended December 31, 1997,
which contains among other things, a description of the business, the latest
audited consolidated financial statements and notes thereto, together with
Management's Discussion and Analysis of Financial Condition and Results of
Operations as of December 31, 1997, and for the year then ended. Therefore, only
material changes in financial condition and results of operations are discussed
in the remainder of Part I.
NOTE (2) - SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION
In September 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related Information" ("SFAS 131").
SFAS 131 establishes standards for the way that public business enterprises
report information about operating segments in annual financial statements and
requires that those enterprises report selected information about operating
segments in interim financial reports issued to shareholders. It also
establishes standards for related disclosures about products and services,
geographic areas and major customers. SFAS 131 supersedes FASB Statement No. 14,
"Financial Reporting for Segments of a Business Enterprise," but retains the
requirement to report information about major customers. It amends FASB
Statement No. 94, "Consolidation of All Majority-Owned Subsidiaries," to remove
the special disclosure requirements for previously unconsolidated subsidiaries.
SFAS 131 is effective for financial statements for periods beginning after
December 15, 1997. In the initial year of application, comparative information
for earlier years is to be restated. SFAS 131 need not be applied to interim
financial statements in the initial year of its application, but comparative
information for interim periods in the initial year of application is to be
reported in financial statements for interim periods in the second year of
application. To date, Downey is still examining the impact of SFAS 131 and has
not determined what operating segments will be reported.
NOTE (3) - NET INCOME PER SHARE
Net income per share is calculated on both a basic and diluted basis. Basic
net income per share excludes dilution and is computed by dividing net income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted net income per share reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock or resulted from the issuance of
common stock that then shared in earnings.
NOTE (4) - DERIVATIVES
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133").
SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, (collectively referred to as derivatives) and for hedging activities.
It requires that
6
an entity recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value. If
certain conditions are met, a derivative may be specifically designated as (a) a
hedge of the exposure to changes in the fair value of a recognized asset or
liability or an unrecognized firm commitment, (b) a hedge of the exposure to
variable cash flows of a forecasted transaction, or (c) a hedge of the foreign
currency exposure of a net investment in a foreign operation, an unrecognized
firm commitment, an available for sale security, or a
foreign-currency-denominated forecasted transaction.
Under SFAS 133, an entity that elects to apply hedge accounting is required
to establish at the inception of the hedge the method it will use for assessing
the effectiveness of the hedging derivative and the measurement approach for
determining the ineffective aspect of the hedge. Those methods must be
consistent with the entity's approach to managing risk.
This statement is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999.
As part of its secondary marketing activities, Downey utilizes forward sale
contracts to hedge the value of loans originated for sale against adverse
changes in interest rates. At September 30, 1998, such contracts amounted to
approximately $393 million. These contracts have a high correlation to the price
movement of the loans being hedged. There is no recognition of unrealized gains
and losses on these contracts in the balance sheet or statement of income. When
the related loans are sold, the deferred gains or losses from these contracts
are recognized in the statement of income as a component of net gains or losses
on sales of loans and mortgage-backed securities.
NOTE (5) - INCOME TAXES
During the first quarter of 1998, the Internal Revenue Service ("IRS")
completed its review of Downey's federal income tax returns for years 1990
through 1995. As a result of that review, the IRS proposed additions to tax of
approximately $20 million. Of that amount, Downey has paid approximately $5
million for items not disputed. The balance of the remaining tax additions
primarily relates to the sale and leaseback of computer equipment in 1990.
Management believes substantial legal authority exists for the positions taken
on the tax returns and intends to vigorously defend those positions, and that
adequate provisions have been provided for the potential exposure.
7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Certain statements under this caption constitute "forward-looking
statements" under the Private Securities Litigation Reform Act of 1995 which
involve risks and uncertainties. Downey's actual results may differ
significantly from the results discussed in such forward-looking statements.
Factors that might cause such a difference include, but are not limited to,
economic conditions, competition in the geographic and business areas in which
Downey conducts its operations, fluctuations in interest rates, credit quality
and government regulation.
OVERVIEW
Net income for the third quarter of 1998 totaled $12.8 million or $0.45 per
share on a diluted basis, up 20.9% from the $10.6 million or $0.37 per share
earned in the third quarter of 1997.
The increase in net income between third quarters reflected several
factors. Net interest income increased $5.2 million or 13.9% due to an increase
in the effective interest rate spread. An increase of $1.7 million in other
income and reductions of $0.6 million in provision for loan losses and $0.3
million in costs associated with the net operation of real estate acquired in
settlement of loans also contributed to the improvement in net income. These
positive factors were partially offset by a $3.8 million increase in general and
administrative expense reflecting higher lending volumes and branch expansion.
For the nine months ended September 30, 1998, net income amounted to $45.3
million, or $1.60 per share on a diluted basis, up 45.3% from the $31.2 million,
or $1.11 per share, earned in the same period last year. In addition to the
trends mentioned for the quarter, net income for the first nine months of 1998
also benefited from the settlement of certain loan and real estate investment
obligations of a joint venture partner ("settlement"). The pre-tax amount
associated with the settlement was $8.3 million of which $1.4 million
represented the recovery of a prior loan charge-off thereby reducing provision
for loan losses; $4.3 million was recorded as a reduction of loss on real estate
and joint ventures; $1.0 million was recorded in miscellaneous other income; and
$1.6 million was recorded as a partial recovery of legal fees within general and
administrative expense. Excluding the settlement, net income for the first nine
months of 1998 would have been $40.5 million, up $9.3 million or 29.8% from a
year ago.
For the third quarter of 1998, the return on average assets was 0.87% and
the return on average equity was 11.01%, bringing the returns for the first nine
months of 1998 to 1.03% and 13.42%, respectively. Excluding the previously
mentioned settlement, the returns on average assets and average equity for the
first nine months would have been 0.92% and 12.03%, respectively.
Assets totaled $5.9 billion at September 30, 1998, virtually unchanged from
both a year ago and year-end 1997. The low interest rate environment during the
first nine months of 1998 has generated increased prepayments of residential
loans as customers seek low, fixed rate mortgages. As a result, the portfolio of
loans held for investment and borrowings declined, which was only partially
offset by a temporary increase in loans held for sale.
Single family loan originations totaled a record $961.6 million in the
third quarter of 1998, more than double the $464.0 million in the third quarter
of 1997. Of the current quarter total, $571.1 million represented originations
of loans for sale and $101.6 million represented originations for portfolio of
subprime credits ("A-," "B" and "C") as part of Downey's strategy to enhance the
portfolio's net yield. In addition to single family loans, $102.3 million of
other loans were originated in the quarter including $40.9 million of
construction and land loans and $40.2 million of automobile loans.
Non-performing assets declined $4.2 million during the quarter to $44.6
million or 0.75% of total assets. The decline was in the single family category.
Deposits totaled $5.2 billion at September 30, 1998, up 8.3% from a year
ago and $309.4 million above year-end 1997. Since the growth in deposits during
the first nine months of 1998 was not needed to fund asset growth, borrowings
were reduced by $273.6 million and totaled $210.1 million at the end of the
current quarter. During the quarter, one new in-store branch was opened,
bringing total branches at quarter end to 91 of which 28 are in-store.
8
At September 30, 1998, Downey's primary subsidiary, Downey Savings and Loan
Association, F.A. (the "Bank"), had core and tangible capital ratios of 7.11%
and a risk-based capital ratio of 13.33%. These capital levels are well above
the "well capitalized" standards of 5% and 10%, respectively, as defined by
regulation.
9
RESULTS OF OPERATIONS
NET INTEREST INCOME
Net interest income totaled $42.8 million in the third quarter of 1998, up
$5.2 million or 13.9% from the same period last year. The improvement reflected
an increase in the effective interest rate spread, as average earning assets
declined by 2.2% and averaged $5.6 billion. The effective interest rate spread
averaged 3.05% in the current quarter, up from 2.62% in the year-ago quarter,
reflecting an increase in the yield on earning assets and a decline in funding
costs. For the first nine months of 1998, net interest income totaled $128.6
million, up $15.6 million or 13.9% from the same period a year ago.
The following table presents for the periods indicated the total dollar
amount of interest income from average interest-earning assets and resultant
yields and the interest expense on average interest-bearing liabilities and the
resultant costs, expressed both in dollars and rates. The table also sets forth
the net interest income, the interest rate spread and the effective interest
spread. The effective interest spread, which reflects the relative level of
interest-earning assets to interest-bearing liabilities, equals (i) the
difference between interest income on interest-earning assets and interest
expense on interest-bearing liabilities, (ii) divided by average
interest-earning assets for the period. The table also sets forth the net
earning balance (the difference between the average balance of interest-earning
assets and the average balance of interest-bearing liabilities) for the periods
indicated. Non-accrual loans are included in the average interest-earning assets
balance. Interest from non-accrual loans is included in interest income only to
the extent that payments are received and to the extent that Downey believes it
will recover the remaining principal balance of the loan. Average balances are
computed using the average of each month's daily average balance during the
period indicated.
10
Three Months Ended
-----------------------------------------------------------------
September 30, 1998 September 30, 1997
-----------------------------------------------------------------
Average Average
Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ...................................... $5,270,387 $ 103,949 7.89% $5,471,077 $ 105,150 7.69%
Mortgage-backed securities ................. 40,390 654 6.48 53,663 884 6.59
Investment securities ...................... 300,918 4,379 5.77 210,748 3,067 5.77
- --------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ............ 5,611,695 108,982 7.77 5,735,488 109,101 7.61
Non-interest-earning assets .................... 252,334 243,519
- --------------------------------------------------------------------------------------------------------------------
Total assets ............................. $5,864,029 $5,979,007
====================================================================================================================
Interest-bearing liabilities:
Deposits ................................... $5,202,075 $ 64,243 4.90% $4,715,233 $ 59,476 5.00%
Borrowings ................................. 131,097 1,952 5.91 788,919 12,071 6.07
- --------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities ....... 5,333,172 66,195 4.92 5,504,152 71,547 5.16
Non-interest-bearing liabilities ............... 67,124 63,883
Stockholders' equity ........................... 463,733 410,972
- --------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $5,864,029 $5,979,007
====================================================================================================================
Net interest income/interest rate spread ....... $ 42,787 2.85% $ 37,554 2.45%
Excess of interest-earning assets over
interest-bearing liabilities ............... $ 278,523 $ 231,336
Effective interest rate spread ................. 3.05% 2.62%
====================================================================================================================
Nine Months Ended
-----------------------------------------------------------------
September 30, 1998 September 30, 1997
-----------------------------------------------------------------
- --------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ...................................... $5,300,229 $ 314,877 7.92% $5,129,838 $ 298,214 7.75%
Mortgage-backed securities ................. 44,169 2,200 6.64 56,548 2,795 6.59
Investment securities ...................... 265,638 11,425 5.75 205,763 8,952 5.82
- --------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ............ 5,610,036 328,502 7.81 5,392,149 309,961 7.66
Non-interest-earning assets .................... 252,414 249,617
- --------------------------------------------------------------------------------------------------------------------
Total assets ............................. $5,862,450 $5,641,766
====================================================================================================================
Interest-bearing liabilities:
Deposits ................................... $5,110,184 $ 188,780 4.94% $4,511,764 $ 166,982 4.95%
Borrowings ................................. 233,850 11,119 6.36 664,488 30,024 6.04
- --------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities ....... 5,344,034 199,899 5.00 5,176,252 197,006 5.09
Non-interest-bearing liabilities ............... 68,242 61,893
Stockholders' equity ........................... 450,174 403,621
- --------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $5,862,450 $5,641,766
====================================================================================================================
Net interest income/interest rate spread ....... $ 128,603 2.81% $ 112,955 2.57%
Excess of interest-earning assets over
interest-bearing liabilities ............... $ 266,002 $ 215,897
Effective interest rate spread ................. 3.06% 2.79%
====================================================================================================================
11
Changes in Downey's net interest income are a function of both changes in
rates and changes in volumes of interest-earning assets and interest-bearing
liabilities. The following table sets forth information regarding changes in
interest income and expense for Downey for the periods indicated. For each
category of interest-earning asset and interest-bearing liability, information
is provided on changes attributable to: (i) changes in volume (changes in volume
multiplied by comparative period rate); (ii) changes in rate (changes in rate
multiplied by comparative period volume); and (iii) changes in rate-volume
(changes in rate multiplied by changes in volume). Interest-earning asset and
interest-bearing liability balances used in the calculations represent average
balances computed using the average of each month's daily average balance during
the period indicated.
Three Months Ended Nine Months Ended
--------------------------------------------------------------------------------------------
September 30, 1998 versus September 30, 1997 September 30, 1998 versus September 30, 1997
Changes Due To Changes Due To
--------------------------------------------------------------------------------------------
Rate/ Rate/
(In Thousands) Volume Rate Volume Net Volume Rate Volume Net
- -----------------------------------------------------------------------------------------------------------------------------
Interest income:
Loans ..................... $ (3,857) $ 2,757 $ (101) $ (1,201) $ 9,906 $ 6,540 $ 217 $ 16,663
Mortgage-backed securities (219) (15) 4 (230) (612) 22 (5) (595)
Investment securities ..... 1,312 -- -- 1,312 2,605 (102) (30) 2,473
- -----------------------------------------------------------------------------------------------------------------------------
Change in interest income (2,764) 2,742 (97) (119) 11,899 6,460 182 18,541
- -----------------------------------------------------------------------------------------------------------------------------
Interest expense:
Deposits .................. 6,141 (1,245) (129) 4,767 22,148 (309) (41) 21,798
Borrowings ................ (10,073) (1,215) 1,169 (10,119) (19,474) 1,918 (1,349) (18,905)
- -----------------------------------------------------------------------------------------------------------------------------
Change in interest expense (3,932) (2,460) 1,040 (5,352) 2,674 1,609 (1,390) 2,893
- -----------------------------------------------------------------------------------------------------------------------------
Change in net interest income . $ 1,168 $ 5,202 $ (1,137) $ 5,233 $ 9,225 $ 4,851 $ 1,572 $ 15,648
=============================================================================================================================
PROVISION FOR LOAN LOSSES
Provision for loan losses was $1.0 million in the current quarter, down
from $1.6 million in the year-ago quarter. For the first nine months of 1998,
provision for loan losses totaled $2.7 million, compared to $5.6 million in the
year-ago period. Included in the nine-month 1998 amount was a $1.4 million
reduction due to the recovery of a prior loan charge-off as a result of the
previously mentioned settlement. For information regarding the allowance for
loan losses, see "Asset Quality - Valuation Allowances" on page 24.
OTHER INCOME
Total other income was $9.7 million in the third quarter of 1998, up $1.7
million from the year-ago quarter. The increase between third quarters reflected
increases of $1.2 million each in loan and deposit related fees and income from
real estate held for investment, and $0.2 million in net gains on sales of
loans. Partially offsetting those increases were declines in loan servicing fees
and the other category of other income. Loan servicing fees in the current
quarter reflected a loss of $0.4 million compared to income of $0.3 million in
the year-ago period. The current quarter loss resulted from a $0.7 million
addition to the valuation allowance for mortgage servicing rights due to higher
that expected prepayments from the current low interest rate environment. At
quarter end, capitalized mortgage servicing rights, net of the valuation
allowance, totaled $4.3 million. The $0.3 million decline in the other category
primarily reflects a loss in the current quarter from the early termination of a
lease by a lessee in Downey's corporate building. For the first nine months of
1998, total other income was $36.5 million, up $12.2 million from a year ago,
and included $5.3 million from the previously mentioned settlement.
12
The following table presents a breakdown of the key components comprising
income from real estate and joint venture operations.
Three Months Ended
---------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- -------------------------------------------------------------------------------------------------------------------------
Operations, net:
Rental operations, net of expenses ................. $ 894 $1,260 $ 881 $ 868 $ 124
Equity in net income from joint ventures ........... 2,605 1,116 5,226 636 467
Interest from joint venture advances ............... 380 336 686 359 382
- -------------------------------------------------------------------------------------------------------------------------
Total operations, net ............................ 3,879 2,712 6,793 1,863 973
Net gains on sales of wholly owned real estate ........ -- 70 -- 1,094 1,505
Reduction of losses on real estate and joint ventures . 139 2,221 2,722 109 317
- -------------------------------------------------------------------------------------------------------------------------
Income from real estate and joint venture operations $4,018 $5,003 $9,515 $3,066 $2,795
=========================================================================================================================
OPERATING EXPENSE
Operating expense totaled $28.9 million in the current quarter, up $3.5
million or 13.6% from the third quarter of 1997. General and administrative
expense increased $3.8 million or 15.4% and reflected higher lending volumes and
branch expansion. The increase in general and administrative expense was
partially offset by a $0.3 million decline in costs associated with the
operation of real estate acquired in settlement of loans. For the first nine
months of 1998, operating expenses totaled $82.8 million after a reduction of
$1.6 million to legal fees from the previously mentioned settlement, compared to
$76.9 million in the same period of 1997.
PROVISION FOR INCOME TAXES
Income taxes for the third quarter totaled $9.8 million, resulting in an
effective tax rate of 43.3%, compared to $8.0 million and 43.0% for the like
quarter of a year ago. For the first nine months of 1998, the effective tax rate
was 43.1% compared to 43.0% in the same period of 1997. For further information
regarding income taxes, see "Note (5) - Income Taxes" on page 7.
13
FINANCIAL CONDITION
LOANS AND MORTGAGE-BACKED SECURITIES
Total loans and mortgage-backed securities, including those held for sale,
increased $59.6 million during the third quarter to a total of $5.4 billion, or
91.2% of assets, at September 30, 1998. Although customer preference for
adjustable rate mortgages ("ARMs") has been significantly reduced, the
origination of adjustable rate loans almost equaled prepayments during the
quarter. This enabled the single family loan portfolio to remain essentially
unchanged, while the portfolio of residential one-to-four unit loans held for
sale increased by $60.7 million as fixed rate loans were originated for sale
into the secondary market.
The following table sets forth originations of loans held for investment
and loans originated for sale.
Three Months Ended
-----------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- ---------------------------------------------------------------------------------------------------------------
Loans originated for investment:
Residential - one-to-four adjustable (1) $ 383,483 $ 309,468 $ 190,490 $ 254,028 $ 383,204
Residential - one-to-four fixed (2) .... 6,921 6,824 4,791 6,705 6,049
Other (3) .............................. 102,319 88,013 93,672 85,527 120,204
- ---------------------------------------------------------------------------------------------------------------
Total loans originated for investment 492,723 404,305 288,953 346,260 509,457
Loans originated for sale (primarily
residential - fixed) ................... 571,146 592,931 257,669 79,429 74,721
- ---------------------------------------------------------------------------------------------------------------
Total loans originated ................. $1,063,869 $ 997,236 $ 546,622 $ 425,689 $ 584,178
===============================================================================================================
<FN>
(1) For the three months ended June 30, 1998, March 31, 1998, December 31, 1997
and September 30, 1997, $1.5 million, $2.6 million, $5.6 million and $6.7
million, respectively, of loans purchased through correspondent lending
relationships were included.
(2) Primarily represents loans to facilitate the sale of real estate acquired
in settlement of loans and loans that meet certain yield and other approved
guidelines. Included also in the three months ended June 30, 1998 were $1.5
million of purchased loans.
(3) For the three months ended September 30, 1998, June 30, 1998, March 31,
1998 and September 30, 1997, $0.4 million, $0.2 million, $0.1 million and
$0.4 million, respectively, of loans purchased through correspondent
lending relationships were included.
</FN>
Originations of one-to-four unit residential loans totaled a record $961.6
million in the third quarter of 1998, of which $390.5 million were for portfolio
and $571.1 million were for sale. This was above the previous record set in the
second quarter of 1998, and more than double the $464.0 million originated in
the year-ago quarter. Of the current quarter total, $101.6 million represented
originations of subprime credits ("A-," "B" and "C") as part of Downey's
strategy to enhance the portfolio's net yield. During the current quarter, 68%
of Downey's residential one-to-four unit originations represented refinancings
of existing loans (existing Downey loans were 3%). This is similar to the
previous quarter and up from 49% (existing Downey loans were 3%) in the year-ago
third quarter. In addition to single family loans, $102.3 million of other loans
were originated in the quarter including $40.9 million of construction and land
loans, and $40.2 million of automobile loans.
During the current quarter, loan originations for investment consisted
primarily of ARMs tied to Federal Home Loan Bank ("FHLB") Eleventh District Cost
of Funds Index, an index which lags the movement in market interest rates. This
experience is similar to that of recent quarters. Increasingly, the majority of
ARM originations reprice monthly; however, Downey also originates ARM loans
which reprice semi-annually and annually. With respect to ARMs that primarily
adjust monthly, there is a lifetime interest rate cap, but no other specified
limit on periodic interest rate adjustments. Instead, monthly adjustment ARMs
have a periodic cap on changes in the required monthly payments, which adjust
annually. Monthly adjustment ARMs allow for negative amortization (the addition
to loan principal of accrued interest that exceeds the required loan payment).
There is a limit on the amount of negative amortization allowed, expressed as a
percentage of principal plus the amount added relative to the original loan
amount. That limit has been 110%, but was increased to 125% during the current
quarter. At September 30, 1998, $2.8 billion of the ARMs in Downey's loan
portfolio were subject to negative amortization of which $41.4 million
represented the amount of negative amortization included in the loan balance.
14
Downey also continues to originate residential fixed interest rate mortgage
loans to meet consumer demand, but intends to sell the majority of all such
loans. Sales of loans and mortgage-backed securities originated by Downey were
$507.5 million for the third quarter of 1998, compared to $553.9 million in the
previous quarter and $362.1 million for the third quarter of 1997 of which
$290.5 million represented the sale of COFI ARMs from loans held for investment.
All were secured by residential one-to-four unit property and at September 30,
1998, loans held for sale totaled $272.9 million.
At September 30, 1998, Downey had commitments to fund loans amounting to
$584.8 million of which $314.0 million were fixed rate one-to-four unit
residential loans being originated for sale in the secondary market, loans in
process of $78.5 million, undrawn lines of credit of $71.9 million and letters
of credit of $0.9 million. Downey believes its current sources of funds will
enable it to meet these obligations while exceeding all regulatory liquidity
requirements.
15
The following table sets forth the origination, purchase and sale activity
relating to loans and mortgage-backed securities for the periods indicated.
Three Months Ended
------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- ---------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO:
Loans originated:
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable .................................... $ 283,468 $ 229,106 $ 127,871 $ 159,656 $ 297,963
Adjustable - subprime ......................... 100,015 78,845 60,017 88,820 78,531
- ---------------------------------------------------------------------------------------------------------------------------
Total adjustable ........................... 383,483 307,951 187,888 248,476 376,494
Fixed ......................................... 5,351 3,980 3,319 5,865 5,054
Fixed - subprime .............................. 1,535 1,329 1,472 825 995
Five or more units:
Adjustable .................................... -- -- 875 -- --
Fixed ......................................... 13,229 -- -- -- --
- ---------------------------------------------------------------------------------------------------------------------------
Total residential .......................... 403,598 313,260 193,554 255,166 382,543
Commercial real estate ........................... -- -- 4,214 3,685 --
Construction ..................................... 17,266 19,023 29,906 16,842 26,200
Land ............................................. 23,640 6,883 7,851 -- 13,310
Non-mortgage:
Commercial ....................................... 645 4,421 610 6,435 1,628
Automobile ....................................... 40,158 46,153 45,552 51,985 70,757
Other consumer ................................... 7,016 10,738 4,537 6,580 7,951
- ---------------------------------------------------------------------------------------------------------------------------
Total loans originated ........................ 492,323 400,478 286,224 340,693 502,389
Real estate loans purchased (1) ....................... 400 3,827 2,729 5,567 7,068
- ---------------------------------------------------------------------------------------------------------------------------
Total loans originated and purchased ............... 492,723 404,305 288,953 346,260 509,457
Loan repayments ....................................... (490,358) (498,516) (376,371) (321,020) (302,116)
Other net changes (2), (3) ............................ 553 (11,740) (14,747) (1,113) (312,185)
- ---------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for
investment...................................... 2,918 (105,951) (102,165) 24,127 (104,844)
- ---------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO:
Residential, one-to-four units:
Originated whole loans ............................. 571,146 592,931 257,669 79,429 74,721
Loans transferred from (to) the investment
portfolio (3) .................................... -- 162 604 (156) 290,606
Originated whole loans sold (3) .................... (354,371) (429,434) (79,686) (41,540) (345,198)
Loans exchanged for mortgage-backed securities ..... (153,175) (124,505) (39,211) (28,566) (16,854)
Other net changes .................................. (2,851) (1,369) (97) (35) 6
- ---------------------------------------------------------------------------------------------------------------------------
Net increase in loans held for sale .............. 60,749 37,785 139,279 9,132 3,281
- ---------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities, net:
Received in exchange for loans ..................... 153,175 124,505 39,211 28,566 16,854
Sold ............................................... (153,175) (124,505) (39,211) (28,566) (16,854)
Repayments ......................................... (4,242) (3,724) (3,020) (3,112) (2,823)
Other net changes .................................. 127 (13) (296) 480 147
- ---------------------------------------------------------------------------------------------------------------------------
Net decrease in mortgage-backed securities
available for sale ............................. (4,115) (3,737) (3,316) (2,632) (2,676)
- ---------------------------------------------------------------------------------------------------------------------------
Net increase in loans and mortgage-backed
securities held for sale and available for sale 56,634 34,048 135,963 6,500 605
- ---------------------------------------------------------------------------------------------------------------------------
Total net increase (decrease) in loans and
mortgage-backed securities ..................... $ 59,552 $ (71,903) $ 33,798 $ 30,627 $(104,239)
===========================================================================================================================
<FN>
(1) Primarily one-to-four unit residential loans. Included in the three months
ended September 30, 1998, June 30, 1998, March 31, 1998 and September 30,
1997, were $0.4 million, $0.2 million, $0.1 million, and $0.4 million,
respectively, of five or more unit residential loans. Included also in the
three months ended June 30, 1998 were $0.6 million of commercial real
estate loans.
(2) Primarily includes borrowings against and repayments of lines of credit and
construction loans, changes in loss allowances, loans transferred to real
estate acquired in settlement of loans or to the held for sale portfolio,
and interest capitalized on loans (negative amortization).
(3) Includes $290.5 million of one-to-four unit residential ARMs transferred
from the held for investment portfolio during the three months ended
September 30, 1997, and sold servicing released.
</FN>
16
The following table sets forth the composition of Downey's loan and
mortgage-backed securities portfolios at the dates indicated.
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- -----------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO:
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable ............................ $ 3,791,187 $ 3,892,221 $ 4,027,520 $ 4,190,160 $ 4,260,831
Adjustable - subprime ................. 461,646 372,608 303,058 245,749 158,987
Fixed ................................. 153,408 155,741 161,518 168,315 169,978
Fixed - subprime ...................... 7,516 5,993 4,672 3,321 2,500
- -----------------------------------------------------------------------------------------------------------------------------
Total one-to-four units ............ 4,413,757 4,426,563 4,496,768 4,607,545 4,592,296
Five or more units:
Adjustable ............................ 18,707 18,802 30,129 29,246 41,636
Fixed ................................. 22,436 8,934 8,748 9,032 9,260
Commercial real estate:
Adjustable ............................... 44,215 47,045 73,013 87,604 115,923
Fixed .................................... 112,687 114,379 118,476 114,821 95,941
Construction ............................... 92,779 95,664 89,989 70,865 60,459
Land ....................................... 39,222 29,857 32,510 25,687 26,270
Non-mortgage:
Commercial ................................. 27,710 27,298 25,478 26,024 23,741
Automobile ................................. 355,955 356,504 350,316 342,326 325,216
Other consumer ............................. 44,026 44,530 45,529 47,735 47,067
- -----------------------------------------------------------------------------------------------------------------------------
Total loans held for investment .......... 5,171,494 5,169,576 5,270,956 5,360,885 5,337,809
Increase (decrease) for:
Undisbursed loan funds ..................... (88,213) (85,367) (78,888) (64,884) (65,783)
Deferral of fees and discounts, net of costs 24,962 21,408 19,581 18,088 16,762
Allowance for estimated loss ............... (31,444) (31,736) (31,817) (32,092) (30,918)
- -----------------------------------------------------------------------------------------------------------------------------
Total loans held for investment, net ..... 5,076,799 5,073,881 5,179,832 5,281,997 5,257,870
- -----------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO, NET:
Loans held for sale (all one-to-four units):
Adjustable ................................. 9,480 13,692 10,019 1,617 4,614
Fixed ...................................... 263,433 198,472 164,360 33,483 21,354
- -----------------------------------------------------------------------------------------------------------------------------
Total loans held for sale ................ 272,913 212,164 174,379 35,100 25,968
Mortgage-backed securities available for sale:
Adjustable ................................. 12,795 14,575 16,135 17,751 18,716
Fixed ...................................... 25,336 27,671 29,848 31,548 33,215
- -----------------------------------------------------------------------------------------------------------------------------
Total mortgage-backed securities available
for sale .............................. 38,131 42,246 45,983 49,299 51,931
- -----------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities
held for sale and available for sale .. 311,044 254,410 220,362 84,399 77,899
- -----------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities $ 5,387,843 $ 5,328,291 $ 5,400,194 $ 5,366,396 $ 5,335,769
=============================================================================================================================
Loans held for sale are carried at the lower of cost or market. At
September 30, 1998, no valuation allowance was required as the market value
exceeded book value on an aggregate basis.
Mortgage-backed securities available for sale are carried at fair value
and, at September 30, 1998, reflect an unrealized gain of $1.0 million. The
current quarter-end unrealized gain, less the associated tax effect of $0.3
million, is reflected within a separate component of other comprehensive income
until realized.
17
INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
Downey's investment in real estate and joint ventures amounted to $47.9
million at September 30, 1998, compared to $41.4 million at December 31, 1997,
and $40.9 million at September 30, 1997.
The following table is a summary of the activity of Downey's allowance for
real estate held for investment for the periods indicated. The $1.3 million
charge-off in the current quarter resulted from the sale of land for which an
allowance was provided in prior periods.
Three Months Ended
-----------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- ------------------------------------------------------------------------------------------------
Balance at beginning of period $ 9,558 $ 18,140 $ 21,244 $ 21,353 $ 21,670
Provision .................... (139) (2,221) (2,722) (109) (317)
Charge-offs .................. (1,268) (6,361) (382) -- --
Recoveries ................... -- -- -- -- --
- ------------------------------------------------------------------------------------------------
Balance at end of period ..... $ 8,151 $ 9,558 $ 18,140 $ 21,244 $ 21,353
================================================================================================
In addition to losses charged against the allowance for loan losses, Downey
has recorded losses on real estate acquired in settlement of loans by direct
write-off to net operations of real estate acquired in settlement of loans and
against an allowance for losses specifically established for such assets. The
following table is a summary of the activity of Downey's allowance for real
estate acquired in settlement of loans for the periods indicated.
Three Months Ended
-----------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- ------------------------------------------------------------------------------------------------
Balance at beginning of period $ 671 $ 898 $ 839 $ 1,083 $ 1,182
Provision .................... 160 5 304 (24) 235
Charge-offs .................. (249) (232) (245) (220) (334)
Recoveries ................... -- -- -- -- --
- ------------------------------------------------------------------------------------------------
Balance at end of period ..... $ 582 $ 671 $ 898 $ 839 $ 1,083
================================================================================================
18
DEPOSITS
At September 30, 1998, deposits totaled $5.2 billion, up $396.6 million or
8.3% from the year-ago quarter end, and up $309.4 million or 6.4% from year-end
1997. Compared to the year-ago period, transaction accounts (i.e., checking,
regular passbook and money market) increased $165.1 million or 18.0%, while
certificates of deposits increased $231.5 million or 6.0%. The following table
sets forth information concerning Downey's deposits and average rates paid at
the dates indicated.
September 30, 1998 June 30, 1998 March 31, 1998 December 31, 1997 September 30, 1997
------------------- ------------------- ------------------- -------------------- --------------------
Weighted Weighted Weighted Weighted Weighted
Average Average Average Average Average
(Dollars in Thousands) Rate Amount Rate Amount Rate Amount Rate Amount Rate Amount
- -----------------------------------------------------------------------------------------------------------------------------
Transaction accounts ... 2.18% $1,080,734 2.17% $1,021,428 2.10% $1,007,323 2.15% $ 935,869 2.10% $ 915,647
Certificates of deposit:
Less than 3.00% ..... 2.63 26,686 2.63 27,290 2.63 29,543 2.64 30,623 2.66 32,279
3.00-3.49 ........... 3.03 449 3.02 677 3.01 581 3.02 766 3.04 623
3.50-3.99 ........... 3.91 40,115 -- -- -- -- -- -- 3.99 24
4.00-4.49 ........... 4.16 14,754 4.13 59,708 4.20 60,410 4.31 60,095 4.38 55,701
4.50-4.99 ........... 4.88 468,922 4.90 208,774 4.89 134,194 4.87 40,356 4.87 44,012
5.00-5.99 ........... 5.57 3,162,420 5.60 3,072,092 5.63 2,947,539 5.63 2,896,291 5.61 2,740,673
6.00-6.99 ........... 6.06 382,502 6.05 778,300 6.06 925,762 6.06 901,920 6.07 989,209
7.00 and greater .... 7.25 2,798 7.24 3,107 7.21 3,470 7.22 4,058 7.21 4,626
- -----------------------------------------------------------------------------------------------------------------------------
Total certificates
of deposit ..... 5.50 4,098,646 5.61 4,149,948 5.66 4,101,499 5.68 3,934,109 5.68 3,867,147
- -----------------------------------------------------------------------------------------------------------------------------
Total deposits ... 4.81% $5,179,380 4.93% $5,171,376 4.96% $5,108,822 5.00% $4,869,978 5.00% $4,782,794
=============================================================================================================================
BORROWINGS
During the 1998 third quarter, borrowings increased $54.5 million to $210.1
million, but remain well below the year-ago level of $599.0 million. Downey
terminated its commercial paper program which was credit enhanced by an FHLB
letter of credit during the current quarter as it was no longer price
competitive to alternative borrowing sources. The following table sets forth
information concerning Downey's FHLB advances and other borrowings at the dates
indicated.
September 30, June 30, March 31, December 31, September 30,
(Dollars in Thousands) 1998 1998 1998 1997 1997
- ------------------------------------------------------------------------------------------------------------------
FHLB advances .................................. $197,935 $123,347 $209,854 $352,458 $467,637
Reverse repurchase agreements .................. -- -- -- 34,803 --
Commercial paper ............................... -- 19,982 44,517 83,811 118,635
Other borrowings ............................... 12,166 12,256 12,712 12,663 12,760
- ------------------------------------------------------------------------------------------------------------------
Total borrowings ........................... $210,101 $155,585 $267,083 $483,735 $599,032
==================================================================================================================
Weighted average rate on borrowings during
the period ................................. 5.91% 6.60% 6.42% 6.16% 6.07%
Total borrowings as a percentage of total assets 3.55 2.67 4.55 8.29 10.23
==================================================================================================================
ASSET/LIABILITY MANAGEMENT AND MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. Downey's market risk arises primarily from interest rate risk in
its lending and deposit taking activities. This interest rate risk occurs to the
degree that interest-bearing liabilities reprice or mature more rapidly or on a
different basis than interest-earning assets. Since Downey's earnings depend
primarily on its net interest income, which is the difference between the
interest and dividends earned on interest-earning assets and the interest paid
on interest-bearing liabilities, a principal objective of
19
Downey is to actively monitor and manage the effects of adverse changes in
interest rates on net interest income while maintaining asset quality. There has
been no significant change in market risk since December 31, 1997.
The following table sets forth the repricing frequency of Downey's major
asset and liability categories as of September 30, 1998, as well as certain
information regarding the repricing and maturity differences between
interest-earning assets and interest-bearing liabilities ("gap") in future
periods. The repricing frequencies have been determined by reference to
projected maturities, based upon contractual maturities as adjusted for
scheduled repayments and "repricing mechanisms" (provisions for changes in the
interest and dividend rates of assets and liabilities). Prepayment rates are
assumed on substantially all of Downey's loan portfolio based upon its
historical loan prepayment experience and anticipated future prepayments.
Repricing mechanisms on certain of Downey's assets are subject to limitations,
such as caps on the amount that interest rates and payments on Downey's loans
may adjust, and accordingly, such assets do not normally respond as completely
or rapidly as Downey's liabilities to changes in market interest rates. The
interest rate sensitivity of Downey's assets and liabilities illustrated in the
table would vary substantially if different assumptions were used or if actual
experience differed from the assumptions set forth.
September 30, 1998
--------------------------------------------------------------------------
Within 7 - 12 1 - 5 5 - 10 Over Total
(Dollars in Thousands) 6 Months Months Years Years 10 Years Balance
- ------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Investment securities and FHLB stock (1) $ 150,398 $ -- $ 116,629 $ -- $ -- $ 267,027
Loans and mortgage-backed securities:
Mortgage-backed securities (2) 18,645 5,210 13,240 956 80 38,131
Loans secured by real estate:
Residential:
Adjustable (2) 4,194,758 80,484 14,320 -- -- 4,289,562
Fixed (2) 293,205 22,774 89,745 26,952 14,117 446,793
Commercial real estate (2) 50,569 6,708 84,508 8,795 2,667 153,247
Construction (2) 36,014 -- -- -- -- 36,014
Land (2) 14,688 42 365 559 268 15,922
Non-mortgage:
Commercial (2) 17,773 -- -- -- -- 17,773
Consumer (2) 93,910 55,738 240,753 -- -- 390,401
- ------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed
securities ............................ 4,719,562 170,956 442,931 37,262 17,132 5,387,843
- ------------------------------------------------------------------------------------------------------------------------
Total ................................. $4,869,960 $ 170,956 $ 559,560 $ 37,262 $ 17,132 $ 5,654,870
========================================================================================================================
Deposits and borrowings:
Interest bearing deposits:
Fixed maturity deposits (1) $2,532,512 $ 1,221,357 $ 344,777 $ -- $ -- $ 4,098,646
Transaction accounts (3) 940,363 -- -- -- -- 940,363
Non-interest bearing transaction deposits 140,371 -- -- -- -- 140,371
- ------------------------------------------------------------------------------------------------------------------------
Total deposits ........................ 3,613,246 1,221,357 344,777 -- -- 5,179,380
- ------------------------------------------------------------------------------------------------------------------------
Borrowings .............................. 127,424 21,470 60,207 1,000 -- 210,101
- ------------------------------------------------------------------------------------------------------------------------
Total deposits and borrowings ......... $3,740,670 $ 1,242,827 $ 404,984 $ 1,000 $ -- $ 5,389,481
========================================================================================================================
Excess (short fall) of interest-earning
assets over interest-bearing liabilities. $1,129,290 $(1,071,871) $ 154,576 $ 36,262 $ 17,132 $ 265,389
Cumulative gap ............................. 1,129,290 57,419 211,995 248,257 265,389
Cumulative gap - as a % of total assets:
September 30, 1998 ...................... 19.11% 0.97% 3.59% 4.20% 4.49%
December 31, 1997 ....................... 24.82 1.35 2.71 3.54 3.93
September 30, 1997 ...................... 19.85 0.79 1.60 2.68 3.19
========================================================================================================================
<FN>
(1) Based upon contractual maturity and repricing date.
(2) Based upon contractual maturity, repricing date and projected repayments
and prepayments of principal.
(3) Subject to immediate repricing.
</FN>
20
The six-month gap at September 30, 1998, was a positive 19.11% (i.e., more
interest-earning assets reprice within six months than interest-bearing
liabilities). This compares to a positive six-month gap of 24.82% at December
31, 1997, and 19.85% at September 30, 1997. Downey's strategy of emphasizing the
origination of adjustable rate mortgages for portfolio continues to be pursued.
For the twelve months ended September 30, 1998, Downey originated and purchased
for investment $1.5 billion of adjustable rate loans and mortgage-backed
securities which represented approximately 93% of all loans and mortgage-backed
securities originated and purchased for investment during the period.
At September 30, 1998, 99% of Downey's interest-earning assets mature,
reprice or are estimated to prepay within five years, essentially unchanged from
December 31, 1997, and a year ago. At September 30, 1998, loans and
mortgage-backed securities with adjustable interest rates represented 83% of
Downey's loans and mortgage-backed securities portfolios. During the third
quarter of 1998, Downey continued to offer residential fixed rate loan products
to its customers primarily for sale in the secondary market. Downey prices and
originates such fixed rate mortgage loans for sale into the secondary market in
order to increase opportunities for originating ARMs and generate fee and
servicing income. Downey does originate fixed rate loans for portfolio to
facilitate the sale of real estate acquired in settlement of loans and which
meet certain yield and other approved guidelines.
At September 30, 1998, $5.0 billion or 91% of the total loan portfolio
(including mortgage-backed securities) consisted of adjustable rate loans,
construction loans and loans with a due date of five years or less, compared to
$4.7 billion or 94% at December 31, 1997, and $5.1 billion or 94% at September
30, 1997.
The following table sets forth on a consolidated basis the interest rate
spread on Downey's interest-earning assets and interest-bearing liabilities as
of the dates indicated.
September 30, June 30, March 31, December 31, September 30,
1998 1998 1998 1997 1997
- --------------------------------------------------------------------------------------------------------
Weighted average yield:
Loan and mortgage-backed securities 7.82% 7.91% 7.94% 7.95% 7.80%
Investment securities ............. 5.78 5.84 5.84 5.79 5.75
- --------------------------------------------------------------------------------------------------------
Earning assets yield .............. 7.73 7.82 7.86 7.87 7.72
- --------------------------------------------------------------------------------------------------------
Weighted average cost:
Deposits .......................... 4.81 4.93 4.96 5.00 5.00
Borrowings:
FHLB advances ................... 5.85 6.18 6.17 6.11 6.04
Other borrowings ................ 8.36 6.56 6.19 6.15 5.78
- --------------------------------------------------------------------------------------------------------
Combined borrowings ............... 6.00 6.26 6.17 6.12 5.98
- --------------------------------------------------------------------------------------------------------
Combined funds .................... 4.86 4.97 5.02 5.11 5.11
- --------------------------------------------------------------------------------------------------------
Interest rate spread .................. 2.87% 2.85% 2.84% 2.76% 2.61%
========================================================================================================
The weighted average yield on the loan and mortgage-backed securities
portfolios at September 30, 1998, decreased to 7.82%, compared to 7.91% at June
30, 1998, 7.95% at December 31, 1997, and 7.80% at September 30, 1997. At
September 30, 1998, the one-to-four unit residential ARM portfolio, including
mortgage-backed securities, totaled $4.3 billion with a weighted average rate of
7.56%, compared to $4.5 billion with a weighted average rate of 7.58% at
December 31, 1997, and $4.5 billion with a weighted average rate of 7.41% at
September 30, 1997.
ASSET QUALITY
Non-Performing Assets
Non-performing assets declined during the quarter by $4.2 million to $44.6
million at September 30, 1998, or 0.75% of total assets. The decline was in the
single family category. Non-performing assets at quarter end include non-accrual
loans aggregating $16.9 million which were not contractually past due, but were
deemed non-accrual due to management's assessment of the borrower's ability to
pay.
21
The following table summarizes the non-performing assets of Downey at the
dates indicated.
September 30, June 30, March 31, December 31, September 30,
(Dollars in Thousands) 1998 1998 1998 1997 1997
- --------------------------------------------------------------------------------------------------------------------
Non-accrual loans:
One-to-four unit residential .................... $15,397 $19,047 $17,736 $20,816 $21,602
One-to-four unit residential - subprime ......... 2,479 1,107 832 -- 174
Other ........................................... 20,677 20,259 20,060 20,883 20,383
- --------------------------------------------------------------------------------------------------------------------
Total non-accrual loans ....................... 38,553 40,413 38,628 41,699 42,159
Real estate acquired in settlement of loans, net .... 5,423 7,576 10,414 9,626 13,072
Repossessed automobiles ............................. 611 764 688 795 477
- --------------------------------------------------------------------------------------------------------------------
Gross non-performing assets ..................... $44,587 $48,753 $49,730 $52,120 $55,708
====================================================================================================================
====================================================================================================================
Allowance for loan losses (1):
Amount .......................................... $31,444 $31,736 $31,817 $32,092 $30,918
As a percentage of non-performing loans ......... 81.56% 78.53% 82.37% 76.96% 73.34%
Non-performing assets as a percentage of total assets 0.75 0.84 0.85 0.89 0.95
====================================================================================================================
<FN>
(1) Allowance for loan losses does not include the allowance for real estate
and real estate acquired in settlement of loans.
</FN>
At September 30, 1998, the recorded investment in loans for which
impairment has been recognized totaled $13.5 million (all of which were on
non-accrual status). The total allowance for possible losses related to such
loans was $1.3 million. During the third quarter of 1998, total interest
recognized on the impaired loan portfolio, on a cash basis, was $0.5 million.
For the first nine months of 1998, such income totaled $1.4 million.
Delinquent Loans
During the 1998 third quarter, total delinquencies declined $2.5 million or
6.1%. The decrease occurred primarily in the residential one-to-four units
category which declined $3.7 million. That decline was partially offset by an
increase in automobile loans of $1.0 million. As a percentage of loans
outstanding, delinquencies were 0.71% at the end of the 1998 third quarter,
compared to 0.79% at year-end 1997 and 0.85% a year ago.
22
The following table sets forth the amounts of Downey's past due loans at
the dates indicated.
September 30, 1998 June 30, 1998
---------------------------------------- ----------------------------------------
30-59 60-89 90+ 30-59 60-89 90+
(Dollars in Thousands) Days Days Days (1) Total Days Days Days (1) Total
- -----------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $10,601 $ 4,302 $12,408 $27,311 $12,500 $ 5,271 $14,497 $32,268
One-to-four units - subprime ......... 741 1,334 505 2,580 535 -- 762 1,297
Five or more units ................... 155 -- -- 155 -- -- -- --
Commercial real estate ................. -- -- -- -- -- -- -- --
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 11,497 5,636 12,913 30,046 13,035 5,271 15,259 33,565
Non-mortgage:
Commercial ............................. -- -- -- -- -- -- -- --
Automobile ............................. 5,330 1,105 990 7,425 4,795 860 819 6,474
Other consumer ......................... 119 143 496 758 222 208 227 657
- -----------------------------------------------------------------------------------------------------------------------------------
Total loans ........................ $16,946 $ 6,884 $14,399 $38,229 $18,052 $ 6,339 $16,305 $40,696
===================================================================================================================================
Delinquencies as a percentage of total
loans .............................. 0.31% 0.13% 0.27% 0.71% 0.34% 0.12% 0.31% 0.77%
===================================================================================================================================
March 31, 1998 December 31, 1997
---------------------------------------- ----------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $14,532 $6,096 $14,487 $35,115 $12,099 $4,101 $18,579 $34,779
One-to-four units - subprime ......... 287 359 186 832 185 -- -- 185
Five or more units ................... 222 -- -- 222 -- 222 -- 222
Commercial real estate ................. 241 -- -- 241 -- -- 279 279
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 15,282 6,455 14,673 36,410 12,284 4,323 18,858 35,465
Non-mortgage:
Commercial ............................. -- -- -- -- -- -- -- --
Automobile ............................. 4,005 946 716 5,667 4,167 981 961 6,109
Other consumer ......................... 73 57 457 587 218 54 533 805
- -----------------------------------------------------------------------------------------------------------------------------------
Total loans ........................ $19,360 $7,458 $15,846 $42,664 $16,669 $5,358 $20,352 $42,379
===================================================================================================================================
Delinquencies as a percentage of total
loans .............................. 0.36% 0.14% 0.29% 0.79% 0.31% 0.10% 0.38% 0.79%
===================================================================================================================================
September 30, 1997
----------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $14,950 $5,851 $17,405 $38,206
One-to-four units - subprime ......... -- 114 60 174
Five or more units ................... 223 135 -- 358
Commercial real estate ................. -- -- 279 279
Construction ........................... -- -- -- --
Land ................................... -- -- -- --
- ---------------------------------------------------------------------------------------
Total real estate loans .............. 15,173 6,100 17,744 39,017
Non-mortgage:
Commercial ............................. -- -- -- --
Automobile ............................. 3,903 1,312 672 5,887
Other consumer ......................... 355 173 58 586
- ---------------------------------------------------------------------------------------
Total loans ........................ $19,431 $7,585 $18,474 $45,490
=======================================================================================
Delinquencies as a percentage of total
loans .............................. 0.36% 0.14% 0.35% 0.85%
=======================================================================================
<FN>
(1) All 90 day or greater delinquencies are on non-accrual status and reported
as part of non-performing assets.
</FN>
23
Valuation Allowances
Allowances for losses on all assets (including loans) were $40.6 million,
$54.8 million and $53.9 million, at September 30, 1998, December 31, 1997, and
September 30, 1997, respectively. For information on valuation allowances
associated with real estate and joint venture loans, see "Investments in Real
Estate and Joint Ventures" on page 18.
The total allowance for possible loan losses was $31.4 million at September
30, 1998, substantially unchanged from recent quarter ends. Included in the
current quarter-end total allowance was $31.1 million of general loan valuation
allowances, of which $2.8 million represents an unallocated portion. These
general loan valuation allowances may be included as a component of risk-based
capital, up to a maximum of 1.25% of risk-weighted assets. Net charge-offs
totaled $1.3 million in the 1998 third quarter, compared to $1.8 million in the
year-ago quarter. Included in the current quarter net charge-offs were $0.1
million associated with one-to-four unit residential loans and $1.2 million
associated with automobile loans.
The following table is a summary of the activity of Downey's allowance for
loan losses for the periods indicated.
Three Months Ended
----------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 1998 1998 1998 1997 1997
- -----------------------------------------------------------------------------------------------
Balance at beginning of period $ 31,736 $ 31,817 $ 32,092 $ 30,918 $ 31,188
Provision .................... 985 1,462 272 3,034 1,578
Charge-offs .................. (1,540) (1,877) (2,381) (2,346) (2,001)
Recoveries ................... 263 334 1,834 (1) 486 153
- -----------------------------------------------------------------------------------------------
Balance at end of period ..... $ 31,444 $ 31,736 $ 31,817 $ 32,092 $ 30,918
===============================================================================================
<FN>
(1) Includes a $1.4 million recovery of a prior commercial real estate loan
charge-off due to the previously mentioned settlement.
</FN>
24
The following table indicates the allocation of the total valuation
allowance for loan losses to the various categories of loans for the dates
indicated.
September 30, 1998 June 30, 1998 March 31, 1998
------------------------------- ------------------------------- -------------------------------
Gross Allowance Gross Allowance Gross Allowance
Loan Percentage Loan Percentage Loan Percentage
Portfolio to Loan Portfolio to Loan Portfolio to Loan
(Dollars in Thousands) Allowance Balance Balance Allowance Balance Balance Allowance Balance Balance
- ------------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units ........... $13,603 $4,413,757 0.31% $14,143 $4,426,563 0.32% $13,960 $4,496,768 0.31%
Five or more units .......... 409 41,143 0.99 309 27,736 1.11 399 38,877 1.03
Commercial real estate ........ 3,656 156,902 2.33 3,766 161,424 2.33 4,118 191,489 2.15
Construction .................. 1,087 92,779 1.17 1,137 95,664 1.19 1,072 89,989 1.19
Land .......................... 498 39,222 1.27 382 29,857 1.28 415 32,510 1.28
Non-Mortgage:
Commercial .................... 204 27,710 0.74 199 27,298 0.73 192 25,478 0.75
Automobile .................... 8,349 355,955 2.35 8,272 356,504 2.32 8,105 350,316 2.31
Other consumer ................ 838 44,026 1.90 728 44,530 1.63 756 45,529 1.66
Not specifically allocated ....... 2,800 -- -- 2,800 -- -- 2,800 -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans held for investment $31,444 $5,171,494 0.61% $31,736 $5,169,576 0.61% $31,817 $5,270,956 0.60%
====================================================================================================================================
December 31, 1997 September 30, 1997
------------------------------- -------------------------------
Loans secured by real estate:
Residential:
One-to-four units ........... $14,652 $4,607,545 0.32% $14,426 $4,592,296 0.31%
Five or more units .......... 314 38,278 0.82 417 50,896 0.82
Commercial real estate ........ 4,112 202,425 2.03 4,592 211,864 2.17
Construction .................. 847 70,865 1.20 718 60,459 1.19
Land .......................... 331 25,687 1.29 349 26,270 1.33
Non-Mortgage:
Commercial .................... 196 26,024 0.75 164 23,741 0.69
Automobile .................... 8,016 342,326 2.34 6,746 325,216 2.07
Other consumer ................ 824 47,735 1.73 706 47,067 1.50
Not specifically allocated ....... 2,800 -- -- 2,800 -- --
- ---------------------------------------------------------------------------------------------------
Total loans held for investment $32,092 $5,360,885 0.60% $30,918 $5,337,809 0.58%
===================================================================================================
CAPITAL RESOURCES AND LIQUIDITY
The primary sources of funds generated in the third quarter of 1998 were
principal repayments (including prepayments, but excluding Downey refinances) on
loans and mortgage-backed securities held for investment and available for sale
of $484.4 million and a net increase in borrowings of $54.5 million.
These funds were used primarily to originate loans held for investment of
$478.9 million (net of Downey refinances of $10.2 million) and to fund the net
increase of $60.7 million of loans held for sale.
The minimum liquidity ratio set by the regulators was reduced in the fourth
quarter of 1997 from 5% to 4%. At September 30, 1998, the Bank's ratio of
regulatory liquidity was 4.0%, compared to 4.8% at December 31, 1997, and 5.0%
at September 30, 1997.
Stockholders' equity totaled $470.8 million at September 30, 1998, compared
to $430.3 million at December 31, 1997, and $417.7 million at September 30,
1997.
25
REGULATORY CAPITAL
The following table is a reconciliation of the Bank's stockholder's equity
to federal regulatory capital as of September 30, 1998. The core and tangible
capital ratios were 7.11% and the risk-based capital ratio was 13.33%. The
Bank's capital ratios exceed the "well capitalized" standards of 5% for core and
10% for risk-based, as defined by regulation.
Tangible Capital Core Capital Risk-Based Capital
----------------- ----------------- ------------------
(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio
- -----------------------------------------------------------------------------------------------------------------------
Stockholder's equity ............................... $460,893 $460,893 $460,893
Adjustments:
Deductions:
Investment in subsidiary, primarily real estate (40,408) (40,408) (40,408)
Goodwill ....................................... (4,662) (4,662) (4,662)
Non-permitted mortgage servicing rights ........ (430) (430) (430)
Additions:
Unrealized gain on securities available for sale (1,403) (1,403) (1,403)
General loss allowance - Investment in DSL ..... 1,561 1,561 1,561
Loan general valuation allowances (1) .......... -- -- 31,149
- -----------------------------------------------------------------------------------------------------------------------
Regulatory capital ................................. 415,551 7.11% 415,551 7.11% 446,700 13.33%
Well capitalized requirement ....................... 87,610 1.50 (2) 292,035 5.00 335,092 10.00 (3)
- -----------------------------------------------------------------------------------------------------------------------
Excess ............................................. $327,941 5.61% $123,516 2.11% $111,608 3.33%
=======================================================================================================================
<FN>
(1) Limited to 1.25% of risk-weighted assets.
(2) Represents the minimum requirement for tangible capital, as no "well
capitalized" requirement has been established for this category.
(3) A third requirement is Tier 1 capital to risk-weighted assets of 6%, which
the Bank meets and exceeds with a ratio of 12.4%.
</FN>
YEAR 2000
Risks of the Year 2000 Issue
The Year 2000 issue is the result of computer programs being written using
two digits rather than four digits to represent the calendar year (e.g., "98"
for "1998"). Software so developed, and not corrected, could produce inaccurate
or unpredictable results or system failures commencing January 1, 2000, when
dates present a lower two digit year number than dates in the prior century.
Such occurrences may have a material adverse effect on Downey's financial
condition, results of operation, business or business prospects, as Downey, like
most financial organizations, is significantly subject to the potential impact
of the Year 2000 issue due to the nature of financial information. Potential
impacts to Downey may arise from software, computer hardware, and other
equipment both within Downey's direct control and outside Downey's ownership,
yet with which Downey electronically or operationally interfaces. Financial
institution regulators have intensively focused upon Year 2000 exposures,
issuing guidance concerning the responsibilities of management and the board of
directors. Year 2000 testing and certification is being addressed as a key
safety and soundness issue in conjunction with regulatory exams and the Office
of Thrift Supervision has authority to bring enforcement actions against any
institution under its supervision which it believes is not properly addressing
Year 2000 issues.
State of Readiness
Downey has established a four-phase process to address the Year 2000 issue.
In addition, Downey's Board of Directors oversees the Year 2000 compliance
project's progress through monthly status reports and quarterly reviews with the
Year 2000 project manager.
As part of the first phase, which is now completed, Downey completed an
inventory of all data systems to determine which are most critical to support
customer transaction processing and provide customer services. This inventory
not only included in-house systems, but those provided by third party vendors as
well. Systems were prioritized
26
as being mission critical, high risk, moderate risk or low risk, from which
modification plans were developed which place priority emphasis on those systems
requiring change and classified mission critical or high risk. Third party
vendors were contacted during this phase to determine their process and timeline
in correcting any Year 2000 compliance issues. In addition, commercial loan
borrowers of Downey were also contacted to determine the extent of their
preparations for Year 2000 and any potential impact Year 2000 may have on their
businesses and ability to repay loan obligations to Downey. Commercial lending
does not represent a significant portion of Downey's loan portfolio (i.e.,
approximately 0.3%); therefore, Downey believes the Year 2000 preparedness of
its commercial loan borrowers does not pose a significant risk.
Phase two of the process consists of making appropriate Year 2000
programming changes to Downey's in-house systems, while phase three consists of
acceptance testing and sign-off of both Downey's in-house and vendor provided
systems. The fourth and final phase of the Year 2000 compliance project includes
installation of the system modifications into Downey's daily operation. The
fourth phase is scheduled to occur once a system has been successfully tested
and determined to be Year 2000 compliant.
In addition to phase one, phase two has been completed and phase three has
begun with respect to Downey's in-house mainframe system, which performs all
significant loan, deposit and general ledger accounting processes. It is
expected that acceptance testing of the in-house mainframe system will be
completed by year-end 1998, with installation completed by the end of first
quarter 1999.
For Downey developed PC-based systems classified mission critical, all
programming changes and acceptance testing have been completed. Completion of
programming and acceptance testing of all other Downey developed PC-based
systems is expected to be completed by the end of first quarter 1999, as is the
installation of Year 2000 modifications.
The timing of Year 2000 acceptance testing and installation of all third
party vendor changes is dependent upon when such systems become available to
Downey. Downey has in place a process to monitor third party vendor progress in
making required Year 2000 corrections and, when completed, requires third party
vendors to represent that their systems are Year 2000 compliant. Although such
vendor representations are requested, Downey does not intend to rely solely upon
them. Rather, Downey intends to test such vendor programs or review testing
conducted by others for Year 2000 compliance.
In addition to the computer systems utilized by Downey, Downey has also
inventoried other essential services that may be impacted by Year 2000 issues
such as credit bureau information, telecommunications and utilities. Downey is
monitoring such essential service providers to determine their progress and how
they are addressing Year 2000 issues. To date, no information exists to suggest
such essential services will not be Year 2000 compliant.
Costs to Address the Year 2000 Issue
Currently Downey estimates that Year 2000 project costs will approximate $6
million. This cost is in addition to existing personnel who are working on the
project and includes estimates for hardware and software renovation or
replacement, as well as additions to existing staff who will be specifically
devoted to the project. Approximately 50% of the cost represents costs to
migrate to a new personal computer environment and to replace certain older
automated teller machines, both of which Downey might otherwise have implemented
/ replaced during the period notwithstanding the Year 2000 issue. As such, that
portion of Year 2000 costs will be amortized over the useful life of the
equipment. Of the estimated total expense, approximately $0.9 million has been
incurred to-date, $0.1 million in 1997 and $0.8 million during the first nine
months of 1998. The table below summarizes by year the estimated amount and
anticipated timing of the planned Year 2000 expense.
(In Millions) 1997 1998 1999 2000 Thereafter Total
- -------------------------------------------------------------------------------
Estimated Year 2000 expense $0.1 $1.9 $2.1 $1.0 $0.9 $6.0
===============================================================================
As Downey progresses in addressing the Year 2000 compliance project and
additional information becomes available, estimates of costs could change. At
this time, no significant data system projects have been delayed as a result of
Downey's Year 2000 compliance effort.
27
Contingency Plans
Downey believes its Year 2000 compliance process should enable it to be
successful in modifying its computer systems to be Year 2000 compliant. As
previously stated, acceptance testing and sign-off has begun with respect to
Downey's in-house mainframe system which performs all significant loan, deposit
and general ledger accounting processes. Acceptance testing and sign-off is
expected to be completed by year-end 1998, with installation completed by the
end of first quarter 1999. In addition to Year 2000 compliance system
modification plans, Downey has also developed contingency plans for all other
systems classified as mission critical and high risk. These contingency plans
provide timetables to pursue various alternatives based upon the failure of a
system to be adequately modified and / or sufficiently tested and validated to
ensure Year 2000 compliance. However, there can be no assurance that either the
compliance process or contingency plans will avoid partial or total system
interruptions or the costs necessary to update hardware and software would not
have a material adverse effect upon Downey's financial condition, results of
operation, business or business prospects.
28
PART II - OTHER INFORMATION
Item 6 - Exhibits and Reports on Form 8-K
(A) None.
(B) There were no reports on Form 8-K filed for the nine months ended September
30, 1998.
SIGNATURES: Pursuant to the requirements of Section 13 or 15 (d) of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
DOWNEY FINANCIAL CORP.
Date: November 2, 1998 /s/ James W. Lokey
-------------------------------------------------
James W. Lokey
President and Chief Executive Officer
Date: November 2, 1998 /s/ Thomas E. Prince
-------------------------------------------------
Thomas E. Prince
Executive Vice President/ Chief Financial Officer
29