Payment Card Industry Swallows Its Own Tail

By Anthony M. Freed, Information-Security-Resources.com Financial Editor

PCI DSS, the self-regulatory set of guidelines that the payment card industry and retail merchants use to encourage financial information security, may well have entered it’s death throes Tuesday, as evidenced by revealing testimony during the House of Representative’s Committee on Homeland Security hearings.

Why the dire prognosis?

Anyone who has been following the cascade of security failures plaguing the payment card industry in the last year, and punctuated by the still-shrouded breaches at RBS WorldPay (RBS) and Heartland Payment systems (HPY), has to acknowledge that there are major problems with security that need to be addressed pronto.

But the greatest threat to the survival of PCI DSS (Payment Card Industry Data Security Standard) may not be the ever-evolving tactics of the criminal hackers intent on a “big score,” but instead the dysfunctional nature of the relationships between the very parties the standards are meant to serve.

The squabbling and finger pointing displayed during the first quarter of 2009 within the industry itself has resulted in nothing less than a public relations nightmare in my opinion, as major card brands, processors, and merchants each seek to deflect responsibility onto the others.

Someone on the sidelines, intently watching the game, would have to wonder what the heck these people are thinking.

First, RBS WorldPay and Heartland maintain that because they had been PCI DSS compliant at some point before their systems were breached, they can essentially shrug off any any culpability for the security lapses, offering only the caveat that they are doing the best they can with what they have.

Almost simultaneously, the PCI Security Standards Council was staunchly asserting that no company that suffers a breach can be considered PCI compliant – regardless of their being listed as in good standing with the council at the time of the breach.  From Securosis.com:

Businesses that are compliant with PCI standards have never been breached, says Bob Russo, general manager of the PCI Security Standards Council, or at least he’s never seen such a case. Victims may have attained compliance certification at some point, he says, but none has been in compliance at the time of a breach, he says.

Visa (V) echoed this sentiment in an interview with BankInfoSecurity.com:

“We’ve never seen anyone who was breached that was PCI compliant,” Phillips says without specifically naming – or excluding — Heartland. “The breaches that we have seen have involved a key area of non-compliance.”

To add to the confusion, Visa issued statements that RBS WorldPay and Heartland had been belatedly removed from the PCI Compliant list, in what has been widely considered to be merely legal maneuvering to effectively shield themselves from culpability while blocking the only alibi the processors have.

“It’s all legal maneuvering by Visa,” says Gartner security analyst Avivah Litan in an interview with ComputerWorld.com. “This is PCI enforcement as usual: They’re making the rules up as they go.”

This was apparently seen as an opportunity by some Heartland competitors to move in on some of Heartland’s clients, with reports of merchants being warned by other processors that they may be violating PCI compliance by continuing to do business with Heartland, and prompting Heartland to respond with threats of lawsuits.

Then, during Tuesday’s Congressional hearings, representatives of the merchant community, long thought to bear the brunt of security protocol “cram-downs” by the issuing brands, threw their hat into the ring in what now amounts to an industry free-for-all.  From Forbes.com:

Michael Jones, the chief information officer at the retail company Michael’s, testified that the PCI rules were “expensive to implement, confusing to comply with and ultimately subjective both in their interpretation and their enforcement.”

Now bear in mind, all of these factions are supposed on the same team, and all are supposed to be working in unison to continue the evolution of ever more secure systems to thwart the increasingly resourceful criminal hackers.

Is it any wonder that the future of PCI DSS is in question?

And what could possibly be worse than an entire industry at each others throats in the midst of the biggest security problems they have faced to date?

Well, they could make enough of a brouhaha that they attract the attention of lawmakers, as they have succeeded in doing; lawmakers who have regularly demonstrated their intention of late to force industries of all stripes to cede to their “better judgment.”  Also from Forbes.com:

“I’m concerned that as long as the payment card industry is writing the standards, we’ll never see a more secure system,” (Rep. Bennie) Thompson said. “We in Congress must consider whether we can continue to rely on industry-created standards, particularly if they’re inadequate to address the ongoing threat.”

This means that the PCI Security Council, keepers of the PCI DSS flame, have their work cut out for them if they want to remain the chief regulating body for PCI security. Maybe they left these issues to simmer on the back burner for too long, and maybe someone will be looking for a scapegoat.

It’s all uphill now.

During a phone call in early March with Lib de Veyra, VP of emerging technologies at JCB International and recently named Chair of the PCI Security Council, I expressed my concern over the state of relations between the various elements that make up the payment card industry.

I likened the public displays of policy incongruity and the tendency for all interested parties to respond to news of security lapses by rushing to throw each other under the bus, to that of the image of a snake swallowing its own tail.

I expressed concern by offering my opinion that the biggest threat to PCI DSS does not come from the endless supply of criminal hackers the industry will certainly face in perpetuity, but instead comes from the fractured portrait of an industry in crisis, and its inability to effectively manage itself.

That was one long month ago, and opportunity to avert the creation of a new regulatory body to oversee PCI may have already come and gone, which is most unfortunate everyone concerned.

PCI DSS is not broken, but the collective will to make it an effective standard for security just might be.

Anthony is a researcher, analyst and freelance writer who worked as a consultant to senior members of product development, secondary, and capital markets from the largest financial institutions in the country during the height of the credit bubble. Anthony’s work is featured by leading Internet publishers including Reuters, The Chicago Sun-Times, Business Week’s Business Exchange, Seeking Alpha, and ML-Implode.

The Author gives permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author and to Information-Security-Resources.com

Prime Targets in the Vicious Circle of Blame

By Guest Author and Good Friend Scott J. Wilson

Sunday March 22, 2009, Dateline NBC aired a piece called “Inside the Financial Fiasco,” in which Chris Hanson finally takes a break from exposing sexual predators to take a closer look at the current housing mess.

NBC attempts to assign blame for the mortgage meltdown, and also tries to make it seem like they have finally identified the handful people who were the “only ones who knew”  what lay in store for the economy when Wall Street embarked on the derivatives end-run that fueled the crisis.

So let’s go down the list of people that are prime candidates in the vicious circle of blame, and what their role where in the making of this fiasco.

Let’s start at the top.  Back in the mid ‘90’s, The Government loosened credit guidelines and required lenders to make mortgages available to more to minority buyers.

By doing this, they gave the lenders an open check book to write questionable loans, all the while  knowing that they would be able to sell them on the secondary market (Wall Street).

This was the creation of the infamous “Subprime” loans which later morphed into Alt-A and Expanded Approval loans.

Next, let’s look at the  Product Managers who wrote the underwriting guidelines for the toxic  loans known as SISA’s and NINA’s, which required little or no documentation of income and assets.  The SISA loans are highlighted in the Dateline piece.

Do you think that these product managers had no idea that these types of loans may be misused, or did they only see the underlying profit that was possible from billions of dollars of loan fees collected by creating millions of loans that were virtually just ticking time bombs?

Yes, there are some cases where these loans were appropriate, such as for the business owner who had a lot of write offs, or the borrower whose spouse may not have the best of credit, but will nonetheless contribute towards the monthly mortgage payments.

But the types of borrowers who where actually put into these loans were completely unqualified, as mentioned in the NBC piece.

People like Delores Parker Jackson, who took out multiple loans on four condos totaling over $1.3 million with a negative (-$6000) shown on her tax returns.

Mrs. Jackson, who claims to have run a profitable daycare, and says that she is not to blame, but is actually the victim of predatory lending.

REALLY?  She took out multiple mortgages on four different properties totaling over a million dollars with a payment of more than $10k a month, and she claims she had no idea that she could not afford the terms. Now she wants to pretend that she is not culpable, and that the mortgage company committed fraud?

Come on, do seem we that stupid?

Thirdly, let’s look at another “innocent” party:  The CEO’s of all the banks and mortgage companies.

These people should have overseen the product managers and acted as the final line of defense by looking out for the company’s long term interests by saying “Hey, stop!  These loans may be too risky.”

But the CEO’s saw only a “pot of gold” in the form of billions in loan fees, and where slaves to the corporate bottom line.

Do you think that Angelo Mozilo, the former CEO of Countrywide who earned over $400 million during his last five years at the company, had absolutely no idea that SISA and NINA loans with zero money down would backfire?

Chris Hansen attempts to talk to Mr. Mozilo, but to no avail.

Since he quit Countrywide and the mortgage mess started to blow up, Mozilo has been hiding out at his palatial estate in Southern California, ala Howard Hughes.  Chris tried to get the guard at Mr. Mozilo’s gate outside his house to let him in, but was turned away.

Also to blame are the former CEO’s at places like Bear Stern’s and Lehman Brothers, who ended up driving their companies into the ground by buying up these toxic securities.  And none of these guys saw the writing on the wall?

I think they did, but also saw big dollar signs in the racket, and choose to ignore the hazards.

Next up for their heaping of blame are The Borrowers.  I was an LO for 15 yrs, and used Countrywide as a purchaser for many of my loans.

I knew that some of my borrowers were “less than qualified,” but the underwriting said to “make the loan.”

Like when I would be working for a builder, and a borrower would come to me and asked what loan amount they qualified for, my reply often was, “How much can you afford?”

I told them that I could tell them all day how much they can and cannot get approved for, but only they could tell me how much they really afford.

I could tell them on paper or with calculator that you could qualify to pay,  but only the borrower could tell me if they could actually maintain that payment.

I cannot tell you how many times I was told by borrowers, “Don’t worry about me affording it.  You just write that mortgage.”

This is where I move on to include the next culprit in this mess,  The Loan Officers.

How many LO’s wrote loans for people that they knew would end up in foreclosure?

Many borrowers who I turned down for a mortgage would come back to me later to say, “See, I knew I could get approved.  Thanks for nothing.”

At the height of the bubble, there were so countless mortgage brokers who were willing to do anything to write a loan and collect a fee.

They would falsify the numbers to make them work if they had to.

In the Dateline piece, they showcase a woman who was employed as a personal trainer, and who claimed to of told the LO at People’s Choice that she only made $1600/mo.

She was approved for a $259k loan.

Even after she was told that the payment would be over $2100/mo, she figured that she would just have her sister move in and help with the payment.

Do you think that the LO at People’s Choice had any idea that she may NOT be able to make the payment on this house? When Chris Hansen looked at the original paperwork, it stated that she made $7300/mo, which surprised the woman.

She claims she never provided that figure to the LO.

How many LO’s committed fraud because the commissions that they were going to make on each loan they closed could be well into the tens-of-thousands of dollars?

Even though my job was commissioned based, I only made loans if I had some degree of certainty that the borrower had both the ability to pay the mortgage payment and that they completely understood why I was giving them a SISA or NINA loan product.

I did not want a former borrower hunting me down in the parking lot some night after work because I put them in a loan that that left them flat broke.

Next in line is a major player, one who no one seems to put much blame on or even mention much, The Appraiser’s. I believe these guys  had a huge impact on the housing explosion, and no one seems to want to bring them up.

As the appraisers continued to inflate the values of the properties, the mortgage companies continued to write mortgages to cover the obscene appraisals.

I knew that if a borrower told me that they were short on funds to close, I could call the appraiser and ask him to “bump up” the value of the property a bit, so that I could give the borrower the money cover closing costs.

This was considered a legitimate practice because real estate only increases in value, remember? But in reality, the value of that house did not go up $5k in the 2-3 weeks since they had done the actual appraisal.

I also found out the hard way how much of an “opinion” an appraisal really was.

Prior to working for the builder, I worked for a short time as a mortgage broker.  I only did one loan at the place. , and it was for a gentleman who was doing some renovations on his house, but did not have enough money to finish the project.

Less than a year earlier, the value of the house came in at $85k.  When he wanted to do another cash-out refinance a year later, but the new appraisal came in again at $85k.  So when I went to my boss and told him that I did not have the value to support the loan, he handed me a business card and said, “Call him.”

Two weeks later, I had an appraisal for $115k, enough to cover the loan.

Was there that much movement in the values of the house?  Did it really go up $20k in three weeks, or did the new appraiser just want more business?

What do you think?  I know when I worked for one of the big mortgage companies and did a ton of refi’s, every time I had to put an initial value of a home on an application (which typically came from the borrower) nine times out of ten, the appraisal came back with the exact same value.

Curious.

Another big part of the mess, the people who were supposed to catch any fraud or mistakes, were The Underwriters.

They were the final check points in the mortgage process, and when they were presented with a SISA loan that showed that a “house cleaner” made $12k/mo, they should have sounded the alarm.

Like the appraisers, the underwriters are merely mentioned in the piece on Dateline.

Ilene Lanacano, who worked for “People’s Choice,” says that when she brought up some of these problems with the questionable loans, she was often overruled by the CEO of the company.

She states that she was often offered “incentives” by loan officers (money, jewelry, even a car) to approve loans.  Ilene says that she never took any of these incentives.

She also claimed that there was harassment and intimidation if you did not approve loans, such as flattened tires and physical threats.

Ilene finally left “People’s Choice” for a consulting firm whose business was to analyze the loans to be pooled in Mortgage Backed Securities (MBS’s).  When she raised some flags, she ended up getting in trouble by management.

Next, let’s look to good old Wall Street. You would think that one of the supposed guru’s of Wall Street could have seen the possibility that at least some of these loans were destine fail.  But  they too, only saw the bottom line, and they sold these MBS to everyone:  investors, pension funds, municipalities and other countries.

And then there is China, who bought up trillions of dollars in MBS in an attempt to control the US.  By owning all these MBS, China has a huge stake in our mortgage meltdown.

They were only briefly mentioned in the “Dateline” piece, and no real repsonsibility was levied on them.  If China had not been so greedy, there wouldn’t have such a demand for MBS, which would have cut down the toxic loans being written.

And the Chinese are smart, shouldn’t they have seen some of the signs?

Next ones to heap some blame on are the Bond Rating Agencies, such as Standard and Poors, who was also briefly mentioned in NBC’s piece.

As Dateline explained, they were hired to give credit ratings to these MBS, which are supposed to indicate their level of risk to investors. “AAA” was the highest rating that they could give a security, and 80% of MBS received that top stamp of approval.

They suggested that most MBS would perform well, despite the fact that the agencies did not have any historical data to back the ratings up.  Richard Gufliota of S&P, stated that they were so over inundated with securities to rate that most were not examined to the extent that they should have been.

It should also be mentioned that they made their money in volume too.  More quantity over quality.

Finally, a lesser acknowledged culprit of this financial fiasco is The Media itself.

If it wasn’t for the greed of the media (TV, Radio and Newsprint), rolling out with advertisement after advertisement for these mortgage companies and their products, borrowers would not have been so encouraged to accept some of these toxic loan.

In years leading up to this mess, there wasn’t a commercial break that did not produce a mortgage ad.

Often advertised were the No Closing Cost, Stated Income, No Income Verified, and so forth.

There wasn’t a Radio host in the nation who didn’t have at least one mortgage company in their back pocket paying them to be their spokesperson.

Did any of them look into the products that they were pitching to their listeners?  Nope.  I think they just laughed all the way to the bank.

And what is strange about the media’s role, is that I have yet to see anyone try to add them into the equation.  Now, all you hear out of radio talk show hosts  spewed crap about how everyone else is to blame.  None have come forward to say, “Hey, I guess I had a hand in it too.”

All in all, it is going to be a vicious circle of blame.

There is plenty of blame to go around, and I think when it comes down to it, we can sum it all up with one little word:  “GREED;” the Greed of the Government, the greed of the Product Managers, the greed of the CEO’s, the greed of the borrowers, the greed of the Loan officers, the greed of the Appraisers, the greed of the Underwriters, the greed of Wall Street, the greed of China, the greed of the Bond Raters, and greed of the media.

“60 Minutes” Hauls Water for the FDIC

By Guest Author and Good Friend Scott J. Wilson

Is 60 Minutes the new propaganda department of the FDIC, or what?  Again, they drop the ball in their coverage of the mortgage crisis, leaving viewers more misinformed than ever.

My esteem for the fabled news show is quickly diminishing.

“Reporter” Scott Pelley had a piece on 60 Minutes on Sunday (03/08/09), in which he tries to comfort us by examining a bank being taken over on February 27, 2009, Heritage Community Bank in Chicago.

By showing the inside workings of a take over, “60 Minutes” (I think) was trying to put our minds at ease by showing how smoothly it goes.

But this is a bank of only 5 branches, with a total 12,000 deposits worth only $200 million. Not pocket change, but not any where in the same ballpark or even league as a big bank like B of A (BAC) or Chase (C).

In the story, they state that when Indy Mac (IDMCQ) went down it held close to $11 billion.  The FDIC levies premiums that they charge banks  to insure the deposits, and put the funds into a reserve for such failures.

The FDIC states that there were 25 closings in 2008, but as of the first two months 2009, there have  already 1been 6 closings.  The FDIC estimates that they will need $65 billion to cover closings over the next five years.

Let’s do the math:

-$65 billion over then next five years = $13 billion per year.

-If HCB is an average bank, don’t think that with five branches is that big = $200 million.

-That means they can handle 65 closings a year of these small banks.

So that being said, what happens if another Indy Mac goes down?

According to Sheila Bair (Chairman of the FDIC) the FDIC will never go broke.  It will always be backed by the government.

What does Bair think?  That the fed will just print some more money and give to her?  That doesn’t sound so good.

Now I have done some investigating of my own:   According to this piece, there are three things that the FDIC can do when a bank fails:

-They can close the bank and pay the depositors.

-They can close the bank as it was and run it themselves.

-They can sell the bank (as was the case in the HCB in this story.)

In the story, Heritage was sold to MB Financial (MBF) and things went on as normal they next day (Saturday) after the FDIC take over.  The FDIC paid MB $3.5 million dollars to take over Heritage.  The FDIC also insures that if any loan by HCB that goes bad in the near future will re-reimbursed up to 80% of the loan loss.

Okay, so this situation seems to have a happy ending.

But let’s say that a bank fails and the FDIC fails to get a suitable buyer, what happens if they don’t want to run it and they close it down.

I brought this question to the attention of my banker at Regions Bank (RF).  He informed me that the FDIC has up to TWO years to pay depositors their claim.  Yes it is insured, but if you don’t have access to your money for up to two years, what good is it going to do you?

What about the people who live pay check to pay check?  Or the seniors that have a limited cash flow and everything they own is in that one bank that went under?

Once I heard this from my banker at Regions, my wife and I decided to diversify in three banks.  This way if one goes under and no one buys it, I will have a back up.  We also took some cash and put it into our safe.

1. Why, do you say or wonder?  Well, lets to some thinking here:
2. Who, if anybody, remembers what happened during the depression?  Who really lived it?  Answer:  Seniors.
3. Who has some of the most assets?  Answer:  Seniors.
4. If there is a massive scare and there is a run on the banks, who do you think will be the first to come to the bank and withdraw all of their savings?  Answer:  Seniors.

And last, how many “average Joe” accounts would it take to equal what one senior couple would have in their account?  Answer:  I don’t know, but I know it is probably at least 10 to 1, probably close to 20 to 1 or higher.

So this is where we and the FDIC must be careful.

Keeping the confidence in the people who have the most at stake…seniors.  If there is a run on the banks, you can bet that the seniors will be the first ones in line to get their cash.

In the “60 Minutes” piece, they in fact show a senior citizen come in with an empty brief case in order to withdraw all his money.  Nothing  in this story examines how seniors can make or break this mess with run on the banks.

I have never been involved with a bank that was being taken over, but I am sure it is not as nice as the way they show it in this piece.

Heritage had been in business for 45 yrs and probably didn’t take some of the most risky loans such as the Chases (JPM), B of A’s and Well’s (WFC), but they get bailed out where these small banks seem to be just kicked to wayside.

One other thing that is brought up is when Pelley brings to the attention of Bair about what would happen if a big bank goes under and why they get bailed out and the small banks don’t, she suggests that we need to legislate the size of the big banks.

Make it so that they cannot exceed a certain limit to insure the fact that they cannot get too big and fail.

Bair says that the FDIC can and will not fail, what will happen if a Chase or B of A goes under.  I think that the FDIC would have a hard time handling one of those.

They won’t be able to just “print money” to clean up the mess without creating another snowball effect on the value of the dollar, let alone the consumer confidence.  That is something that Pelley should have investigated instead of how nice it was when this little five branch bank failed.

Heartland Now Under SEC Investigation

By Anthony M. Freed, Information-Security-Resources.com Financial Editor.

(Click to Enlarge)

During Heartland Payment Systems (HPY) quarterly Earnings conference call, CFO and President Robert Baldwin revealed that Heartland is indeed under SEC investigation, though the details of exactly why they are being investigated have not been released.

Company President and Chief Financial Officer Robert Baldwin Jr. disclosed the investigations during Heartland’s quarterly conference call with investigators (sic) Tuesday, saying that the SEC had launched an informal inquiry into the company and that there is also a related investigation by the Department of Justice. The U.S. Department of the Treasury’s Office of the Comptroller of the Currency (OCC), which regulates national banks and their service providers, has launched an inquiry, as has the FTC, he said.

Reached Wednesday, a Heartland spokesman could not say why the SEC was investigating the company.

However, the investigation may relate to stock trades made by Heartland Chairman and CEO Robert Carr after Visa notified Heartland of suspicious activity on Oct. 28, 2008. According to insider trade filings, Carr sold just under US$8 million worth of stock between Oct. 29 and the day the breach was disclosed. Heartland’s stock was trading in the $15-to-$20 range for most of these transactions, but it dropped following the breach disclosure. It closed Wednesday at $5.49.

This is trenchant to my January 29 analysis about the possibility that knowledge of the 2008 information breach may have influenced stock trades by Heartland CEO Robert O. Carr.  The article prompted an email response direct to me from Heartland representatives in which  they categorically denied any illicit trading activity on the part of Carr:

At the time of this announcement, Mr. Carr was not under any trading restrictions pursuant to the company’s insider trading policy and was not in possession of any material non-public information concerning the company. Under this 10b5-1 plan, programmed sales of company stock were made on Mr. Carr’s behalf, and he had no discretion regarding the timing or other aspects of those sales.

Although he was not required to do so, Mr. Carr terminated his 10b5-1 when the company confirmed the security breach it disclosed in the company’s press release of January 20, 2009. As has been reported, Heartland first learned of a potential problem from the card associations on October 28th of last year, well after the announcement of this 10b5-1 plan. Heartland categorically denies that Mr. Carr was aware of a potential security breach at the time he adopted his trading plan.

As CEO of the sixth largest payment card processor, I would hope that Carr would at times possess some non-public information on the company he built, but that is a topic for a different discussion on the overall CEO performance levels and our failing economy.

Here is the time line of the breach and Carr’s trades so far:

May 14, 2008:  Breach reported to have began May 20, 2008 Carr Makes first stock sale of the year, 2695 shares August (first week), 2008:  CEO Robert Carr’s 10b5-1 is proposed August 8, 2008:  Board approves 10b5-1 plan August 8 – August 14, 2008:  Carr makes six separate sales of stocks totalling 60,000 shares August 19, 2008:  Breach reported to have ended August 28, 2008:  Carr sells 80,000 shares September 3, 2008:  Carr sells 80,000 shares September 17, 2008:  Carr sells 80,000 shares October 15, 2008:  Carr sells 80,000 shares October 28, 2008:  Visa and MasterCard notify Heartland of problems; Carr sells 80,000 shares November 6, 2008:  Carr sells 80,000 shares November 20, 2008:  Carr sells 80,000 shares December 11, 2008:  Carr sells 80,000 shares December 26, 2008:  Carr sells 42,900 shares January 7, 2009:  Carr sells 80,000 shares January 12, 2009: Carr suspends his 10b5-1 stock selling plan January 20, 2009:  Breach Announced Sources:  (http://www.secform4.com/insider-trading/1144354.htm) (http://www.2008breach.com/)

Revelations that the SEC is investigating the stock trades comes on top of class action lawsuits spurred by the breach, as well as a steady decline in stock price.

Heartland has also been hit with a class-action lawsuit relating to the breach, which was publicly disclosed on Jan. 20. “We may, in the future, be subjected to other governmental inquiries and investigations,” Baldwin said during the call. “We intend to vigorously defend any claims asserted against us.”

An unofficial transcript of Heartland’s call can be found here.

The Heartland breach, which has now affected more than 500 banks across the country, leaving an untold number of consumers at risk of financial identity theft and Heartland stakeholders with a loss exceeding 50% in about one month’s time.

There is also another “undisclosed” breach which we are hearing about.  The breach itself has already been confirmed by Visa, and it is possible the breach will exceed Heartland in size.

Our team has been predicting that 2009 will be the year that InfoSec moves to the forefront of the economic crisis with Homeland Security implications.  We believe the somewhat obscure issue will be as familiar to the American public as the notorious subprime and pay option ARMs have in the last year or two.

Much like the meltdown of the mortgage industry, the revelations of lax governance in the handling of sensitive and private data will likely shock the public and the business community alike, and those revelations are bound to come all too painfully slow, especially for shareholders.

The data loss debacle at Heartland highlights the fact that the failure to secure information is the next major shareholder derivative, director and officer liability, regulatory, consumer product safety, and class-action issue to impact our economy.

More updates to follow.

More Heartland News:

Heartland Now Under SEC Investigation

Another Payment Card Processor Hacked

Heartland Breach: Fraud Activity Reported

Heartland Update: Reps Respond to Questions

Did Heartland CEO Make Insider Trades?

Anthony is a researcher, analyst and freelance writer who worked as a consultant to senior members of product development, secondary, and capital markets from the largest financial institutions in the country during the height of the credit bubble. Anthony’s work is featured by leading Internet publishers including Reuters, The Chicago Sun-Times, Business Week’s Business Exchange, Seeking Alpha, and ML-Implode.

The Author gives permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author and to Information-Security-Resources.com

Did Heartland CEO Make Insider Stock Trades?

By  Anthony M. Freed, Information-Security-Resources.com Financial Editor

Heartland Payment Systems (HPY) and Federal investigators have released more details about the technical nature of the massive financial data breach made public last week, but have refused to pinpoint the exact date that Heartland first became aware there may have been a problem with their network security.

The date they settle on may well be the difference between market serendipity and an SEC investigation for insider trading, as an examination of stock sales made by Heartland CEO Robert O. Carr in the second half of 2008 raises some serious questions about just who knew what and when in the latest version of the worst-ever information security breach which has now spawned a class action lawsuit.

Chart:  http://information-security-resources.com/wp-content/uploads/2009/01/heartland-stock-sales.gif

Federal investigators and the Secret Service have apparently traced the Heartland data breach to sources outside of North America, with some reports indicating Eastern Europe as being the most likely origin of the unauthorized access.

The principles and methods used by the perpetrator(s) have been uncovered, with evidence that is somewhat contradictory in nature, some of which is suspected of being nothing more than red haring planted by the hacker(s) to throw investigators off their trail.

Excerpts from Evan Schuman:

The sniffer malware that surreptitiously siphoned tons of payment card data from card processor Heartland Payment Systems hid in an unallocated portion of a server’s disk. The malware, which was ultimately detected courtesy of a trail of temp files, was hidden so well that it eluded two different teams of forensic investigators brought in to find it after fraud alerts went off at both Visa (V) and MasterCard (US:MA) according to Heartland CFO Robert Baldwin.

“A significant portion of the sophistication of the attack was in the cloaking,” Baldwin said.

Another consultant-who also wanted his name left out-said the ability to write directly to specific disk sectors is frightening. “Somehow, these guys went directly to the base level of the machine (to an area) that was not part of the file table for the disk,” he said. “Somehow, they got around the operating system. That’s a scary mother in and of itself.”

Other industry brains were less impressed. One nationally recognized and certified information security expert who I corresponded with Wednesday evening regarding the breach indicated that the hackers exploited a system weakness that should have been well known to Heartland, for which protocols issued several years ago.

From my email conversation:

“This was an ‘I told you so’ moment for me. I know exactly which part of the process got hit. It was the un-encrypted Point-to-Point connection which occurs between the Host Security Module (HSM) and the Application Security Module (ASM).

“But that means that they had to have had a hole in their firewall to insert the sniffer into unallocated disk space. “

“Now Heartland is crying poor me, and the making it sound like they are heroes by claiming that they are going to ‘develop’ end to end encryption. They should have been using the ISO Banking Security Standards which were promulgated in 2004/2005. They should be expected to uphold the standard.”

It looks as if the techies have already dissected the mechanics of this modern day cyber-cat-burglar, but ten days later we still have no clear idea of how long the sensitive data was exposed or when Carr and other Heartland executives first had an indication that something was not as it should be.

More from Evan Schuman:

Heartland CFO Robert) Baldwin also added more details to the sketchy timeframes that have been revealed thus far about the attacks, specifying that Heartland was contacted by Visa and MasterCard “in very late October,” possibly October 28.

Given that authorities are conducting an investigation, it is understandable that many details will not be released until after an arrest is made, but given the nature of the details that have and have not been revealed, one has to wonder who all is actually under investigation here.

Usually in an on-going criminal investigation, details are withheld from the press and public for many different reasons, but generally it is the mechanistic details of the crime, and often all the press has to report on is the headline and a timestamp.

Oddly enough it is the those details of the crime that have been trickling out that one would not expect – including the suspects possible location – but yet the generalities are being obscured, like what was stolen when did they steal it?

The answer to the latter of the two questions is of particular issue.

If Heartland personnel, and particularly Bob Carr, had absolutely no indication that something was awry with their processing system security until they were alerted by Visa and MasterCard at the end of October, then there is no problem.

Under this scenario, according to the chart above, Carr just happened to be in the middle of a major sell off of Heartland stock unlike any he has ever undertaken before when he found out “late in the fall” about the existence of problems.

It could simply be the case that Carr just happen to decide to sell 80,000 shares of Heartland stock for roughly $1.6 Million a pop on nine separate occasions about every other week in the four month period leading up to the announcement of the breach. These uncharacteristically large and more than frequent liquidations just happen to have occurred while the company was in the middle of an expensive acquisition and expansion of services push, all of course while the credit markets were in total dysfunction.

If on the other hand, company communiqué and records reveal that Heartland knew of possible anomalies in the processing security at the end of August instead of at the end of October, then we have a whole other scenario to apply the data to.

Under this hypothetical situation, Heartland may have discovered problems prior to end of August and may have known it was something serious simply because no one could figure it out. According to the official company statements, this was a difficult intrusion to detect, one that was missed more than once.

Again from Evan Schuman:

The initial internal conclusion was that “it looked most likely that it would be in a certain segment of our processing platform,” said Baldwin, adding that Heartland does not want to identify what that segment was. The company hired a forensic investigation team to come in and focus solely on that one area, an effort that ultimately proved fruitless. “We found issues in a large segment of our processing environment. The one that looked like the most promising turned out to be clean,” he said.

That second team “was nearing conclusion” and was about to make the same assessment the first team did: clean bill of health. But one of the last things that external, qualified risk assessor did was to try and match various temp files with their associated application. When some orphans-.tmp files that couldn’t be matched to any application or the OS-were turned over to Heartland’s internal IT group, they also couldn’t explain them, saying that it was “not in a format we use,” Baldwin said. More investigation ultimately concluded that those temp files were the byproduct of malware, and more searching eventually located the files in the unallocated portions of server disk drives.

So, continuing with the hypothetical scenario, Heartland would have had inside personnel looking for the problem when they get a call of Visa and MasterCard with the friendly heads-up. Heartland could have just not acknowledged the problem until their business partners forced them to.

The end of August is of interest because this is when Carr began to sell of large blocks of stock about every other week, and this was a significantly different trading pattern than Carr had engaged in previously.

If documentation turns up that indicates Heartland knew of serious problems with their network security prior to August 28th, these huge and rapid sell-offs by Carr may look more than suspect to the SEC.

I can not see the strategic value of withholding an accurate timeline of what exactly the company and Carr knew, and when exactly they knew it. But, if it turns out that everything is kosher here and all is as Heartland has indicated so far – which is very little – then I guess I just don’t understand Carr’s trading strategy over the last half of 2008 and how it related to his goals as a CEO for the growth an performance of his company.

They seem to be at odds, but that is no crime, just ask anyone who shorts their own company from time to time. It just needs to be cleared up. Not to worry though, as this is nothing that a solid and well documented timeline won’t be able to take care of (hint hint).

Meanwhile, Heartland’s stock (HPY) bounced back a little Wednesday, but is still trading at nearly half of it’s value prior to the breach announcement.

The data loss debacle at Heartland highlights the fact that the failure to secure information is a growing national security threat, and will be the next major shareholder derivative, director and officer liability, regulatory, consumer product safety, and class-action issue to impact our economy. 

By  Anthony M. Freed, Information-Security-Resources.com Financial Editor. Anthony is a researcher, analyst and freelance writer who worked as a consultant to senior members of product development, secondary, and capital markets from the largest financial institutions in the country during the height of the credit bubble. Anthony’s work is featured by leading Internet publishers including Reuters, The Chicago Sun-Times, Business Week’s Business Exchange, Seeking Alpha, and ML-Implode.

The Author gives permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author and  Information-Security-Resources.com

Heartland CEO: Breach as Bad as Tylenol Poisonings

 

By Anthony M. Freed, Information-Security-Resources.com Financial Editor

Heartland Payment Systems stock (HPY) was hit hard in the wake of what is being described as the biggest single breach of consumer and financial data security ever. The company issued statements Friday (1/23) in an effort at damage control in which the CEO compares the potential industry-wide impact of the breach to none other than that of the Tylenol poisonings of some twenty-five years ago that nearly brought down the drug maker.

Not the kind of association I would want to make for my company, but then it’s not my company.

Worse yet, Heartland’s press release was crafted with the kind of classic crisis-response-mode denials, deflections, and spin that we have all become so accustomed to in other sectors of the financial industry.

The data loss debacle at Heartland highlights the fact that information security will be the next major shareholder derivative and D&O liability issue, regulatory, consumer, and national security threat, and class-action litigation subject to impact our ailing economy.

Heartland CEO Robert O. Carr’s statements do not contain any details of the breach or anything resembling an apology to consumers and shareholders. Instead, Carr gave himself a pat on the back for expanding Heartland’s client base in spite of exposing millions of people and hundreds of banks to fraud and losses.

“Despite the headwinds of the economy and attacks by some of our competitors, we have installed new merchants, new payroll clients and new check management clients since our disclosure of the breach on Tuesday morning,” Carr stated.

The press release further states “Heartland Payment Systems added more than 400 merchants to its client base in the past few days – exceeding results for the same period from last year.”

When Carr does finally address the breach, he seems to imply that the lapse in data security is some kind of validation of Heartland’s capacity to respond to threats to its customer base and stakeholders, but only after a breach is uncovered.  Carr even managed to sound almost self-congratulatory in the process:

“Our energized organization called on the owners of more than 150,000 business locations these past three days to help them understand the breach and what it means to them. I couldn’t be prouder of our entire organization for the way everyone has pulled together to help.”

Kudos Heartland? No.  The congratulations should instead go to the kind of executives who are proactive enough to make sure that the measures are in place from day one of contract negotiations with the systems and security providers to insure these kinds of problems never materialize.

As soon as Heartland’s stock began to tank in earnest late this week, leadership chose to respond to this breathtaking lapse in security and due diligence by acting first to reassure their clients and shareholders that all was well at the company, even a bit exciting lately – what with the opportunities the new security vulnerability will give those in the payment industry to share ideas with one another.

Now what about that data breach?  You know, the whole reason for the press release in the first place? Little was offered in the press release:

“No confidential merchant data, Social Security numbers, unencrypted personal identification numbers (PIN), addresses or telephone numbers were retrieved in what is believed to be a global cyber-fraud operation.”

If no critical data was exposed, what’s the real problem then?  Well, there are many.

First and most obviously is that for an unknown period of time some consumer and merchant data worthy of encryption were exposed to hackers and thieves when the data were briefly unencrypted and encrypted again during processing, according to bankinfosecurity.com.

Card reissue would solve that problem, albeit at some expense to the companies. I say companies (plural) because if Heartland’s system was exposed then it can be expected that the same vulnerabilities have been exploited in systems at other companies, perhaps even in other industries with similar data security software and systems.

Hence the scramble by law enforcement (FBI) and the entire financial industry to figure out what happened.

Also of note is a problem that has been at the forefront of information security from the beginning: The bad guys tend to know more than we do about the vulnerabilities in our data systems because it is worth a lot of money to them.

Aside from network audits and professionals who hunt for holes in security systems for a living (some of whom where at one time themselves hackers), most companies find out about information security issues after their networks are breached.

Even though industry leaders can show that they spend hundreds of millions of dollars on cyber-security, more and more resources – time, talent, money, reputation – are all being lost by reacting to threats after the fact.

There has been a marked increase in attempted and successful attacks on corporate, government, and military systems, yet the looming economic realities today are forcing information security executives and IT departments to try to do more protecting at less cost.

This situation poses a threat to the security of I call our financial identities, which are made up of the ever-accumulating bits of electronic information that increasingly represent the bulk of our identity and net worth, which can disappear in minutes from a sharp dip in the markets, or in the blink of eye with just the click of a mouse.

The economic downturn is further exposing our financial identities to fraud and exploitation from external threats such as criminally intent hackers, as well as from internal threats like budget cuts, cutting corners on security due diligence, or cash-hungry employees who may succumb to the temptation to sell sensitive datain the lucrative information and identity black-markets that thrive on the Internet.

Another big problem is that despite Heartland’s assurances, the company understands neither the size nor scope of the breach, let alone how it happened.

“Heartland does not yet know how many card numbers were obtained. Many reports in the press are speculative,” the press release states.

Well, there is a lot to speculate about.

Given the financial industry’s record of not fully disclosing damaging information to consumers or shareholders, even as required by law, it can be expected that further details of this case will reveal this breach is much worse than anyone is letting on, especially Heartland executives.

Heartland is the sixth-largest payment processor in the country, with as many as a quarter of a million payment and payroll clients, and they may be only one of many similar companies targeted in a broader criminal activity meant to defraud through malicious software known as “malware.”

Visa and MasterCard, who first recognized discrepancies in their own records, notified Heartland of a potential problems late in 2008.

“Visa and Mastercard instructing many card issuers to offer fraud-monitoring protection, replace cards, or do a combination of both for customers whose card purchases were processed by Heartland.”

Visa and MasterCard wouldn’t elaborate, citing an ongoing FBI criminal investigation. 

“Heartland should feel urgency to notify everyone who could be a victim, says Todd Davis, CEO of LifeLock, a fraud-monitoring service. “Victims are sitting naked, not knowing whether to take extra steps to protect themselves,” he says. “The default should be toward notifying all possible victims,” according to the Detroit Free Press.

Oh yes! The victims of this fiasco – what is on the agenda for them? Heartland’s press release instructs them to basically fend for themselves for now, which is a fairly typical response to consumer data breaches. 

“Consumers will know if their card account numbers have been used by reviewing their monthly statements. Cardholders should report suspicious activity to their issuing banks (the bank that issued the card, not the card brand). If unauthorized use is confirmed, cardholders are reimbursed for the fraudulent purchases and are not held financially responsible,” Heartland assures in their press release. 

Sounds painless enough, but I really doubt it will be pain free for those who will have to deal with it. 

Not only will this be a tremendously stressful and potentially time consuming endeavor for the affected cardholders, this is also a tremendous drain on the financial resources of an already troubled industry.

Heartland (HPY)‘s stock value has lost more than 50% of it’s twelve-month high. Visa (V) and MasterCard (US:MA) have seen similar declines. Ultimately, the lawyers will join the fray, multiple lawsuits will be filed, the costs will continue to climb, and shareholder value will continue to decline.

Information and data security are essential to protecting every single individuals financial identity, and every corporation’s value from falling prey to the most sophisticated forms of cyber-attack conceivable.

President Obama has indicated he is taking cyber-security very seriously, going so far as to announce the pending appointment of a cyber-advisor to spearhead efforts.

In this age of electronic everything, more than at any other time in history, losing data translates in very real terms to losing dollars, and that is widely accepted across most industries.

Moving forward, we should also start thinking of our financial identities, our investments, our assets, and all of our wealth as really being nothing more than data. Data to be to be kept safely, not lost or stolen.

Carr concluded, “Just as the Tylenol(R) crisis engendered a whole new packaging standard, our aspiration is to use this recent breach incident to help the payments industry find ways to protect its data – and therefore businesses and consumers – much more effectively.”

If Carr is comparing this breach to the Tylenol poisonings, a textbook commercial and consumer nightmare of epic proportion – including multiple deaths – then you know this breach is going to be something really, really big in the end.

The Authors give permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is given to Information-Security-Resources.com.

Anthony M. Freed, Information-Security-Resources.com Financial Editor, researcher, analyst and freelance writer who worked as a consultant to senior members of product development, secondary, and capital markets from the largest financial institutions in the country during the height of the credit bubble. Anthony’s work is featured by leading Internet publishers including Reuters, The Chicago Sun-Times, Business Week’s Business Exchange, Seeking Alpha, and ML-Implode. 

Financing The MBS Fix: The 800 Pound Gorilla

by Scott J. Wilson and Anthony M. Freed  

Since the United States Government has decided to go into the MBS business (Mortgage Backed Securities), I have noticed in all of the debate and coverage that there is a serious lack of knowledge on the part of our congressional membership and in the news media regarding the mechanics of such a plan, and no one has even come close to outlining the actual costs that will be incurred. 

I don’t expect government bureaucrats news jockeys to know and understand all the intricacies of the mortgage business, but someone, somewhere has to have wondered what exactly the long term costs required to administrate a program of this magnitude would be. 

What will happen when the government buys trillions and trillions of dollars of these “toxic” loans in this MBS bailout?  How many thousands of people will it take to do all the legwork on these mortgages?   Will there have to be a new government division created just for this purpose?  How many hundreds-of-millions of dollars will this plan need that has not been budgeted for – or even considered as of yet? 

Or will they contract this all out?  Then the real corruption can begin!  Can you imagine all the “deals” that will be made with “friends” to get these huge government-paid contracts? 

Everybody, there is an 800 lbs gorilla sitting in the living room of this banking bailout, and the general public doesn’t see it.  Trust me it’s there, and there are more than a few bank executives  that have taken notice. 

I know Hank Paulson and Ben Bernanke are quite aware of the situation. 

I worked for one of the three largest banks still standing, and I have done everything from marketing, originating, processing, closing, secondary markets, and even foreclosures – at one particular bank I would estimate that there were no less than 2000 people who work in foreclosures, loss mitigation, and short sales alone – and that was before the bubble popped when foreclosures were minimal. 

Thousands upon thousands people will be needed to take care of foreclosures alone. 

In addition to this new government agency that will need to be created to manage these loans, there is also a highly complex computer system that will have to be developed to handle all the different formats and software that currently store the loan information at the different banks. 

There is also a tremendous risk to data security and system integrity in this process, with aditional costs of their own.

I know what a hassle it was when the bank that I was at purchased a block of loans from another bank:  We basically had to “build” a new in-house system to adapt to the format of the system that the loan information was stored on, and it could take weeks. 

This is just one bank assimilating one block of loans from another bank, nothing like the task of assimilating thousands of blocks of toxic loans from hundreds of different banks, with dozens of different systems and software packages being consolidated into one single system, and then expecting that system to run properly. 

As it never ran well with only two different systems, I can not imagine the nightmare of problems that lie ahead for the programmers on this project.  It literally will take years to get the data organized, and at a tremendous cost that has not been addressed. 

And then there are the servicing problems. 

The banks I worked for made tens-of-millions of dollars a month for “servicing” loans.   The bank gets a “servicing fee” every month for basically just collecting your payment.  They don’t make a lot on every loan, the basic principal is making a little on a large volume – and they do. 

This is a huge profit machine for banks, but it takes a large number of loans to be profitable, so large in fact that many banks just opt to sell the “servicing rights” to the big banks like Chase, Bank of America, and Wells Fargo for an SRP (service release premium), basically an upfront payment against the value of the servicing fees. 

The issue that I am getting at is this:  Who will do the servicing for all these toxic loans when the government buys them all up? 

If they let the banks service them even though the government holds all of the risk, the banks will be getting the best of both worlds.  The banks will get rid of the bad debt on their books courtesy of the American Taxpayer, and they still get to make a ton of money by servicing them for the government. 

And what happens if the taxes and insurance are not paid on the loan?  Normally it is the servicer’s responsibility to pay the taxes and insurance whether the borrower has paid them or not. 

Will this cost be passed on to the taxpayers too? 

Again, this is a division of the banks that employ tens-of-thousands of people – will this mean yet another government department will have to created?  Will it be contracted out? Either way, it is a tremendous expense to taxpayers that is not being addressed in any of the MBS bailout talk, and will be in addition to the cost of the assets to begin, which is all they seem to be discussing. 

More unseen costs of this MBS bailout. 

I don’t expect the government officials and journalists to know or understand all these small details of how the mortgage business operates, but if this is the business they are itching to get into, they should at least understand the basics of it before they dig our nation into a financial hole we will not be able to climb out of.

Goldman Sachs Evades Taxes, Takes Tarp Funds

By Anthony M. Freed

After being granted TARP bailout funds from good friend and former boss Hank Paulson, Secretary of the Treasury, it turns out Goldman Sachs is paying a whopping paying 1% on $2.3BB in profits for 2009, down from a more respectable 39% in 2008.

Although earnings were down and losses up in the end of 2008, Goldman sources reported that the astonishing tax windfall was more due to “changes in our geographic earnings mix.”

(click to enlarge)

When I heard “changes in our geographic earnings mix,”  I immediately thought of a document that a friend had sent me a while back, with a rather long list of off-shore hedge funds and other tax-evading rackets located in the Cayman Islands, Bermuda, Mauritius, and the British Virgin Islands – all infamous for their anti-American tax havens and utilized by US corporations to evade their legal dues – all of which are owned in one way or another by Goldman Sachs.

It kills me to think Goldman probably spends millions of dollars in order to avoid billions of dollars in taxes, and then turns around and asks the American people for a handout.

Oh, and then here come the layoffs…

Hopefully the Democratic led Congress will get to the bottom of some of the illicit relationships between regulators like Paulson and their Wall Street connections, unless they are too scared they will have to accept responsibility for some of the Fannie and Freddie mess.

How can we continue to subsidize tax evasion by our largest corporations while the nation is in an economic tailspin, and people are being thrown out on the streets.

It’s like asking the American Taxpayer to dig their own grave. It’s criminal!

The List:

Scadbury Funding Limited, Cayman Islands

Scadbury II Assets Limited, Cayman Islands

GS Killingholme Cayman Investments Ltd., Cayman Islands

GS Killingholme Cayman Investments II Ltd, Cayman Islands

Forres Investments Limited, Cayman Islands

GS Funding Management Limited (1), Cayman Islands

GS Capital Funding (Cayman) Limited, Cayman Islands

Goldman Sachs Investments (Mauritius) I Limited, Mauritius

Goldman Sachs LLC, Mauritius

Tiger Strategic Investments LTD, Mauritius

MLT Investments LTD., Mauritius

JLQ LLC Cayman Islands,

Goldman Sachs (Japan) Ltd., British Virgin Islands

GSEM Bermuda Holdings, L.P. Bermuda

GS Equity Markets, L.P. Bermuda

Goldman Sachs (Cayman) Holding Company, Cayman Islands

Linden Wood, LTD., Cayman Islands

Goldman Sachs Credit Partners L.P,. Bermuda

Goldman Sachs Specialty Lending CLO-I, LTD., Cayman Islands

Amagansett Funding Limited, Cayman Islands

Amagansett II Assets Limited, Cayman Islands

GS European Funding I LTD,. Cayman Islands

GS Funding Europe II Ltd., Cayman Islands

 

Sources:

http://sec.edgar-online.com/2008/01/29/0000950123-08-000857/Section57.asp

http://www2.goldmansachs.com/worldwide/cayman-islands/index.html

60 Minutes Blows the POA/ALT-A Loan Story

by guest author and good friend Scott J. Wilson

I know that I am just smart enough to get by, and I know am not a genius by any stretch of the imagination.  I have just been in the mortgage industry – working everything from mortgage sales to secondary markets – for more than fifteen years.

I happen to be watching CBS’s 60 Minutes tonight (12-14-08) and they had a piece called Mortgage Meltdown:  Where’s the Bottom? with Scott Pelley, who did the story, and not a very good job of it.  Either he or his writers need to better research their topic before they to such a report. 

Mr. Pelley failed to note that POA’s qualified borrowers with “teaser” interest rates, and not the actual “payment” interest rates.  But that is not what I am griping about.  My complaint lay in Pelley’s false assumption that no one but a few sage individuals could see these consequences of poor lending standards coming.

All of my experience is in the explosive Orlando, Florida area, so I know a thing or two about exotic mortgage products like the soon to be infamous Pay Option ARM (POA), ticking time-bomb of the mortgage world, and the subprime’s little brother ALT A.

 

During the bubble from in 2004-2006, I worked for one of the biggest lenders in the nation (one of the survivors thus far) and I doing a truckload of Condo-conversions.  I sold a hell of a lot POA’s to borrowers during that period, and most will all be recasting over the next two years.

I tried to always do one thing when I did sell a POA, I tried to explain to the borrowers exactly what these loans were intended for – people with season variances in income like construction and tourist trades, or for those whose income is mostly delivered from quarterly bonuses like sales people.

I did my best to point out to the borrower advantages and traps in POA’s.  That being said, I am no “expert” by 60 Minutes standards, let alone “one of (only) six experts in the nation who saw this (tsunami of foreclosures) coming,” as 60 Minutes called Mr. Eagan in tonight’s story.

I knew way back when in the bubble, as did most of the loan officers that I worked with, that these were potentially bad products if they were sold to the wrong borrowers, and that most would probably fail if they allowed more than 80% loan to value (LTV), or made them available to speculators and subprime borrowers.

I also know that most of these loan officers were not geniuses either.  Could we have been the only ones to know?  I doubt it.  So to say that the banks that offered them had no idea that POA’s had a high risk of potentially failing is just completely incorrect.

The bank’s own greed got the best of them; all they saw was the dollar signs in their eyes, as fees and points that filled their coffers.

The borrowers were really no less greedy– like I said, I did my best to explain, even tried to talk some borrowers out of using a POA to buy the property that they were interested in. But most times, it was to no avail.  They either didn’t care about the risks or worse yet, their Realtor “over talked” me and told them that I did not know what I was talking about, and that the POA was their best choice:

Real estate always goes up, remember? It’s different here!  No need to worry about that negative amortization loan if you stick with the only payment you can really afford, the one with the 1% teaser, your house will be worth double what you paid for it in a year or two!

But, unfortunately, the problem as the banks saw it wasn’t that these loans were going to fail in droves, nope.

The problem the banks saw was that the people were using these loans as short-term real estate investment loans with a really low initial payment, giving the investors time to remodel the property in order to “flip” the house and then move on to the next investment without having to sink so much capital into principle and interest with a higher interest commercial loan payment.

The banks were not making enough money, so they started tacking on prepayment penalties, which investors took as a cost of doing business and the banks thought of as a new revenue stream.

So the big banks and mortgage lenders had to have done some sort of analysis of these POA loans (I know Anthony did when he worked for them, whether the executives ever really read them I don’t know).

Did they not anticipate that the loans would be bad?  That if someone who was taking this completely unaffordable loan out for a long period of time they would get burned, especially if the borrower had a two or three year pre-pay penalty on it and the market took a quick downturn, leaving them unable to refinance – just like it did.

Come on though, everyone can’t be so smart that we all saw this coming, but the leadership at Corporate of these mega-institutions did not – especially when they were offering No Income/No Asset options as well – now commonly know as “Liar-Loans” for their lack of any documentation in exchange for a higher interest rate.

Again, profit driven.

At one point, I told people that it was not a matter of if you can qualify or not for an Option ARM or not, if you had below-average or sub-prime credit, you would qualify , with no problems.  All I had to do, was run their credit and if they had a 620 credit score (below average credit at the time), then I told them that they were approved with out even having an underwriter look at it.

Underwriters could approve even lower scores with the advent of “risk-based” and “exception” pricing add-ons, basically charging more for the additional risk posed by a riskier borrower, hence the birth of the ALT A loan, among other expanded approval products meant to sell more loans to more people.

So to have Mr. Pelley and 60 Minutes do this completely un-researched and absolutely baseless story that has little or no semblance to the truth is a more than a shame – lots of people knew this crisis was headed our way.  

Hell, I wouldn’t be surprised if close to a million people knew that these loans were problems and a lot of them were going to fail.  Do you think that any of them just might have worked in upper management of a these now failing banks?

Or are we really all just geniuses after all?   

Well in that case then, I’d say my superior intellect makes me really doubt it.

**************************************

Please check out our new website: 

Information Security Resources:

Or goal is to help financial industry stakeholders, government regulators, and the public better understand and address the mounting information security threats inherent in the current financial crisis. 

 Our concern is centered around the failure of organizations to adequately protect regulated systems and data.  Our current focus is on the exposure of private info and sensitive systems during the financial meltdown, including identity theft, privacy breach, info stolen, credit card fraud, and other enormous liabilities. 

 

In addition to the obvious threat to market stability, the financial debacle has the added element of national and global security concerns. We believe we are among the very first working to highlight this national security problem.

 

We believe this is the next national security, shareholder derivative, D&O liability, regulatory, consumer product safety, and class-action issue.  We teach you how to find this problem, and fix it.

New York Federal Reserve Opens ‘Pawn Shop’ to Buy Up ABS Junk

By Anthony M. Freed

On Wednesday, December 3, 2008 The New York Federal Reserve website reported that they will begin to purchase Asset Backed Securities (ABS) from failed mortgage giants Fannie Mae and Freddie Mac, as well as the Federal Home Loan Banks. They also hinted that they will stop there – everything seems to be on the table now, officially.  Treasuries and stocks may see direct effects, with outcomes mixed.

Initially, the program will concentrate on non-callable, fixed-rate senior benchmark securities such as Mortgage Backed Securities (MBS), but there are indications in the language used that the program may expand to include other ABS such as privately issued MBS (non-GSE), bonds, stocks and other equities.

The New York Fed will post the time and date of the auctions and the list of securities to be included in the auctions one business day in advance.

From the perspective of several analysts I have spoken with this morning, the consensus is that this is the most significant effort the Government has made to date, and not surprisingly they are moving forward with as little fanfare as possible as they basically kick the barn doors wide open on this bailout – just as many of us predicted when they first pitched this bailout as an effort to help homeowners.

This program is only making taxpayer dollars available to everyone who lost money in risky securities that had promised high yields in short periods, and doing nothing to stem the flood of foreclosures, and doing nothing to modify the mortgages of those who can avoid foreclosure at current 30 year market rates, if given the opportunity.

Again, everyone except the taxpayers benefit. Remember, the beneficiaries of these bailouts are the same people who realized obscene profits while helping to manufacture the bubble.  Now that those profits have been divvied up, their companies have been left broken and under-capitalized because of their greed and ineptitude, they are back for more of our money.

There may be benefits to borrowers, as the effort to relieve the balance sheets of banks may further reduce interest rates, which in turn could help boost real estate sales and mortgage applications – if the banks decide to let go of some of the capital reserves they have been trying to squirrel away in anticipation of a tough market and more writedowns in 2009.

From ClusterStock:

The Federal Reserve has also implemented a series of actions aimed at restoring the normal functioning of financial markets and restarting the flow of credit, including providing liquidity to a range of financial institutions, working with the Treasury and the Federal Deposit Insurance Corporation (FDIC) to help stabilize the banking system, and providing backstop liquidity to the commercial paper market. The Federal Reserve supported the actions by the Federal Housing Finance Agency (FHFA) and the Treasury to put the housing-related government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, into conservatorship, thereby stabilizing a critical source of mortgage credit. The Federal Reserve has also recently announced that it will purchase up to $100 billion of the debt issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and up to $500 billion in mortgage-backed securities issued by the GSEs.

The threat to everyone lies in exactly how the Government intends to pay for all of these various bailout plans without further stimulating inflation. Perhaps the reprieve in energy costs may allow for this program to get to work before there are any immediate inflationary concerns – many analysts are still just as worried the real threat may lay in deflation now that we know for sure that we have been in a recession for a year.

From In Money Today:

Paulson & Company have resorted to some extremely desperate measures to pull this one off. To fund the TALF, approximately $600-800 billion will have to be committed, which nearly equals the amount of the original bailout plan. $20 billion of that money is, in fact, coming from the bailout plan. The other remaining billions are being leveraged, a fairly astonishing fact whose implications remain unclear. One thing is for certain: if the Fed wishes to avoid an inflationary spiral, destruction of money will become a necessity once this crisis begins to abate.

With this much unprecedented Government intervention in the markets, I find it difficult to apply any models effectively in a predictive fashion. In the long run, I believe will be inflation and devaluation of the dollar – combined with the aftermath of record writedowns, mergers, buyouts, and outright failures that we will see in 2009 – that will be the legacy of these efforts.

More Band-Aids or bloodletting? 2009 will tell.

Purchasing Direct Obligations of Housing-Related GSEs

 

The following is intended to address operational questions about the program announced by the Federal Reserve on November 25, 2008 to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Effective December 3, 2008.In addition, individual auction results, including accepted offers, will be made available via FedTrade to the participating primary dealers. Similar to other outright operations conducted by the New York Fed, pricing information related to transactions will not be disclosed publicly.

Whom do dealers call if they experience difficulties during the auction?Primary dealers may call the New York Fed Trading Desk with submission and verification questions. For system related problems, dealers may call New York Fed Primary Dealer Support at 877-376-9837.

  

What is the policy objective of the Federal Reserve’s program to purchase direct obligations of the housing-related GSEs?The goal of these debt purchases, combined with the purchases of mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac and Ginnie Mae announced on November 25, 2008, is to reduce the cost and increase the availability of credit for the purchase of houses. Purchases of GSE direct obligations are intended to lower the spreads between rates on GSE direct obligations and U.S. Treasury debt, which have widened recently.

 

What type of GSE direct obligations will the Federal Reserve purchase under the program?At the beginning of the program, purchases will focus on fixed-rate, non-callable senior benchmark securities issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Over the course of the program, the Federal Reserve may change the scope of purchasable securities.

 

Who is eligible to sell GSE direct obligations to the Federal Reserve under the program?Primary dealers are eligible to transact directly with the Federal Reserve and are encouraged to submit offers for themselves and their customers.

 

How long will the program be in place?The program to purchase up to $100 billion in GSE direct obligations will be in place for the next several quarters, subject to conditions in the market for such securities.

 

Will these operations be reserve neutral?No, these operations will be financed through the creation of additional bank reserves.

 

Will the Federal Reserve Bank of New York lend GSE direct obligations purchased as a result of the program?Initially, GSE direct obligations held by the System Open Market Account (SOMA) will not be available to be borrowed through the SOMA’s daily securities lending program. The New York Fed may include GSE direct obligations in the SOMA’s daily securities lending program at a later date.

 

How will the auctions be conducted?Auctions will be conducted via FedTrade. Awards will be based on a multiple-price competitive auction process.

 

How often will the New York Fed conduct auctions to purchase GSE direct obligations?On average, purchases of GSE direct obligations will occur about once per week, subject to market conditions and holiday schedules. The New York Fed will publicly announce each auction on its website one business day prior to the auction.

 

How will the New York Fed determine which issues will be included in the auctions?The New York Fed will consult market participants and solicit available inventory from primary dealers in order to determine the list of securities to be included in each auction.

 

When will the New York Fed announce the auctions?The New York Fed will post the time and date of the auction and the list of securities to be included in the auction one business day in advance.

 

How will dealers submit their offers in the auction?Primary dealers will submit their offers via FedTrade once the auction has been opened, or approximately 30 minutes prior to the announced close time. The auctions will normally last 30 minutes and may be shortened or extended, at the discretion of the New York Fed.

 

How many offers can a dealer submit during an auction?Dealers are limited to three propositions per issue.

 

What is the minimum amount for which a dealer may submit offers?The minimum offer size is $1 million, with a minimum increment of $1 million.

 

How will the New York Fed communicate the auction results?Auction results will be posted on the New York Fed website following each auction. The announcement will include the offers received, offers accepted, and amount purchased per issue.

In addition, individual auction results, including accepted offers, will be made available via FedTrade to the participating primary dealers. Similar to other outright operations conducted by the New York Fed, pricing information related to transactions will not be disclosed publicly.

Whom do dealers call if they experience difficulties during the auction?Primary dealers may call the New York Fed Trading Desk with submission and verification questions. For system related problems, dealers may call New York Fed Primary Dealer Support at 877-376-9837.

 

FDIC Graphs Show the Extent of Financial Crisis

 

More Institutions Report Declining Earnings, Quarterly Losses: Troubled assets continued to mount at insured commercial banks and savings institutions in the third quarter of 2008, placing a growing burden on industry earnings. Expenses for credit losses topped $50 billion for a second consecutive quarter, absorbing one-third of the industry’s net operating revenue (net interest income plus total noninterest income). Third quarter net income totaled $1.7 billion, a decline of $27.0 billion (94.0 percent) from the third quarter of 2007. The industry’s quarterly return on assets (ROA) fell to 0.05 percent, compared to 0.92 percent a year earlier. This is the second-lowest quarterly ROA reported by the industry in the past 18 years. Evidence of a deteriorating operating environment was widespread. A majority of institutions (58.4 percent) reported year-over-year declines in quarterly net income, and an even larger proportion (64.0 percent) had lower quarterly ROAs. The erosion in profitability has thus far been greater for larger institutions. The median ROA at institutions with assets greater than $1 billion has fallen from 1.03 percent to 0.56 percent since the third quarter of 2007, while at community banks (institutions with assets less than $1 billion) the median ROA has declined from 0.97 percent to 0.72 percent. Almost one in every four institutions (24.1 percent) reported a net loss for the quarter, the highest percentage in any quarter since the fourth quarter of 1990, and the highest percentage in a third quarter in the 24 years that all insured institutions have reported quarterly earnings. 

Lower Asset Values Add to the Downward Pressure on Earnings:  Loan-loss provisions totaled $50.5 billion in the quarter, more than three times the $16.8 billion of a year earlier. Total noninterest income was $905 million (1.5 percent) lower than in the third quarter of 2007. Securitization income declined by $1.9 billion (33.0 percent), as reduced demand in secondary markets limited new securitization activity. Gains on sales of assets other than loans declined by $1.0 billion (78.7 percent) year-over-year, and losses on sales of real estate acquired through foreclosure rose by $518 million (588 percent). Among the few categories of noninterest income that showed improvement, loan sales produced net gains of $166 million in the third quarter, compared to $1.2 billion in net losses a year earlier, and trading revenue was up by $2.8 billion (129.2 percent). Sales of securities and other assets yielded net losses of $7.6 billion in the third quarter, compared to gains of $77 million in the third quarter of 2007. Expenses for impairment of goodwill and other intangible asset expenses were $1.8 billion (58.6 percent) higher than a year ago.  

Loan Losses Continue to Mount:  The industry reported year-over-year growth in net charge-offs for the seventh consecutive quarter. Net charge-offs totaled $27.9 billion in the quarter, an increase of $17.0 billion (156.4 percent) from a year earlier. Two-thirds of the increase in charge-offs consisted of loans secured by real estate. Charge-offs of closed-end first and second lien mortgage loans were $4.6 billion (423 percent) higher than in the third quarter of 2007, while charged-off real estate construction and development (C&D) loans were up by $3.9 billion (744 percent). Charge-offs of home equity lines of credit were $2.1 billion (306 percent) higher. Charge-offs of loans to commercial and industrial (C&I) borrowers increased by $2.3 billion (139 percent), credit card loan charge-offs rose by $1.5 billion (37.4 percent), and charge-offs of other loans to individuals were $1.7 billion (76.4 percent) higher. The quarterly net charge-off rate in the third quarter was 1.42 percent, up from 1.32 percent in the second quarter and 0.57 percent in the third quarter of 2007. This is the highest quarterly net charge-off rate for the industry since 1991. The failure of Washington Mutual on September 25 meant that a significant amount of charge-off activity was not reflected in the reported industry totals for the quarter1.

 

Growth in Reported Noncurrent Loans Remains High:  The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased to $184.3 billion at the end of September. This is $21.4 billion (13.1 percent) more than insured institutions reported as of June 30 and is up by $101.2 billion (122 percent) over the past 12 months. The percentage of total loans and leases that were noncurrent rose from 2.04 percent to 2.31 percent during the quarter and is now at the highest level since the third quarter of 1993. The growth in noncurrent loans during the quarter was led by closed-end first and second lien mortgage loans, where noncurrents rose by $9.6 billion (14.3 percent). Noncurrent real estate C&D loans increased by $6.9 billion (18.1 percent), while noncurrent loans secured by nonfarm nonresidential properties rose by $2.2 billion (18.1 percent). Noncurrent C&I loans were up by $1.8 billion (13.7 percent) during the quarter.

 

Nine Failures in Third Quarter Include Washington Mutual Bank:  The number of insured commercial banks and savings institutions fell to 8,384 in the third quarter, down from 8,451 at midyear. During the quarter, 73 institutions were absorbed in mergers, and 9 institutions failed. This is the largest number of failures in a quarter since the third quarter of 1993, when 16 insured institutions failed. Among the failures was Washington Mutual Bank, an insured savings institution with $307 billion in assets and the largest insured institution to fail in the FDIC’s 75-year history. There were 21 new institutions chartered in the third quarter, the smallest number of new charters in a quarter since 17 new charters were added in the first quarter of 2002. Four insured savings institutions, with combined assets of $1.0 billion, converted from mutual ownership to stock ownership in the third quarter. The number of insured institutions on the FDIC’s “Problem List” increased from 117 to 171, and the assets of “problem” institutions rose from $78.3 billion to $115.6 billion during the quarter. This is the first time since the middle of 1994 that assets of “problem” institutions have exceeded $100 billion.

 

Failure-Related Restructuring Contributes to a Decline in Reported Capital:  Total equity capital fell by $44.2 billion (3.3 percent) during the third quarter. A $14.6-billion decline in other comprehensive income, driven primarily by unrealized losses on securities held for sale, was a significant factor in the reduction in equity, but most of the decline stemmed from the accounting effect of the failure of Washington Mutual Bank (WaMu)2. The WaMu failure had a similar effect on the reported industry totals for tier 1 capital and total risk-based capital, which declined by $33.6 billion and $35.3 billion, respectively. Unlike equity capital, these regulatory capital amounts are not affected by changes in unrealized gains or losses on available-for-sale securities. Almost half of all institutions (48.5 percent) reported declines in their leverage capital ratios during the quarter, and slightly more than half (51.2 percent) reported declines in their total risk-based capital ratios. Many institutions reduced their dividends to preserve capital; of the 3,761 institutions that paid dividends in the third quarter of 2007, more than half (57.4 percent) paid lower dividends in the third quarter of 2008, including 20.7 percent that paid no dividends. Third quarter dividends totaled $11.0 billion, a $16.9-billion (60.7-percent) decline from a year ago.

 

Source FDIC:  http://www2.fdic.gov/qbp/index.asp

For more on what the graphs are telling you, read What are CAMELS ratings? Is My Bank Okay?

Graphs From Q2-2008:  Graphs – Not Laughs – From the FDIC Report

More:  Graphs show Gaffes – More from the FDIC Report

 

Federal Authorities Seize Newport Beach-Based Downey Savings and Loan

Downey Savings and Loan finally drew it’s last, painful breath, then released it in a sigh of utter relief as one of the longest, most painful bank insolvencies to date.

The body has been claimed by US Bank, which means if they don’t get killed by the same disease Downey did, they may end up owning as many homes in SoCal as people in SoCal do.

I think that US Bank is assuming we will all pull out of this economic tailspin soon, but it’s a still a hell of a long ways down, and the new pilot is just another Goldman Sachs – Council on Foreign Relations – IMF guy, and those are the guys that got us into this in the first place.

This from the OC Register, which has had to watch the Downey death throes up close for too long:

“Federal authorities seized Newport Beach-based Downey Savings and Loan as the thrift fell below capital requirements to stay in business, authorities said late Friday.”

“The Federal Deposit Insurance Corp. announced it was turning over management of the 51-year-old thrift to Minneapolis-based U.S. Bank. As part of the same action, the FDIC also turned over Pomona-based PFF Bank & Trust to U.S. Bank.”

“Depositors will automatically become depositors of U.S. Bank. Deposits will continue to be insured by the FDIC, so there is no need for customers to change their banking relationship to retain their deposit insurance coverage,” the announcement said.”

read more | digg story

Fannie and Freddie Suspend Foreclosures into January 2009

More “Hope for Homeowners” facing foreclosure, or just more hot-air from Washington, DOA?  Well it appears that Fannie Mae and Fredie  Mac – the semi-defunct, quasi-government holders of trillions in mortgage debt have announce today, November 20, 2008 that they will suspend foreclosure proceedings into January 2009, obviously the very very least they could do. 

The suspension will effect as many as 16,000 families facing a Holiday heave-ho.

In order to support the streamlined modification program announced on November 11, 2008, Fannie Mae (NYSE: FNM) today issued a notice to its loan servicing organizations and retained foreclosure attorneys directing them to suspend foreclosure sales on occupied single-family properties as well as the completion of evictions from occupied single-family properties scheduled to occur from November 26, 2008 until January 9, 2009.

The temporary suspension of foreclosures is designed to allow affected borrowers facing foreclosure to retain their homes while Fannie Mae works with mortgage servicers to implement the streamlined modification program scheduled to launch December 15. Foreclosure attorneys and loan servicers will be instructed to use the additional time to reach out to borrowers who have defaulted on their loans and continue to pursue workout options. The initiative applies to loans owned or securitized by Fannie Mae.

The streamlined modification program is aimed at the highest risk borrower who has missed three payments or more, owns and occupies the primary residence, and has not filed for bankruptcy. The program creates a fast-track method for getting troubled borrowers into an affordable monthly payment through a mix of reducing the mortgage interest rate, extending the life of the loan or even deferring payments on part of the principal. Servicers have flexibility in the approach, but the objective is to create a more affordable payment for borrowers at risk of foreclosure.

This is on the heels of FDIC Chair Sheila Bair’s announcement that yet another program to help stop this ridiculous and economically dangerous level of forecosures.

What about the thousands of families getting foreclosed upon between today and the day before Thanksgiving – they still need to make “other arrangements” for things like sleeping, eating, staying warm and dry, getting the kids to school, not losing their job while living out of their car – just the usual Holiday hustle and bustle.

So far the Federal Government has only had to pass one Bailout Bill for the Banks to get help (and everyone else who does not deserve it) and just one Bailout Bill to help out the most back-ass-wardly managed industry in the nation – the forever tank-building, electric car killing, anti-gas efficiency Auto contingency – but somehow it is taking four or five programs to help a fraction of the taxpayers at risk of foreclosure.

The WSJ Blogs had some premature self-congradulations from Fannie – given the record of troubled loan workouts ove the past year (numbers vary greatly from source to source), Fannie officials may want to tone down the expectations:

Fannie Mae will be working with foreclosure attorneys and servicers to reach out to the more than 10,000 borrowers the company estimates would be affected during this period. Borrowers who have Fannie Mae loans that are scheduled for foreclosure between November 26, 2008 and January 9, 2009, will be contacted directly by the attorney handling the foreclosure. If the home is occupied, Fannie Mae has instructed servicers and attorneys to suspend the foreclosure.

Allison also said Fannie Mae’s loan servicers are prepared to work with borrowers during this period, even if previous workout efforts have been unsuccessful. As part of the company’s “Second Look” initiative, Fannie Mae personnel have been reviewing seriously delinquent loans to determine if the borrower has been contacted and all workout options have been exhausted.

Given that everyone and their uncle seems to have lost their jobs – or are under threat of losing their jobs – we need all of the folks we can to be stable and housed – not on the virge of economic ruin and eviction – if we even think we are going to have a chance of beating down this Depression Demon that is trying to come to life.

Where’s the new Prez?  We need some serious leadership here and now, or this thing is going to be completely beyond reason by Q2-09.

A Foreclosure Solution so Simple it Would Work

By Anthony M. Freed

Here is the solution to most of the ills of the current housing crisis – in the form of a languishing US House Bill that would allow homeowners facing foreclosure the option to stay in their homes as renters, and perhaps even compel their lenders to be more cooperative with the distressed borrowers when negotiating loan workouts.

That’s right – a solution to the foreclosure problem that would save banks from certain ruin, keep homeowners in their homes instead of out on the streets and onto Public Assistance, put a bottom on the housing price crash while allowing for high-cost areas to come into par with median income levels, and save the taxpayer trillions of dollars in debt that is to be piled on to the trillions of dollars in debt we already own.

Sound too good to be true? That is understandable considering the constant barrage and misinformation being shoveled by the Federal Government’s sycophants like Paulson and Bernanke, the ridiculous political posturing of Barney Frank and his faux-hearings orchestrated to merely put the “official story” into the congressional record, and the complete and utter surrender of the Fourth Estate to news cycles and sound-bites.

The newest old proposal you have never heard of: Saving Family Homes Act.

Millions of people face the loss of their homes over the next few years. While the politicians in Congress have developed a wide variety of complex schemes in order to hold back this flood of foreclosures, including one passed into law last summer that provided up to $300 billion guarantees for new mortgages on homes facing foreclosure, none have had much impact thus far.

The unavoidable problem with these schemes is that it is difficult to design a plan that aids families facing foreclosure without giving an incentive to other homeowners to also default on their mortgage.

In addition, it is hard to justify taxing the people who are struggling to keep up with their own mortgages in order to help those who default. It is even harder to justify taxing ordinary people to help out the bank executives, who issued hundreds of billions of dollars of bad loans.

As a result, to date these programs have not prevented a tidal wave of foreclosures and evictions. The number of foreclosure filings (there are typically two or more filing for every actual foreclosure) is now approaching 300,000 per month.

 

I am sure there are some drawbacks somewhere in this plan, and it can be expected that there will be responses to this article and the legislation that will make some reasonable arguments as to why this bill should continue to languish in committee – as it has since MAY 2008.

But, I defy anyone to come up with a plan that is more practical, more easily implemented, would help more borrowers and lenders, and that would save the American Taxpayer trillions of dollars and a protracted economic downturn, perhaps even an economic depression.

With passage of this bill, the banks would be forced to either become the nation’s landlords – which is a business they do not want to be in under any circumstance – or working with homeowners to refinance or modify mortgages into affordable 30 Year Fixed products at current market rates.

This bill, or something similar to it could also provide opportunities to the renting ex-homeowners to later assume a mortgage and repurchase the home from the bank when the economy or as their personal financial situations allow.

While the basic point of the right to rent is simple, it can be extended in various ways to further aid homeowners. Bernard Wasow, at the Century Foundation, has proposed some additional measures to facilitate the transition to rental status or possibly a return to ownership. Daniel Alpert, of Westwood Capital, has a somewhat different version that creates a mechanism for homeowners to buy back their homes after five years.  

 

The alternative is a tsunami of foreclosures that further drives housing prices down for all of us as the banks potentially become the owners of 1/3 of all US homes, a drawn-out cycle of bank failures and continued taxpayer bailouts of a ‘select’ few banks, and ultimately the destruction of the dollar as a world currency with permanent state of stagflation.

That would be the end of the middle class.

The Bill: H.R. 6116: Saving Family Homes Act of 2008

HR 6116 IH

110th CONGRESS

2d Session

H. R. 6116

To allow homeowners of moderate-value homes who are subject to mortgage foreclosure proceedings to remain in their homes as renters.

IN THE HOUSE OF REPRESENTATIVES

May 21, 2008

Mr. GRIJALVA introduced the following bill; which was referred to the Committee on Financial Services

—————————————————————————

A BILL

To allow homeowners of moderate-value homes who are subject to mortgage foreclosure proceedings to remain in their homes as renters.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the ‘Saving Family Homes Act of 2008’.

SEC. 2. RIGHT TO RENT HOME SUBJECT TO FORECLOSURE.

(a) Exercise of Right- If, at any time after notice under subsection (b) for an eligible mortgage is provided to the eligible mortgagor and before the commencement of the 7-day period that ends on the first date that the foreclosing creditor may first commence or execute such foreclosure pursuant to such notice, the eligible mortgagor under the eligible mortgage that is subject to such foreclosure provides notice in accordance with section 3, notwithstanding such foreclosure or any other interests in the property, the eligible mortgagor may, at the sole option of the eligible mortgagor, continue to occupy the foreclosed property during the 20-year period that begins upon the commencement of such occupancy, subject to the requirements of subsection (c).

(b) Limitation on Timing of Foreclosure; Notice of Default and Right To Rent- Notwithstanding any other provision of law or any contract, a foreclosure of an eligible mortgage may not be commenced or executed before the expiration of the 28-day period beginning upon the receipt, by the eligible mortgagor, of written notice provided by the foreclosing creditor for the mortgage that–

(1) clearly states that–

(A) the eligible mortgagor is in default on the mortgage; and

(B) foreclosure on the mortgage may or will be commenced on account of such default;

(2) clearly states that the eligible mortgagor has the right, notwithstanding foreclosure, to continue to occupy the foreclosed property in accordance with this Act, and sets forth the terms of such occupancy under subsections (a) and (c); and

(3) identifies the first date, pursuant to this section and any other provisions of law and contract, that such foreclosure may be commenced.

(c) Terms of Periodic Tenancy- Occupancy, by an eligible mortgagor, of a foreclosed property pursuant to subsection (a) shall be under a periodic month-to-month tenancy under which the owner of the property may terminate the tenancy for material breach but shall have no authority, at will, to terminate the tenancy during the occupancy pursuant to subsection (a) if the mortgagor–

(1) timely pays to the owner of the foreclosed property rent on a monthly basis in the amount of the fair market rent for the property determined in accordance with section 4; and

(2) uses property as the principal residence of the mortgagor.

SEC. 3. REQUIRED NOTICE.

With respect to an eligible mortgage for which notice under subsection (b) has been provided, notice in accordance with this section is notice that–

(1) is made in writing;

(2) is submitted to–

(A) the court having jurisdiction and venue to conduct the covered foreclosure proceeding for the eligible mortgage or, in the case of nonjudicial foreclosure, the court in which an action is brought pursuant to section 5; and

(B) the foreclosing creditor; and

(3) states that the eligible mortgagor is exercising the authority under section 2(a) to continue to occupy the foreclosed property.

SEC. 4. DETERMINATION OF FAIR MARKET RENT.

(a) Initial Determination- For purposes of this Act, the fair market rent for a foreclosed property involved in a covered foreclosure proceeding shall be the amount that is determined by an independent appraiser who is licensed or certified, as applicable, to conduct appraisals in the jurisdiction in which the property is located, who shall be appointed for such purpose by the court conducting such proceeding or hearing an action pursuant to section 5.

(b) Periodic Adjustments- The fair market rent determined under subsection (a) for a foreclosed property shall be adjusted annually to reflect changes in the owners’ equivalent rent of primary residence component, for the appropriate city, region, or class of city, as available, of the Consumer Price Index for All Urban Consumers of the Bureau of Labor Statistics of the Department of Labor.

(c) Redetermination- If the owner of a foreclosed property or the eligible mortgagor under the eligible mortgage requests the court described in subsection (a) to redetermine the fair market rent for a foreclosed property determined pursuant to this section (as such amount may have been adjusted pursuant to subsection (b)) and agrees to pay any costs of such redetermination (including costs of the appraisal involved), the court shall provide for redetermination of the fair market rent for the foreclosed property in the manner provided under subsection (a), except that no such redetermination shall be made pursuant to a request under this subsection made before the expiration of the 12-month period beginning upon the most recent redetermination conducted at the request of the same party.

SEC. 5. NONJUDICIAL FORECLOSURE PROCEEDINGS.

In the case of any covered foreclosure proceeding that is not conducted or administered by a court, the eligible mortgagor may bring an action in an appropriate court of the State in which the foreclosed property is located for a determination of fair market rent for the foreclosed property for purposes of this Act, by filing notice in accordance with section 3 with such court and otherwise complying with the rules of such court.

SEC. 6. NO BAR TO FORECLOSURE.

This Act may not be construed to delay, or otherwise modify, affect, or alter any right of a creditor under an eligible mortgage to foreclose on the mortgage and to sell the foreclosed property in connection with such foreclosure, except that the right of any owner of the property to possession of the property shall be subject to the leasehold interest established pursuant to section 2(c).

SEC. 7. RIGHT TO REINSTATEMENT.

This Act may not be construed to affect any right of any eligible mortgagor to reinstatement of an eligible mortgage, including any right established under contract or State law.

SEC. 8. JURISDICTION OF FEDERAL COURTS.

At the option of the eligible mortgagor, a proceeding under section 4 or 5 shall be removed to the appropriate district court of the United States in accordance with section 1441 of title 28, United States Code.

SEC. 9. EFFECT ON STATE LAW.

This Act does not annul, alter, affect, or exempt any person subject to the provisions of this Act from complying with the laws of any State regarding foreclosure on residential properties, except to the extent that such laws are inconsistent with any provision of this Act, and then only to the extent of such inconsistency.

SEC. 10. DEFINITIONS.

For purposes of this Act, the following definitions apply:

(1) COVERED FORECLOSURE PROCEEDING- The term ‘covered foreclosure proceeding’ means a foreclosure proceeding with respect to an eligible mortgage, and includes any foreclosure proceeding authorized under the law of the applicable State, including judicial and non-judicial foreclosure proceedings.

(2) ELIGIBLE MORTGAGOR- The term ‘eligible mortgagor’ means a mortgagor under an eligible mortgage.

(3) ELIGIBLE MORTGAGE- The term ‘eligible mortgage’ means a first mortgage–

(A) on property that–

(i) is a single family property; and

(ii) has been used as the principal residence of the eligible mortgagor for a period of not less than 2 years immediately preceding the initiation of the covered foreclosure proceeding involved;

(B) that was made in connection with the purchase of the property by the mortgagor for a purchase price that is less than the median purchase price for residences that are located in–

(i) the same metropolitan statistical area; or

(ii) if the property is not located in a metropolitan statistical area or information for the area is not available, the same State; and

(C) that was originated before July 1, 2007.

For purposes of subparagraph (B), the median purchase price of residences located within a metropolitan area or State shall be determined according to information collected and made available by the National Association of Realtors for such area or State for the most recently completed month for which such information is available.

(4) FORECLOSED PROPERTY- The term ‘foreclosed property’ means, with respect to a covered foreclosure proceeding, the single family property that is subject to the eligible mortgage being foreclosed under the proceeding.

(5) FORECLOSING CREDITOR- The term ‘foreclosing creditor’ means, with respect to a covered foreclosure proceeding, the creditor that is foreclosing the eligible mortgage through such proceeding.

(6) OWNER- The term ‘owner’ means, with respect to a foreclosed property, the person who has title to the property pursuant to the foreclosure proceeding for the property, and any successor or assign of such person.

(7) SINGLE FAMILY PROPERTY- The term ‘single family property’ means–

(A) a structure consisting of 1 to 4 dwelling units;

(B) a dwelling unit in a multi-unit condominium property together with an undivided interest in the common areas and facilities serving the property; or

(C) a dwelling unit in a multi-unit project for which purchase of stock or a membership interest entitles the purchaser to permanent occupancy of that unit.

SEC. 11. APPLICABILITY AND SUNSET.

(a) Applicability- Subject to subsection (b), this Act shall apply to any covered foreclosure proceeding that has not been finally adjudicated as of the date of the enactment of this Act.

(b) Sunset- This Act shall not apply to any foreclosure proceeding commenced after the expiration of the 5-year period beginning on the date of the enactment of this Act.

Bernanke, Paulson and Bair Testify – But Can We get a Witness?

Bernanke, Paulson and Bair Testify – But Can We get a Witness?

By Anthony M. Freed

Two months ago, in late September, I penned a piece titled Liars, and the Lying Lies They Are Telling You, which examined just one single publicly available FDIC document from 2002 which shows beyond any doubt that the Feds were not only aware of the problems in the finance industry that have led to near economic collapse today, they were already convinced that there would soon be dire repercussions.

Yet, today we have Treasury Secretary Hank Paulson and his mini-me Neel Kashkari, as well as a host of other top Federal officials, testifying under oath that the threats to our economic security were not immediately apparent until just months ago – hence the gun-to-the-head threats that produced the biggest bailout of private industry in history, while prescribing less governance on the application of those funds than is required to redeem a typical twenty-cent manufacturers coupon for kitty-litter.

Now we will see Barney Frank and others on the Hill posture and shuffle, as they feign attempts to look like they are in control of anything whatsoever, and they will act surprised that they had handed Paulson and his boy a blank check, and they is spending it as they sees fit.

Well, there should be no surprise there if they actually took the time to read the legislation they passed.

Paulson, who is overseeing the bailout program for the Bush administration, changed course and announced last week that the government would not use any of the money to buy rotten mortgages and other bad assets from banks. That had been the centerpiece of the plan when Paulson and Bernanke originally pitched it to lawmakers.

“Our assessment … is that this is not the most effective way” to use the bailout money, Paulson said at that time.

Instead, Paulson said the department would focus on rolling out a capital injection program to pour $250 billion into banks in return for partial ownership stakes in them.

The idea behind the capital injection program is for banks to use the money to rebuild reserves and lend more freely to customers. However, banks do have the leeway to use the money for other things, such as buying other banks or paying dividends to investors. That has touched a nerve with some lawmakers. Locked-up lending is a prime reason why the U.S. is suffering through the worst financial crisis since the 1930s. All the fallout from the housing, credit and financial crises have badly hurt the economy, which is almost certainly in recession, analysts say.

FDIC chief Sheila Bair continues to be the loan voice – I mean lone voice – advocating that some of the crumbs of the Bailout Cake be scattered in the direction of distressed borrowers who are, or will soon be, facing foreclosure.

In a break with the administration stance, Sheila Bair, chairman of the Federal Deposit Insurance Corp., who also will testify Tuesday, recently proposed using $24 billion of the bailout money to help some American households avoid foreclosure. So far, the Treasury Department has pledged $250 billion for banks and has agreed to devote $40 billion to troubled insurer American International Group(AIG Quote – Cramer on AIG – Stock Picks) — its first slice of funds going to a company other than a bank. That leaves just $60 billion available from Congress’ first bailout installment of $350 billion.

As much as I appreciate that there is at least one person in the Federal Government’s ivory tower who has some sense of the pain and heartache that the American Homeowner is facing, even if her advocacy basically ends with the gavel and the conclusion of the hearings.

The hearings may address a lot of things today, but the most important thing they will not address is who is responsible for letting us get into this terrible position in the first place? Are we and the now completely vegetative national press, really expected to believe that no one saw this entire catastrophe heading our way, when a simple Google search will produce hundreds of documents that show that version of the truth is ridiculously false?

In the article Liars, and the Lying Lies They Are Telling You, I featured testimony by Karen Shaw Petrou and others who were sounding the alarm repeatedly, exposing the vulnerabilities to the system posed by the nearly industry-wide use of risk-abatement models that only work in a market that never contracts.

That was a fatal strategy on the part of the financial industry. The notion that Federal Regulatory agencies were not aware of the risks is patently false. From 2002:

“The next panelist, Karen Shaw Petrou, Managing Partner of Federal Financial Analytics, had a considerably different take on the appropriateness of the Basel initiative. Ms. Petrou said that she has significant concern with Basel II, not because the individual pieces of it are necessarily wrong but because “nobody understands how it all works together.”

Ms. Petroustressed that reliance on models on which the Basel rules are based must be evaluated with tremendous caution and a careful look at the bottom line. She also highlighted problems with the operational risk rule. Reputation risk is not included in the Basel definition of operational risk for purposes of determining a capital requirement. As another weakness of the Basel II proposal, Ms. Petrou stressed the difficulty with relying on models.

She suggested that the Basel Committee move forward only with the provisions of the rule on which there is widespread agreement and considerable evidence of immediate need.”

In the article, I half-jokingly asked if any readers happened to know where Karen Shaw Petrou was today, and wheter or not she was available to take either Paulson’s or Bernake’s jobs. Well, a friend from OpenSalon.com – Tom Cordle – was curious enough to follow through, and what he found is gold: More proof that the Federal Regulatory Agencies charged with protecting the economy, the nation, and the American taxpayer from the reckless profiteering that is the nature of capitalism were at best asleep on the job – at worst they were completely complicit in the manufacturing of this crisis.

The long and short of it is – WE ARE BEING LIED TO REPEATEDLY, AND THE PROOF IS AVAILABLE TO EVERYONE – CONGRESS, THE PRESS, AND ALL OF US…

Trillions of dollars of our tax money to bailout foreign investors, and nothing for distressed homeowners but failed programs and broken promises. The bailout money is now being directed to the Credit Card companies and foreign investors, and the icing is that they want us to believe that they never imagined this could happen.

That is a bald-faced lie. The following is subsequent Congressional testimony from Karen Shaw Petrou, this time the pudding is from 2006:

Testimony Of Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Before the Subcommittee on Financial Institutions and Consumer Credit

Committee on Financial Services

U.S. House of Representatives

September 14, 2006

This panel has led the way in recognizing the critical importance of the Basel risk-based capital rules, starting the policy debate in early 2002 with the first Congressional hearings on the rules long before many in the industry realized their critical importance. I was honored to testify then to offer views on the rules at that early stage and am grateful again now to outline ways to modernize the regulatory-capital requirements governing U.S. financial-services firms.

Sad to say, much of what I will say today is what I said in 2002 and at several later hearings on the proposal in the House and Senate. For example, in 2002, I urged the regulators carefully to consider the competitive implications of their rules. The House Financial Services Committee has pressed hard on this point and the agencies are now paying heed to it, but I fear that many aspects of the most recent proposal still do not address ongoing problems raised by the unique nature of the U.S. industry. It is different in many key respects from other national financial-services regimes, and U.S. rules must thus be carefully tailored to reflect U.S. reality.

There is, though, one key difference between 2002 and now: the Basel risk-based capital rules – for better or worse – are final everywhere else but here. Thus, we no longer have the luxury of pushing for a better international Accord. That is now final, and banks around the world will start to operate under it in January of 2007. This means not only that internationally-active U.S. banks will operate under anachronistic capital rules that place them at a disadvantage and that put the banking system at risk – that would be bad enough. However, it also means that foreign firms may have an undue capital advantage with which to enter the U.S. and acquire banks and other financial-services firms. As I said before this panel in May of 2005, M&A by global firms here is fine if it’s a fair fight. It isn’t fine, though, if our domestic institutions are gobbled up by foreign competitors able to engage in “regulatory arbitrage” solely because we can’t make up our minds on our capital standards.

What are the key U.S. financial-system realities that must be kept carefully in mind as new capital rules are finalized? Put very simply, they are:

• We are facing emerging financial risks, most notably in housing and mortgage markets. We can debate all day long if the housing “bubble” will burst or fizzle, but we know for sure that U.S. consumers are highly leveraged and are making use in unparalleled fashion of high-risk mortgage products. The current Basel I rules applicable to all U.S. institutions woefully under-capitalize high-risk assets, creating a regulatory incentive for banks to hold them. Getting the risk right in risk-based capital is not just an issue for model builders. It’s a critical challenge to protect the FDIC and the economy more generally.
• In the U.S. bank regulatory capital rules cover only insured depositories and a subset of parent holding companies. We have a wide range of charter options, the consolidated supervised entity (CSE) importantly among them, that permit astute companies to pick and choose among the charters. Outside the U.S., almost all firms fall under the Basel rules, eliminating much of the competitiveness concerns critical in the U.S. The Basel rules as now finalized may be good, bad or indifferent, but they will apply with few distinctions outside the U.S., ensuring the proverbial “level playing field.” We will have a most uneven one – with dangerous systemic-risk ramifications – if the final U.S. bank capital rules do not reflect our charter and supervisory diversity. The proposed operational risk capital standard is particularly problematic in our competitive and legal reality.
• We have a unique capital requirement, the “leverage” standard proposed now to continue under the Basel IA and II regimes. Advocates of leverage argue that it will counteract possibly risky drops in regulatory capital. However, the leverage standard, while providing false comfort, exacerbates the charter disparities noted above because it applies only to some financial-services players, not to all of them. It is, further, no panacea for the problems in Basel. This panel will well remember the thousands of banks and S&Ls that failed in the 1980s and early 1990s even as the leverage standard applied to each and every one of them.
• We have thousands of banks, savings associations and credit unions – not just the four or five big players that dominate most other markets. Initial plans simply to ignore all but the biggest U.S. banks in the Basel rules have rightly been shelved, but the current proposal still has unnecessary restraints on what size institution may choose which capital regime. Each insured depository and, when applicable, holding company should choose the rules it thinks are right for it, not have that choice defined by its regulators. Supervisors have full powers – actually expanded under the Basel proposals – to intervene and add more capital if they think an institution’s choice is risky.

With these thoughts in mind, I offer and urge the following recommendations related to the Basel rules in the U.S.:

• First, we need to get our rules in place as fast as possible. If we can’t make up our minds on the more complex issues, leave them aside and finalize at least the simpler, “standardized” sections of the rules (revised for U.S. mortgage and other issues as necessary) and the Basel IA requirements. As noted, the current Basel I rules encourage risk-taking because there is no regulatory capital penalty for it. A simple rewrite that better equates risk-based capital to risk is urgently needed, and debate over the fine points of these highly-complex rules should not deter action on their key points on which there is, in fact, broad general agreement.
• Second, we should not cling to the leverage standard in hopes that it will protect us from “undue” capital drops. I very much doubt that risk-based capital under Basel II would drop here in anywhere near the amounts suggested by the fourth quantitative impact study, which was based on top-of-the-cycle numbers and back-of-the-envelope estimates. Putting banks and their holding companies through all of the hoops and all the added expense of the Basel rules and then slapping the leverage standard atop them undermines the entire point and purpose of the Basel standards and – importantly – is far from the guarantee of safety and soundness hoped by those now pushing for retaining the leverage standard. It should be discarded – especially for holding companies – and regulators should rely on their own powers and market discipline to press banks that might consider unwise capital reductions to think again.
• Third, the U.S. rules should not include an operational risk-based capital (ORBC) standard. The Basel IA proposal rightly does not include this and it should similarly be omitted from the Basel II rules. While this will put the U.S. Basel II rules at still more variance with the international Accord, it is necessary because of the lack of any agreed-upon methodology or measurement systems for operational risk. Worse still, a focus on ORBC will distract both banks and supervisors from urgently-needed disaster preparedness and contingency planning – capital is no substitute for back-up systems and advance planning as was made all too clear after September 11 and Hurricane Katrina.
• Finally, we must make up our mind and move forward. All of the benchmarks, caveats, limits and questions in the Basel II rules create wholesale uncertainty about what capital rules will apply when to whom. As noted, U.S. banks operate in the real world of aggressive competitors at home and abroad. We have proposed imposing not only new risk-based capital standards, but also new powers for regulators to buttress these – Pillar 2 – and new disclosure standards – Pillar 3 – to enhance market discipline. Far too little attention has been paid in the current debate to these critical elements of the overall Basel framework – indeed, they are almost unmentioned in the current notice of proposed rulemaking. Rightly structured, however, these two additional pillars will give U.S. regulators all the tools they need to ensure that capital is right for each bank under their purview without forcing institutions into the one-size-fits-all leverage standard, benchmarks, and other constraints on Basel now under consideration.

In conclusion, Basel critics might wish none of this had started and the U.S. could just get back to Basel I as is. This is understandable given all the flaws in the initial proposal and all the problems to which regulators turned a deaf ear for so long. However, it is critical to remember that Basel I as is rewards risk-taking and the leverage standard as is will do nothing to constrain this. It is also vital to remember that major competitors at home and abroad are now or will soon come under a more risk-sensitive capital regime with no leverage standard. Each and every one of these firms is a major force to be reckoned with in the U.S. whether or not it chooses to become a bank under the Federal Reserve’s domain or headquarter itself here.

Thus, Basel II is here like it or not. Charters will be selected and deals done based on it, like it or not. The longer U.S. banks are kept under Basel wraps, the fewer of them there will be under our traditional regulatory framework. The longer Basel I is in place, the riskier our banking system will be – leverage standards now have no meaningful impact on risk other than to encourage taking it. Unless Congress is prepared to rewrite our rules and force all banks – big and small – and all competitors under the same capital regime – a major challenge that would keep Congresses busy for years to come – U.S. banks cannot be the last ones allowed to come under modern, risk-sensitive regulatory capital standards.

Message to Distressed Borrowers: You Have to Help Yourselves

By Anthony M. Freed

So you find yourself in tough times – a job loss, health problems, falling property values, or unexpected financial distress. Whichever the circumstances that may have brought you to this point, the facts are you find yourself falling behind on your mortgage payments, and the time to make some tough decisions is upon you.

Unfortunately, once you have reached this stage, the options available to you are few, and each has their own inherent advantages and disadvantages. Depending on your particular situation, one or another of these options may prove to be more advantageous to you down the road – or at least may leave fewer black marks on your credit report.

If you are a borrower under threat of foreclosure, and you are looking for an easy, pain-free resolution, I feel obligated to tell you now that there is no such option available to you. My hope is that the Government will somehow find a way to help distressed homeowners avoid foreclosure by requiring lenders to negotiate in good faith any and every alternative, but so far there seems to be little more than rhetoric available.

As it stands, the banks and financial institutions will be the only ones receiving anything in the way of support during this crisis. Homeowners will be left to the mercy of the lenders, who will decide for themselves whether or not they want to use our tax dollars to stop the tsunami of foreclosures, or whether they just want to sit on our money and pad their pockets with hundreds of millions of dollars in unjustifiable bonuses.

I think it’s safe to say we are all on our own for now.

What are the choices available, and what are the pitfalls? Obviously there is foreclosure, the least appealing of our options. Preferably, we are looking at alternatives to foreclosure, or a troubled loan workout as the industry refers to them.

Of these options we have a few to choose from, listed generally in order of preference to the borrower’s position (although each borrower’s situation is unique and the consultation of a professional long before you are facing foreclosure is highly recommended): the Refinance; the Modification; the Short Sale; and the Deed in Lieu of Foreclosure.

Today we cover the Refinance: Probably the device most understood by borrowers, the refinance entails entering into negotiations with a lender on a completely new mortgage note, with the potential to have a completely different term (the period in which all principle and interest payments must be satisfied), interest rate (the cost of financing the mortgage), points (the cost to secure the rate), closing costs (the fees paid to secure a mortgage, often requiring some out of pocket expenses such as a new appraisal), different monthly payments (principle, interest, taxes, and insurance – PITI), and different Private Mortgage Insurance (PMI) requirements (typically required on any mortgage with a Loan to Value (LTV) greater than 80%).

Refinance is the obvious first choice for everyone involved. The problem is that the vast majority of troubled mortgages were structured in such a way as to make refinance all but impossible. This is, of course, completely contrary to the “expert” advice the borrower probably received from the Broker or Loan Officer – not to put the blame all on their professions, as most were honest people who were pressured by management heavy-weights to perform or hit the road.

It was management at the most senior levels at the banks and mortgage companies who failed to employ proper risk-abatement in their race to be number one in the market by volume: Volume x Fees = tons of money in their pockets by cutting corners.

The loans they pushed were mostly high risk loans from 90% LTV to as much as 105% LTV. These loans were booked at the height of the housing bubble, and because home prices did not continue to rise at a ridiculous pace (which is what the risk-abatement models the lenders were using needed to have happen in order to be worth a damn, hence the mess we are all now in as a nation).

The major obstacle to refinance has resulted from rapidly dropping property values that leave most borrowers “upside-down” or “underwater” in their mortgage – this means that the borrower owes more on their current mortgage than the home is currently worth in the open market.

Most of the opinions I have encountered on this subject are completely unsympathetic to the borrower in general; so, if you put no money down on your home, secured an Adjustable Rate Mortgage (ARM), an Interest Only loan (I/O), or a Pay Option ARM (POA), qualified at the minimum payment to get into a bigger home, and now you find yourself unable to make the full payment for pretty much any reason at all, don’t expect anyone to give you any quarter.

Regardless of the circumstances – even those completely outside of your control – you are now automatically lumped into the same category as greedy house-flipping profiteers who gamed the system with multiple loans that left them leveraged to the hilt.

Sorry to break the news to you, but most everyone seems to agree that even if the lender lied to you about the terms or your mortgage and promised that you could refinance into a Fixed mortgage at anytime in the future, it’s considered to be your fault for being a sucker and not looking out for yourself.

Not in my opinion, as I think the lenders are liable for damages to borrowers for breach of fiduciary duty, but conventional wisdom these days seems to be completely unsympathetic to your situation. I highly recommend you don’t go looking for any, especially on internet web forums.

Trust me, it will only be salt in your wounds.

But what of those folks who did put 20% down at the peak, who have now seen median prices drop as much as 50%, and who now find themselves upside-down in their mortgage? These folks played by more traditional rules and now find themselves in a pickle, as the lender who holds the note refuses to refinance them out of their current terms and into the nice 30 year Fixed like they said they would.

Unfortunately, there is not much more sympathy for you than those that took the 100% financing. Sorry, but someone has to tell you.

Even more unfortunate is the fact that the rates on a Conforming ARM(less than $417k in most areas, but may be higher in some high-cost markets) are still more attractive than the current 30 year fixed rate, and they still allow homebuyers to borrow more for the purchase of a home than if they were to apply for the Fixed rate.

This is because a lower initial interest rate translates into a lower initial monthly payment, and thus can translate into a larger initial principle balance while maintaining the current Debt-to-Income ratio (DTI). The lenders only look at your ability to make the payment now, and give little regard to your ability to make the payment after the initial terms expire and the interest rate – and therefore the payment – adjusts to a significantly higher monthly payment than what the borrower can afford.

This is a major reason we are in such trouble now – so no matter how attractive those ARM rates are, my suggestion is that you seriously consider your ability to pay the adjusted rate, and not count on variables like rising property values or a future pay raise at work when considering the best mortgage product for your situation.

If you had put 20% down and now find that you owe more on your property than it is worth in the open market, I am sorry to tell you that there are no easy options for you at this point. The most important thing you can do is to take action before you miss any payments. If you are already behind in your payments, it is imperative that you act immediately to protect your interests.

The longer a borrower who is having, or anticipates having, financial problems that will prevent them from satisfying their contractual obligations as outlined in their mortgage waits to seek help, the fewer the options that will be available to them to prevent a foreclosure. Act now to get help before your credit is damaged.

The first step is to contact your Lender or Loan Servicer. The Servicer of your loan may be different than the lender who originated the loan, and also may be different than the current owner of the loan. This is because many lenders originate a loan and take the corresponding fees, then sell the loan to an investor, or to another lender. They may or may not retain the Servicing rights – which only means they act as the billing service for the note holder – and they may have no authority to negotiate a resolution.

You can waste a lot of time and energy barking up the wrong tree, so take the time to determine who the appropriate party to negotiate with is. If your loan was sold, you would have received a fairly non-explanatory letter to that effect, and you might have noticed you are getting billed by someone you have never heard of.

Once you have identified the correct party to negotiate with, you should make attempts to contact multiple parties within the company through multiple channels – regular mail, email, and by phone. If you want to find the person who can help you, you will need to blitz them with requests, because although the lenders and the Government have unveiled multiple programs to help distressed homeowners under threat of foreclosure, that does not mean they are actually doing them to the extent they like to pretend they are in the media.

Be sure to look for departments that have to do with legal, loss-mitigation, or modification. There will also be well-hidden departments who specifically handle the applications for Hope Now, the Hope for Homeowners, and other nearly-nonexistent programs designed to help homeowners avoid foreclosure. Unless you are lucky enough to be under or completely un-employed, you will probably not find enough hours in the day to jump through all of the hoops and do all of the self-educating you will need to do in order to save your home and credit rating.

Seek outside help.

There are multiple for-profit businesses and not-for-profit and organizations that are actively helping borrowers avoid foreclosure. Caution, there are a lot of scammers out there taking advantage of distressed homeowners, too.

Avoid any program that wants you to walk away from your mortgage, any program that encourages you to delay a foreclosure by filing for bankruptcy, and any program that stipulates you sign over interest-in or ownership-of your home to any other party. This includes any lease/buy-back programs that offer to buy your home and lease it back to you until you are able to repurchase the home in the future.

Although there may be valid options among these listed, generally they prove to be more problem than solution. I highly advise seeking the advice of a lawyer or community legal service prior to signing any contracts or obligating yourself any further.

Finally, if anyone offers you a solution to your current mortgage problem that does not involve some financial pain and loss, I would tend to believe that they are not giving you all of the facts. There are solutions beyond Refinance, as listed above, and articles to follow will address them one at a time in detail.

The takeaways from this article should be that there is some hope for help, and the earlier a homeowner can see the trouble coming and begin a dialogue with their lender, the better chance they will achieve a loan workout with the minimum of pain and loss.

(NEXT ARTICLE: Loan Modifications)

Related: “A Hardship Letter to Countrywide – Family on the Brink of Disaster”

“No Hope for Homeowners – Foreclosure Prevention Program Falters”

“Armed with Experience: A SHORT SALE STORY”

Armed with Experience: A SHORT SALE STORY

Mr. Freed, 

I just finished reading your article with “Kitty’s” Hardship Letter“ to Countrywide. This brought back some bad memories. Below is my short sale story I wrote for Wiki last July (2008).

If you can use it to help others please do. I wrote this for others to learn from my experience seeking no reward or payment.

All is verifiably true and unexaggerated as it happened. Please feel free to use it on your sight if you think it will help others.

Thanks Bart Horn

 

A SHORT SALE STORY

By Guest Author Bart Horn

 

I need to start off by saying I’m just an average hardworking homeowner caught up in this crisis, as many others are.  I have no professional training in the mortgage industry what so ever.  What is to follow is based off my own short sale experience. 

Negotiating with the lender and my real estate agent (REA) was extremely painful, and motivation enough to share this with the Wiki readership. I learned the hard way that it is a grave mistake to go forward with a short sale unprepared, without competent, professional assistance.

I was not careless or of simple mind, I was uninformed, plain and simple.

To put all circumstances in perspective, after living in a home we purchased for three full years, our first – not an investment property – we relocated to another state due to self imposed job transfer to facilitate my wife, who is permanently disabled, so as to be closer to her immediate family.

We placed our home on the market in June 2006, anticipating an expeditious sale at the beginning of the decline. Needless to say the home remained unsold and vacant for 18 months.

With all equity earned in the home sucked dry by unexpected home repairs from undisclosed problems with the home, that left us unable to reduce the price of the home to make the sale more attractive, that’s entirely another story. An offer did come in as last ditch effort, the only offer to enter escrow was right before the close; the buyer went into default in Dec 2007.  Merry Christmas.

All resources depleted we in turn defaulted with our lender the following month.

Seven mortgage payments behind with our home in the final stages of the foreclosure process, I was clueless to the real financial disaster in the making as I was just walking away from the loan, as the rest of the nation was doing in situations like mine. I had swallowed this “Wolfe Cookie” as I like to call it in its entirety.

I had it on the good authority from coworkers and colleagues who dabble in real estate that I could just walk away, let the bank own the problem, you’re safe, and they can’t come after you, what you going to do now that you have all that extra income?

Easy words to swallow. (I later discovered there is no “just walk away” regardless what anybody says. Here is a snapshot of the situation that awakened me to the truth of the matter, when I accidentally discover that I am in serious trouble.

With only three months remaining until the auction gavel falls, a near pay off CASH offer appears. Somebody up there must like me. Read on you will see it was quite the opposite. The $475K cash offer is what led me to this epiphany of doom.

My REA informed me of this offer late in July 08, that’s great, wow, still deaf, dumb and blind to the catastrophic train wreck about to happen. The question; what is the actual pay off price of the loan. With seven months of interest and late fees piling up the last 6 months I was unsure what the full pay off price actually was. I won’t go too far into this, but it is worth mentioning.

Three days spent with me and my REA I trying to get the banks attention to inform of this near payoff cash offer. Previously $120K and $160K down were denied a loan. What, were the banks out of money? I would call the lender who referred me to the law firm handling the collections matters who then would refer me back to the lender (law firm handling collections?).

Intensely frustrated as I was doing them a favor, I was to gain nothing from this; well I would be saving my credit, another mistruth. Looking back on it how could I make assumptions on something this important?

Unable to get satisfaction with either the lender or law firm to this simple question, I called a friend and neighbor where the home is located who also happened to be a local broker, maybe he could shed some light on a pay off price as I knew it was close.

Ground Zero!

It was then that my friend and neighbor informed me of the truth. The state I now reside in does not allow deficiency of judgments (DOJ) just as my coworkers and friends informed no hefty judgment to be concerned with however, to my shock and awe my friend drops a bomb that weakens me at the knees when I discover DOJ laws very from state to state, the state of the homes location does allow DOJ that indeed a hefty judgment will be coming at me very soon.

To compound my anxiety I discover not only am I liable for what would be the remaining deficiency of the unpaid balance on the note, but also the remaining deficiency of the “Fair Market Value” of the home or which ever is higher (who said carpet bagging is out of style).

Yep you guessed it, I was fortunate enough to live in one of the areas home depreciation did not hit the hardest, six figures easy I’m in Ohhh Nooo BK! WAIT, the cash offer will saver the day I’m sure of it. Now I am motivated to make this deal happen.

Friends of Wiki, as good intentioned as my coworkers and colleges were, never, never take advice from anyone other than competent professionals, as the road to HAIL is paved with good intentions.

When I emailed the DOJ news to my “Agent”, she politely informed me in her reply she was not an attorney, these types of legal matters should be referred to someone in a legal capacity. 3 points will earned. I don’t know how to say this other than with all caps:

THERE IS NO REQUIREMENT FOR REA (“Agent”) REPRESENTATION IN A SHORT SALE SITUATION

Period!

Now to finally get to the beginning of the negotiations process where I can answer your question using my example. In the beginning of August 08 we finally have the lenders attention confident this cash offer was a no-brainer short sale for the lender, buyer is in a hurry with a 30 day close, sold as is, subtracting REA commissions and various other costs incurred through escrow broken down in the HUD-1 left a deficiency of $34K.

Don’t lose track of the HUD-1 I will explain how it in itself was a primary cause to reconsider my position and the nail that sealed the coffin. Have I confused you yet, it will become clear in a moment.

In order to keep from getting sued I will use first names only. Bring on the lender’s highly trained loss mitigation team who skillfully know how far to go and which lines not to cross; I was tagged teamed by two of the finest, The Negotiators; Julio and Antonio! You got to be kidding me. I asked my “Agent” what the next step was she informed me to give them a call that she had no experience in these types of negotiations. I realized then I was standing alone.

Facing a giant of a lender which research showed (many, many hours of it) that this particular lender was and is one of the most notorious in predatory lending practices. I am feeling that lump in the back of my throat thinking of this next paragraph, I’m 22 years retired military I don’t get emotional easily).

If it were not for the direct involvement of one of the leading contributors of Wiki who as chance would have it answered the phone late on a Sunday evening and gave me insight and comfort as I was no longer standing alone, this new found friend would help me through it all to fight the good fight.

This person will remain anonymous as I don’t want to bother this person again on a Sunday afternoon to ask permission to use their name, although we remain good friends. With out this friend of Wiki’s involvement I would have been doomed. My friend made it clear that I held all the cards as I was the one with nothing left to lose. Allow me to explain:

1. Past due on over 5 months of mortgage payments, irreparable damage to my credit score far greater than BK or foreclosure, a short sale benefits nothing.

2. Monetary gain, this is a short sale, again benefits me nothing, all other parties the lender, the buyer and of course my “Agent” make out like Fat Cats.

 

Knowing all of this I was coached, no warned that these guys would rather commit financial suicide than to cave into my demands, to be prepared for that out come. The demands I was advised to put on the negotiation table were simple;

 

A. Instruct the lender to write off all the deficiency as paid in full with a “Credit Bureau Report” CBR clause (My mentor passed this beauty on to me) (still don’t know what it actually does). The CBR would nullify the lenders ability for the short sale to impact my already damaged credit score. In addition no 1099 to worry about, I walk away owing nothing or I’m BK we all lose. In other words;

 

I’m a man at the negotiation table with a grenade in each hand the pins in his teeth projecting a sardonic smile, but I’m not smiling. Now I know exactly where I stand. Take my terms or we’ll all go down together.

To summarize the final outcome and to finally answer your question: Three words “HARD SHIP PACKAGE” actually two words. Hardship Package (HP) or lack there of, the dummies lost the first one I sent via mail months earlier keeping the house on the market a tad longer.

Julio and Antonio insisted I send again. I let all the cats out of the bag my terms alone told them I was being coached by someone savvy. They set me up on a “super secure” server of the lenders for all further correspondence. I have yet to submit the HP, my “Agent” seems to think I have lost all control of my senses, angrily stating; this is not fair to the buyer to keep them hanging on like this (not fair to the buyer)? Leaning on me hard to get the HP in. HUD-1 submitted, the two BPO’s were in (favorable) all is ready except me and the HP. I almost did it. I’ll take the credit for this one; if it doesn’t smell right don’t bite into it.

I asked myself these questions and came up with one conclusion:

1. Two BPO’s were ordered (I pulled a BPO accession sheet from Fannie on line, isn’t the information age wonderful folks) A BPO is completed by REA “AGENTS” not appraisers. Looking at comps I suppose. They both came in lower than expected in the mid $400K. I looked at the comps myself they did not support the BPO’s, and the lender REP’s would not provide a hardcopy when I requested them.

Why not? (Foreclosure listing last week Sep 08 of the home listed a market value $518K. Not six figures but substantially higher than both verbal BPO estimates. Minimum bid $480, 12:00 pm sharp at the court house 01 Oct 08). They knew I would run if I knew the truth.

 

2. Why would another major lender not a settlement company “The Lender” offer me an 80% forgiveness on over $30K of unsecured debt? Around $10K less than the deficiency owed on the home loan on a “simple phone call agreement. No HP required. Written documented agreement faxed to me the following day. I was in the middle of my second of three installments of $2600 the terms of the settlement agreement and the reason I did not want to send my hardship package to the lender, as my records would indicate a residual of $2600, which I could only pay the first installment after selling a vehicle, tightening our belts so hard and forego paying any other creditors.

It could still be considered FRAUD my friends.

They want your entire portfolio how much does your kid make throwing news paper EVERYTHING, TWO YEARS WORTH……why? To use your package against you at a time you may least expect it. They have easy access to my credit report they can see I’m in trouble, I make a good living, sure if I lived in Kansas (nothing against Kansas beautiful State cheaper cost of living mind you). The cheapest house in the track of homes we live in built in 1963 is $1.3 mill, enough said.

3. I caught Julio and Antonio in at least one deception, one is all it takes; Julio informed my realtor who whole heartily agreed; that if I were to apply for a “small” loan we could make this a full pay off, there would be no 1099 concern. Julio must have thought I was genuinely stupid, small loan my barnacles, with my credit score, 28% with payments sure to put me into BK – not to mention his sidekick Antonio already let it out a week earlier that the lender would not write off a loss, that a promissory note would be drafted for the deficiency at 0% interest, written over the next 50 years would be more likely.

A perfect example of a lender deception, almost as we were friends, these reps are not your friends. The long term no interest promissory note I had indication of already reading of it here in Wiki.

 

4. Why would a law firm be in charge of collections? You can bet your Jolly’s a document was drafted up as soon as they received my file waiting for the hardship package to arrive to fill in the blanks to hand to a judge to know exactly how much of a judgment to go for, to max it out, better off with a BK judge.

Now to finally answer your question.

I refused to submit my hardship packages I’d rather go BK. Julio and Antonio walked away. With the leverage I had, a win win cash offer, saving the lender the law firm fees and the risk of a sale at auction. They did as my mentor warned, they committed financial suicide rather than cave to my demands.

Threats do not faze these guys or at least the two individuals I dealt with belonging to this particular lender. Maybe they don’t want to start a trend, who knows, everyone took a bath except me……

I’m getting that lump again………

“Sometimes the answer lay in front of your nose all along, blinded by fear and emotion refusing to let the power of all things good to take the helm and steer the course”.

There is a happy ending believe it or not.

I became alarmed a day earlier about taxes, surely there was some provision made for this as my “Agent” knew I was tapped. I took a closer at the HUD-1, an eye opening look. Below is a cut and paste from the email I sent dismissing her services.

HHEEErrrreeeessss Johnny!

…If you’re wondering by now what in the world is wrong with Bart? Well I’ll tell you what’s wrong with old Bart is that he smelled a rat when he read the below cut and paste from the HUD-1 this morning. Your agency will be affectionately referred to from here on out as the 700 club.

Why didn’t you mention this, who was representing who, which was I, 701 or 702, Good Grief! Look at 704! No mention of this at all, hiding in plain sight but never mentioned:

700 TOTAL SALES/BROKER’S COMMISSION

701 Commissions to MY AGENTS AGENCY 700 CLUB LLC 14,250.00

702 Commissions to MY AGENTS AGENCY 700 CLUB LLC 14,250.00

704 COMMISSIONS PAID AT SETTLEMENT 28,500.00

No wonder you were pushing me so hard into financial hell, that a lot dough in there, how ironic the 700 club helped old Bart buy that nightmare as well, that be $38.4K of Bart’s sweat and blood given protecting your freedom. Not bad for a minutes work. Not today my friend not today.

(In all fairness this could have been a typo, a fat finger as claimed, but I will never really know for sure. It was enough to get me highly motivated to get my bones moving out of this entire mess, and by the way if I would have moved forward with a short sale $7K state tax bill was coming my way. Who would you rather owe the lender or the state? The state does not forgive in BK).

The happy ending; My current monetary residual is modest $1200 a month with a mountain of debt to pay off, making the most I have ever made in my life inching up to a six figure annual gross. My wife, my best friend has been, disabled for 16 years with me away for almost half of that. We have two minor children whom I don’t really know.

The Solution: Quit the job, happily take in my 73 year old father who needs a place to lite, File Chapter 7 wipe all debt, Antonio and Julio may have some explaining to do, with a combined income of my military pension, my wife’s disability and my Fathers SSI along with moving to a lower cost of living area where nice rentals are going for a grand a month…….guess what…….we are left with the same modest residual of $1200 month without the debt in a better quality of life and I get to stay home and take care of my wife, which I’m now understanding that’s not such a popular idea any longer, be careful what you ask for Love.

NEVER GIVE UP!

Thank you Wiki! And a special heart filled thanks from my entire family to my mentor and friend always who by helping a fellow human being standing alone against giants was reward enough!

Respectfully and Yours Aye! Bart H, OSC(SW) USN ret.

(Folks it would be impossible to make up a story like this, this is the brutal truth non-exaggerated as it happened, and I have the email and other documents I will gladly Submit to the Wiki Staff for verification).

Downey Savings and Loan FORM 10-Q

 

LINK:  Downey 10-Q Analysis

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

___________________________

FORM 10-Q

 

(Mark One)

For the quarterly period ended September 30, 2008OR

For the transition period from __________ to __________

Commission File Number 1-13578(Exact name of registrant as specified in its charter)

N/A

 

(Former name, former address and former fiscal year, if changed since last report.)

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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non -accelerated filer, or a

smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule

12b-2 of the Exchange Act. (Check one):

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OFo TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF(State or other jurisdiction of

incorporation or organization)

33-0633413

 

(I.R.S. Employer Identification No.)

3501 Jamboree Road, Newport Beach, CA

 

(Address of principal executive office)

92660

 

(Zip Code)

Registrant’s telephone number, including area code (949) 854-0300Large accelerated filer þ Accelerated filer o

Non-accelerated filer o (Do not check if a smaller

reporting company)

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b -2 of the Exchange Act).

Yes o No þ

At September 30, 2008, 29,080,777 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.

Page Navigation Links

PART I – FINANCIAL INFORMATION

 

ITEM 1. – FINANCIAL STATEMENTS 1

Consolidated Balance Sheets at September 30, 2008 and 2007 and December 31, 2007 1

Consolidated Statements of Income (loss) for the three and nine months ended

September 30, 2008 and 2007 2

Consolidated Statements of Comprehensive Income (loss) for the three and nine months ended

September 30, 2008 and 2007 3

Consolidated Statements of Cash Flows for the nine months ended

September 30, 2008 and 2007 4

Notes To Consolidated Financial Statements 6

ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 27

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 75

ITEM 4. – CONTROLS AND PROCEDURES 75

PART II – OTHER INFORMATION

 

ITEM 1. – LEGAL PROCEEDINGS 76

ITEM 1A. – RISK FACTORS 77

ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 80

ITEM 3. – DEFAULTS UPON SENIOR SECURITIES 80

ITEM 4. – SUBMISSION OF MATTERS TO A VOTE OF SECURITIY HOLDERS 80

ITEM 5. – OTHER INFORMATION 81

ITEM 6. – EXHIBITS 81

AVAILABILITY OF REPORTS 82

SIGNATURES 82

Page i Navigation Links

September 30, December 31, September 30,

(Dollars in Thousands, Except Per Share Data) 2008 2007 2007

Assets

 

Cash $ 451,815 $ 83,840 $ 86,072

Federal funds and interest earning due from banks 101,129 5,900 1,551

Cash and cash equivalents 552,944 89,740 87,623

U.S. Treasury, government sponsored entities and other investment

securities available for sale, at fair value 592,542 1,549,879 2,142,278

Loans held for sale, at lower of cost or fair value 7,673 103,384 90,228

Mortgage-backed securities available for sale, at fair value 104 111 112

Loans held for investment 11,511,330 11,381,327 11,744,063

Allowance for loan losses (761,824 ) (348,167 ) (142,218 )

Loans held for investment, net 10,749,506 11,033,160 11,601,845

Investments in real estate and joint ventures 15,606 68,679 58,715

Real estate acquired in settlement of loans, net 278,091 115,623 59,773

Premises and equipment, net 113,663 115,846 117,535

Federal Home Loan Bank stock, at cost 133,255 70,964 70,058

Mortgage servicing rights:

Measured at fair value 22,814 – –

Amortized – 19,512 21,849

Other assets 161,884 113,761 130,889

Income tax receivable 133,852 6,312 27,900

Deferred tax asset 19,265 122,086 8,912

$ 12,781,199 $ 13,409,057 $ 14,417,717

Liabilities and Stockholders’ Equity

 

Deposits $ 9,618,384 $ 10,496,041 $ 10,662,618

Securities sold under agreements to repurchase – – 566,350

Federal Home Loan Bank advances 2,110,061 1,197,100 1,308,867

Senior notes 198,593 198,445 198,398

Accounts payable and accrued liabilities 82,447 183,054 237,258

Total liabilities 12,009,485 12,074,640 12,973,491

Stockholders’ equity

 

Preferred stock, par value of $0.01 per share; authorized 5,000,000 shares;

outstanding none – – –

Common stock, par value of $0.01 per share; authorized 50,000,000 shares;

issued 29,080,777 shares at September 30, 2008 and 28,235,022 shares at

December 31, 2007 and September 30, 2007; outstanding 29,080,777 shares

at September 30, 2008 and 27,853,783 at December 31, 2007 and

September 30, 2007 291 282 282

Additional paid-in capital 93,835 93,792 93,792

Accumulated other comprehensive income (loss) (6,231 ) 2,768 388

Retained earnings 683,819 1,254,367 1,366,556

Treasury stock, at cost, 381,239 at December 31, 2007 and

September 30, 2007 – (16,792 ) (16,792 )

See accompanying notes to consolidated financial statements.

 

Total stockholders’ equity 771,714 1,334,417 1,444,226

$ 12,781,199 $ 13,409,057 $ 14,417,717

Page 1 Navigation Links

Three Months Ended Nine Months Ended

September 30, September 30,

(Dollars in Thousands, Except Per Share Data) 2008 2007 2008 2007

Interest income

 

Loans $ 154,479 $ 208,314 $ 493,193 $ 690,869

U.S. Treasury and government sponsored entities securities 12,977 26,350 49,330 65,644

Mortgage-backed securities 2 3 8 9

Other investment securities 1,610 1,207 3,713 5,396

Total interest income 169,068 235,874 546,244 761,918

Interest expense

 

Deposits 67,726 108,514 243,047 333,977

Federal Home Loan Bank advances and other borrowings 22,010 26,088 50,601 83,494

Senior notes 3,305 3,302 9,913 9,904

Total interest expense 93,041 137,904 303,561 427,375

 

Net interest income

76,027 97,970 242,683 334,543

Provision for credit losses

130,291 81,562 626,035 91,684

Net interest income (loss) after provision for credit losses (54,264 ) 16,408 (383,352 ) 242,859

Other income, net

 

Loan and deposit related fees 8,152 8,913 24,595 27,087

Real estate and joint ventures held for investment, net (10,749 ) (7,892 ) (16,625 ) (7,527 )

Net gain on sale of real estate related contracts 69,972 – 69,972 –

Secondary marketing activities:

Loan servicing income (loss), net (56 ) (294 ) 2,724 (1,519 )

Net gains on sales of loans and mortgage-backed securities 677 2,506 6,898 20,224

Net gains on sales of investment securities – – 837 –

Other 219 (197 ) 817 (16 )

Total other income, net 68,215 3,036 89,218 38,249

Operating expense

 

Salaries and related costs 37,611 36,699 118,197 119,931

Premises and equipment costs 9,224 9,736 27,402 27,667

Advertising expense 1,473 1,400 2,750 4,469

Deposit insurance premiums and regulatory assessments 8,117 2,413 15,509 7,659

Professional fees 3,000 489 4,146 1,779

Impairment writedown of goodwill – – 3,149 –

Other general and administrative expense 11,802 8,275 29,256 24,271

Total general and administrative expense 71,227 59,012 200,409 185,776

Net operation of real estate acquired in settlement of loans 31,428 3,664 79,763 4,903

Total operating expense 102,655 62,676 280,172 190,679

Income (loss) before income taxes (tax benefits)

(88,704 ) (43,232 ) (574,306 ) 90,429

Income taxes (tax benefits) (7,634 ) (19,871 ) (26,620 ) 38,183

 

Net income (loss)

$ (81,070 ) $ (23,361 ) $ (547,686 ) $ 52,246

See accompanying notes to consolidated financial statements.

Per share information

 

Basic $ (2.89 ) $ (0.84 ) $ (19.64 ) $ 1.87

Diluted $ (2.89 ) $ (0.84 ) $ (19.64 ) $ 1.87

Cash dividends declared and paid $ 0.01 $ 0.12 $ 0.25 $ 0.36

Weighted average shares outstanding

 

Basic 27,960,478 27,853,783 27,889,608 27,853,783

Diluted 27,960,478 27,853,783 27,889,608 27,882,804

Page 2 Navigation Links 

See accompanying notes to consolidated financial statements.

Net income (loss)

$ (81,070 ) $ (23,361 ) $ (547,686 ) $ 52,246

Other comprehensive income (loss), net of income taxes (tax benefits)

Three Months Ended Nine Months Ended

September 30, September 30,

(In Thousands) 2008 2007 2008 2007

Unrealized gains (losses) on securities available for sale:

U.S. Treasury, government sponsored entities and other investment

securities available for sale, at fair value (6,054 ) 6,644 (9,113 ) 5,926

Mortgage-backed securities available for sale, at fair value – 1 – 1

Unrealized gains (losses) on cash flow hedges:

Net derivative instruments (175 ) (216 ) (390 ) 609

Reclassification of realized amounts included in net income 302 27 504 (944 )

Total other comprehensive income (loss), net of income tax benefits (5,927 ) 6,456 (8,999 ) 5,592

Comprehensive income (loss)

$ (86,997 ) $ (16,905 ) $ (556,685 ) $ 57,838

Page 3 Navigation Links

See accompanying notes to consolidated financial statements.

Cash flows from operating activities

Nine Months Ended

September 30,

(In Thousands) 2008 2007

Net income (loss) $ (547,686 ) $ 52,246

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

Depreciation 10,744 10,811

Amortization 10,963 79,541

Impairment writedown of goodwill 3,149 –

Provision for losses on loans, loan-related commitments, investments in

real estate and joint ventures, mortgage servicing rights,

real estate acquired in settlement of loans, and other assets 699,465 94,833

Net gains on sales of loans and mortgage-backed securities, mortgage servicing rights,

investment securities, real estate and other assets (84,947 ) (21,952 )

Interest capitalized on loans (negative amortization) (74,013 ) (199,382 )

Changes in fair value of mortgage servicing rights due to:

Changes in valuation model inputs or assumptions (536 ) –

Other changes 2,095 –

Federal Home Loan Bank stock dividends (3,142 ) (5,185 )

Loans originated or purchased for sale (596,374 ) (1,380,371 )

Proceeds from sales of loans held for sale, including those sold

as mortgage-backed securities 687,875 1,635,997

Other, net (157,175 ) (196,610 )

Net cash provided by (used for) operating activities (49,582 ) 69,928

Cash flows from investing activities

 

Proceeds from:

Sales of wholly owned real estate and real estate acquired in settlement of loans 204,122 20,560

Real estate related contracts 69,972 –

Redemption of Federal Home Loan Bank stock 2,400 95,046

Maturities or calls of U.S. Treasury, government sponsored entities

and other investment securities available for sale 14,958,610 276,200

Purchase of:

U.S. Treasury, government sponsored entities and other investment securities

available for sale (14,011,366 ) (825,030 )

Premises and equipment (8,469 ) (17,134 )

Federal Home Loan Bank stock (61,549 ) (6,967 )

Originations of loans held for investment (net of refinances of $143,307 for the

nine months ended September 30, 2008 and $572,331 for the nine months ended

September 30, 2007) (1,744,354 ) (1,209,487 )

Principal payments on loans held for investment and mortgage-backed securities

available for sale 1,120,183 3,457,620

Net change in undisbursed loan funds (38,056 ) (36,655 )

Investments in real estate held for investment (9,368 ) 2,061

Other, net 2,171 4,293

Net cash provided by investing activities $ 484,296 $ 1,760,507

Page 4 Navigation Links

See accompanying notes to consolidated financial statements.

Cash flows from financing activities

Nine Months Ended

September 30,

(In Thousands) 2008 2007

Net decrease in deposits $ (877,657 ) $ (1,122,251 )

Proceeds from Federal Home Loan Bank advances and other borrowings 12,995,860 12,583,559

Repayments of Federal Home Loan Bank advances and other borrowings (12,086,350 ) (13,326,330 )

Cash dividends (6,962 ) (10,027 )

Other, net 3,599 7,371

Net cash provided by (used for) financing activities 28,490 (1,867,678 )

Net increase (decrease) in cash and cash equivalents 463,204 (37,243 )

Cash and cash equivalents at beginning of period 89,740 124,866

Cash and cash equivalents at end of period

$ 552,944 $ 87,623

Supplemental disclosure of cash flow information:

Interest paid $ 307,498 $ 431,774

Income taxes paid 1,599 186,100

Income tax refund (4,872 ) –

Supplemental disclosure of non-cash investing:

Loans transferred to held for investment from held for sale 7,177 26,417

Loans transferred from held for investment to held for sale 1,723 2,856

U.S. Treasury, government sponsored entities and other investment securities

available for sale, purchased and not settled – 150,000

Real estate acquired in settlement of loans 403,297 74,886

Loans to facilitate the sale of real estate acquired in settlement of loans 22,601 1,413

Page 5 Navigation LinksIn the opinion of Downey Financial Corp. and subsidiaries (“Downey,” “we,” “us” and “our”), the accompanying consolidated financial

statements contain all adjustments (consisting of normal recurring accruals unless otherwise disclosed in this Form 10-Q) necessary for a fair

presentation of Downey’s financial condition as of September 30, 2008, December 31, 2007 and September 30, 2007, the results of operations and

comprehensive income (loss) for the three months and nine months ended September 30, 2008 and 2007, and changes in cash flows for the nine months

ended September 30, 2008 and 2007. 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 U.S. generally accepted accounting principles for

interim financial statements 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 condition, results of operations, comprehensive income (loss) and cash flows. The information under the

heading Management’s Discussion and Analysis of Financial Condition and Results of Operations presumes 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, 2007, 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, 2007 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) – Loans

 

Loans are summarized as follows:

(a) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we

included the fair value of MSRs in the fair value of the interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan

Commitments Recorded at Fair Value Through Earnings.

 

At September 30, 2008, approximately 90% of the real estate securing Downey’s loans was located in California. As a result, the value of the

underlying collateral for a significant portion of our loans may be unfavorably impacted by adverse changes in the California economy and real estate

market.

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

Loans held for investment

 

Loans secured by real estate:

Residential:

One-to-four units $ 10,959,601 $ 10,894,889 $ 10,712,235 $ 10,877,228 $ 11,227,561

Home equity loans and lines of credit 132,907 131,531 133,338 138,305 143,948

Five or more units 204,172 121,403 100,374 100,963 104,672

Commercial real estate 29,838 22,633 24,749 26,427 26,598

Construction 97,907 105,991 74,730 81,098 58,231

Land 10,708 10,524 10,373 49,521 50,864

Non-mortgage:

Commercial 5,305 5,505 5,305 5,000 5,000

Consumer 5,993 5,823 5,934 5,989 6,057

Total loans held for investment 11,446,431 11,298,299 11,067,038 11,284,531 11,622,931

Increase (decrease) for:

Undisbursed loan funds and net

deferred costs and premiums 64,899 65,067 96,216 96,796 121,132

Allowance for losses (761,824 ) (732,354 ) (546,751 ) (348,167 ) (142,218 )

Total loans held for investment, net $ 10,749,506 $ 10,631,012 $ 10,616,503 $ 11,033,160 $ 11,601,845

Loans held for sale

 

Residential one-to-four units $ 7,624 $ 85,854 $ 110,685 $ 103,320 $ 89,794

Net deferred costs and premiums (16 ) (146 ) (362 ) (109 ) 53

Capitalized basis adjustment (a) 65 (150 ) (1,070 ) 173 381

Total loans held for sale, net $ 7,673 $ 85,558 $ 109,253 $ 103,384 $ 90,228

Page 6 Navigation LinksThe combined weighted average interest rate on loans held for investment and sale was 6.26% at September 30, 2008, 7.41% at December 31, 2007,

and 7.45% at September 30, 2007. These rates exclude adjustments for non-accrual loans; amortization of net deferred costs to originate loans, premiums

and discounts, troubled debt restructuring (“TDR”) yield adjustments; and prepayment and late fees.

Most of Downey’s adjustable rate mortgages adjust the interest rate monthly and the payment amount annually. These monthly adjustable rate

mortgages allow for negative amortization, which is the addition to loan principal of accrued interest that exceeds the required monthly loan payments.

At September 30, 2008, loans subject to negative amortization represented 52% of Downey’s residential one-to-four unit adjustable rate portfolio held

for investment, of which $318 million represented the amount of negative amortization included in the loan balance. This compares to 69% and $379

million, respectively, at December 31, 2007. During the third quarter of 2008, approximately 10% of our loan interest income represented negative

amortization, down from 15% in the second quarter of 2008 and 26% from the year-ago third quarter.

A summary of activity in the allowance for loan losses for loans held for investment during the quarters indicated follows:

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

Real

(In Thousands) Estate Commercial Consumer Total

 

Balance at June 30, 2007 $ 68,794 $ 11 $ 302 $ 69,107

Provision 81,356 1 78 81,435

TDR yield adjustment (a) – – – –

Charge-offs (8,323 ) – (45 ) (8,368 )

Recoveries 40 – 4 44

Balance at September 30, 2007 141,867 12 339 142,218

Provision 218,603 24 23 218,650

TDR yield adjustment (a) (483 ) – – (483 )

Charge-offs (12,185 ) – (35 ) (12,220 )

Recoveries – – 2 2

Balance at December 31, 2007 347,802 36 329 348,167

Provision 237,052 3 32 237,087

TDR yield adjustment (a) (1,461 ) – – (1,461 )

Charge-offs (37,015 ) – (28 ) (37,043 )

Recoveries – – 1 1

Balance at March 31, 2008 546,378 39 334 546,751

Provision 258,490 1 26 258,517

TDR yield adjustment (a) (2,670 ) – – (2,670 )

Charge-offs (70,219 ) – (26 ) (70,245 )

Recoveries – – 1 1

Balance at June 30, 2008 731,979 40 335 732,354

Provision (reduction) 130,400 (5 ) 35 130,430

TDR yield adjustment (a) (3,352 ) – – (3,352 )

Charge-offs (97,586 ) – (27 ) (97,613 )

Recoveries – – 5 5

Balance at September 30, 2008 $ 761,441 $ 35 $ 348 $ 761,824

Page 7 Navigation LinksA summary of activity in the allowance for loan losses for loans held for investment for the year-to-date periods indicated follows:

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

 

During the current quarter, our provision for loan losses totaled $130.4 million, up $49.0 million from a year ago. The increase in our provision for

loan losses reflects continued weakening and uncertainty relative to the housing market and disruption in the secondary markets which have

unfavorably impacted our borrowers and the value of their loan collateral. As a result, an increase in the allowance for loan losses was deemed

appropriate. Included within the current quarter provision for loan losses was $25.7 million related to the specific allowance associated with certain

troubled debt restructurings resulting from a borrower retention program. The allowance related to the troubled debt restructurings that are not

collateral dependent is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash

flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for loan losses in

current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield, thereby decreasing the allowance

balance, or as a reduction of the provision if the loan is prepaid.

Net charge-offs to average loans was 3.62% in the current quarter, higher than the 0.43% in the fourth quarter of 2007 and 0.28% in the year-ago

third quarter. The current quarter net charge-offs primarily related to residential one-to-four unit loans.

For the first nine months of 2008, the provision for loan losses totaled $626.0 million and net charge-offs were $204.9 million. This compares with a

$91.3 million provision for loan losses and net charge-offs of $10.0 million a year ago. The increase in the year-to-date provision for loan losses reflected

the same underlying weaknesses as mentioned above.

A summary of activity in the allowance for loan-related commitment losses for loans held for investment, included in accounts payable and

accrued liabilities, during the quarters indicated follows:

Real

(In Thousands) Estate Commercial Consumer Total

 

Balance at December 31, 2006 $ 60,611 $ 14 $ 318 $ 60,943

Provision (reduction) 91,228 (2 ) 95 91,321

TDR yield adjustment (a) – – – –

Charge-offs (10,263 ) – (81 ) (10,344 )

Recoveries 291 – 7 298

Balance at September 30, 2007 $ 141,867 $ 12 $ 339 $ 142,218

Balance at December 31, 2007 $ 347,802 $ 36 $ 329 $ 348,167

Provision (reduction) 625,942 (1 ) 93 626,034

TDR yield adjustment (a) (7,483 ) – – (7,483 )

Charge-offs (204,820 ) – (81 ) (204,901 )

Recoveries – – 7 7

Balance at September 30, 2008 $ 761,441 $ 35 $ 348 $ 761,824

Real

(In Thousands) Estate Commercial Consumer Total

 

Balance at June 30, 2007 $ 1,244 $ 4 $ 43 $ 1,291

Provision for (reduction of) estimated losses 125 6 (4 ) 127

Balance at September 30, 2007 1,369 10 39 1,418

Reduction of estimated losses (195 ) (7 ) (1 ) (203 )

Balance at December 31, 2007 1,174 3 38 1,215

Reduction of estimated losses (217 ) – – (217 )

Balance at March 31, 2008 957 3 38 998

Provision for (reduction of) estimated losses 357 1 (1 ) 357

Balance at June 30, 2008 1,314 4 37 1,355

Provision for (reduction of) estimated losses (139 ) 1 (1 ) (139 )

Balance at September 30, 2008 $ 1,175 $ 5 $ 36 $ 1,216

Page 8 Navigation LinksA summary of activity in the allowance for loan-related commitment losses for loans held for investment, included in accounts payable and

accrued liabilities, for the year-to-date periods indicated follows:

There were 3,355 impaired loans at September 30, 2008, compared with 1,003 at year end.

The following table presents impaired loans with specific allowances and the amount of such allowances and impaired loans without specific

allowances.

At September 30, 2008, the recorded investment in loans for which we recognized impairment totaled $1.477 billion, up from $486 million at

December 31, 2007 and $12 million at September 30, 2007. Of the current quarter total, $1.464 billion related to residential one-to-four unit loan TDRs with

an allowance for loss of $131 million and $12 million related to two construction loans with an allowance for loss of $2 million. This is up from 2007 yearend

totals of $441 million related to residential one-to-four unit loan TDRs with an allowance for loss of $39 million, $29 million related to one land loan

with an allowance for loss of $4 million, $15 million related to two construction loans with an allowance for loss of $2 million, and $1 million related to

Real

(In Thousands) Estate Commercial Consumer Total

 

Balance at December 30, 2006 $ 1,011 $ 3 $ 41 $ 1,055

Provision for (reduction of) estimated losses 358 7 (2 ) 363

Balance at September 30, 2007 $ 1,369 $ 10 $ 39 $ 1,418

Balance at December 31, 2007 $ 1,174 $ 3 $ 38 $ 1,215

Provision for (reduction of) estimated losses 1 2 (2 ) 1

Balance at September 30, 2008 $ 1,175 $ 5 $ 36 $ 1,216

Investment Specific Carrying

(In Thousands) Value Allowance Value

 

September 30, 2007:

Loans with specific allowances $ 8,201 $ (721 ) $ 7,480

Loans without specific allowances 3,316 – 3,316

Total impaired loans $ 11,517 $ (721 ) $ 10,796

December 31, 2007:

Loans with specific allowances $ 485,017 $ (45,066 ) $ 439,951

Loans without specific allowances 676 – 676

Total impaired loans $ 485,693 $ (45,066 ) $ 440,627

March 31, 2008:

Loans with specific allowances $ 778,728 $ (66,801 ) $ 711,927

Loans without specific allowances 636 – 636

Total impaired loans $ 779,364 $ (66,801 ) $ 712,563

June 30, 2008:

Loans with specific allowances $ 1,177,801 $ (102,013 ) $ 1,075,788

Loans without specific allowances – – –

Total impaired loans $ 1,177,801 $ (102,013 ) $ 1,075,788

September 30, 2008:

Loans with specific allowances $ 1,476,573 $ (133,140 ) $ 1,343,433

Loans without specific allowances – – –

Total impaired loans $ 1,476,573 $ (133,140 ) $ 1,343,433

one residential one-to-four unit loan with no allowance for loss; and up from the year-ago quarter total of $12 million with an allowance of less than $1

million. During the current quarter, the total interest recognized on the impaired portfolio was $27.0 million, compared to $19.9 million in the second

quarter of 2008 and no interest recognized in the year-ago quarter.

The aggregate amount of non-accrual loans that are in the foreclosure process, restructured, contractually past due 90 days or more as to

principal or interest, or upon which interest collection is doubtful was $1.723 billion and $364 million at September 30, 2008 and 2007, respectively.

Downey had $578 million of commitments to lend additional funds to borrowers whose loans were on non-accrual status. At September 30, 2008,

Downey’s troubled debt restructurings were $1.452 billion, of which, $831 million were on non-accrual status, compared with troubled debt

restructurings of $432 million with $432 million on non-accrual status at year end and $102 million troubled debt restructurings at September 30, 2007 all

of which are on non-accrual status.

Page 9 Navigation LinksInterest due on non-accrual loans, but excluded from interest income, was approximately $47.6 million at September 30, 2008, compared with $21.0

million at December 31, 2007 and $10.4 million at September 30, 2007.

Downey has had, and expects in the future to have, transactions in the ordinary course of business with executive officers, directors and their

associates on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other

non-related parties. In the opinion of management, those transactions neither involve more than the normal risk of collectibility nor present any

unfavorable features. At September 30, 2008, the Bank had extended loans to one director and his associates totaling $17.3 million, compared with $18.8

million and $16.7 million at December 31, 2007 and September 30, 2007, respectively. All such loans are performing in accordance with their loan terms.

Presented below is a summary of activity with respect to such loans during the quarters indicated:

Presented below is a summary of activity with respect to such loans for the year-to-date periods indicated:

NOTE (3) – Real Estate Acquired in Settlement of Loans

 

Real estate acquired in settlement of loans was $278 million at September 30, 2008, compared to $116 million and $60 million at December 31, 2007

and September 30, 2007, respectively.

A summary of net operation of real estate acquired in settlement of loans included in Downey’s results of operations during the quarters indicated

follows:

A summary of net operation of real estate acquired in settlement of loans included in Downey’s results of operations for the year-to-date periods

indicated follows:

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 18,250 $ 18,579 $ 18,769 $ 16,713 $ 16,852

Additions – – – 2,142 –

Repayments (1,000 ) (329 ) (190 ) (86 ) (139 )

Balance at end of period $ 17,250 $ 18,250 $ 18,579 $ 18,769 $ 16,713

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Balance at beginning of period $ 18,769 $ 20,674

Additions – –

Repayments (1,519 ) (3,961 )

Balance at end of period $ 17,250 $ 16,713

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net (gains) losses on sales $ 2,508 $ 760 $ 205 $ 739 $ (392 )

Net operating expense 9,591 8,667 4,099 2,726 1,998

Provision for estimated losses 19,329 14,712 19,892 1,118 2,058

Net operations of real estate acquired in

settlement of loans $ 31,428 $ 24,139 $ 24,196 $ 4,583 $ 3,664

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net (gains) losses on sales $ 3,473 $ (797 )

Net operating expense 22,357 3,079

Provision for estimated losses 53,933 2,621

Net operations of real estate acquired in settlement of loans $ 79,763 $ 4,903

Page 10 Navigation LinksDowney values real estate acquired through foreclosure at fair value less cost to sell, with any subsequent losses recorded as a direct write-off to

net operations. Given the decline in home values in the residential market, we had a valuation allowance at quarter end of $11 million for our one-to-four

unit residential properties acquired through foreclosure. This valuation allowance reflects recent loss experience from sales compared to their fair value

prior to sale. As that loss experience changes over time, our estimate of this valuation allowance will be reassessed.

The following table summarizes the activity in Downey’s allowance for real estate acquired in settlement of loans for the quarters indicated.

The following table summarizes the activity in Downey’s allowance for real estate acquired in settlement of loans for the year-to-date periods

indicated.

NOTE (4) – Mortgage Servicing Rights (“MSRs”)

 

Effective January 1, 2008, Downey adopted the fair value provision of Statement of Financial Accounting Standards No. 156, Accounting for

Servicing of Financial Assets – an amendment of Financial Accounting Standards Board (“FASB”) Statement No. 140 (“SFAS 156”) and remeasured its

mortgage servicing rights (“MSRs”) at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding

cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity. The following

table shows the adjustment recorded to the opening balance of MSRs, income taxes, and retained earnings for the remeasurement of Downey’s MSRs

at fair value.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 17,592 $ 12,334 $ – $ – $ –

Provision 19,329 14,712 19,892 1,118 2,058

Charge-offs (25,850 ) (9,454 ) (7,558 ) (1,118 ) (2,058 )

Recoveries – – – – –

Balance at end of period $ 11,071 $ 17,592 $ 12,334 $ – $ –

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Balance at beginning of period $ – $ –

Provision 53,933 2,621

Charge-offs (42,862 ) (2,621 )

Recoveries – –

Balance at end of period $ 11,071 $ –

(Dollars in Thousands) MSRs Deferred Tax Asset Retained Earnings

 

Balance at December 31, 2007 $ 19,512 $ 122,086 $ 1,254,367

Remeasurement of MSRs upon adoption of SFAS 156 1,543 (651 ) 892

Balance at January 1, 2008 $ 21,055 $ 121,435 $ 1,255,259

Page 11 Navigation LinksThe following table summarizes the activity in MSRs using the fair value method and, prior to 2008, using the amortized cost method for the

periods indicated.

(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(b) Included minor amounts repurchased.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 23,558 $ 19,425 $ 21,973 $ 22,114 $ 21,707

Remeasurement of mortgage servicing rights

to fair value (a) – – (918 ) – –

Adjusted balance at beginning of period 23,558 19,425 21,055 22,114 21,707

Additions (b) 901 1,557 1,122 945 1,394

Amortization – – – (1,085 ) (950 )

Sales – – (262 ) – –

Impairment write-down – – – (1 ) (37 )

Changes in fair value due to:

Changes in valuation model inputs or

assumptions (c) (1,038 ) 3,325 (1,751 ) – –

Other changes (d) (607 ) (749 ) (739 ) – –

Balance at end of period 22,814 23,558 19,425 21,973 22,114

Allowance balance at beginning of period – – 2,461 265 88

Remeasurement of mortgage servicing rights

to fair value (a) – – (2,461 ) – –

Adjusted balance at beginning of period – – – 265 88

Provision for impairment – – – 2,197 214

Impairment write-down – – – (1 ) (37 )

Allowance balance at end of period – – – 2,461 265

Total mortgage servicing rights, net $ 22,814 $ 23,558 $ 19,425 $ 19,512 $ 21,849

As a percentage of associated mortgage loans 0.91% 0.95% 0.80% 0.80% 0.90%

Fair value (e) $ 22,814 $ 23,558 $ 19,425 $ 20,991 $ 23,935

Weighted average expected life (in months) 67 69 50 53 69

Custodial account earnings rate 3.23% 3.75% 3.72% 4.53% 4.57%

Weighted average discount rate 11.74 11.78 11.47 11.45 11.63

At period end

 

Mortgage loans serviced for others:

Total $ 5,347,377 $ 5,435,529 $ 5,431,475 $ 5,525,357 $ 5,622,331

With capitalized mortgage servicing rights:(e)

Amount 2,495,492 2,471,000 2,428,098 2,436,278 2,419,432

Weighted average interest rate 5.89% 5.87% 5.88% 5.88% 5.83%

Total loans sub-serviced without mortgage

servicing rights: (f)

Term – less than six months $ 96,428 $ 103,972 $ 69,810 $ 81,123 $ 76,870

Term – indefinite 2,751,711 2,857,191 2,933,567 2,995,119 3,112,895

Custodial account balances $ 75,452 $ 67,710 $ 71,479 $ 81,778 $ 84,819

(d) Represents changes due to realization of expected cash flows over time.

(e) Excludes loans sub-serviced without capitalized mortgage servicing rights. The estimated fair values for periods presented prior to 2008 may

exceed book value for certain asset strata and excluded loans sold or securitized prior to 1996.

(f) Servicing is performed for a fixed fee per loan each month.

 

Page 12 Navigation LinksThe following table summarizes the activity in MSRs and its related allowance for the year-to-date periods indicated.

(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(b) Included minor amounts repurchased.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

(d) Represents changes due to realization of expected cash flows over time.

 

Upon adoption in 2008 of the fair value provision of SFAS 156, Downey capitalizes MSRs at fair value for residential one-to-four unit mortgage

loans we originate and sell with servicing rights retained or acquired through purchase. Downey discloses MSRs associated with the origination and

sale of loans in the financial statements as a component of the net gains on sales of loans and mortgage-backed securities. MSR fair value adjustments

are recorded as a component of loan servicing income (loss), net. Prior to 2008, Downey capitalized MSRs at fair value except for those acquired

through purchase, which were recorded at the lower of cost or fair value. MSRs were amortized over the estimated servicing period with impairment

losses recorded through a valuation allowance with both the associated provisions and amortization recorded as a component of loan servicing income

(loss), net category.

Downey’s loan servicing portfolio normally increases in value as interest rates rise and loan prepayments decrease and declines in value as

interest rates fall and loan prepayments increase. The change in fair value for MSRs reflects changes in assumptions and changes due to the realization

of expected cash flows over time. Key assumptions used to determine the fair value of MSRs, which vary due to changes in market interest rates,

include: expected prepayment speeds, which impact the average life of the portfolio; the earnings rate on custodial accounts, which impacts the value

of custodial accounts; expected delinquencies and losses, which impact the servicing income (loss); and the discount rate used in valuing future cash

flows. Once a quarter, Downey conducts model validation procedures by obtaining three independent broker results for the fair value of MSRs and

compares them to the results of its MSR model.

Prior to 2008, under the amortization method of recording MSRs, impairment was measured on a disaggregated basis based upon the predominant

risk characteristics of the underlying mortgage loans, which include loans by loan term and coupon rate (stratified in 50 basis point increments).

Impairment losses were recognized through a valuation allowance for each impaired stratum. Certain strata may have impairment, while other strata may

not. Therefore, changes in overall fair value may not equal provisions for or reductions of the valuation allowance.

Nine Months Ended September 30,

(Dollars in Thousands) 2008 2007

 

Balance at beginning of period $ 21,973 $ 21,435

Remeasurement of mortgage servicing rights to fair value (a) (918 ) –

Adjusted balance at beginning of period 21,055 21,435

Additions (b) 3,580 4,661

Amortization – (2,941 )

Sales (262 ) (868 )

Impairment write-down – (173 )

Changes in fair value due to:

Changes in valuation model inputs or assumptions (c) 536 –

Other changes (d) (2,095 ) –

Balance at end of period 22,814 22,114

Allowance balance at beginning of period 2,461 239

Remeasurement of mortgage servicing rights to fair value (a) (2,461 ) –

Adjusted balance at beginning of period – 239

Provision for impairment – 199

Impairment write-down – (173 )

Allowance balance at end of period – 265

Total mortgage servicing rights, net $ 22,814 $ 21,849

Page 13 Navigation LinksThe following table summarizes the estimated changes in the fair value of MSRs for changes in those assumptions individually and in

combination associated with an immediate 100 basis point increase or decrease in market rates. The sensitivity analysis in the table below is

hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 100 basis point variation in assumptions

generally cannot be easily extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in

this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumptions. In

reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

(a) The weighted-average expected life of the MSRs portfolio becomes 88 months.

(b) The weighted-average expected life of the MSRs portfolio becomes 34 months.

 

The following table presents a breakdown of the components of loan servicing income (loss), net included in Downey’s results of operations for

the periods indicated.

(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received

when a loan prepays prior to the end of the month. However, loan servicing income (loss), net does not reflect interest income derived from the use of

loan repayments which is included in net interest income.

(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

(d) Represents changes due to realization of expected cash flows over time.

Expected Custodial

Prepayment Accounts Discount

(Dollars in Thousands) Speeds Rate Rate Combination

 

Increase rates 100 basis points: (a)

Increase (decrease) in fair value $ 3,797 $ 1,419 $ (541 ) $ 3,795

Decrease rates 100 basis points: (b)

Increase (decrease) in fair value (7,705 ) (1,521 ) 552 (8,789 )

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net cash servicing fees $ 1,797 $ 1,750 $ 1,765 $ 2,166 $ 1,657

Payoff and curtailment interest cost (a) (208 ) (350 ) (471 ) (544 ) (787 )

Change in fair value of mortgage servicing

rights due to:(b)

Change in valuation model inputs or

assumptions (c) (1,038 ) 3,325 (1,751 ) – –

Other changes (d) (607 ) (749 ) (739 ) – –

Amortization of mortgage servicing rights – – – (1,085 ) (950 )

Provision for impairment of mortgage

servicing rights – – – (2,197 ) (214 )

Total loan servicing income (loss), net $ (56 ) $ 3,976 $ (1,196 ) $ (1,660 ) $ (294 )

Page 14 Navigation LinksThe following table presents a breakdown of the components of loan servicing income (loss), net included in Downey’s results of operations for

the year-to-date periods indicated.

(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received

when a loan prepays prior to the end of the month. However, loan servicing income (loss), net does not reflect interest income derived from the use of

loan repayments which is included in net interest income.

(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

(d) Represents changes due to realization of expected cash flows over time.

NOTE (5) – Derivatives, Hedging Activities, Financial Instruments with Off-Balance Sheet Risk and Other Contractual Obligations (Risk

Management)

Derivatives

 

Downey offers short-term interest rate lock commitments to help attract potential home loan borrowers. The commitments guarantee a specified

interest rate for a loan if underwriting standards are met, but do not obligate the potential borrower. Accordingly, some commitments never become

loans and merely expire. The residential one-to-four unit interest rate lock commitments Downey ultimately expects to result in loans and sell in the

secondary market are treated as derivatives. Consequently, as derivatives, the hedging of the interest rate lock commitments does not qualify for hedge

accounting. Effective January 1, 2008, Downey adopted the Securities and Exchange Commission Staff Accounting Bulletin No. 109, Written Loan

Commitments Recorded at Fair Value Through Earnings, that specifically states the expected net future cash flows related to the associated servicing of

a loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. Associated fair

value adjustments to the notional amount of interest rate lock commitments and, beginning in 2008, the associated MSRs are recorded in current

earnings under net gains on sales of loans and mortgage-backed securities with an offset to the balance sheet in either other assets, or accounts

payable and accrued liabilities. Fair values for the notional amount of interest rate lock commitments are based on dealer quoted market prices acquired

from third parties. Fair values for the associated MSRs are determined by computing the present value of the expected net servicing income from the

portfolio by strata, determined by key characteristics of the underlying loans, primarily coupon interest rate and whether the loans have a fixed or

variable rate. The carrying amount of loans held for sale includes a basis adjustment to the loan balance at funding resulting from the change in fair

value of the interest rate lock derivative and, beginning in 2008, the associated MSRs from the date of rate lock to the date of funding. At September 30,

2008, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $26 million, with

a change in fair value resulting in a recorded gain of $0.1 million.

Downey does not generally enter into derivative transactions for purely speculative purposes.

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net cash servicing fees $ 5,312 $ 4,862

Payoff and curtailment interest cost (a) (1,029 ) (3,241 )

Change in fair value of mortgage servicing rights due to:(b)

Change in valuation model inputs or assumptions (c) 536 –

Other changes (d) (2,095 ) –

Amortization of mortgage servicing rights – (2,941 )

Provision for impairment of mortgage servicing rights – (199 )

Total loan servicing income (loss), net $ 2,724 $ (1,519 )

Page 15 Navigation LinksAs part of its secondary marketing activities, Downey typically utilizes short-term loan forward sale and purchase contracts-derivatives-that

mature in less than one year to offset the impact of changes in market interest rates on the value of residential one-to-four unit interest rate lock

commitments and loans held for sale. In general, interest rate lock commitments associated with fixed rate loans require a higher percentage of loan

forward sale contracts to mitigate interest rate risk than those associated with adjustable rate loans. Contracts designated as hedges for the forecasted

sale of loans from the held for sale portfolio are accounted for as cash flow hedges because these contracts have a high correlation to the price

movement of the loans being hedged (within a range of 80% – 125%). The measurement approach for determining the ineffective aspects of the hedge is

established at the inception of the hedge. Changes in fair value of the notional amount of loan forward sale contracts not designated as cash flow

hedges and the ineffectiveness of hedge transactions are recorded in net gains on sales of loans and mortgage-backed securities. Changes in expected

future cash flows related to the fair value of the notional amount of loan forward sale contracts designated as cash flow hedges for the forecasted sale

of loans held for sale are recorded in other comprehensive income (loss), net of tax, provided cash flow hedge requirements are met. The offset to these

changes are recorded in the balance sheet as either other assets, or accounts payable and accrued liabilities. The amounts recorded in accumulated

other comprehensive income (loss) will be recognized in the income statement when the hedged forecasted transactions impact earnings. Downey

estimates that all of the related unrealized gains or losses in accumulated other comprehensive income will be reclassified into earnings within the next

three months. Fair values for the notional amount of loan forward sale contracts are based on dealer quoted market prices acquired from third parties. At

September 30, 2008, the notional amount of loan forward sale contracts amounted to $54 million, with a change in fair value resulting in a loss of $0.2

million, of which $7 million were designated as cash flow hedges. The notional amount of loan forward purchase contracts at September 30, 2008

amounted to $21 million, with a change in fair value resulting in a loss of $0.1 million.

Downey has not discontinued any designated derivative instruments associated with loans held for sale due to a change in the probability of

settling a forecasted transaction.

In connection with its interest rate risk management, Downey from time to time enters into interest rate exchange agreements (“swap contracts”)

with certain national investment banking firms or the Federal Home Loan Bank of San Francisco (“FHLB”) under terms that provide mutual payment of

interest on the outstanding notional amount of swap contracts. These swap contracts help Downey manage the effects of adverse changes in interest

rates on net interest income. Downey has interest rate swap contracts on which it pays variable interest based on the 3-month London Inter-Bank

Offered Rate (“LIBOR”) while receiving fixed interest. The swaps were designated as a hedge against changes in the fair value of certain FHLB fixed

rate advances due to changes in market interest rates. The payment and maturity dates of the swap contracts match those of the advances. This hedge

effectively converts fixed interest rate advances into debt that adjusts quarterly to movements in 3-month LIBOR. Because the terms of the swap

contracts match those of the advances, the hedge has no ineffectiveness and results are reported in interest expense. The fair value of interest rate

swap contracts is based on dealer quoted market prices acquired from third parties and represents the estimated amount Downey would receive or pay

upon terminating the contracts, taking into consideration current interest rates and the remaining contract terms. The fair value of the swap contracts is

recorded on the balance sheet in either other assets or accounts payable and accrued liabilities. With no ineffectiveness, the recorded swap contract

values will essentially act as fair value adjustments to the advances being hedged. At September 30, 2008, swap contracts with a notional amount

totaling $430 million were outstanding and had a fair value gain of $0.1 million recorded on the balance sheet in other assets and as an increase to the

advances being hedged.

The following table summarizes Downey’s interest rate swap contracts at September 30, 2008.

Weighted

Notional Average

(Dollars in Thousands) Amount Interest Rate Term

 

Pay – Variable (3-month LIBOR) $ (100,000 ) 2.50% March 2004 – October 2008

Receive – Fixed 100,000 3.20

Pay – Variable (3-month LIBOR) (130,000 ) 2.58 March 2004 – October 2008

Receive – Fixed 130,000 3.21

Pay – Variable (3-month LIBOR) (100,000 ) 2.73 March 2004 – November 2008

Receive – Fixed 100,000 3.26

Pay – Variable (3-month LIBOR) (100,000 ) 2.78 March 2004 – November 2008

Receive – Fixed 100,000 3.27

Page 16 Navigation LinksThe following table shows the impact from non-qualifying hedges and the ineffectiveness of cash flow hedges on net gains (losses) on sales of

loans and mortgage-backed securities (i.e., SFAS 133 effect), as well as the impact to other comprehensive income (loss) from qualifying cash flow

transactions for the periods indicated. Also shown are the notional amounts or balances for Downey’s non-qualifying and qualifying hedge

transactions.

(a) Amount represents the notional amount of the commitments or contracts reduced by an anticipated fallout factor for those commitments not

expected to fund. The notional amount for interest rate lock commitments before the reduction of expected fallout was $38 million.

 

The following table shows the impact from non-qualifying hedges and the ineffectiveness of cash flow hedges on net gains (losses) on sales of

loans and mortgage-backed securities (i.e., SFAS 133 effect), as well as the impact to other comprehensive income (loss) from qualifying cash flow

transactions for the year-to-date periods indicated.

These loan forward sale and swap contracts expose Downey to credit risk in the event of nonperformance by the other parties-primarily

government-sponsored enterprises such as Federal National Mortgage Association, securities firms and the FHLB. This risk consists primarily of the

termination value of agreements where Downey is in an unfavorable position. Downey manages the credit risk associated with its other parties to the

various derivative agreements through credit review, exposure limits and monitoring procedures. Downey does not anticipate nonperformance by the

other parties.

Financial Instruments with Off-Balance Sheet Risk

 

Downey utilizes financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net gains (losses) on non-qualifying hedge transactions $ (1,601 ) $ 2,099 $ (69 ) $ (460 ) $ (553 )

Net gains on qualifying cash flow hedge transactions:

Unrealized hedge ineffectiveness – – – – –

Less reclassification of realized hedge ineffectiveness – – – – –

Total net gains (losses) recognized in sales of loans and

mortgage-backed securities (SFAS 133 effect) (1,601 ) 2,099 (69 ) (460 ) (553 )

Other comprehensive income (loss) 127 593 (606 ) (101 ) (189 )

Notional amount or balance at period end

 

Non-qualifying hedge transactions:

Interest rate lock commitments (a) $ 25,963 $ 54,095 $ 78,131 $ 53,250 $ 92,742

Associated loan forward sale contracts 47,392 57,837 94,676 57,924 94,567

Associated loan forward purchase contracts 21,000 4,000 13,000 – 10,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value 7,673 85,558 109,253 103,384 90,228

Associated loan forward sale contracts 6,608 72,163 96,868 93,576 77,433

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed 430,000 430,000 430,000 430,000 430,000

Associated interest rate swap contracts –

pay-variable, receive-fixed 430,000 430,000 430,000 430,000 430,000

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net gains on non-qualifying hedge transactions $ 429 $ 564

Net gains on qualifying cash flow hedge transactions:

Unrealized hedge ineffectiveness – –

Less reclassification of realized hedge ineffectiveness – –

Total net gains recognized in sales of loans and

mortgage-backed securities (SFAS 133 effect) 429 564

Other comprehensive income (loss) 114 (335 )

and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to originate fixed and variable rate

mortgage loans held for investment, undisbursed loan funds, lines and letters of credit, commitments to purchase loans and mortgage-backed securities

for portfolio and commitments to invest in community development funds. The contract or notional amounts of those instruments reflect the extent of

involvement Downey has in particular classes of financial instruments.

Page 17 Navigation LinksCommitments to originate fixed and variable rate mortgage loans held for investment are agreements to lend to a customer as long as there is no

violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may

require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future

cash requirements. Undisbursed loan funds on construction projects and unused lines of credit on home equity and commercial loans include

committed funds not disbursed. Letters of credit are conditional commitments issued by Downey to guarantee the performance of a customer to a third

party. Downey also enters into commitments to purchase loans and mortgage-backed securities, investment securities and to invest in community

development funds.

The following is a summary of commitments with off-balance sheet risk at the dates indicated.

Downey uses the same credit policies in making commitments to originate loans held for investment and lines and letters of credit as it does for

on-balance sheet instruments. For commitments to originate loans held for investment, the commitment amounts represent exposure to loss from market

fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. Downey

manages the credit risk of its commitments to originate loans held for investment through credit approvals, limits and monitoring procedures. The credit

risk involved in issuing lines and letters of credit requires the same creditworthiness evaluation as that involved in extending loan facilities to

customers. Downey evaluates each customer’s creditworthiness.

Downey receives collateral to support commitments when deemed necessary. The most significant categories of collateral include real estate

properties underlying mortgage loans, liens on personal property and cash on deposit with Downey.

Downey maintains an allowance for losses to provide for inherent losses for loan-related commitments associated with undisbursed loan funds

and unused lines of credit. The allowance for losses on loan-related commitments was $1 million at September 30, 2008, December 31, 2007 and

September 30, 2007.

Other Contractual Obligations

 

Downey sells all loans without recourse. When a loan sold to an investor without recourse fails to perform according to the contractual terms of

the note, the investor will typically review the loan file to determine whether defects in the origination process occurred and whether such defects give

rise to a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, Downey may be

required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, Downey has no commitment to

repurchase the loan. During the first nine months of 2008, Downey recorded repurchase or indemnification losses related to defects in the origination

process of $0.7 million and repurchased $6 million of loans and $2 million of real estate acquired in settlement of loans.

The loan and servicing sale contracts may also contain provisions to refund sales price premiums to the purchaser if the related loans prepay

during a period of typically 90 days, but never more than 120 days, from the sale’s settlement date. Downey reserved less than $1 million at September

30, 2008, December 31, 2007 and September 30, 2007 to cover the estimated loss exposure related to early payoffs. However, if all the loans related to

those sales prepaid within the refund period, as of September 30, 2008, Downey’s maximum sales price premium refund would be $1.9 million.

Through the normal course of operations, Downey has entered into certain contractual obligations. Downey’s obligations generally relate to the

funding of operations through deposits and borrowings, loan servicing, as well as leases for premises and equipment. Downey has obligations under

long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period, with options to extend, and are noncancelable.

Downey also has vendor contractual relationships, but the contracts are not considered to be material.

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Commitments to originate adjustable rate loans

held for investment $ 138,092 $ 362,317 $ 524,978 $ 196,471 $ 211,277

Undisbursed loan funds and unused lines of credit 267,719 277,757 265,493 306,532 310,677

Page 18 Navigation LinksAt September 30, 2008, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, senior notes and future operating

minimum lease commitments were as follows:

Litigation

Judicial Proceedings

 

On October 29, 2004, two former traditional branch employees brought an action in Los Angeles County Superior Court, Case No. BC323796,

entitled Margie Holman and Alice A. Mesec, et al. v. Downey Savings and Loan Association. The first amended complaint seeks unspecified damages

for alleged unpaid regular and overtime wages, inadequate meal breaks, failure to pay split-shift and reporting time wages, and related claims. The

plaintiffs are seeking class action status to represent all other current and former Downey Savings and Loan Association, F.A. (“Bank”) employees who

held the position of Customer Service Supervisor and/or Customer Service Representative at the Bank’s in-store branches at any time from October 29,

2000 to date. The Bank has opposed the claim and asserted all appropriate defenses, and has provided for what is believed to be a reasonable estimate

of exposure for this matter in the event of loss. While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of

this matter will not have a material adverse effect on Downey’s operations, cash flows or financial position.

Two purported shareholder class actions, one brought on behalf of Waterford Township General Employees Retirement System, Case No. CV-08-

03261, and the other brought on behalf of Stephen J. Mihalacki, Case No. SACV08-00609, were filed on May 16, 2008 and June 2, 2008, respectively, in

the United States District Court for the Central District of California against Downey Financial Corp. (“Holding Company”) and certain of its current and

former officers and certain former directors. The complaints, filed on behalf of all persons who purchased Holding Company common stock during

October 16, 2006 to March 14, 2008, seek unspecified damages for alleged violation of federal securities laws, claiming that the defendants made

misleading statements and omissions regarding Downey’s business and financial results, thereby artificially inflating the common stock price.

Specifically, the plaintiffs contend that the defendants concealed that (a) the Bank’s portfolio of option ARMs contained millions of dollars worth of

impaired and risky securities; (b) the Bank had been aggressive in acquiring loans from mortgage brokers that were highly risky; (c) the Bank had failed

to properly account for highly leveraged loans; (d) the Bank had inadequate underwriting practices, which led to large numbers of loan defaults; and (e)

the Bank had not adequately reserved for option ARM loans. A motion to consolidate the two actions was granted on August 14, 2008 with Waterford

Township General Partnership Employees Retirement System as lead plaintiff. The plaintiffs filed a consolidated complaint on September 30, 2008 and,

pursuant to a stipulation between the parties, have until November 12, 2008 to file a first amended consolidated complaint.

Related to the shareholder class actions, two purported shareholder derivative lawsuits, one entitled Michael L. McDougall v. Daniel D., Case No. 30-2008-00180029, and the other entitled Joyce Mendlin v. Maurice L. McAlister, et al., Case No. 30-2008-00087854, were

Rosenthal, et al.

filed on June 10, 2008 and July 28, 2008, respectively, in Orange County Superior Court, in California. The plaintiffs, who purport to bring the lawsuits

on behalf of the Holding Company against certain of its current and former officers, its current directors and certain former directors, allege that

commencing in October 2006, the defendants caused or allowed Downey to issue a series of press releases and other statements that significantly

overstated Downey’s business prospects and financial results; that the statements failed to disclose that Downey was more exposed to the subprime

market crisis than it had disclosed; that Downey’s portfolio of subprime and option ARM mortgage-related assets was overvalued; and that as a result,

Downey’s reported earnings and business prospects were inaccurate. The plaintiffs allege that the defendants’ action constitutes breaches of fiduciary

duty, waste of corporate assets and unjust enrichment, and seek, among other relief, unspecified damages to be paid to the Holding Company,

corporate governance reforms, and equitable and injunctive relief, including restitution and the creation of a constructive trust.

Downey has been named as a defendant in other legal actions arising in the ordinary course of business, none of which, in the opinion of

management, will have a material adverse effect on its operations, cash flows or financial position.

After 1 After 3

Within Through 3 Through 5 Beyond Total

(In Thousands) 1 Year Years Years 5 Years Balance

 

Certificates of deposit $ 6,865,770 $ 614,856 $ 110,554 $ – $ 7,591,180

FHLB advances 935,061 500,000 675,000 – 2,110,061

Senior notes – – – 198,593 198,593

Operating leases 5,473 7,542 2,386 344 15,745

Total other contractual obligations $ 7,806,304 $ 1,122,398 $ 787,940 $ 198,937 $ 9,915,579

Page 19 Navigation LinksOn September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. For

more information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

NOTE (6) – Income Taxes

 

FASB Interpretation 48: Accounting for Uncertainty in Income Taxes requires the affirmative evaluation that it is more likely than not, based on

the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns. If a tax

position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements.

Management has determined that there are no unrecognized tax benefits to be reported in Downey’s financial statements, and none are anticipated

during the next 12 months.

Downey’s federal tax returns have been examined by the Internal Revenue Service (“IRS”) through 2005. Tax years subsequent to 2005 remain

subject to federal examination, while state tax returns for years subsequent to 2003 are subject to examination by taxing authorities. When applicable,

Downey classifies interest (net of tax) and penalties on the underpayment of taxes as income tax expense.

SFAS 109, Accounting for Income Taxes, requires that when determining the need for a valuation allowance against a deferred tax asset,

management must assess both positive and negative evidence with regard to the realizability of the tax losses represented by that asset. To the extent

available sources of taxable income are insufficient to absorb tax losses, a valuation allowance is necessary. Sources of taxable income for this analysis

include prior years’ tax returns, the expected reversals of taxable temporary differences between book and tax income, prudent and feasible tax-planning

strategies, and future taxable income.

Downey has recorded a valuation allowance of $216 million against its deferred tax asset of $235 million as of September 30, 2008, after considering

all available evidence related to the amount of the tax asset that is more likely than not to be realized.

Downey’s deferred tax asset resulted from a significant increase in its loan loss allowance. To the extent the loan loss allowance is not allocable to

specific loans, it represents future tax benefits which would be realized when actual charge-offs are made against the allowance. Given Downey’s recent

operating losses, the valuation allowance recorded at September 30, 2008 reduces the deferred tax asset to the amount management deems more likely

than not to be realized only through the carry back of tax losses to prior years’ federal tax returns.

Since generally accepted accounting principles require Downey to spread its expected annual tax benefit across the entire year through an

effective tax rate, we expect to continue realizing a tax benefit for the remainder of 2008, but at a lower-than-normal effective tax rate, due to the effect of

the valuation allowance discussed above.

NOTE (7) – Employee Stock Option Plans and Restricted Grant

 

During 1994, the Bank adopted and Downey’s stockholders approved the Downey Savings and Loan Association 1994 Long Term Incentive Plan

(“LTIP”). The LTIP provided for the granting of stock appreciation rights, restricted stock, performance awards and other awards. The LTIP specified

an authorization of 434,110 shares (adjusted for stock dividends and splits) of the Bank’s common stock available for issuance under the LTIP. Effective

January 23, 1995, the Holding Company and the Bank executed an amendment to the LTIP by which the Holding Company adopted and ratified the

LTIP such that shares of the Holding Company shall be issued upon exercise of options or payment of other awards, for which payment is to be made

in stock, in lieu of the Bank’s common stock. The LTIP terminated in 2004; however, options granted and outstanding at termination remain exercisable

until the specific termination date of the option. At September 30, 2008, options for 23,430 shares were outstanding, all of which were exercisable at a

weighted average option price per share of $25.44, which represented at least the fair market value of such shares on the date the options were granted

and expire at December 31, 2008. No other stock based plan exists.

On September 16, 2008, in connection with the Chief Executive Officer’s commencement of employment at Downey, 1,226,994 shares of restricted

stock in Downey were granted him by the Board of Directors. At the grant date, the stock had a fair value of $3.71 per share, which resulted in

compensation expense for the current quarter of $52,000. During September 2008, all of Downey’s treasury stock of 381,239 was reissued at below cost

to satisfy part of the stock grant. As of the date of the grant, the restricted stock was unvested. The CEO shall vest in the restricted stock at a rate of

25% each year and be fully vested in the restricted stock upon the fourth anniversary of the grant date.

Page 20 Navigation LinksEarnings (loss) per share of common stock is calculated on both a basic and diluted basis based on the weighted average number of common and

common equivalent shares outstanding, excluding common shares in treasury. Basic earnings per share excludes dilution and is computed by dividing

income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings 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.

The following table presents a reconciliation of the components used to derive basic and diluted earnings per share for the periods indicated.

(a) For the three months ended September 30, 2008, there was no dilutive effect from our 23,430 outstanding stock options.

 

The following table presents a reconciliation of the components used to derive basic and diluted earnings per share for the year-to-date periods

indicated.

(a) For the nine months ended September 30, 2008, there was no dilutive effect from our 23,430 outstanding stock options.

NOTE (9) – Fair Value of Financial Instruments

 

Fair value measurements for Downey’s financial instruments are determined at a specific point in time based on the assumptions that market

participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we have

established a fair value hierarchy as required by the FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements, (“SFAS

157”). The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from sources

independent of Downey (observable inputs) and (2) Downey’s own assumptions about market participant assumptions developed based on the best

information available in the circumstances (unobservable inputs). The notion of unobservable inputs allows for situations in which there is little, if any,

market activity for the asset or liability at the measurement date. Because no active market exists for a portion of Downey’s financial instruments, fair

value estimates are subjective in nature. Additionally, the fair value estimates do not necessarily reflect the price Downey might receive if it were to sell

at one time its entire holding of a particular financial instrument.

Fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The highest priority (Level 1

inputs) is for quoted prices (unadjusted) in active markets for identical assets or liabilities, the next priority (Level 2 inputs) is for other than quoted

prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, and the lowest priority (Level 3 inputs) is for

unobservable inputs. In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair

value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair

Three Months Ended September 30,

2008 2007

Weighted Weighted

Average Average

Net Shares Per Share Net Shares Per Share

(Dollars in Thousands, Except Per Share Data) Loss Outstanding Amount Loss Outstanding Amount

 

Basic loss per share $ (81,070 ) 27,960,478 $ (2.89 ) $ (23,361 ) 27,853,783 $ (0.84 )

Effect of dilutive stock options (a) – – – –

–

–

Diluted loss per share $ (81,070 ) 27,960,478 $ (2.89 ) $ (23,361 ) 27,853,783 $ (0.84 )

Nine Months Ended September 30,

2008 2007

Weighted Weighted

Average Average

Net Shares Per Share Net Shares Per Share

(Dollars in Thousands, Except Per Share Data) Loss Outstanding Amount Income Outstanding Amount

 

Basic earnings (loss) per share $ (547,686 ) 27,889,608 $ (19.64 ) $ 52,246 27,853,783 $ 1.87

Effect of dilutive stock options (a) – – – – 29,021 –

Diluted earnings (loss) per share $ (547,686 ) 27,889,608 $ (19.64 ) $ 52,246 27,882,804 $ 1.87

value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment

considering factors specific to the asset or liability and could significantly affect the fair value estimate.

Page 21 Navigation LinksDowney’s valuation techniques used to measure fair value are as follows:

l Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.

l Level 2 – Valuation is based upon quoted prices for similar instruments or assets in active markets, quoted prices for identical or similar

instruments or assets in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable

in the market.

l Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These

unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability.

Valuation techniques include use of pricing models, discounted cash flow models and similar techniques.

The following table presents for each of these hierarchy levels, Downey’s assets and liabilities that are measured at fair value on a recurring basis

at the date indicated.

The following table summarizes the activity in the Level 3 fair value category for the year-to-date period indicated.

(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity. Amount in Net Unrealized Gains/(Losses) column excludes changes in fair value

due to changes from the realization of expected cash flows over time.

 

Also, we may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with U. S.

generally accepted accounting principles. The adjustments to fair value usually result from application of lower-of-cost-or-market accounting or writedowns

of individual assets.

The following table provides a level of valuation assumptions used to determine each adjustment and the carrying value of assets measured at fair

value on a nonrecurring basis at the date and for the period indicated.

September 30,

(In Thousands) Level 1 Level 2 Level 3 2008

 

U.S. Treasury, government sponsored entities and other

investment securities, available for sale $ 592,481 $ – $ 61 $ 592,542

Mortgage-backed securities available for sale – – 104 104

Mortgage servicing rights – – 22,814 22,814

Net derivative assets (liabilities) – (261 ) 135 (126 )

Total $ 592,481 $ (261 ) $ 23,114 $ 615,334

Net Unrealized

Gains/(Losses) Net

At Gains/(Losses) In Other Purchases Transfers At Net

December 31, In Net Comprehensive Sales and In/out of September 30, Unrealized

(In Thousands) 2007 Income (a) Income Settlements Level 3 2008 Gains/(Losses)

 

U.S. Treasury, government sponsored

entities and other investment

securities, available for sale $ 61 $ – $ – $ – $ – $ 61 $ –

Mortgage-backed securities

available for sale 111 – – (7 ) – 104 –

Mortgage servicing rights 19,512 5,659 – (2,357 ) – 22,814 536

Net derivative assets (liabilities) 198 (63 ) – – – 135 135

Total $ 19,882 $ 5,596 $ – $ (2,364 ) $ – $ 23,114 $ 671

Gains/(Losses)

for the Nine

Months Ended

At September 30,

(In Thousands) Level 1 Level 2 Level 3 September 30, 2008

(a) Amount at September 30, 2008 is net of an $11 million valuation allowance related to Downey’s single family residential properties which

reflects recent loss experience from sales compared to their fair value prior to sale.

 

Loans held for investment $ – $ – $ 48,728 $ 48,728 $ (11,871 )

Real estate acquired in settlement of loans (a) – – 278,091 278,091 (57,406 )

Investment in real estate and joint ventures – – 13,661 13,661 (19,899 )

Total $ – $ – $ 340,480 $ 340,480 $ (89,176 )

Page 22 Navigation LinksThe following table presents the operating results and selected financial data by business segments for the periods indicated.

Real Estate

(In Thousands) Banking Investment Elimination Totals

Three months ended September 30, 2008

 

Net interest income $ 75,998 $ 29 $ – $ 76,027

Provision for credit losses 130,291 – – 130,291

Other income (loss) 78,820 (10,605 ) – 68,215

Operating expense 102,325 330 – 102,655

Net intercompany income (expense) 3 (3 ) – –

Loss before income tax benefits (77,795 ) (10,909 ) – (88,704 )

Income taxes (tax benefits) (8,769 ) 1,135 – (7,634 )

Net loss $ (69,026 ) $ (12,044 ) $ – $ (81,070 )

At September 30, 2008

 

Assets:

Loans and mortgage-backed securities, net $ 10,757,283 $ – $ – $ 10,757,283

Investments in real estate and joint ventures – 15,606 – 15,606

Other 2,004,305 11,356 (7,351 ) 2,008,310

Total assets 12,761,588 26,962 (7,351 ) 12,781,199

Equity $ 771,714 $ 7,351 $ (7,351 ) $ 771,714

Three months ended September 30, 2007

 

Net interest income $ 97,656 $ 314 $ – $ 97,970

Provision of credit losses 81,562 – – 81,562

Other income (loss) 10,756 (7,720 ) – 3,036

Operating expense 62,365 311 – 62,676

Net intercompany income (expense) 22 (22 ) – –

Loss before income tax benefits (35,493 ) (7,739 ) – (43,232 )

Income tax benefits (16,642 ) (3,229 ) – (19,871 )

Net loss $ (18,851 ) $ (4,510 ) $ – $ (23,361 )

At September 30, 2007

 

Assets:

Loans and mortgage-backed securities, net $ 11,692,185 $ – $ – $ 11,692,185

Investments in real estate and joint ventures – 58,715 – 58,715

Other 2,710,006 30,420 (73,609 ) 2,666,817

Total assets 14,402,191 89,135 (73,609 ) 14,417,717

Equity $ 1,444,226 $ 73,609 $ (73,609 ) $ 1,444,226

Real Estate

(In Thousands) Banking Investment Elimination Totals

Nine months ended September 30, 2008

 

Net interest income $ 242,465 $ 218 $ – $ 242,683

Provision for credit losses 626,035 – – 626,035

Other income (loss) 105,483 (16,265 ) – 89,218

Operating expense 279,204 968 – 280,172

Net intercompany income (expense) 71 (71 ) – –

Loss before income tax benefits (557,220 ) (17,086 ) – (574,306 )

Income tax benefits (25,229 ) (1,391 ) – (26,620 )

Net loss $ (531,991 ) $ (15,695 ) $ – $ (547,686 )

Nine months ended September 30, 2007

 

Net interest income $ 333,505 $ 1,038 $ – $ 334,543

Provision for credit losses 91,684 – – 91,684

Other income (loss) 45,056 (6,807 ) – 38,249

Operating expense 189,700 979 – 190,679

Net intercompany income (expense) 53 (53 ) – –

Income (loss) before income taxes (tax benefits) 97,230 (6,801 ) – 90,429

Income taxes (tax benefits) 41,044 (2,861 ) – 38,183

Net income (loss) $ 56,186 $ (3,940 ) $ – $ 52,246

Page 23 Navigation LinksOn September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. The

Bank Order requires the Bank to, among other things:

l meet and maintain a minimum Tier I Core Capital ratio of 7% and a minimum Total Risk-Based Capital ratio of 14% at each quarter-end;

l submit to the OTS an updated capital augmentation and strategy plan addressing how the Bank will meet and maintain the foregoing capital

ratios and that provides for the raising of new equity and a capital infusion by no later than December 31, 2008, together with an alternative

strategy to meet and maintain the Bank’s capital and ensure its safe and sound operation if the plan to raise additional capital is not successful;

l submit for OTS approval within prescribed time periods (i) a comprehensive classified asset reduction plan, (ii) a real estate owned disposition

plan, (iii) an updated business plan containing strategies for a reduction in concentration of payment option adjustable rate mortgage and stated

income loans and (iv) a plan to strengthen executive management;

l notify, or in certain cases receive the approval or non-objection of, the OTS prior to (i) increasing its total assets in any quarter in excess of an

amount equal to net interest credited on deposits during the quarter; (ii) making certain changes to its directors or senior executive officers; (iii)

entering into, renewing, extending or revising any contractual arrangement related to compensation or benefits with any director or senior

executive officer of the Bank; (iv) making any golden parachute or prohibited indemnification payments; (v) paying dividends or making other

capital distributions; and (vi) entering into certain transactions with affiliates;

l refrain from any unsafe and unsound practices regarding lending and from resuming payment option adjustable rate mortgage or stated income

lending programs; and

l comply with the OTS’ most recent report of examination with respect to the Bank.

In light of the capital directive set forth in the Bank Consent Order, the Bank is deemed to be “adequately capitalized” rather than “well

capitalized” despite exceeding all “well capitalized” regulatory ratios.

Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by no later than December 31,

2008, bank regulators could take enforcement action before that date, which could include placing the Bank into receivership.

The Consent Order that the Holding Company entered into requires it to notify, or in certain cases receive the approval or non-objection of, the

OTS prior to (i) accepting or requesting that the Bank pay or make, or commit to pay or make, any dividends or other capital distributions; (ii) making

certain changes to its directors or senior executive officers; (iii) entering into, renewing, extending or revising any contractual arrangement related to

compensation or benefits with any director or senior executive officer of the Holding Company; (iv) making any golden parachute payments or

prohibited indemnification payments; and (v) incurring, issuing, renewing or rolling over any debt, increasing any current lines of credit or guaranteeing

the debt of any entity.

Liquidity

 

Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, available for sale

securities, and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments. Interest rates, real

estate sales activity and general economic conditions significantly affect repayments on loans and deposit inflows and outflows.

In addition to its deposits, our principal source of liquidity is our ability to utilize borrowings, as needed. The Bank’s primary source of

borrowings is the FHLB. At September 30, 2008, the Bank’s FHLB borrowings totaled $2.1 billion, representing 16.5% of total assets. The Bank currently

is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional

$0.9 billion of borrowing capacity from the FHLB as of September 30, 2008. The amount the FHLB is willing to advance differs based on the quality and

character of qualifying collateral offered by the Bank, and the advance rates for the same collateral may be adjusted upwards or downwards by the

FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to

the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank of San Francisco as a back-up source of liquidity. As of

September 30, 2008 the Bank had no outstanding

Page 24 Navigation Linksborrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying collateral would have permitted it to borrow up to an

additional $1.1 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is obligated to lend to us under these loan facilities. To the

extent deposit renewals and deposit growth are not sufficient to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing

and future loans and investment securities and otherwise fund working capital needs and capital expenditures, the Bank may utilize additional

borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements. However, if elevated levels of net deposit outflows occur, the

Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing

arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional

capital or enter into additional financing arrangements. As a result of being “adequately capitalized” rather than “well capitalized,” the Bank is subject

to restrictions on accepting brokered deposits, which have not historically been a significant part of the Bank’s deposit base, and upper limits on

interest rates the Bank may pay on deposits.

As of September 30, 2008, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $216

million, of which $38 million were related to residential one-to-four unit loans being originated for sale in the secondary market. We also had

undisbursed loan funds and unused lines of credit of $268 million, loan forward purchase contracts of $21 million and operating leases of $16 million.

Subsequent to September 30, 2008, we closed our wholesale lending channel which traditionally provided about 80% of our single family loan

originations and scaled back our retail loan channel. Therefore, loan origination volumes will decline in future periods. For further information, see Note

5 of Notes to the Consolidated Financial Statements on page 15.

Limitations imposed by the OTS currently prohibit the Bank from providing a dividend to the Holding Company without the prior written approval

of the OTS, and currently prohibit the Holding Company from paying a dividend without the prior non-objection of the OTS. At September 30, 2008, the

Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million, down from $102 million at the end of 2007 due

primarily to $80 million in capital contributions made to the Bank. In addition, the Holding Company may not issue new debt or renew existing debt

without the prior non-objection of the OTS. At this time, there is no other source of repayment of the senior notes. Absent additional capital, the

Holding Company will default on the notes within a year.

Downey’s stockholders’ equity totaled $772 million at September 30, 2008, down from $1.3 billion at December 31, 2007 and $1.4 billion at

September 30, 2007. No future dividends will be paid without the prior non-objection of the OTS.

Capital Adequacy

 

At September 30, 2008, the Bank was above the minimum capital ratios required by its Consent Order, with core and tangible capital ratios of

7.48% and a total risk-based capital ratio of 14.50%. In addition, the Bank’s Consent Order requires the Bank to complete a capital raising initiative by

December 31, 2008. As a direct result of these requirements, during the quarter, we sold certain non-core real estate assets to a third party resulting in

an enhancement to the Bank’s regulatory capital of $109 million and the Holding Company made a capital contribution of $30 million. These capital

enhancements were more than offset by the net loss recorded in the current quarter. Based on the Bank’s current and projected levels of capital, the

Bank anticipates that it will not be able to satisfy the Tier I Core Capital and Total Risk-Based Capital minimum ratios of its Consent Order as of

December 31, 2008, unless it raises additional capital on or prior to that date. In the current economic environment, there is a significant risk that the

Bank will not be able to raise sufficient additional capital to ensure compliance with the capital requirements of the Bank Consent Order by year-end.

For more information, see “Part II – Other Information – Item 1A. – Risk Factors – If we do not raise additional capital by December 31, 2008, it is highly

unlikely that we will be in compliance with the capital requirements of the Bank Consent Order at year-end, which could have a material adverse effect

upon us.” on page 77.

Going Concern

 

The circumstances described above, raise substantial doubt concerning the ability of the Holding Company and the Bank to continue as going

concerns for a reasonable period of time.

Page 25 Navigation LinksIn March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging

Activities (“SFAS 161”). This standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring

enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows.

This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application

encouraged. Downey is currently evaluating the impact, if any, that this statement will have on its disclosures related to hedging activities.

Statement of Financial Accounting Standards No. 162

 

In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted Accounting

Principles, (“SFAS 162”). This standard is intended to improve financial reporting by identifying the sources of accounting principles and a consistent

framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S.

GAAP for nongovernmental entities. SFAS 162 will be effective 60 days after the U.S. Securities and Commission approves the Public Company

Accounting Oversight Board’s amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting

Principles.” Adoption of SFAS 162 is not expected to have a material impact on Downey.

NOTE (13) – Subsequent Event

 

On October 16, 2008, the Bank closed its Wholesale Loan Department and the loan processing centers supporting that Department, and began

contracting its Retail Loan Department. For more information, see “Capital Resources and Liquidity” on page 70.

Page 26 Navigation Links

Certain statements under this caption may constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995,

which involve risks and uncertainties. Forward-looking statements do not relate strictly to historical information or current facts. Some forwardlooking

statements may be identified by use of terms such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or

words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.” Our actual results or outcomes 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 we conduct our operations, new, changed or increased

regulatory restrictions, pending or threatened litigation, a decrease in our customers, including a decrease in our deposit base, the possible loss of

key personnel, the inability to successfully implement strategic initiatives, changes in deposit flows and loan demand, limitations on our ability to

borrow to fund our assets and operations, risk of credit losses, risk associated with residential mortgage lending, risk associated with a slowdown

in the housing market or high interest rates, fluctuations in interest rates, credit quality, the outcome of ongoing audits, taxing authorities and

government regulation and factors, identified under part II – Other Information Item 1A. Risk Factors on page77 and in our other current and

periodic reports filed from time to time with the SEC. All forward-looking statements in this document are made as of the date hereof, based on

information available to us as of the date hereof. We do not undertake to update forward-looking statements to reflect the impact of circumstances or

events that arise after the date the forward-looking statements were made, except as required by law. We are not able to make any assurances,

including but not limited to any assurances that the increased rate of sale of foreclosed homes will continue in future periods, that the rate of deposit

withdrawals will not increase in future periods, that the percentage of unsold homes in escrow or under negotiation will be representative of the

number or percentage of homes sold in future periods, we will have adequate liquidity in future periods, capital levels will exceed levels required by

our regulators in future periods or that we will be able to meet other requirements imposed by our regulators.

OVERVIEW

 

A net loss was recorded for the third quarter of 2008 of $81.1 million or $2.89 per share on a diluted basis, compared with a net loss of $23.4 million

or $0.84 per share in the year-ago third quarter.

The $45.5 million unfavorable change in pre-tax loss between third quarters was due primarily to:

l A $48.7 million or 59.7% increase in provision for credit losses primarily due to a higher level of delinquent loans and an increase in loss severity

from the continuing decline in housing values that provide the underlying collateral for our loans;

l A $40.0 million or 63.8% increase in operating expense, of which approximately 69% was due to higher costs related to the operation of real

estate acquired in settlement of loans, with the balance of the increase primarily associated with higher deposit insurance premiums,

professional fees and consulting fees; and

l A $21.9 million or 22.4% decline in net interest income due to both a lower level of interest-earning assets and a lower effective interest rate

spread.

These unfavorable items were partially offset by an increase in other income of $65.2 million primarily due to the sale of non-core real estate related

contracts.

For the first nine months of 2008, the net loss totaled $547.7 million or $19.64 per share on a diluted basis, compared with net income of $52.2

million or $1.87 per share on a diluted basis for the first nine months of 2007. The decline primarily reflected an increase in our provision for credit

losses, lower net interest income and higher operating expenses.

For the third quarter, our return on average assets was a negative 2.42%, and our return on average equity was a negative 39.04%. These compare

to year-ago negative returns of 0.64% on average assets and 6.36% on average equity. For the nine months ended September 30, 2008, our return on

average assets was a negative 5.51%, and our return on average equity was a negative 69.68%. These compare to year-ago positive returns of 0.46% on

average assets and 4.82% on average equity.

Page 27 Navigation LinksAt September 30, 2008, assets totaled $12.781 billion, down $1.637 billion or 11.4% from a year ago. During the current quarter, assets increased

$149 million. Our cash and cash equivalents increased $460 million during the quarter reflecting a cautionary measure relative to our liquidity given

depositor and market place concerns as various banks failed during the period. In addition, the increase in total assets reflected an increase of $118

million in loans held for investment, $54 million in Federal Home Loan Bank stock, and $33 million in other assets. Those asset increases were partially

offset by declines of $406 million in investment securities, $78 million in loans held for sale and $48 million in investments in real estate and joint

ventures. Included within loans held for investment at quarter end were $5.715 billion of single family adjustable rate mortgages subject to negative

amortization, down $527 million from June 30, 2008. These loans comprised 52% of the single family residential loan portfolio held for investment at

quarter end, compared with 74% a year ago. The amount of negative amortization included in loan balances declined $27 million during the current

quarter to $318 million or 5.6% of loans subject to negative amortization. During the current quarter, approximately 10% of loan interest income

represented negative amortization, down from 15% in the second quarter 2008 and 26% in the year-ago third quarter.

Loan originations (including purchases) totaled $804 million in the current quarter, up $110 million or 15.8% from $694 million originated a year ago

but down from $1.027 billion originated in the second quarter of 2008. Single family residential loans originated for portfolio increased $128 million or

29.6% from a year ago to $560 million, while other loans originated for portfolio increased $79 million to $96 million in the current quarter. Those

increases were partially offset by a decline in loans originated for sale, which declined $98 million or 39.8% to $147 million.

Not included in the above originations are loans for which we modify the terms of a borrower’s loan. During the current quarter, we modified $157

million of loans associated with our borrower retention program, wherein the borrower was current with their loan payments and the new interest rate

was no less than that afforded new borrowers, and an additional $149 million of loans at below market interest rates in loan workout situations. All of

the portfolio retention modifications were adjustable rate loans, which permitted negative amortization, that were modified into five-year interest-only

adjustable rate loans with interest rates that adjust semi-annually but do not permit negative amortization. Most of the other modifications were

modified for a two year period into a fixed rate interest-only product.

Deposits totaled $9.618 billion at quarter end, down $1.044 billion or 9.8% from a year ago. At quarter end, the number of branches totaled 175 (170

in California and five in Arizona). At quarter end, the average deposit size of our 85 traditional branches was $89 million, while the average deposit size

of our 90 in-store branches was $23 million. During the current quarter, borrowings increased by $487 million and represented 18% of total assets at

quarter end.

Non-performing assets increased during the quarter by $44 million to $2.002 billion and represented 15.66% of total assets, compared with 7.77%

at year-end 2007 and 2.94% a year ago. Virtually all of the increase in the current quarter was related to our single family residential lending activity.

Included in non-performing assets are loans modified pursuant to our borrower retention program. This program was initiated at the beginning of the

third quarter of 2007 to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loan that

permitted negative amortization to a less costly financing alternative. To the extent borrowers whose loans were modified as part of this program are

current with their loan payments and included in non-performing assets, it is relevant to distinguish those from total non-performing assets because,

unlike other loans classified as non-performing assets, these loans are paying interest at interest rates no less than those afforded new borrowers. At

September 30, 2008, 72% of such borrowers had made all loan payments due. Accordingly, the 15.66% ratio of non-performing assets to total assets

includes 3.20% related to performing troubled debt restructurings resulting in an adjusted ratio of 12.46%.

At September 30, 2008, Downey Financial Corp.’s primary subsidiary, Downey Savings and Loan Association, F.A. (the “Bank”), had core and

tangible capital ratios of 7.48%, and a total risk-based capital ratio of 14.50%. In each case, these ratios exceeded the minimum regulatory capital ratios

required to be maintained by the Bank of 7.00% for core and tangible and 14.00% for risk-based. The Bank’s regulatory capital position was enhanced

during the current quarter by $109 million from the sale of certain non-core real estate assets, and a $30 million contribution of equity from Downey

Financial Corp. (the “Holding Company”). These were more than offset by the net loss recorded in the current quarter. For more information, see Note

11 of Notes to the Consolidated Financial Statements on page 24.

Page 28 Navigation LinksIn light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have continued to work

closely with the Bank’s federal banking regulators. On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with

the OTS, effective as of the same date. The Bank Order requires the Bank to, among other things:

l meet and maintain a minimum Tier I Core Capital ratio of 7% and a minimum Total Risk-Based Capital ratio of 14% at each quarter-end;

l submit to the OTS an updated capital augmentation and strategy plan addressing how the Bank will meet and maintain the foregoing capital

ratios and that provides for the raising of new equity and a capital infusion by no later than December 31, 2008, together with an alternative

strategy to meet and maintain the Bank’s capital and ensure its safe and sound operation if the plan to raise additional capital is not successful;

l submit for OTS approval within prescribed time periods (i) a comprehensive classified asset reduction plan, (ii) a real estate owned disposition

plan, (iii) an updated business plan containing strategies for a reduction in concentration of payment option adjustable rate mortgage and stated

income loans and (iv) a plan to strengthen executive management;

l notify, or in certain cases receive the approval or non-objection of, the OTS prior to (i) increasing its total assets in any quarter in excess of an

amount equal to net interest credited on deposits during the quarter; (ii) making certain changes to its directors or senior executive officers; (iii)

entering into, renewing, extending or revising any contractual arrangement related to compensation or benefits with any director or senior

executive officer of the Bank; (iv) making any golden parachute or prohibited indemnification payments; (v) paying dividends or making other

capital distributions; and (vi) entering into certain transactions with affiliates;

l refrain from any unsafe and unsound practices regarding lending and from resuming payment option adjustable rate mortgage or stated income

lending programs; and

l comply with the OTS’ most recent report of examination with respect to the Bank.

In light of the capital directive set forth in the Bank Consent Order, the Bank is deemed to be “adequately capitalized” rather than “well

capitalized” despite exceeding all “well capitalized” regulatory ratios.

Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by no later than December 31,

2008, bank regulators could take enforcement action before that date, which could include placing the Bank into receivership.

The Consent Order that the Holding Company entered into requires it to notify, or in certain cases receive the approval or non-objection of, the

OTS prior to (i) accepting or requesting that the Bank pay or make, or commit to pay or make, any dividends or other capital distributions; (ii) making

certain changes to its directors or senior executive officers; (iii) entering into, renewing, extending or revising any contractual arrangement related to

compensation or benefits with any director or senior executive officer of the Holding Company; (iv) making any golden parachute payments or

prohibited indemnification payments; and (v) incurring, issuing, renewing or rolling over any debt, increasing any current lines of credit or guaranteeing

the debt of any entity.

The circumstances described in Note 11 (page 24) and in Risk Factors (page 77), raise substantial doubt concerning the ability of the Holding

Company and the Bank to continue as going concerns for a reasonable period of time.

Page 29 Navigation LinksWe have established various accounting policies which govern the application of accounting principles generally accepted in the United States

of America in the preparation of our financial statements. Certain accounting policies require us to make significant estimates and assumptions which

could have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The

estimates and assumptions are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual

results could differ significantly from these estimates and assumptions which could have a material impact on the future carrying value of assets and

liabilities and our results of operations for the reporting periods. We believe the following four critical accounting policies require the most judicious

estimates and assumptions, which are particularly susceptible to significant change in the preparation of our financial statements:

l the valuation of interest rate lock commitments;

l the allowance for credit and real estate losses;

l the valuation of mortgage servicing rights (“MSRs”); and

l the prepayment reserves related to sales of loans and MSRs.

The nature of these judgments, estimates and assumptions are described in greater detail in Downey’s Annual Report on Form 10-K for the year ended

December 31, 2007 in the “Critical Accounting Policies” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial

Statements – “Summary of Significant Accounting Policies.”

In addition to those critical accounting policies addressed in Downey’s Annual Report on Form 10-K for the year ended December 31, 2007, we

have added:

l the calculation of our income tax provision and related tax accruals as they could have a material impact on the future value of assets and

liabilities and our results of operations. Accrued income taxes represent the estimated amounts due or to be received from the various taxing

jurisdictions where we have established a business presence. The balance also includes, when appropriate, a contingent reserve for potential

taxes, interest and penalties related to uncertain tax positions. On a quarterly basis, management evaluates the contingent tax accruals to

determine if they are sufficient based on a probability assessment of potential outcomes. The determination is based on facts and

circumstances, including the interpretation of existing law, new judicial or regulatory guidance and the status of tax audits. The provision for

income taxes is based on amounts reported in the consolidated statements of income which are adjusted to reflect the permanent and temporary

differences in the tax and financial accounting for certain assets and liabilities. Deferred income taxes represent the tax effect of the basis

differences in tax and financial reporting arising from temporary differences in accounting treatment. On a quarterly basis, management

evaluates its deferred tax assets to determine if these tax benefits are expected to be realized in future periods. This determination is based on

facts and circumstances, including our current and future tax outlook. To the extent a deferred tax asset is not considered “more likely than not”

to be realized, a valuation allowance is established. At September 30, 2008, we recorded a valuation allowance of $216 million against our

deferred tax assets of $235 million.

l the valuation of real estate acquired in settlement of loans. Real estate acquired through foreclosure is recorded at fair value less cost to sell on

the date of foreclosure and any subsequent fair value changes are recorded in net operations, with a corresponding charge to the asset value.

Fair value is measured based on the lower of the sales price, an appraisal or the list price and an additional loss allowance may be established

based on current market trends. List prices are determined based on Management’s estimate of value and take into consideration sources of

value such as a broker’s price opinion, internal appraisal review and market trends. At September 30, 2008, it was deemed necessary to maintain

an allowance for losses of $11 million against our single family residential real estate acquired in settlement of loans based on recent loss

experience from sales compared to their fair values prior to sale. For further information, see Note 3 on page 10 of Notes to the Consolidated

Financial Statements and Problem Loans and Real Estate on page 60.

Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of

Directors.

Page 30 Navigation LinksNet interest income is the difference between the interest and dividends earned on loans, mortgage-backed securities and investment securities

(“interest-earning assets”) and the interest paid on deposits and borrowings (“interest-bearing liabilities”). The spread between the yield on interestearning

assets and the cost of interest-bearing liabilities and the relative dollar amounts of these assets and liabilities principally affects net interest

income.

Our net interest income totaled $76.0 million in the third quarter of 2008, down $21.9 million or 22.4% from a year ago, reflecting a $1.828 billion or

13.0% decline in average interest-earning assets to $12.214 billion and a decline in our effective interest rate spread. The average effective interest rate

spread was 2.49% in the current quarter, down 0.30% from a year ago and 0.24% from the second quarter of 2008. The decline in the current quarter

effective interest spread from a year ago primarily reflected the negative impact of a higher proportion of non-performing assets. The decline in our

effective interest spread from the second quarter of 2008 reflected both a higher level of non-performing assets as well as an increase in non-interest

bearing cash related assets for liquidity purposes funded with interest-bearing liabilities.

For the first nine months of 2008, net interest income totaled $242.7 million, down $91.9 million or 27.5% from the year-ago period. The decline was

due to lower interest-earning assets and a lower effective interest rate spread in the current period.

The following table presents for the periods indicated the total dollar amount of:

l interest income from average interest-earning assets and resultant yields; and

l interest expense on average interest-bearing liabilities and resultant costs, expressed as rates.

The table also sets forth our net interest income, interest rate spread and effective interest rate spread. The effective interest rate spread reflects the

relative level of interest-earning assets to interest-bearing liabilities and equals:

l the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities, divided by

l average interest-earning assets for the period.

Page 31 Navigation LinksThe table also sets forth the difference between the average balance of interest-earning assets and the average balance of total deposits and

borrowings for the quarters indicated. While we included non-accrual loans in the average interest-earning assets balance, interest from non-accrual

loans has not been included in interest income unless we received payments and we believe the remaining principal balance of the loans will be

recovered. We computed average balances for the quarter using the average of each month’s daily average balance during the periods indicated.

(a) Yields for securities available for sale are calculated using historical cost balances and are not adjusted for changes in fair value that are

reflected as a separate component of stockholders’ equity.

(b) Included amounts swept into money market deposit accounts.

(c) The impact of swap contracts was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month London Inter-Bank Offered

Rate (“LIBOR”) variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.

Three Months Ended September 30,

2008 2007

Average Average Average Average

(Dollars in Thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate

Average balance sheet data

 

Interest-earning assets:

Loans:

Loan prepayment fees $ 463 0.02% $ 8,542 0.29%

Write-off of deferred costs and

premiums from loan payoffs (3,391 ) (0.13 ) (16,315 ) (0.55 )

All other 157,407 5.84 216,087 7.22

Total loans $ 10,783,449 154,479 5.73 $ 11,973,516 208,314 6.96

Mortgage-backed securities 105 2 4.78 113 3 5.77

Investment securities (a) 1,430,431 14,587 4.06 2,068,187 27,557 5.29

Total interest-earnings assets 12,213,985 $ 169,068 5.54% 14,041,816 $ 235,874 6.72%

Non-interest-earning assets 1,158,650 485,648

Total assets $ 13,372,635 $ 14,527,464

Transaction accounts:

Non-interest-bearing checking (b) $ 766,544 $ – -% $ 730,179 $ – -%

Interest-bearing checking (b) 400,758 1,142 1.13 470,516 340 0.29

Money market 108,361 280 1.03 139,808 367 1.04

Regular passbook 864,663 1,952 0.90 1,117,084 2,660 0.94

Total transaction accounts 2,140,326 3,374 0.63 2,457,587 3,367 0.54

Certificates of deposit 7,564,088 64,352 3.38 8,455,461 105,147 4.93

Total deposits 9,704,414 67,726 2.78 10,913,048 108,514 3.94

FHLB advances and other borrowings (c) 2,538,497 22,010 3.45 1,766,933 26,088 5.86

Senior notes 198,565 3,305 6.66 198,381 3,302 6.66

Total deposits and borrowings 12,441,476 93,041 2.98 12,878,362 137,904 4.25

Other liabilities 100,624 179,944

Stockholders’ equity 830,535 1,469,158

Total liabilities and stockholders’ equity $ 13,372,635 $ 14,527,464

Net interest income/interest rate spread $ 76,027 2.56% $ 97,970 2.47%

Excess of interest-earning assets over

deposits and borrowings $ (227,491) $ 1,163,454

Effective interest rate spread 2.49 2.79

Page 32 Navigation Links

(a) Yields for securities available for sale are calculated using historical cost balances and are not adjusted for changes in fair value that are

reflected as a separate component of stockholders’ equity.

(b) Included amounts swept into money market deposit accounts.

(c) The impact of swap contracts was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable interest,

which contracts serve as a permitted hedge against a portion of our FHLB advances.

Nine Months Ended September 30,

2008 2007

Average Average Average Average

(Dollars in Thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate

Average balance sheet data

 

Interest-earning assets:

Loans:

Loan prepayment fees $ 3,632 0.04% $ 47,937 0.50%

Write-off of deferred costs and

premiums from loan payoffs (15,669 ) (0.19 ) (66,454 ) (0.69 )

All other 505,230 6.21 709,386 7.37

Total loans $ 10,854,805 493,193 6.06 $ 12,829,398 690,869 7.18

Mortgage-backed securities 108 8 5.45 127 9 5.85

Investment securities (a) 1,520,402 53,043 4.66 1,781,837 71,040 5.33

Total interest-earnings assets 12,375,315 $ 546,244 5.89% 14,611,362 $ 761,918 6.95%

Non-interest-earning assets 874,532 478,398

Total assets $ 13,249,847 $ 15,089,760

Transaction accounts:

Non-interest-bearing checking (b) $ 704,296 $ – -% $ 762,050 $ – -%

Interest-bearing checking (b) 436,960 2,208 0.67 481,867 1,117 0.31

Money market 126,724 982 1.04 145,141 1,128 1.04

Regular passbook 973,320 6,687 0.92 1,183,810 8,423 0.95

Total transaction accounts 2,241,300 9,877 0.59 2,572,868 10,668 0.55

Certificates of deposit 7,793,586 233,170 4.00 8,742,787 323,309 4.94

Total deposits 10,034,886 243,047 3.24 11,315,655 333,977 3.95

FHLB advances and other borrowings (c) 1,832,461 50,601 3.69 1,909,513 83,494 5.85

Senior notes 198,520 9,913 6.66 198,334 9,904 6.66

Total deposits and borrowings 12,065,867 303,561 3.36 13,423,502 427,375 4.26

Other liabilities 135,922 219,667

Stockholders’ equity 1,048,058 1,446,591

Total liabilities and stockholders’ equity $ 13,249,847 $ 15,089,760

Net interest income/interest rate spread $ 242,683 2.53% $ 334,543 2.69%

Excess of interest-earning assets over

deposits and borrowings $ 309,448 $ 1,187,860

Effective interest rate spread 2.61 3.05

Page 33 Navigation LinksChanges in our net interest income are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities.

The following table sets forth information regarding changes in our interest income and expense for the periods indicated. For each category of interestearning

assets and interest-bearing liabilities, we have provided information on changes attributable to:

l changes in volume: changes in volume multiplied by comparative period rate;

l changes in rate: changes in rate multiplied by comparative period volume; and

l 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 quarterly average balances computed using the average

of each month’s daily average balance during the periods indicated.

Provision for Credit Losses

 

During the current quarter, our provision for credit losses totaled $130.3 million, up $48.7 million from a year ago. The increase in our provision for

credit losses reflects continued weakening and uncertainty relative to the housing market and disruption in the secondary markets which have

unfavorably impacted our borrowers and the value of their loan collateral.

For the first nine months of 2008, the provision for credit losses totaled $626.0 million, compared with $91.7 million a year ago. For further

information, see Allowance for Credit and Real Estate Losses on page 65.

Other Income

 

Other income totaled $68.2 million in the current quarter, up $65.2 million from a year ago primarily due to a $70.0 million gain from the sale of

certain non-core real estate contracts. Offsetting contributors to this increase between third quarters was:

l A $2.9 million unfavorable change in income from investments in real estate and joint ventures; and

l A $1.8 million decline in net gains on sale of loans and mortgage-backed securities, reflecting a decline in loans sold, partially offset by a higher

gain per dollar of loan sold.

Three Months Ended September 30, Nine Months Ended September 30,

2008 Versus 2007 2008 Versus 2007

Changes Due To Changes Due To

Rate/ Rate/

(In Thousands) Volume Rate Volume Net Volume Rate Volume Net

 

Interest income:

Loans $ (20,705 ) $ (36,786 ) $ 3,656 $ (53,835 ) $ (106,333 ) $ (107,959 ) $ 16,616 $ (197,676 )

Mortgage-backed securities (1 ) – – (1 ) (1 ) – – (1 )

Investment securities (8,523 ) (6,429 ) 1,982 (12,970 ) (10,395 ) (8,909 ) 1,307 (17,997 )

Change in interest income (29,229 ) (43,215 ) 5,638 (66,806 ) (116,729 ) (116,868 ) 17,923 (215,674 )

Interest expense:

Transaction accounts:

Interest-bearing checking (50 ) 1,001 (149 ) 802 (104 ) 1,318 (123 ) 1,091

Money market (82 ) (5 ) – (87 ) (147 ) – 1 (146 )

Regular passbook (605 ) (133 ) 30 (708 ) (1,492 ) (297 ) 53 (1,736 )

Total transaction accounts (737 ) 863 (119 ) 7 (1,743 ) 1,021 (69 ) (791 )

Certificates of deposit (11,133 ) (33,159 ) 3,497 (40,795 ) (35,019 ) (61,833 ) 6,713 (90,139 )

Total interest-bearing deposits (11,870 ) (32,296 ) 3,378 (40,788 ) (36,762 ) (60,812 ) 6,644 (90,930 )

FHLB advances and other

borrowings 11,563 (10,887 ) (4,754) (4,078 ) (3,373 ) (30,765 ) 1,245 (32,893 )

Senior notes 3 – – 3 9 – – 9

Change in interest expense (304 ) (43,183 ) (1,376 ) (44,863 ) (40,126 ) (91,577 ) 7,889 (123,814 )

Change in net interest income $ (28,925 ) $ (32 ) $ 7,014 $ (21,943 ) $ (76,603 ) $ (25,291 ) $ 10,034 $ (91,860 )

Page 34 Navigation LinksFor the first nine months of 2008, other income totaled $89.2 million, up $51.0 million or 133.3% from a year ago. The increase primarily reflected the

current period gain from the sale of certain non-core real estate contracts, partially offset by unfavorable changes in net gains from sales of loans and

mortgage-backed securities and income from real estate and joint ventures held for investment.

Below is a further detailed discussion of the major other income categories.

Loan and Deposit Related Fees

 

Our loan and deposit related fees totaled $8.2 million in the current quarter, down $0.8 million from a year ago. The decline was primarily related to

lower automated teller machine fees.

The following table presents a breakdown of loan and deposit related fees during the quarters indicated.

For the first nine months of 2008, loan and deposit related fees totaled $24.6 million, down $2.5 million from the same period of 2007. The decline

was primarily related to lower automated teller machine fees of $1.4 million or 20.3% and loan related fees of $1.0 million or 44.2%.

The following table presents a breakdown of loan and deposit related fees during the year-to-date periods indicated.

Real Estate and Joint Ventures Held for Investment

 

A loss of $10.7 million was recorded from our real estate and joint ventures held for investment, compared to a loss of $7.9 million a year ago. The

$2.8 million unfavorable change is primarily related to current quarter net losses from sales of wholly owned real estate of $2.4 million. Both the current

quarter and the year-ago quarter included writedowns associated with declines in the value of single family lots in which we are a joint venture partner.

In the current quarter, the writedown is recorded in provision for losses on real estate and joint ventures, whereas in the year-ago quarter the writedown

appears in deficit in net loss from joint ventures.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Loan related fees $ 445 $ 377 $ 422 $ 467 $ 572

Deposit related fees:

Automated teller machine fees 1,747 1,859 1,997 2,285 2,287

Other fees 5,960 5,968 5,820 6,215 6,054

Total loan and deposit related fees $ 8,152 $ 8,204 $ 8,239 $ 8,967 $ 8,913

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Loan related fees $ 1,244 $ 2,233

Deposit related fees:

Automated teller machine fees 5,603 7,032

Other fees 17,748 17,822

Total loan and deposit related fees $ 24,595 $ 27,087

Page 35 Navigation LinksThe following table sets forth the key components comprising our income from real estate and joint venture operations during the quarters

indicated.

For the first nine months of 2008, a loss of $16.6 million was recorded from real estate and joint ventures held for investment, compared to a loss of

$7.5 million a year ago. The unfavorable change primarily reflected an increase in the writedowns of single family lots in which we are a joint venture

partner, partially offset by net gains from sales.

The following table sets forth the key components comprising our income from real estate and joint venture operations during the year-to-date

periods indicated.

Secondary Marketing Activities

 

We service loans for others and those activities generated a loss of $0.1 million in the current quarter, down from a loss of $0.3 million in the yearago

quarter. This primarily reflected a $0.6 million favorable change in payoff and curtailment interest cost, partially offset by a $0.5 million unfavorable

change from the measurement of MSRs to fair value. Payoff and curtailment interest costs represent the difference between the contractual obligation

to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. Loan servicing

income (loss), net does not reflect the interest income we derive from the use of those loan repayments as it is included in net interest income.

Effective January 1, 2008, we adopted the fair value provision of Statement of Financial Accounting Standards No. 156, Accounting for Servicing

of Financial Assets – an amendment of FASB Statement No. 140 (“SFAS 156”) and remeasured our MSRs at fair value. For further information regarding

the adoption of SFAS 156 and our MSRs, see Note 4 of Notes to Consolidated Financial Statements on page 11.

At September 30, 2008, MSRs totaled $23 million or 0.91% of the $2.495 billion of associated loans serviced for others, up $1 million from the year

ago balance accounted for under the amortized cost method. In addition to the loans we serviced for others with capitalized MSRs, at September 30,

2008, we serviced $2.848 billion of loans on a sub-servicing basis where we receive a fixed fee per loan, with no risk associated with changing MSR

values.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net rental operations and income from community

development funds $ (127 ) $ 133 $ 331 $ (49 ) $ 576

Net gains (losses) on sales of wholly owned real estate

estate (2,388 ) 6,129 – – –

Equity (deficit) in net income (loss) from

joint ventures (181 ) (79 ) (945 ) 681 (8,492 )

(Provision for) reduction of losses on real estate

and joint ventures (8,053 ) (11,454 ) 9 10 24

Total income (loss) from real estate and

joint ventures held for investment, net $ (10,749 ) $ (5,271 ) $ (605 ) $

642

$ (7,892 )

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net rental operations and income from community development funds $ 337 $ 1,170

Net gains on sales of wholly owned real estate 3,741 22

Deficit in net loss from joint ventures (1,205 ) (8,390 )

Provision for losses on real estate and joint ventures (19,498 ) (329 )

Total loss from real estate and joint ventures held for investment, net $ (16,625 ) $ (7,527 )

Page 36 Navigation LinksThe following table presents a breakdown of the components of our loan servicing income (loss), net for the quarters indicated.

(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received

when a loan prepays prior to the end of the month. However, loan servicing activities do not include the benefit of the use of total loan repayments

to increase net interest income.

(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

(d) Represents changes due to realization of expected cash flows over time.

 

For the first nine months of 2008, income of $2.7 million was recorded from loan servicing activities, compared to a loss of $1.5 million for the same

period of 2007. The favorable change primarily reflected a reduction in payoff and curtailment interest costs and a favorable change in the fair value of

MSRs in the current period versus the amortization of MSRs a year ago.

The following table presents a breakdown of the components of our loan servicing income (loss), net during the year-to-date periods indicated.

(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received

when a loan prepays prior to the end of the month. However, loan servicing activities do not include the benefit of the use of total loan repayments

to increase net interest income.

(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a

pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008

beginning balance of retained earnings in stockholders’ equity.

(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.

(d) Represents changes due to realization of expected cash flows over time.

 

Our net gains on sales of loans and mortgage-backed securities totaled $0.7 million in the current quarter, down $1.8 million from a year ago,

reflecting a decline in loans sold, partially offset by a higher gain per dollar of loan sold. The current quarter included a $1.6 million loss due to the

SFAS 133 impact of valuing derivatives associated with the sale of loans, compared with a SFAS 133 loss of $0.6 million in the year-ago quarter.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net cash servicing fees $ 1,797 $ 1,750 $ 1,765 $ 2,166 $ 1,657

Payoff and curtailment interest cost (a) (208 ) (350 ) (471 ) (544 ) (787 )

Changes in fair value of mortgage servicing

rights due to: (b)

Change in valuation model inputs or

assumptions (c) (1,038 ) 3,325 (1,751 ) – –

Other changes (d) (607 ) (749 ) (739 ) – –

Amortization of mortgage servicing rights – – – (1,085 ) (950 )

Provision for impairment of mortgage

servicing rights – – – (2,197 ) (214 )

Total loan servicing income (loss), net $ (56 ) $ 3,976 $ (1,196 ) $ (1,660 ) $ (294 )

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net cash servicing fees $ 5,312 $ 4,862

Payoff and curtailment interest cost (a) (1,029 ) (3,241 )

Change in fair value of mortgage servicing rights due to: (b)

Changes in valuation model inputs or assumptions (c) 536 –

Other changes (d) (2,095 ) –

Amortization of mortgage servicing rights – (2,941 )

Reduction of impairment of mortgage servicing rights – (199 )

Total loan servicing income (loss), net $ 2,724 $ (1,519 )

Excluding the impact of SFAS 133, a gain was realized equal to 1.03% on secondary market sales of $221 million, compared with the year-ago gain of

0.91% on secondary market sales of $337 million.

Page 37 Navigation LinksThe following table presents a breakdown of the components of our net gains on sales of loans and mortgage-backed securities for the quarters

indicated.

For the first nine months of 2008, our sales of loans and mortgage-backed securities totaled $685 million, down from $1.622 billion a year ago. Net

gains associated with these sales totaled $6.9 million in the current period, or $13.3 million lower than the prior year amount. Excluding the impact of

SFAS 133, a gain equal to 0.94% per dollar of loan sold was realized in the current year, down from the year-ago gain of 1.21%.

The following table presents a breakdown of the components of our net gains on sales of loans and mortgage-backed securities during the yearto-

date periods indicated.

Operating Expense

 

Operating expense totaled $102.7 million in the current quarter, up $40.0 million or 63.8% from a year ago. The increase primarily reflected an

increase of $27.8 million in net operations of real estate acquired in the settlement of loans due to a higher number of foreclosed properties and general

and administrative expense of $12.2 million or 20.7%. The increase in general and administrative expense between third quarters was primarily a result of

increases of:

l $5.7 million in deposit insurance premiums and regulatory assessments due, in part, to a special credit received in the year-ago period and higher

premium rates in the current quarter;

l $3.5 million in other expense due primarily to a search fee related to executive search fees and higher consulting fees;

l $2.5 million in professional fees; and

l $0.9 million in salaries and related costs due, in part, to the year-ago reversal of certain management incentive plan accruals.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Mortgage servicing rights $ 901 $ 1,557 $ 1,122 $ 945 $ 1,394

All other components excluding SFAS 133 1,377 916 596 (393 ) 1,665

SFAS 133 (1,601 ) 2,099 (69 ) (460 ) (553 )

Total net gains on sales of loans and

mortgage-backed securities $ 677 $ 4,572 $ 1,649 $ 92 $ 2,506

Secondary marketing gain excluding SFAS

133 as a percentage of associated sales 1.03% 1.05% 0.75% 0.31% 0.91%

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Mortgage servicing rights $ 3,580 $ 4,661

All other components excluding SFAS 133 2,889 14,999

SFAS 133 429 564

Total net gains on sales of loans and mortgage-backed securities $ 6,898 $ 20,224

Secondary marketing gain excluding SFAS 133 as a percentage of associated sales 0.94% 1.21%

Page 38 Navigation LinksThe following table presents a breakdown of key components comprising operating expense for the quarters indicated.

For the first nine months of 2008, operating expense totaled $280.2 million, up $89.5 million or 46.9% from a year ago. The increase primarily

reflected higher net operations of real estate acquired in the settlement of loans, deposit insurance premiums, other general and administrative expense

category, a goodwill impairment charge during the first quarter of 2008, and professional fees. Those increases were partially offset by a decline in

salaries and related costs and advertising expense.

The following table presents a breakdown of key components comprising operating expense during the year-to-date periods indicated.

Provision for Income Taxes

 

A tax benefit of $7.6 million was recorded in the current quarter, reflecting an effective tax rate of 8.6%, compared with the year-ago effective tax

rate of 46.0%. For the first nine months of 2008, the effective tax rate benefit was 4.6%, compared with an effective tax rate of 42.2% a year ago. For

further information, see Note 6 of Notes to Consolidated Financial Statements on page 20.

Business Segment Reporting

 

The previous discussion and analysis of the Results of Operations pertained to our consolidated results. This section discusses and analyzes the

results of operations of our two business segments: banking and real estate investment. For more information, see Note 10 of Notes to Consolidated

Financial Statements on page 23.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Salaries and related costs $ 37,611 $ 40,884 $ 39,702 $ 38,882 $ 36,699

Premises and equipment costs 9,224 9,181 8,997 10,257 9,736

Advertising expense 1,473 816 461 1,443 1,400

Deposit insurance premiums and regulatory

assessments 8,117 3,689 3,703 2,516 2,413

Professional fees 3,000 843 303 916 489

Impairment writedown of goodwill – – 3,149 – –

Other general and administrative expense 11,802 8,974 8,480 8,732 8,275

Total general and administrative expense 71,227 64,387 64,795 62,746 59,012

Net operation of real estate acquired in

settlement of loans 31,428 24,139 24,196 4,583 3,664

Total operating expense $ 102,655 $ 88,526 $ 88,991 $ 67,329 $ 62,676

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Salaries and related costs $ 118,197 $ 119,931

Premises and equipment costs 27,402 27,667

Advertising expense 2,750 4,469

Deposit insurance premiums and regulatory assessments 15,509 7,659

Professional fees 4,146 1,779

Impairment writedown of goodwill 3,149 –

Other general and administrative expense 29,256 24,271

Total general and administrative expense 200,409 185,776

Net operation of real estate acquired in settlement of loans 79,763 4,903

Total operating expense $ 280,172 $ 190,679

Page 39 Navigation LinksThe following table presents by business segment our net income (loss) for the periods indicated.

The following table presents by business segment our net income for the year-to-date periods indicated.

Banking

 

A net loss of $69.0 million was recorded in the current quarter related to our banking operations, compared with a loss of $18.9 million a year ago.

The unfavorable change between second quarters primarily reflected:

l A $48.7 million increase in provision for credit losses;

l A $40.0 million increase in operating expense, of which approximately 69% was due to higher costs related to the operation of real estate

acquired in settlement of loans, with the balance of the increase associated with higher deposit insurance premiums, professional fees and

consulting fees; and

l A $21.7 million or 22.2% decline in net interest income due to a lower level of interest-earning assets and a lower effective interest rate spread.

These unfavorable items were partially offset by an increase in other income of $68.1 million primarily due to the sale of non-core real estate related

contracts.

The following table sets forth our banking operational results and selected financial data for the quarters indicated.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Banking net loss $ (69,026 ) $ (215,707 ) $ (247,258 ) $ (109,282 ) $ (18,851 )

Real estate investment net income (loss) (12,044 ) (3,212 ) (439 ) 437 (4,510 )

Total net loss $ (81,070 ) $ (218,919 ) $ (247,697 ) $ (108,845 ) $ (23,361 )

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Banking net income (loss) $ (531,991 ) $ 56,186

Real estate investment net loss (15,695 ) (3,940 )

Total net income (loss) $ (547,686 ) $ 52,246

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net interest income $ 75,998 $ 82,866 $ 83,601 $ 89,059 $ 97,656

Provision for credit losses 130,291 258,874 236,870 218,447 81,562

Other income 78,820 17,224 9,439 7,424 10,756

Operating expense 102,325 88,207 88,672 67,038 62,365

Net intercompany income 3 22 46 15 22

Loss before income taxes (tax benefits) (77,795 ) (246,969 ) (232,456 ) (188,987 ) (35,493 )

Income taxes (tax benefits) (8,769 ) (31,262 ) 14,802 (79,705 ) (16,642 )

Net loss $ (69,026 ) $ (215,707 ) $ (247,258 ) $ (109,282 ) $ (18,851 )

At period end

 

Assets:

Loans and mortgage-backed securities, net $ 10,757,283 $ 10,716,676 $ 10,725,865 $ 11,136,655 $ 11,692,185

Other 2,004,305 1,902,632 2,392,047 2,258,746 2,710,006

For the first nine months of 2008, our net loss from our banking operations totaled $532.0 million, compared to income of $56.2 million a year ago.

The unfavorable change primarily reflected a higher provision for credit losses, lower net interest income and higher operating expense, partially offset

by higher other income.

Total assets 12,761,588 12,619,308 13,117,912 13,395,401 14,402,191

Equity $ 771,714 $ 858,937 $ 1,090,484 $ 1,334,417 $ 1,444,226

Page 40 Navigation LinksThe following table sets forth our banking operational results for the year-to-date periods indicated.

Real Estate Investment

 

A net loss of $12.0 million was recorded in the current quarter from our real estate investment operations, compared to a net loss of $4.5 million a

year ago. The unfavorable change primarily reflects net losses from the sale of wholly owned real estate in the current quarter.

The following table sets forth real estate investment operational results and selected financial data for the quarters indicated.

For the first nine months of 2008, a net loss of $15.7 million was recorded related to our real estate investment operations, compared to a loss of

$3.9 million a year ago. The unfavorable change primarily reflected an increase in the writedowns of single family lots in which we are a joint venture

partner, partially offset by higher net gains from sales.

The following table sets forth our real estate investment operational results for the year-to-date periods indicated.

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net interest income $ 242,465 $ 333,505

Provision for credit losses 626,035 91,684

Other income 105,483 45,056

Operating expense 279,204 189,700

Net intercompany income 71 53

Income (loss) before income taxes (tax benefits) (557,220 ) 97,230

Income taxes (tax benefits) (25,229 ) 41,044

Net income (loss) $ (531,991 ) $ 56,186

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Net interest income $ 29 $ 65 $ 124 $ 236 $ 314

Other income (loss) (10,605 ) (5,159 ) (501 ) 803 (7,720 )

Operating expense 330 319 319 291 311

Net intercompany expense (3 ) (22 ) (46 ) (15 ) (22 )

Income (loss) before income taxes (tax benefits) (10,909 ) (5,435 ) (742 ) 733 (7,739 )

Income taxes (tax benefits) 1,135 (2,223 ) (303 ) 296 (3,229 )

Net income (loss) $ (12,044 ) $ (3,212 ) $ (439 ) $ 437 $ (4,510 )

At period end

 

Assets:

Investments in real estate and joint ventures $ 15,606 $ 63,182 $ 71,196 $ 68,679 $ 58,715

Other 11,356 8,224 15,848 19,023 30,420

Total assets 26,962 71,406 87,044 87,702 89,135

Equity $ 7,351 $ 58,395 $ 73,607 $ 74,046 $ 73,609

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Net interest income $ 218 $ 1,038

Our investments in real estate and joint ventures amounted to $16 million at September 30, 2008, down from $69 million at December 31, 2007, and

$59 million at September 30, 2007.

For information on valuation allowances associated with real estate and joint venture loans, see Allowance for Credit and Real Estate Losses on

page 65.

Other loss (16,265 ) (6,807 )

Operating expense 968 979

Net intercompany expense (71 ) (53 )

Loss before income tax benefits (17,086 ) (6,801 )

Income taxes (tax benefits) (1,391 ) (2,861 )

Net income (loss) $ (15,695 ) $ (3,940 )

Page 41 Navigation LinksTotal loans and mortgage-backed securities, including those we hold for sale, increased $41 million during the current quarter to $10.8 billion or

84.2% of total assets at September 30, 2008. During the quarter, loans held for investment increased $119 million while loans held for sale declined $78

million.

Our loan originations, including loans purchased, totaled $804 million in the current quarter, up $110 million or 15.8% from the $694 million we

originated in the year-ago third quarter but 21.8% less than the $1.027 billion we originated in the second quarter of 2008. Loans originated for sale

declined $98 million or 39.8% from a year ago to $147 million, while single family loans originated for portfolio increased $128 million or 29.6% to $560

million. Our prepayment speed, which measures the annualized percentage of loans repaid, for residential one-to-four unit loans held for investment

declined from 27% a year ago to 9% in the current quarter and was down from 13% in the second quarter of 2008. During the current quarter, 42% of our

residential one-to-four unit originations represented refinance transactions, including new loans to refinance existing loans which we or other lenders

originated. This is down from 61% in the second quarter of 2008 and down from 79% in the year-ago third quarter.

Not included in the above originations are loans in which we modified the terms of the notes for borrowers. During the current quarter, we

modified $157 million of loans associated with our borrower retention program. This program provided borrowers who were current with their loan

payments with the opportunity to change from an adjustable rate loan subject to negative amortization to less costly financing alternatives, albeit at

new interest rates that were no less than those offered new borrowers. The majority of these modifications were modified into adjustable rate loans

whereby the interest rate adjusts semi-annually but does not permit negative amortization. An additional $149 million of loans were modified at below

market interest rates in loan workout situations.

We originate residential one-to-four unit mortgage loans both with and without loan origination fees. In mortgage transactions for which we

charge no origination fees, we receive a higher interest rate than those for which we charge origination fees. These loans generally result in deferrable

loan origination costs exceeding loan origination fees. A prepayment fee on these loans may be required if these loans are prepaid within the first three

years.

Originations of adjustable rate residential one-to-four unit loans for portfolio, including loans purchased, totaled $553 million in the current

quarter, up from $432 million in the year-ago quarter but down from $748 million in the second quarter of 2008. Of the current quarter total:

l 94% were adjustable rate loans – fixed for 3-5 years, compared with 74% in the year-ago quarter;

l 3% were adjustable rate loans tied to either the LIBOR index, which typically adjust every six months, or the Constant Maturity Treasury

(“CMT”) index unchanged from the year-ago quarter; and

l 3% were adjustable rate loans tied to either the FHLB Eleventh District Cost of Funds Index (“COFI”) or the 12-month moving average of yields

on actively traded U.S. Treasury securities adjusted to a constant maturity of one year (“MTA”) index and generally have rates that adjust

monthly and provide for negative amortization, compared with 23% in the year-ago quarter. Effective July 2008, we no longer offer to borrowers

loans that provide for negative amortization.

Page 42 Navigation LinksThe following table sets forth loans originated, including purchases, for investment and for sale during the periods indicated.

(a) Originations for the quarter ending September 30, 2007 are net of $1.0 million of cancelled loans that were originated in the previous quarter.

(b) All residential one-to-four unit loans.

 

The following table sets forth loans originated, including purchases, for investment and for sale during the year-to-date periods indicated.

(a) Primarily residential one-to-four unit loans.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

Loans originated and purchased

 

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI $ 16,587 $ 1,515 $ 7,170 $ 77,163 $ 101,698

MTA (a) 354 1,706 740 4,953 (177 )

LIBOR 8,070 6,562 490 2,102 5,968

CMT 7,169 3,677 1,285 7,572 6,415

Adjustable – fixed for 3-5 years 521,273 734,242 424,939 302,705 317,770

Fixed 6,805 2,876 702 – 588

Total residential one-to-four units 560,258 750,578 435,326 394,495 432,262

Other 95,953 64,765 3,382 31,682 16,743

Total for investment portfolio 656,211 815,343 438,708 426,177 449,005

Sale portfolio (b) 147,292 211,726 237,356 192,053 244,831

Total for investment and sale portfolios $ 803,503 $ 1,027,069 $ 676,064 $ 618,230 $ 693,836

Nine Months Ended September 30,

(In Thousands) 2008 2007

Loans originated and purchased

 

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI $ 25,272 $ 257,201

MTA 2,800 7,621

LIBOR 15,122 383,069

CMT 12,131 66,543

Adjustable – fixed for 3-5 years 1,680,454 1,018,805

Fixed 10,383 873

Total residential one-to-four units 1,746,162 1,734,112

Other 164,100 49,119

Total for investment portfolio 1,910,262 1,783,231

Sale portfolio (a) 596,374 1,380,371

Total for investment and sale portfolios $ 2,506,636 $ 3,163,602

Page 43 Navigation LinksThe following table sets forth our investment portfolio of residential one-to-four unit adjustable rate loans by index, excluding our adjustable-

fixed for 3-5 year loans which are still in their initial fixed rate period, at the dates indicated.

(a) Excludes residential one-to-four unit adjustable-fixed for 3-5 year loans still in their initial fixed rate period.

 

Our adjustable rate mortgage loans generally:

l either begin with an incentive interest rate (“start rate”), which is an interest rate below the current market rate, that adjusts to the applicable

index plus a defined margin, subject to periodic and lifetime caps, after one, three, six or twelve months, or have a fixed interest rate for a period

of three to five years then adjust semi-annually or annually thereafter;

l provide that the maximum interest rate cannot exceed the start rate by more than six to twelve percentage points, depending on the type of loan

and the initial rate offered; and

l limit interest rate adjustments, for loans that adjust both the interest rate and payment amount simultaneously, to 1% per adjustment for those

that adjust semi-annually and 2% per adjustment for those that adjust annually.

Our adjustable rate loans subject to negative amortization, which are no longer offered to borrowers, have an interest rate that adjusts monthly

and a minimum monthly loan payment that adjusts annually. The start rate for these loans is lower than the fully-indexed rate and is the rate at which we

earned interest for the loan only during the first month. After the first month, interest accrues at the fully-indexed rate. The start rate, however, is used

to calculate the minimum monthly loan payment for the first twelve months. The borrower is required to make at least the minimum monthly payment,

but retains the option to make a larger payment to reduce loan principal and avoid negative amortization (the addition to loan principal of accrued

interest that exceeds the minimum monthly loan payment). If the borrower chooses to make the minimum monthly loan payment, and the interest accrual

based on the fully-indexed rate results in monthly interest due exceeding the payment amount, the loan balance will increase by the difference. These

payment options were clearly defined in the loan documents signed by the borrower at funding and are explained again on the borrower’s monthly

statement.

More particularly, our adjustable rate loans subject to negative amortization:

l typically limit the maximum loan balance to 110% of the original loan amount if the original loan-to-value ratio (a loan-to-value ratio is the

proportion of the principal amount of the loan to the lower of the sales price or appraised value of the property securing the loan at origination)

is greater than 75%, and to 115% if the loan-to-value ratio is 75% or less;

l have a lifetime interest rate cap, but no periodic cap on interest rate adjustments; and

l include a payment cap that limits the change in minimum monthly loan payments to 7.5% per year, unless the loan is recast (i.e., a new monthly

loan payment is calculated using the fully-indexed interest rate and provides for amortization of the loan balance over the remaining term of the

loan). A loan is recast every five years and additionally when the loan balance reaches the maximum level of loan balance permitted.

The maximum home loan we currently make for our own portfolio, except for a limited amount related to Community Reinvestment Act (“CRA”)

activities and loans to facilitate the sale of real estate acquired in settlement of loans, is equal to 80% of a property’s appraised value. If a loan incurs

negative amortization, the loan-to-value ratio could rise, which increases credit risk, and the fair value of the underlying collateral could be insufficient

to satisfy fully the outstanding loan obligation in the event of a loan default. A loan-to-value ratio is the proportion of the principal amount of the loan

to the lower of the sales price or appraised value of the property securing the loan at origination.

September 30, 2008 June 30, 2008 March 31, 2008 December 31, 2007 September 30, 2007

% of % of % of % of % of

(Dollars in Thousands) Amount Total Amount Total Amount Total Amount Total Amount Total

Loan Investment Portfolio

 

Residential one-to-four units:

Adjustable by index:

COFI $ 5,342,617 75% $ 5,599,857 75% $ 5,893,818 74% $ 6,383,837 75% $ 6,899,483 76%

MTA 950,163 13 1,047,051 14 1,163,661 15 1,256,672 15 1,398,540 15

LIBOR 255,208 4 250,271 3 274,555 3 444,483 5 586,143 7

Other, primarily CMT 579,518 8 588,571 8 595,695 8 394,829 5 204,513 2

Total adjustable loans (a) $ 7,127,506 100% $ 7,485,750 100% $ 7,927,729 100% $ 8,479,821 100% $ 9,088,679 100%

Page 44 Navigation LinksOur loan portfolio held for investment contains loans previously originated with a limit on the maximum loan balance of 125% of the original loan

amount. At September 30, 2008, loans with the higher 125% limit on the maximum loan balance represented 2% of our one-to-four unit residential loan

portfolio, while those with the 115% limit represented 4% and those with the 110% limit represented 46% of that portfolio. We permit adjustable rate

mortgage loans to be assumed by qualified borrowers.

While start rates of our loan products fluctuate with the market, we do not use them to qualify a loan applicant. Rather, we qualify an applicant for

adjustable rate mortgage loans using a fully-amortizing payment calculated from the higher of the fully-indexed rate or, currently, for our:

l lower risk applicants:

l 6.00% for owner occupied; or

l 6.25% for non-owner occupied.

l higher risk applicants:

l 7.00% for owner occupied; or

l 7.25% for non-owner occupied.

At September 30, 2008, $5.7 billion or 52% of our total residential one-to-four unit loans held for investment were subject to negative amortization.

The amount of negative amortization included in the loan balance declined $27 million during the quarter to $318 million or 5.6% of loans subject to

negative amortization. During current quarter, approximately 10% of our loan interest income represented negative amortization, down from 15% in the

second quarter of 2008 and 26% in year-ago third quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%. In addition,

$4.4 billion or 40% of our residential one-to-four unit loans held for investment represented loans requiring interest only payments over the initial terms

of the loans, generally the first three to five years.

Page 45 Navigation LinksThe following table sets forth our investment portfolio of residential one-to-four unit adjustable rate loans subject to negative amortization and

with interest only payments, along with negative amortization included in the loan balance, loan to value ratio information and weighted average age of

the loans, at the dates indicated.

(a) Based on current loan balance relative to the lower of the appraised value or sales price at time of origination. (b) Loans with interest only

payments include loans modified with previously capitalized interest due to negative amortization.

 

Our adjustable rate loans subject to negative amortization require a payment recast every five years and additionally when the loan balance

reaches the maximum permissible level of negative amortization, while interest only loans require a payment recast when the initial fixed rate or interest

only period expires. At payment recast, the fully-indexed interest rate is used to calculate a new monthly loan payment that provides for full

amortization of the loan balance over the remaining term of the loan. Generally, the new loan payment is significantly higher and therefore default risk

typically increases. We have other adjustable rate loans that also are subject to payment recasts but the new loan payments are not likely to be as

Negative Loan to Current Weighted

Amortization Value Loan to Average

Loan % of Included in the Ratio at Value Age

(Dollars in Thousands) Balance Total Loan Balance Origination Ratio (a) (Months)

Loan Investment Portfolio

 

Residential one-to-four units subject to negative amortization:

At September 30, 2008:

With negative amortization:

Balance less than or equal to original loan amount $ 126,949 2% $ 1,063 71% 69% 42

Balance greater than original loan amount 4,925,666 86 316,439 74 79 37

Total with negative amortization 5,052,615 88 317,502 74 79 37

Not utilizing negative amortization 662,451 12 – 70 64 69

Total loans subject to negative amortization $ 5,715,066 100% $ 317,502 73% 77% 41

As a percentage of total residential one-to-four unit loans 52%

Total loans with interest only payments (b) $ 4,373,160 70% 71% 21

As a percentage of total residential one-to-four unit loans 40%

At December 31 2007:

With negative amortization:

Balance less than or equal to original loan amount $ 189,508 3% $ 1,253 70% 69% 37

Balance greater than original loan amount 6,501,649 86 377,411 74 78 29

Total with negative amortization 6,691,157 89 378,664 74 78 30

Not utilizing negative amortization 839,433 11 – 69 65 55

Total loans subject to negative amortization $ 7,530,590 100% $ 378,664 73% 77% 32

As a percentage of total residential one-to-four unit loans 69%

Total loans with interest only payments $ 2,745,117 70% 70% 16

As a percentage of total residential one-to-four unit loans 25%

At September 30, 2007:

With negative amortization:

Balance less than or equal to original loan amount $ 213,427 3% $ 1,358 70% 69% 36

Balance greater than original loan amount 7,104,531 86 386,626 74 78 27

Total with negative amortization 7,317,958 89 387,984 74 78 28

Not utilizing negative amortization 937,431 11 – 69 65 50

Total loans subject to negative amortization $ 8,255,389 100% $ 387,984 73% 76% 30

As a percentage of total residential one-to-four unit loans 74%

Total loans with interest only payments $ 2,456,416 69% 69% 13

As a percentage of total residential one-to-four unit loans 22%

severe as those associated with loans subject to negative amortization or interest only payments because the original loan payments already include

principal amortization.

Page 46 Navigation LinksThe following table sets forth projected first-time loan payment recasts for our investment portfolio of residential one-to-four unit adjustable rate

loans subject to negative amortization and loans with interest only payments for the fourth quarter of 2008 and annually thereafter through 2012. To

determine projected first-time loan payment recasts, we assumed that borrowers will continue to utilize negative amortization at the same rate as they

did in the preceding 12 months and no loans prepay. Therefore, the projected recast amounts may be overstated as some portion of these loans is likely

to prepay or be modified as part of our borrower retention or loan workout programs. For example, at the end of the second quarter of 2008, we

forecasted that $460 million of loans subject to negative amortization and loans with interest only payments would recast for the first-time during the

second quarter of 2008, of which $283 million did recast while:

l $61 million did not recast during the quarter as borrowers reduced their utilization of negative amortization;

l $53 million were modified during the quarter as part of our borrower retention program;

l $36 million were foreclosed upon;

l $16 million were modified as part of our loan workout program; and

l $11 million were paid off.

(a) Represents fully-amortizing adjustable rate loans.

Projected First-Time Loan Recasts at September 30, 2008 for

4th Quarter Year Ended Year Ended Year Ended Year Ended

(Dollars in Thousands) 2008 2009 2010 2011 2012

Loan Investment Portfolio

 

Residential one-to-four units:

Loans subject to negative amortization $ 287,489 $ 1,244,001 $ 1,412,573 $ 888,950 $ 430,995

Loans with interest only payments 1,905 152,819 32,397 1,437,642 1,270,105

All other loans (a) 394 87,283 45,591 302,689 50,908

Total $ 289,788 $ 1,484,103 $ 1,490,561 $ 2,629,281 $ 1,752,008

As a percentage of total residential

one-to-four unit loans 3% 14% 14% 24% 16%

Page 47 Navigation LinksAt September 30, 2008, 15% of our residential one-to-four unit loans were originated in 2008, with an additional 15% in 2007, and 25% in 2006,

which are relatively new and unseasoned. The following table sets forth our investment portfolio of residential one-to-four unit loans by year of

origination segregated by those subject to negative amortization, those with interest only payments and all others at the dates indicated. From year to

year, loans may change categories due to modification.

(a) Represents fully-amortizing adjustable rate loans and fixed rate loans.

Loans by Year of Origination

(Dollars in Thousands) 2004 and Prior 2005 2006 2007 2008 Balance

Loan Investment Portfolio

 

Residential one-to-four units:

At September 30, 2008:

Loans subject to negative amortization $ 1,486,305 $ 2,181,840 $ 1,599,568 $ 410,262 $ 37,091 $ 5,715,066

Hybrid adjustable rate loans:

Interest only payments 108,108 54,633 832,998 1,015,074 1,261,526 3,272,339

Fully amortizing 84,355 73,238 60,069 78,270 332,004 627,936

Total hybrid adjustable rate loans 192,463 127,871 893,067 1,093,344 1,593,530 3,900,275

Non-hybrid interest only loans 221,647 514,022 189,100 140,168 35,884 1,100,821

All other loans (a) 145,253 29,910 15,333 34,699 18,244 243,439

Total residential one-to-four units $ 2,045,668 $ 2,853,643 $ 2,697,068 $ 1,678,473 $ 1,684,749 $ 10,959,601

As a percentage of total residential

one-to-four unit loans 19% 26% 25% 15% 15% 100%

2004 and Prior 2005 2006 2007 2008 Balance

 

At September 30, 2007:

Loans subject to negative amortization $ 2,438,438 $ 3,512,669 $ 1,980,013 $ 324,269 $ – $ 8,255,389

Hybrid adjustable rate loans:

Interest only payments 147,222 51,784 918,761 887,577 – 2,005,344

Fully amortizing 82,773 2,326 51,250 51,861 – 188,210

Total hybrid adjustable rate loans 229,995 54,110 970,011 939,438 – 2,193,554

Non-hybrid interest only loans 43,109 14,001 133,086 260,876 – 451,072

All other loans (a) 160,497 10,936 16,826 139,287 – 327,546

Total residential one-to-four units $ 2,872,039 $ 3,591,716 $ 3,099,936 $ 1,663,870 $ – $ 11,227,561

As a percentage of total residential

one-to-four unit loans 25% 32% 28% 15% -% 100%

Page 48 Navigation LinksAt September 30, 2008, 90% of our residential one-to-four unit loans were concentrated and secured by properties located in California. The

following table sets forth the major geographic distribution of our investment portfolio of residential one-to-four unit loans at the dates indicated.

The following table sets forth our investment portfolio of residential one-to-four unit loans by the Fair Isaac Corporation credit score model

(“FICO”) of the borrower at origination at the dates indicated.

September 30,

2008 2007

% of % of

(Dollars in Thousands) Amount Total Amount Total

Loan Investment Portfolio

 

Residential one-to-four units:

California county:

Los Angeles $ 2,103,692 19% $ 2,053,395 19%

San Diego 1,213,173 11 1,287,091 12

Santa Clara 1,162,620 11 915,134 8

Orange 911,994 8 894,280 8

Alameda 557,382 5 569,392 5

Riverside 483,644 4 565,185 5

Contra Costa 471,255 4 493,200 4

San Mateo 356,430 3 298,290 3

San Bernardino 312,356 3 350,286 3

Sacramento 277,404 3 340,490 3

All other counties 2,038,234 19 2,172,137 19

Total California 9,888,184 90 9,938,880 89

Arizona 431,332 4 480,301 4

All other states 640,085 6 808,380 7

Total residential one-to-four units $ 10,959,601 100% $ 11,227,561 100%

September 30, 2008 June 30, 2008 March 31, 2008 December 31, 2007 September 30, 2007

% of % of % of % of % of

(Dollars in Thousands) Amount Total Amount Total Amount Total Amount Total Amount Total

Loan Investment Portfolio

 

Residential one-to-four units:

FICO score at Origination:

620 or below $ 341,495 3% $ 361,879 3% $ 384,320 4% $ 407,764 4% $ 443,748 4%

621 to 659 2,238,634 20 2,348,417 22 2,463,700 23 2,573,185 24 2,697,313 24

660 to 719 3,990,707 37 4,034,572 37 4,046,287 38 4,122,326 38 4,232,819 38

720 and above 4,262,804 39 4,020,953 37 3,683,490 34 3,630,721 33 3,705,685 33

Not available 125,961 1 129,068 1 134,438 1 143,232 1 147,996 1

Total residential one-to-four units $ 10,959,601 100% $ 10,894,889 100% $ 10,712,235 100% $ 10,877,228 100% $ 11,227,561 100%

Weighted average FICO score for

loan investment portfolio of

residential one-to-four units 704 702 698 697 696

Page 49 Navigation LinksThe following table sets forth our investment portfolio of residential one-to-four unit loans by original loan-to-value ratio at the dates indicated.

For this table, the loan-to-value ratios have been updated to reflect the current loan balance and, if private mortgage insurance has been removed, a

current appraisal.

(a) Primarily related to Community Reinvestment Act activities.

September 30, 2008 June 30, 2008 March 31, 2008 December 31, 2007 September 30, 2007

% of % of % of % of % of

(Dollars in Thousands) Amount Total Amount Total Amount Total Amount Total Amount Total

Loan Investment Portfolio

 

Residential one-to-four units:

80% or below:

60% or less $ 1,600,167 15% $ 1,590,553 15% $ 1,504,295 14% $ 1,539,989 14% $ 1,628,047 14%

61% to 70% 2,185,379 20 2,111,314 19 1,972,543 18 1,931,397 18 1,966,339 18

71% to 80% 6,722,658 61 6,711,241 61 6,717,851 63 6,866,261 63 7,067,710 63

Total 80% or below 10,508,204 96 10,413,108 95 10,194,689 95 10,337,647 95 10,662,096 95

81% to 85%:

With private mortgage insurance:

MGIC 8,255 8,928 8,923 7,805 7,782

RMIC 36,871 38,260 40,032 42,231 42,630

UGI 24,270 27,507 29,176 31,131 32,290

All others 1,096 1,260 1,448 1,452 1,786

Total with private mortgage

insurance 70,492 1 75,955 1 79,579 1 82,619 1 84,488 1

Without private mortgage insurance 2,971 – 2,991 – 2,805 – 1,728 – 1,145 –

Total 81% to 85% 73,463 1 78,946 1 82,384 1 84,347 1 85,633 1

86% to 89%:

With private mortgage insurance:

MGIC 19,167 20,134 20,552 19,563 21,252

RMIC 85,076 94,284 104,558 107,673 111,908

UGI 41,271 45,249 50,402 53,423 55,757

All others 4,319 4,351 4,941 4,959 6,051

Total with private mortgage

insurance 149,833 1 164,018 2 180,453 2 185,618 2 194,968 2

Without private mortgage insurance 5,195 – 4,457 – 4,532 – 4,624 – 4,355 –

Total 86% to 89% 155,028 1 168,475 2 184,985 2 190,242 2 199,323 2

90% and above:

With private mortgage insurance

MGIC 16,658 18,864 19,348 19,981 22,614

RMIC 104,696 113,895 126,184 132,823 140,568

UGI 58,670 62,172 66,047 73,066 77,989

All others 6,482 6,622 7,179 7,398 8,587

Total with private mortgage

insurance 186,506 2 201,553 2 218,758 2 233,268 2 249,758 2

Without private mortgage insurance (a) 33,808 – 30,114 – 28,534 – 28,778 – 27,786 –

Total 90% and above 220,314 2 231,667 2 247,292 2 262,046 2 277,544 2

Not available 2,592 – 2,693 – 2,885 – 2,946 – 2,965 –

Total residential one-to-four units $ 10,959,601 100% $ 10,894,889 100% $ 10,712,235 100% $ 10,877,228 100% $ 11,227,561 100%

Weighted average loan-to-value ratio

for loan investment portfolio of

residential one-to-four units 72 72 72 72 73

In addition to the other credit risks already identified, 74% of our residential one-to-four unit loans held for investment at September 30, 2008 were

underwritten based on borrower stated income and asset verification and an additional 5% were underwritten with no verification of either borrower

income or assets. In April 2008, we changed our guidelines to no longer permit stated income programs for portfolio loans.

Page 50 Navigation LinksCredit risks are mitigated primarily by various minimum borrower credit requirements and maximum loan-to-value ratio limitations. For example, at

September 30, 2008, the average loan-to-value ratio at origination of our residential one-to-four unit loan portfolio was 72%. However, even with these

requirements and limitations, our risk mitigation strategy is limited by potential defects in the underwriting process as well as potential changes in the

loan-to-value ratio due to negative amortization and declines in home values after the loans were originated. For example, while residential property

values increased in the past thereby further reducing our exposure to credit risk, home value declines emerged in 2006 and are continuing in most

markets in which we lend. The uncertainty of future home value changes may materially impact the risk associated with our loan portfolio since 55% of

these loans were originated after 2005.

We originated $3 million of home equity loans and lines of credit in the current quarter, unchanged from both the second quarter of 2008 and yearago

third quarter. During the current quarter, we originated $83 million of residential five or more unit loans, compared to $24 million in the second

quarter of 2008 and none in the year-ago third quarter. During the current quarter we originated less than $1 million of construction loans, down from

$36 million in the second quarter of 2008 and $12 million in the year-ago third quarter. Consumer loan originations totaled $1 million in the current

quarter, up from less than $1 million in the second quarter of 2008 but down from $2 million in the year-ago third quarter.

At September 30, 2008, our unfunded loan application pipeline totaled $423 million. Within that pipeline, we had commitments to borrowers for

short-term interest rate locks, before the reduction of expected fallout, of $216 million, of which $38 million were related to residential one-to-four unit

loans being originated for sale in the secondary market. Furthermore, we had commitments for undrawn lines of credit of $205 million and loans in

process of $63 million. We believe our current sources of funds will be adequate relative to these obligations.

Page 51 Navigation LinksThe following table sets forth the origination, purchase and sale activity relating to our loans and mortgage-backed securities for the quarters

indicated.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

Investment Portfolio

 

Loans originated:

Loans secured by real estate:

Residential one-to-four units:

Adjustable $ 32,180 $ 13,460 $ 9,685 $ 92,109 $ 113,585

Adjustable – fixed for 3-5 years 521,273 734,242 424,939 302,386 318,089

Fixed 6,805 2,876 702 – 588

Total residential one-to-four units 560,258 750,578 435,326 394,495 432,262

Home equity loans and lines of credit 3,325 3,322 2,019 2,268 3,048

Residential five or more units – adjustable 82,970 24,345 – – –

Total residential 646,553 778,245 437,345 396,763 435,310

Commercial real estate 8,180 – – – –

Construction 271 36,478 275 28,524 11,551

Land 197 161 41 103 135

Non-mortgage:

Commercial – – 305 – 300

Consumer 1,010 459 742 787 1,709

Total loans originated 656,211 815,343 438,708 426,177 449,005

Loan repayments (297,790 ) (412,751 ) (552,942 ) (747,862 ) (979,625 )

Other net changes (a) (239,927 ) (388,083 ) (302,423 ) (247,000 ) (71,735 )

Increase (decrease) in loans held for investment, net 118,494 14,509 (416,657 ) (568,685 ) (602,355 )

Sale Portfolio

 

Residential one-to-four unit loans:

Originated 143,610 210,055 236,568 190,816 240,423

Purchased 3,682 1,671 788 1,237 4,408

Loans transferred to the investment portfolio (4,254 ) (1,077 ) (123 ) (579 ) (6,669 )

Originated whole loans sold (16,548 ) (398 ) (1,505 ) (1,999 ) (93,774 )

Loans exchanged for mortgage-backed securities (b) (204,613 ) (234,715 ) (227,482 ) (173,909 ) (243,546 )

Capitalized basis adjustment (c) 215 920 (1,243 ) (208 ) 2,103

Other net changes (d) 23 (151 ) (1,134 ) (2,202 ) (469 )

Increase (decrease) in loans held for sale, net (77,885 ) (23,695 ) 5,869 13,156 (97,524 )

Mortgage-backed securities, net:

Received in exchange for loans (b) 204,613 234,715 227,482 173,909 243,546

Sold (b) (204,613 ) (234,715 ) (227,482 ) (173,909 ) (243,546 )

Repayments (2 ) (3 ) (2 ) (1 ) (2 )

Other net changes – – – –

–

Decrease in mortgage-backed securities

available for sale (2 ) (3 ) (2 ) (1 ) (2 )

Increase (decrease) in loans held for sale and

mortgage-backed securities available for sale (77,887 ) (23,698 ) 5,867 13,155 (97,526 )

Total increase (decrease) in loans and

mortgage-backed securities, net $ 40,607 $ (9,189 ) $ (410,790 ) $ (555,530 ) $ (699,881 )

(a) Primarily included changes in undisbursed funds for lines of credit and construction loans, in loss allowances, in net deferred costs and

premiums, in interest capitalized on loans (negative amortization), and from loans transferred to real estate acquired in settlement of loans or from

(to) the held for sale portfolio.

(b) These transactions typically involve creation of an MBS by a government sponsored entity (GSE) from loans sold by, and delivered by, us to the

GSE. While the GSE is obligated to provide us with the MBS in exchange for the sold loans, the GSE typically fulfills this commitment through

delivery of the MBS directly to the third-party purchaser based on a forward sales commitment made by us to that third party. The sales of both the

loans and MBS are settled typically on a same-day basis such that we do not retain the MBS. If the MBS were to be retained with an intent to sell, we

would classify the security as held for trading and record changes in fair value in our consolidated statement of income.

(c) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we

included the fair value of MSRs in the fair value of interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan

Commitments Recorded at Fair Value Through Earnings.

(d) Primarily included repayments and the change in net deferred costs and premiums.

 

Page 52 Navigation LinksThe following table sets forth the composition of our loan and mortgage-backed securities portfolios at the dates indicated.

(a) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we

included the fair value of MSRs in the fair value of the interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan

Commitments Recorded at Fair Value Through Earnings.

 

We carry loans for sale at the lower of cost or fair value. At September 30, 2008, no valuation allowance was required as the fair value exceeded

book value on an aggregate basis.

We carry mortgage-backed securities available for sale at fair value which, at September 30, 2008, was essentially equal to our cost basis.

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

Investment Portfolio

 

Loans secured by real estate:

Residential one-to-four units:

Adjustable $ 6,989,861 $ 7,343,057 $ 7,781,332 $ 8,302,538 $ 8,999,273

Adjustable – fixed for 3-5 years 3,916,019 3,504,702 2,884,877 2,528,287 2,180,099

Fixed 53,721 47,130 46,026 46,403 48,189

Total residential one-to-four units 10,959,601 10,894,889 10,712,235 10,877,228 11,227,561

Home equity loans and lines of credit 132,907 131,531 133,338 138,305 143,948

Residential five or more units:

Adjustable 193,914 120,565 99,522 100,098 103,798

Fixed 10,258 838 852 865 874

Commercial real estate:

Adjustable 28,796 21,562 23,651 23,837 23,966

Fixed 1,042 1,071 1,098 2,590 2,632

Construction 97,907 105,991 74,730 81,098 58,231

Land 10,708 10,524 10,373 49,521 50,864

Non-mortgage:

Commercial 5,305 5,505 5,305 5,000 5,000

Consumer 5,993 5,823 5,934 5,989 6,057

Total loans held for investment 11,446,431 11,298,299 11,067,038 11,284,531 11,622,931

Increase (decrease) for:

Undisbursed loan funds (64,674 ) (74,228 ) (51,595 ) (60,057 ) (48,063 )

Net deferred costs and premiums 129,573 139,295 147,811 156,853 169,195

Allowance for losses (761,824 ) (732,354 ) (546,751 ) (348,167 ) (142,218 )

Total loans held for investment, net 10,749,506 10,631,012 10,616,503 11,033,160 11,601,845

Sale Portfolio

 

Loans held for sale:

Residential one-to-four units 7,624 85,854 110,685 103,320 89,794

Net deferred costs and premiums (16 ) (146 ) (362 ) (109 ) 53

Capitalized basis adjustment (a) 65 (150 ) (1,070 ) 173 381

Total loans held for sale, net 7,673 85,558 109,253 103,384 90,228

Mortgage-backed securities available for sale:

Adjustable 104 106 109 111 112

Fixed – – – – –

Total mortgage-backed securities available for sale 104 106 109 111 112

Total loans held for sale and mortgage-backed

securities available for sale 7,777 85,664 109,362 103,495 90,340

Total loans and mortgage-backed securities, net $ 10,757,283 $ 10,716,676 $ 10,725,865 $ 11,136,655 $ 11,692,185

Page 53 Navigation LinksThe following table sets forth the composition of our investment securities portfolios at the dates indicated.

The fair value of temporarily impaired investment securities, the amount of unrealized losses and the length of time these unrealized losses existed

as of September 30, 2008 are presented in the following table. The $7 million unrealized loss on investment securities that have been in a loss position

for less than 12 months is due to changes in market interest rates and is not considered to be other than temporary. We have the intent and ability to

hold the securities until that temporary impairment is eliminated.

The following table sets forth the maturities of our investment securities and their weighted average yields at September 30, 2008.

(a) At September 30, 2008, 41% of our investment securities had step-up provisions that stipulate increases in the coupon rate ranging from 0.25% to

1.43% at various specified dates ranging from February 2011 to February 2020. In addition, at September 30, 2008, all of these investment

securities contained call provisions from June 2008 to November 2022. Yields for investment securities available for sale are calculated using

historical cost balances and are not adjusted for changes in fair value that are reflected as a separate component of stockholders’ equity.

Deposits

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Federal funds and interest earning due from banks $ 101,129 $ 11,060 $ – $ 5,900 $ 1,551

Investment securities available for sale:

U.S. Treasury – – – – –

Government sponsored entities 592,481 998,396 1,603,039 1,549,818 2,142,216

Other 61 61 61 61 62

Total investment securities $ 693,671 $ 1,009,517 $ 1,603,100 $ 1,555,779 $ 2,143,829

Less than 12 months 12 months or longer Total

Unrealized Unrealized Unrealized

(In Thousands) Fair Value Losses Fair Value Losses Fair Value Losses

 

Investment securities available for sale:

U.S. Treasury $ – $ – $ – $ – $ – $ –

Government sponsored entities 243,234 6,766 – – 243,234 6,766

Total temporarily impaired securities $ 243,234 $ 6,766 $ – $ – $ 243,234 $ 6,766

Amount Due as of September 30, 2008

In 1 Year After 1 Year After 5 Years After

(Dollars in Thousands) or Less Through 5 Years Through 10 Years 10 Years Total

 

Federal funds and interest earning due

from banks $ 101,129 $ – $ – $ – $ 101,129

Weighted average yield 0.77% -% -% -% 0.77%

Investment securities available for sale:

U.S. Treasury – – – – –

Weighted average yield -% -% -% -% -%

Government sponsored entities (a) – 349,247 98,124 145,110 592,481

Weighted average yield -% 5.09% 4.40% 4.68% 4.87%

Other – – – 61 61

Weighted average yield -% -% -% 6.25% 6.25%

Total investment securities $ 101,129 $ 349,247 $ 98,124 $ 145,171 $ 693,671

Weighted average yield 0.77% 5.09% 4.40% 4.68% 4.27%

At September 30, 2008, our deposits totaled $9.6 billion, down $1.0 billion or 9.8% from the year-ago level and $878 million or 8.4% from year-end

2007. Compared with the year-ago period, certificates of deposit declined $719 million or 8.7% and our transaction accounts (i.e., checking, money

market and regular passbook) declined $325 million or 13.8%. Within our transaction accounts, regular passbook accounts declined $290 million and

checking accounts declined $148 million while money market increased $113 million. Of the decline in checking, $8 million was in custodial accounts

related to loan servicing, which reflected the concurrent decline in loan prepayments.

Page 54 Navigation LinksAt September 30, 2008, our total number of branches was 175, of which 170 were located in California and five were located in Arizona. The

average deposit size of our 85 traditional branches was $89 million, while the average deposit size of our 90 in-store branches was $23 million.

The following table sets forth information concerning our deposits and weighted average rates paid at the dates indicated.

(a) Included amounts swept into money market deposit accounts.

Borrowings

 

At September 30, 2008, our borrowings totaled $2.3 billion, up $235 million from a year ago and up $913 million from year-end 2007. During the

current quarter, borrowings increased by $487 million and represented 18% of total assets at quarter end. This increase is largely due to additional

FHLB advances of $585 million, partially offset by the decline in securities sold under agreements to repurchase of $98 million.

The following table sets forth information concerning our FHLB advances and other borrowings at the dates indicated.

(a) Included the impact of interest rate swap contracts, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable

September 30, 2008 June 30, 2008 March 31, 2008 December 31, 2007 September 30, 2007

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:

Non-interest-bearing

checking (a) -% $ 628,492 -% $ 664,895 -% $ 673,717 -% $ 645,730 -% $ 679,148

Interest-bearing

checking (a) 0.27 365,930 0.27 443,801 0.29 467,051 0.27 464,980 0.27 462,973

Money market 2.26 251,160 1.47 185,036 1.04 137,745 1.04 134,640 1.04 138,256

Regular passbook 0.89 781,622 0.93 1,002,450 0.93 1,033,302 0.95 1,035,964 0.95 1,071,728

Total transaction

accounts 0.67 2,027,204 0.58 2,296,182 0.54 2,311,815 0.55 2,281,314 0.55 2,352,105

Certificates of deposit:

Less than 2.00% 1.26 22,805 1.27 26,765 1.28 26,374 1.25 21,915 1.28 20,070

2.00-2.49 2.45 464,836 2.45 475,931 2.44 118,716 2.31 148 2.33 163

2.50-2.99 2.94 1,532,295 2.92 1,927,169 2.90 370,206 2.83 6,889 2.83 8,068

3.00-3.49 3.15 1,880,018 3.23 1,715,721 3.29 1,094,117 3.28 72,288 3.28 87,110

3.50-3.99 3.84 1,147,577 3.76 776,072 3.75 894,761 3.86 43,481 3.84 49,390

4.00-4.49 4.17 1,552,749 4.24 557,160 4.23 618,422 4.29 306,302 4.26 189,990

4.50-4.99 4.68 924,106 4.80 1,845,236 4.81 4,061,873 4.85 6,026,108 4.91 5,225,991

5.00-5.49 5.05 66,787 5.07 260,735 5.09 747,306 5.10 1,736,673 5.11 2,728,452

5.50 and greater 6.06 7 6.06 7 6.06 699 6.00 923 5.82 1,279

Total certificates

of deposit 3.57 7,591,180 3.67 7,584,796 4.33 7,932,474 4.85 8,214,727 4.93 8,310,513

Total deposits 2.96% $ 9,618,384 2.95% $ 9,880,978 3.47% $ 10,244,289 3.92% $ 10,496,041 3.96% $ 10,662,618

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Securities sold under agreements to repurchase $ – $ 97,838 $ 103,000 $ – $ 566,350

Federal Home Loan Bank advances (a) 2,110,061 1,525,034 1,434,602 1,197,100 1,308,867

Senior notes 198,593 198,543 198,494 198,445 198,398

Total borrowings $ 2,308,654 $ 1,821,415 $ 1,736,096 $ 1,395,545 $ 2,073,615

Weighted average rate on borrowings during

the quarter (a) 3.68% 3.73% 4.74% 5.80% 5.94%

Total borrowings as a percentage of total assets 18.06 14.42 13.22 10.41 14.38

interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.

 

Page 55 Navigation LinksWe consolidate majority-owned subsidiaries that we control. We account for other affiliates, including joint ventures, in which we do not exhibit

significant control or have majority ownership, by the equity method of accounting. For those relationships in which we own less than 20%, we

generally carry them at cost. In the course of our business, we participate in real estate joint ventures through our wholly-owned subsidiary, DSL

Service Company. Our real estate joint ventures do not require consolidation as a result of applying the provisions of Financial Accounting Standards

Board Interpretation 46 (revised December 2003).

We utilize financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These

financial instruments include commitments to originate fixed and variable rate mortgage loans held for investment, undisbursed loan funds, lines and

letters of credit, commitments to purchase loans and mortgage-backed securities for our portfolio and commitments to invest in community

development funds. The contract or notional amounts of these instruments reflect the extent of involvement we have in particular classes of financial

instruments. For further information, see Asset/Liability Management and Market Risk on page 56 and Note 5 of Notes to the Consolidated Financial

Statements on page 15.

We use the same credit policies in making commitments to originate or purchase loans, lines of credit and letters of credit as we do for on-balance

sheet instruments. For commitments to originate loans held for investment, the contract amounts represent exposure to loss from market fluctuations as

well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. We control the credit risk of our

commitments to originate loans held for investment through credit approvals, limits and monitoring procedures.

We do not dispose of loans or assets by means of unconsolidated special purpose entities.

Transactions with Related Parties

 

There are no significant related party transactions required to be disclosed in accordance with FASB Statement No. 57, Related Party Disclosures.

Loans to our executive officers and directors were made in the ordinary course of business and were made on substantially the same terms as

comparable transactions.

Asset/Liability Management and Market Risk

 

Market risk is the risk of loss or reduced earnings from adverse changes in market prices and interest rates. Our market risk arises primarily from

interest rate risk in our lending and deposit taking activities. Interest rate risk primarily occurs to the degree that our interest-bearing liabilities reprice or

mature on a different basis and frequency than our interest-earning assets. Since our earnings depend primarily on our 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, our principal

objectives are to actively monitor and manage the effects of adverse changes in interest rates on net interest income. Our primary strategy in managing

interest rate risk is to emphasize the origination for investment of adjustable rate mortgage loans or loans with relatively short maturities. Interest rates

on adjustable rate mortgage loans are primarily tied to COFI, MTA, LIBOR and CMT. We also may execute swap contracts to change interest rate

characteristics of our interest-earning assets or interest-bearing liabilities to better manage interest rate risk.

In addition to the interest rate risk associated with our lending for investment and deposit-taking activities, we also have market risk associated

with our secondary marketing activities. Changes in mortgage interest rates, primarily fixed rate mortgage loans, impact the fair value of loans held for

sale as well as our interest rate lock commitment derivatives, where we have committed to an interest rate with a potential borrower for a loan we intend

to sell. Our objective is to hedge against fluctuations in interest rates through the use of loan forward sale and purchase contracts with governmentsponsored

enterprises and whole loan sale contracts with various other parties. These contracts are typically obtained at or about the time the interest

rate lock commitments are made. Therefore, as interest rates fluctuate, the changes in the fair value of our interest rate lock commitments and loans held

for sale tend to be offset by changes in the fair value of the hedge contracts. We continue to hedge as previously done before the issuance of SFAS

133. As applied to our risk management strategies, SFAS 133 may increase or decrease reported net income and stockholders’ equity, depending on

interest rates and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on the overall economics

of the transactions. The method used for assessing the effectiveness of a hedging derivative, as well as the measurement approach for determining the

ineffective aspects of the hedge, is established at the inception of the hedge. We generally do not enter into derivative contracts for speculative

purposes.

Page 56 Navigation LinksChanges in mortgage interest rates also impact the value of our MSRs. Rising interest rates typically result in slower prepayment speeds on the

loans being serviced for others which increase the value of MSRs. Declining interest rates typically result in faster prepayment speeds which decrease

the value of MSRs. Over time, we may use derivatives or securities to provide an economic hedge against value changes in our MSRs.

Page 57 Navigation LinksOne measure of our exposure to differential changes in interest rates between assets and liabilities is shown in the following table which sets forth

the repricing frequency of our major asset and liability categories as of September 30, 2008, as well as other information regarding the repricing and

maturity differences between our interest-earning assets and total deposits and borrowings in future periods. We refer to these differences as “gap.”

We have determined the repricing frequencies 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 on

substantially our entire loan portfolio are based upon anticipated future prepayment behavior as derived from external models of loans with similar

characteristics. Repricing mechanisms on a number of our assets are subject to limitations, such as caps on the amount that interest rates and payments

on our loans may adjust, and accordingly, these assets may not respond to changes in market interest rates as completely or rapidly as our liabilities.

The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if we used different assumptions or if

actual experience differed from the assumptions set forth.

September 30, 2008

After 6 Months After 1 Year After 5 Years

Within Through 12 Through 5 Through 10 Beyond Total

(Dollars in Thousands) 6 Months Months Years Years 10 Years Balance

 

Interest-earning assets:

Investment securities and stock (a) $ 447,116 $ 11,291 $ 368,519 $ – $ – $ 826,926

Loans and mortgage-backed securities: (b)

Loans secured by real estate:

Residential one-to-four units:

Adjustable 6,387,381 423,273 3,475,101 – – 10,285,755

Fixed 7,750 2,187 15,038 13,732 19,958 58,665

Home equity loans and lines of credit 131,471 51 347 220 – 132,089

Residential five or more units:

Adjustable 69,242 14,845 68,308 30,145 – 182,540

Fixed 281 364 2,609 6,220 144 9,618

Commercial real estate 15,382 3,250 4,701 3,551 – 26,884

Construction 45,053 – – – – 45,053

Land 7,463 – – – – 7,463

Non-mortgage loans:

Commercial 3,451 – – – – 3,451

Consumer 5,661 – – – – 5,661

Mortgage-backed securities 104 – – – – 104

Total loans and mortgage-backed securities, net 6,673,239 443,970 3,566,104 53,868 20,102 10,757,283

Total interest-earning assets $ 7,120,355 $ 455,261 $ 3,934,623 $ 53,868 $ 20,102 $ 11,584,209

Transaction accounts:

Non-interest-bearing checking (c) $ 628,492 $ – $ – $ – $ – $ 628,492

Interest-bearing checking (d) 365,930 – – – – 365,930

Money market (e) 251,160 – – – – 251,160

Regular passbook (e) 781,622 – – – – 781,622

Total transaction accounts 2,027,204 – – – – 2,027,204

Certificates of deposit (f) 5,138,288 1,727,482 725,410 – – 7,591,180

Total deposits 7,165,492 1,727,482 725,410 – – 9,618,384

FHLB advances and other borrowings (g) 960,061 – 1,150,000 – – 2,110,061

Senior notes – – – 198,593 – 198,593

Total deposits and borrowings $ 8,125,553 $ 1,727,482 $ 1,875,410 $ 198,593 $ – $ 11,927,038

Excess (shortfall) of interest-earning assets

over deposits and borrowings $ (1,005,198 ) $ (1,272,221 ) $ 2,059,213 $ (144,725 ) $ 20,102 $ (342,829 )

Cumulative gap (1,005,198 ) (2,277,419 ) (218,206 ) (362,931 ) (342,829 )

Cumulative gap – as a percentage of total assets:

September 30, 2008 (7.86 )% (17.82 )% (1.71 )% (2.84 )% (2.68 )%

December 31, 2007 3.59 (2.96 ) 7.85 6.46 6.50

(a) Includes FHLB stock and is based on contractual maturity and repricing/call date.

(b) Based on contractual maturity, repricing date and projected repayment of principal. Prepayment rate based on speeds in September 2008

blended for entire portfolio.

(c) Even though no interest is paid on these accounts, they are classified as repricing within six months, which increases negative gap.

(d) Includes amounts swept into money market deposit accounts and is subject to immediate repricing.

(e) Subject to immediate repricing.

(f) Based on contractual maturity.

(g) Excludes embedded interest rate caps with a notional amount of $50 million and a three-month LIBOR strike rate equal to 5.50%.

 

September 30, 2007 5.89 (2.27 ) 9.36 8.07 8.11

Page 58 Navigation LinksOur six-month gap at September 30, 2008 was a negative 7.86%. This means more deposits and borrowings mature or reprice within six months

than total interest-earning assets. This compares to our positive six-month gap of 3.59% at December 31, 2007 and 5.89% a year ago, which reflected

more interest-earning assets repricing within six months than total deposits and borrowings. The change since year-end 2007 from a positive to

negative gap is primarily due to an increase of adjustable rate loans with interest rates fixed for the first 3 to 5 years without a commensurate increase in

the maturities for our FHLB advances and certificates of deposit.

We continue to emphasize the origination of adjustable rate mortgages for our investment portfolio, which includes our adjustable – fixed for 3-5

years loans that carry a fixed interest rate for a period of three to five years then adjust semi-annually or annually thereafter. For the twelve months

ended September 30, 2008, we originated and purchased for investment $2.3 billion of adjustable rate loans, of which $2.0 billion or 85% were adjustable

– fixed for 3-5 years loans, which represented essentially all of the loans we originated and purchased for investment during the period.

At September 30, 2008, December 31, 2007 and September 30, 2007 essentially all of our interest-earning assets mature, reprice or are estimated to

prepay within five years. Essentially all of our loans held for investment and mortgage-backed securities portfolios consisted of adjustable rate loans

and loans with a due date of five years or less, and totaled $11.4 billion at September 30, 2008 compared with $11.2 billion at December 31, 2007 and $11.6

billion a year ago. During the current quarter, we continued to offer residential fixed rate loan products to our customers primarily for sale in the

secondary market. We originate fixed rate loans primarily for sale in the secondary market and price them accordingly to create loan servicing income

and to increase opportunities for originating adjustable rate mortgage loans. However, we may originate fixed rate loans for investment if these loans

meet specific yield, interest rate risk and other approved guidelines, or to facilitate the sale of real estate acquired through foreclosure.

The following table sets forth the interest rate spread between our interest-earning assets and interest-bearing liabilities at the dates indicated.

(a) Excludes adjustments for non-accrual loans, amortization of net deferred costs to originate loans, premiums and discounts, troubled debt

restructuring (“TDR”) yield adjustments, prepayment and late fees.

(b) Excludes FHLB stock dividends and includes the yield on investment securities accounted for on a trade-date basis but for which interest income

will not be recognized until settlement. Yields for investment securities available for sale are calculated using historical cost balances and are not

adjusted for changes in fair value that are reflected as a separate component of stockholders’ equity.

(c) Included the impact of interest rate swap contracts, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable

interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.

 

The period-end weighted average yield on our loans and mortgage-backed securities was 6.26% at September 30, 2008, down from 7.41% at

December 31, 2007 and 7.45% a year ago. At September 30, 2008, our adjustable rate mortgage portfolio of single family residential loans, including

mortgage-backed securities, totaled $10.9 billion with a weighted average rate of 6.24%, compared with $10.8 billion with a weighted average rate of

7.29% at December 31, 2007, and $11.2 billion with a weighted average rate of 7.41% at September 30, 2007.

September 30, June 30, March 31, December 31, September 30,

2008 2008 2008 2007 2007

 

Weighted average yield:

Loans and mortgage-backed securities (a) 6.26% 6.57% 7.10% 7.41% 7.45%

Investment securities (b) 4.27 4.88 5.01 5.09 5.50

Interest-earning assets yield 6.14 6.44 6.84 7.14 7.15

Weighted average cost:

Deposits 2.96 2.95 3.47 3.92 3.96

Borrowings:

Securities sold under agreements to repurchase – 2.40 2.92 – 5.14

Federal Home Loan Bank advances (c) 3.81 3.35 3.49 5.61 5.96

Senior notes 6.50 6.50 6.50 6.50 6.50

Total borrowings 4.04 3.64 3.80 5.74 5.79

Combined funds cost 3.17 3.06 3.52 4.14 4.26

Interest rate spread 2.97% 3.38% 3.32% 3.00% 2.89%

Page 59 Navigation LinksNon-performing assets consist of loans on which we have ceased accruing interest (which we refer to as non-accrual loans), loans restructured at

an interest rate below market and real estate acquired in settlement of loans. At the beginning of the third quarter of 2007, we initiated our borrower

retention program to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loan subject

to negative amortization to a less costly financing alternative. Those loans are considered TDRs and have been placed on non-accrual status even

though the interest rates following modification were no less than those offered new borrowers. The reason for this is because the modified interest rate

was lower than the interest rate on the original loan and the loan was not re-underwritten to prove that the new interest rate was, in fact, a market

interest rate for a borrower with similar credit quality. Interest income is recorded as these borrowers make their loan payments and, in the current

quarter, $8.7 million was recognized including $1.1 million of amortization of associated impairment allowance. If these borrowers perform pursuant to

the modified terms for six consecutive months, the loans will be placed back on accrual status and, while still reported as TDRs, they will no longer be

classified as non-performing assets because the borrower will have demonstrated an ability to perform in accordance with the loan modification and the

interest rate was no less than those afforded new borrowers at the time of modification.

Our non-performing assets totaled $2.002 billion at September 30, 2008, up from $1.042 billion at December 31, 2007 and $424 million at September

30, 2007. Virtually all of the $44 million increase in non-performing assets during the current quarter came from our single family residential loans which,

in turn, reflected the following:

l A $169 million increase in TDR loans modified in loan workout situations and borrower retention program loans where at least one payment due

has not been made; and

l A $30 million net increase in single family residential real estate acquired in settlement of loans.

Those increases were partially offset by declines in performing TDR loans modified as part of our previously disclosed borrower retention program of

$139 million and in our non-TDR loans of $5 million. At September 30, 2008, $621 million of TDR loans for which we have received six consecutive

months of successful loan payments were removed from non-performing assets and placed on accrual status, of which $578 million were associated

with our borrower retention program and $43 million were associated with loans modified in loan workout situations.

Our non-performing assets as a percentage of total assets were 15.66% at September 30, 2008, up from 7.77% at year-end 2007 and 2.94% a year

ago. To the extent borrowers whose loans were modified pursuant to the borrower retention program are current with their loan payments and included

in non-performing assets, it is relevant to distinguish those from total non-performing assets because, these loans are paying interest at interest rates

no less than those offered new borrowers. At September 30, 2008, $409 million or 72% of such borrowers had made all loan payments due. Accordingly,

the 15.66% ratio of non-performing assets to total assets includes 3.20% related to performing TDRs, resulting in an adjusted ratio of 12.46%.

Page 60 Navigation LinksThe following table summarizes our non-performing assets at the dates indicated.

(a) Represents TDRs associated with loans modified pursuant to our borrower retention program and all payments due have been made. These loans

are considered TDRs and have been placed on non-accrual status even though the interest rate following modification was no less than that offered

new borrowers at the time of loan modification. These TDR loans will be on non-accrual status until six consecutive months of successful payment

history has been established, at which time they will be removed from non-accrual status and from non-performing assets; however, they will

continue to be reported as TDRs. While these loans are on non-accrual status, interest income is recognized only when paid by borrowers on a cash

basis.

(b) Amount is net of a valuation allowance of $11 million at September 30, 2008 and $18 million at June 30, 2008, which reflects recent loss

experience from sales compared to their fair value prior to sale.

(c) Represents loans where the borrower has made six consecutive months of successful loan payments and the loan has been placed on accrual

status, including $578 million associated with our borrower retention program and $43 million related to loans modified in loan workout

situations.

 

We evaluate the need for property valuations of non-performing assets on a periodic basis. We generally will obtain a new property valuation

when we believe there may have been an adverse change in the property operations or in the economic conditions of the geographic market of the

property securing our loans. Our policy is to obtain new property valuations at least annually for all real estate acquired in settlement of loans, but in a

declining real estate market such as the recent market, we typically obtain new property valuations more frequently.

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Non-accrual loans:

Residential one-to-four units:

Performing troubled debt restructurings (a) $ 408,976 $ 548,096 $ 589,304 $ 400,562 $ 96,984

Other troubled debt restructurings 410,260 240,775 110,368 31,218 5,173

All other 888,644 894,104 658,334 448,516 253,259

Residential five or more units 2,900 – – – –

Construction 12,195 12,790 14,869 15,933 7,808

Land – – – 29,080 –

Other 448 566 487 837 511

Total non-accrual loans 1,723,423 1,696,331 1,373,362 926,146 363,735

Real estate acquired in settlement of loans (b) 278,091 261,536 189,127 115,623 59,773

Total non-performing assets $ 2,001,514 $ 1,957,867 $ 1,562,489 $ 1,041,769 $ 423,508

Allowance for loan losses:

Amount $ 761,824 $ 732,354 $ 546,751 $ 348,167 $ 142,218

As a percentage of non-accrual loans 44.20% 43.17% 39.81% 37.59% 39.10%

Non-performing assets as a percentage of total assets:

Performing troubled debt restructurings (a) 3.20 4.34 4.49 2.99 0.67

All other non-performing assets 12.46 11.16 7.41 4.78 2.27

Total non-performing assets 15.66% 15.50% 11.90% 7.77% 2.94%

Performing troubled debt restructurings excluded

from non-performing assets (c) $ 620,903 $ 354,842 $ 49,141 $ – $ –

Page 61 Navigation LinksAt September 30, 2008, 90% of our non-performing assets were located in California, compared with 86% a year ago. The following table

summarizes by major geographical area our residential one-to-four unit non-performing assets at the dates indicated.

Troubled Debt Restructurings

 

We consider a restructuring of a debt a TDR when we, for economic or legal reasons related to the borrower’s financial difficulties, grant a

concession to the borrower that we would not otherwise grant. TDRs may include changing repayment terms, reducing the stated interest rate,

reducing the amounts of principal and/or interest due or extending the maturity date. The restructuring of a loan is intended to recover as much of our

investment as possible and to achieve the highest yield possible. During the current quarter, the total interest recognized on the impaired portfolio was

$27.0 million. At September 30, 2008, we had $1.452 billion of principal balance for TDRs of which $1.150 billion related to the borrower retention

program, $290 million related to other residential one-to-four unit loans and $12 million related to two construction loans. Of those TDRs related to our

borrower retention program, $578 million have demonstrated six consecutive months of successful payment history, were accruing interest and were no

longer reported as a non-performing asset at September 30, 2008. During the current quarter, $8.7 million of interest income was recognized from TDR

loan payments, including $1.1 million of amortization of the associated impairment allowance. There are $43 million of TDR loans modified in loan

workout situations that are currently accruing interest and were no longer reported as a non-performing assets at September 30, 2008.

Real Estate Acquired in Settlement of Loans

 

Real estate acquired in settlement of loans consists of real estate acquired through foreclosure or deeds in lieu of foreclosure and totaled $278

million at September 30, 2008. Of this amount, $266 million, net of a $11 million valuation allowance which reflects recent loss experience from sales

compared to their fair value prior to sale, was for 1,080 residential one-to-four unit properties, $8 million represented one property consisting of raw land

for approximately 545 single family lots and $4 million represented one property consisting of 113 single family lots. We generally require private

mortgage insurance on loans in excess of 80% of their appraised value. In the current quarter, subsequent to our acquiring real estate in the settlement

of loans, we collected $6.0 million in private mortgage insurance to mitigate any losses incurred.

September 30, 2008 September 30, 2007

Non- Non- % of Non- Non- % of

Performing Performing Related Performing Performing Related

(Dollars in Thousands) Loans REO Assets Assets Loans REO Assets Assets

Loan Investment Portfolio

 

Residential one-to-four units:

California county:

Los Angeles $ 238,654 $ 21,673 $ 260,327 12.2% $ 26,170 $ 2,835 $ 29,005 1.4%

San Diego 237,981 45,079 283,060 22.5 38,817 10,269 49,086 3.8

Santa Clara 89,249 12,257 101,506 8.6 8,458 1,631 10,089 1.1

Orange 125,587 13,183 138,770 15.0 13,963 619 14,582 1.6

Alameda 72,096 17,112 89,208 15.5 8,915 2,329 11,244 2.0

Riverside 109,688 16,318 126,006 25.2 25,372 2,930 28,302 5.0

Contra Costa 83,095 21,427 104,522 21.2 8,874 3,286 12,160 2.5

San Mateo 39,387 3,687 43,074 12.0 3,079 1,368 4,447 1.5

San Bernardino 66,353 8,687 75,040 23.4 10,662 755 11,417 3.3

Sacramento 69,599 18,655 88,254 29.8 17,910 4,001 21,911 6.4

All other counties 388,589 80,430 469,019 22.1 56,945 15,503 72,448 3.3

Total California 1,520,278 258,508 1,778,786 17.5 219,165 45,526 264,691 2.7

Arizona 66,278 9,149 75,427 17.1 9,197 1,086 10,283 2.1

All other states 121,324 9,893 131,217 20.2 27,477 5,837 33,314 4.1

Valuation allowance – (11,071 ) (11,071 ) (1.0 ) – – – –

Total residential

one-to-four units $ 1,707,880 $ 266,479 $ 1,974,359 17.6% $ 255,839 $ 52,449 $ 308,288 2.7%

Page 62 Navigation LinksThe following table summarizes the activity of our number of residential one-to-four unit properties acquired in settlement of loans and the loss

given default on those sold for the quarters indicated.

(a) Reflects the difference between the net sales proceeds and loan principal balance at foreclosure adjusted for associated deferred costs and fees,

premiums and discounts, and collection of mortgage insurance as a percentage of their loan principal balance at foreclosure. The ratio does not

include the cost to carry or real estate related costs, such as property taxes, which are expensed as incurred.

 

At September 30, 2008, 169 properties or 15.6% of our one-to-four unit residential properties were in escrow to be sold and offers were being

negotiated on an additional 91 properties.

Delinquent Loans

 

At September 30, 2008, loans delinquent 30 days or more as a percentage of total loans was 12.41%, up from 6.05% at December 31, 2007 and

3.30% a year ago. The increase from the year-ago quarter occurred primarily in our residential one-to-four unit loan classification. As a percentage of its

loan category, delinquent residential one-to-four units increased from 3.41% at September 30, 2007 to 12.91% at September 30, 2008, reflecting the

continued weakness in the residential real estate market. A higher incidence of delinquency is expected when the minimum payments reset on our

adjustable rate loans subject to negative amortization or interest only payments, whereby the interest rate is fixed for the first three to five years. For

example, we had loans subject to negative amortization or with interest only payments that have not been modified within our loans held for investment,

which recasted for the first time in 2007 or 2008 of $1.2 billion, of which 47.65% were delinquent 30 days or more at September 30, 2008. The increase in

delinquency is considered when we analyze the adequacy of our credit loss allowance.

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

Number of residential one-to-four unit

properties acquired in settlement of loans

 

Count at beginning of period 888 575 326 162 90

New 596 522 316 212 109

Sold (404 ) (209 ) (67 ) (48 ) (37 )

Count at end of period 1,080 888 575 326 162

Loss given default (a) 35.9% 31.8% 22.3 % 22.2% 8.1%

Page 63 Navigation LinksThe following table indicates the amounts of our past due loans at the dates indicated.

September 30, 2008 June 30, 2008

30-59 60-89 90+ 30-59 60-89 90+

(Dollars in Thousands) Days Days Days (a) Total Days Days Days (a) Total

 

Loans secured by real estate:

Residential:

One-to-four units $ 274,844 $ 200,502 $ 940,731 $ 1,416,077 $ 269,429 $ 209,610 $ 796,358 $ 1,275,397

Home equity loans and lines of credit – 569 365 934 212 – 490 702

Five or more units – – – – – – – –

Commercial real estate – – – – – – – –

Construction – 4,136 – 4,136 – – – –

Land – – – – – – – –

Total real estate loans 274,844 205,207 941,096 1,421,147 269,641 209,610 796,848 1,276,099

Non-mortgage:

Commercial – – – – – – – –

Consumer 32 5 83 120 17 5 76 98

Total delinquent loans $ 274,876 $ 205,212 $ 941,179 $ 1,421,267 $ 269,658 $ 209,615 $ 796,924 $ 1,276,197

Delinquencies as a percentage

of total loans 2.40% 1.79% 8.22% 12.41% 2.37% 1.84% 7.00% 11.21%

March 31, 2008 December 31, 2007

 

Loans secured by real estate:

Residential:

One-to-four units $ 226,100 $ 160,775 $ 576,130 $ 963,005 $ 205,737 $ 134,715 $ 313,528 $ 653,980

Home equity loans and lines of credit 131 – 422 553 – 450 776 1,226

Five or more units – – – – – – – –

Commercial real estate – – – – – – – –

Construction – – – – – – – –

Land – – – – 33,580 – – 33,580

Total real estate loans 226,231 160,775 576,552 963,558 239,317 135,165 314,304 688,786

Non-mortgage:

Commercial – – – – – – – –

Consumer 19 9 65 93 21 12 61 94

Total delinquent loans $ 226,250 $ 160,784 $ 576,617 $ 963,651 $ 239,338 $ 135,177 $ 314,365 $ 688,880

Delinquencies as a percentage

of total loans 2.02% 1.44% 5.16% 8.62% 2.10% 1.19% 2.76% 6.05%

September 30, 2007

 

Loans secured by real estate:

Residential:

One-to-four units $ 129,329 $ 75,757 $ 180,422 $ 385,508

Home equity loans and lines of credit 212 195 444 851

Five or more units – – – –

Commercial real estate – – – –

Construction – – – –

Land – – – –

(a) All 90 day or greater delinquencies are on non-accrual status and reported as part of non-performing assets.

 

Total real estate loans 129,541 75,952 180,866 386,359

Non-mortgage:

Commercial – – – –

Consumer 22 6 67 95

Total delinquent loans $ 129,563 $ 75,958 $ 180,933 $ 386,454

Delinquencies as a percentage

of total loans 1.11% 0.65% 1.54% 3.30%

Page 64 Navigation LinksWe maintain a valuation allowance for credit and real estate losses to provide for losses inherent in those portfolios at the balance sheet date. The

allowance for credit losses includes an allowance for loan losses reported as a reduction of loans held for investment and the allowance for loan-related

commitments reported in accounts payable and accrued liabilities. Management evaluates the adequacy of the allowance quarterly to maintain the

allowance at levels sufficient to provide for inherent losses at the balance sheet date.

We use an internal asset review system and loss allowance methodology designed to provide for timely recognition of problem assets and an

adequate allowance to cover asset and loan-related commitment losses. The amount of the allowance is based upon the total of general valuation

allowances, allocated allowances and specific allowances. General valuation allowances relate to assets and loan-related commitments with no welldefined

deficiency or weakness and take into consideration losses that are embedded within the portfolio but have not yet been realized. Allocated

allowances relate to assets segregated into different classifications with well-defined deficiencies or weaknesses. Loans evaluated individually that are

deemed to be impaired are separated from our other credit loss analysis in accordance with FASB Statement No. 114, Accounting by Creditors for

Impairment of a Loan. If we determine the carrying value of our asset exceeds the net fair value and no alternative payment source exists, then a specific

allowance is recorded for the amount of that difference.

The OTS has the authority to require us to change our asset classifications. If the change results in an asset being classified in whole or in part as

loss, a specific allowance must be established against the amount so classified or that amount must be charged off. The OTS generally directs its

examiners to rely on management’s estimates of adequate general valuation allowances if the Bank’s process for determining adequate allowances is

deemed to be sound.

Provision for credit losses totaled $130.3 million in the third quarter of 2008, compared with $81.6 million a year ago.

At September 30, 2008, the allowance for credit losses was $763 million, comprised of $762 million for loan losses and $1 million for loan-related

commitments. That compares to an allowance for credit losses of $349 million at year-end 2007, comprised of $348 million for loan losses and $1 million

for loan-related commitments. Loan-related commitments are reported on the balance sheet in the category accounts payable and accrued liabilities. The

allowance for credit losses increased $29 million this quarter, of which $24 million was related to specific allowances associated with certain troubled

debt restructurings pursuant to our borrower retention program. These specific allowances totaled $117 million at quarter end and will be accreted into

interest income over the remaining life of the modified loans as long as they remain on accrual status. The balance of the increase in the allowance for

credit losses was primarily due to loan workout modifications.

Downey’s allowance methodology incorporates assumptions related to default probabilities, loss severities and loss horizons based on historical

experience, current market conditions, and the unique characteristics of each borrower, loan and underlying collateral. On a comparative basis, these

factors individually increase or decrease the amount of the allowance for loan losses from prior periods. In the current quarter, loss severities continued

to increase and loss horizons continued to shorten. Further, as a result of deteriorating conditions facing the residential housing market, borrower

equity continues to decline. Partially offsetting this unfavorable trend was a small decrease in default probabilities due to lower mortgage interest rates

and a lower proportion of option ARM loans in our portfolio that have a higher loss experience.

Page 65 Navigation LinksThe following table summarizes the activity in our allowance for losses on loans and loan-related commitments for the quarters indicated.

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

 

The following table summarizes the activity in our allowance for losses on loans and loan-related commitments for the year-to-date periods

indicated.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

Allowance for loan losses

 

Balance at beginning of period $ 732,354 $ 546,751 $ 348,167 $ 142,218 $ 69,107

Provision 130,430 258,517 237,087 218,650 81,435

TDR yield adjustment (a) (3,352 ) (2,670 ) (1,461 ) (483 ) –

Charge-offs (97,613 ) (70,245 ) (37,043 ) (12,220 ) (8,368 )

Recoveries 5 1 1 2 44

Balance at end of period $ 761,824 $ 732,354 $ 546,751 $ 348,167 $ 142,218

Allowance for loan-related commitments

 

Balance at beginning of period $ 1,355 $ 998 $ 1,215 $ 1,418 $ 1,291

Provision (reduction) (139 ) 357 (217 ) (203 ) 127

Balance at end of period $ 1,216 $ 1,355 $ 998 $ 1,215 $ 1,418

Total allowance for credit losses

 

Balance at beginning of period $ 733,709 $ 547,749 $ 349,382 $ 143,636 $ 70,398

Provision 130,291 258,874 236,870 218,447 81,562

TDR yield adjustment (a) (3,352 ) (2,670 ) (1,461 ) (483 ) –

Charge-offs (97,613 ) (70,245 ) (37,043 ) (12,220 ) (8,368 )

Recoveries 5 1 1 2 44

Balance at end of period $ 763,040 $ 733,709 $ 547,749 $ 349,382 $ 143,636

Nine Months Ended September 30,

(In Thousands) 2008 2007

Allowance for loan losses

 

Balance at beginning of period $ 348,167 $ 60,943

Provision 626,034 91,321

TDR yield adjustment (a) (7,483 ) –

Charge-offs (204,901 ) (10,344 )

Recoveries 7 298

Balance at end of period $ 761,824 $ 142,218

Allowance for loan-related commitments

 

Balance at beginning of period $ 1,215 $ 1,055

Provision 1 363

Balance at end of period $ 1,216 $ 1,418

Total allowance for credit losses

 

Balance at beginning of period $ 349,382 $ 61,998

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

 

Provision 626,035 91,684

TDR yield adjustment (a) (7,483 ) –

Charge-offs (204,901 ) (10,344 )

Recoveries 7 298

Balance at end of period $ 763,040 $ 143,636

Page 66 Navigation LinksNet charge-offs of loans totaled $97.6 million in the current quarter, compared to $8.3 million a year ago. The current quarter net charge-offs

primarily related to residential one-to-four unit loans, with an annualized net charge-off ratio associated with these loans increasing to 3.62% from 0.28%

a year ago.

For the first nine months of 2008, the provision for credit losses totaled $626.0 million and net charge-offs were $204.9 million. This compares with

a $91.7 million provision for credit losses and net charge-offs of $10.0 million a year ago.

The following table presents gross charge-offs, gross recoveries and net charge-offs by category of loan for the periods indicated.

Three Months Ended Nine Months Ended

September 30, June 30, March 31, December 31, September 30, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007 2008 2007

Gross loan charge-offs

 

Loans secured by real estate:

Residential:

One-to-four units $ 97,586 $ 70,219 $ 26,207 $ 12,188 $ 4,301 $ 194,012 $ 6,221

Home equity loans and lines

of credit – – 169 – – 169 –

Five or more units – – – – – – –

Commercial real estate – – – – – – –

Construction – – – (3 ) – – 20

Land – – 10,639 – 4,022 10,639 4,022

Non-mortgage:

Commercial – – – – – – –

Consumer 27 26 28 35 45 81 81

Total gross loan charge-offs 97,613 70,245 37,043 12,220 8,368 204,901 10,344

Gross loan recoveries

 

Loans secured by real estate:

Residential:

One-to-four units – – – – 40 – 291

Home equity loans and lines

of credit – – – – – – –

Five or more units – – – – – – –

Commercial real estate – – – – – – –

Construction – – – – – – –

Land – – – – – – –

Non-mortgage:

Commercial – – – – – – –

Consumer 5 1 1

2

4 7

7

Total gross loan recoveries 5 1 1 2 44 7

298

Net loan charge-offs (recoveries)

 

Loans secured by real estate:

Residential:

One-to-four units 97,586 70,219 26,207 12,188 4,261 194,012 5,930

Home equity loans and lines – – 169 – –

of credit – – – – – 169 –

Five or more units – – – – – – –

Commercial real estate – – – – – – –

Construction – – – (3 ) – – 20

Land – – 10,639 – 4,022 10,639 4,022

Non-mortgage:

Commercial – – – – – – –

Consumer 22 25 27 33 41 74 74

Total net loan charge-offs $ 97,608 $ 70,244 $ 37,042 $ 12,218 $ 8,324 $ 204,894 $ 10,046

Net loan charge-offs

as a percentage of average loans 3.62% 2.60% 1.35% 0.43% 0.28% 2.52 % 0.10%

Page 67 Navigation LinksThe following table indicates our allocation of the allowance for loan losses to the various categories of loans at the dates indicated.

The following table indicates our allowance for loan losses as a percentage of loan category balance for the various categories of loans at the

dates indicated.

The following table indicates by loan category the percentage mix of our total loans held for investment at the dates indicated.

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Loans secured by real estate:

Residential:

One-to-four units $ 755,010 $ 727,073 $ 542,248 $ 339,424 $ 134,947

Home equity loans and lines of credit 853 828 767 1,019 850

Five or more units 1,934 1,306 1,005 976 965

Commercial real estate 290 226 247 297 298

Construction 2,569 2,348 1,916 1,857 1,726

Land 785 198 195 4,229 3,081

Non-mortgage:

Commercial 35 40 39 36 12

Consumer 348 335 334 329 339

Total for loans held for investment $ 761,824 $ 732,354 $ 546,751 $ 348,167 $ 142,218

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Loans secured by real estate:

Residential:

One-to-four units 6.89% 6.67% 5.06% 3.12% 1.20%

Home equity loans and lines of credit 0.64 0.63 0.58 0.74 0.59

Five or more units 0.95 1.08 1.00 0.97 0.92

Commercial real estate 0.97 1.00 1.00 1.12 1.12

Construction 2.62 2.22 2.56 2.29 2.96

Land 7.33 1.88 1.88 8.54 6.06

Non-mortgage:

Commercial 0.66 0.73 0.74 0.72 0.24

Consumer 5.81 5.75 5.63 5.49 5.60

Total for loans held for investment 6.66% 6.48% 4.94% 3.09% 1.22%

September 30, June 30, March 31, December 31, September 30,

(Dollars in Thousands) 2008 2008 2008 2007 2007

 

Loans secured by real estate:

Residential:

One-to-four units 95.75% 96.43% 96.80% 96.40% 96.60%

Home equity loans and lines of credit 1.16 1.16 1.20 1.23 1.24

Five or more units 1.78 1.08 0.91 0.89 0.90

Commercial real estate 0.26 0.20 0.22 0.23 0.23

Construction 0.86 0.94 0.68 0.72 0.50

Land 0.09 0.09 0.09 0.44 0.44

Non-mortgage:

Commercial 0.05 0.05 0.05 0.04 0.04

Consumer 0.05 0.05 0.05 0.05 0.05

Total for loans held for investment 100.00% 100.00% 100.00% 100.00% 100.00%

Page 68 Navigation LinksIn determining impairment, we consider large non-homogeneous loans that are on non-accrual, have been restructured or are performing but

exhibit, among other characteristics, high loan-to-value ratios or delinquent taxes. We base the measurement of collateral dependent impaired loans on

the fair value of the loan’s collateral net of costs to sell. We value non-collateral dependent loans based on a present value calculation of expected

future cash flows discounted at the loan’s effective rate or the loan’s observable market price. We generally use cash receipts on impaired loans not

performing according to contractual terms to reduce the carrying value of the loan, unless we believe we will recover the remaining principal balance of

the loan, in which case we may recognize interest income. We include impairment losses in the allowance for loan losses through a charge to provision

for credit losses. We include adjustments to impairment losses due to changes in the fair value of the collateral of impaired loans in provision for credit

losses. For TDRs of residential one-to-four unit loans, we include adjustments to impairment losses due to the change in cash flow as an adjustment to

loan yield. Upon disposition of an impaired loan, we record loss of principal through a charge-off to the allowance for loan losses.

At September 30, 2008, the recorded investment in loans for which we recognized impairment totaled $1.477 billion, up from $486 million at

December 31, 2007 and $12 million at September 30, 2007. Of the current quarter total, $1.464 billion related to residential one-to-four unit loan TDRs with

an allowance for loss of $131 million and $12 million related to two construction loans with an allowance for loss of $2 million. This is up from 2007 yearend

totals of $441 million related to residential one-to-four unit loan TDRs with an allowance for loss of $39 million, $29 million related to one land loan

with an allowance for loss of $4 million, $15 million related to two construction loans with an allowance for loss of $2 million, and $1 million related to

one residential one-to-four unit loan with no allowance for loss; and up from the year-ago quarter total of $12 million with an allowance of less than $1

million. During the current quarter, the total interest recognized on the impaired portfolio was $27.0 million, compared to $19.9 million in the second

quarter of 2008 and no interest recognized in the year-ago quarter.

The following table summarizes the activity in our allowance for credit losses associated with impaired loans for the quarters indicated.

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

 

The following table summarizes the activity in our allowance for credit losses associated with impaired loans for the year-to-date periods

indicated.

(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference

between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the

effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently

amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 102,013 $ 66,801 $ 45,066 $ 721 $ 1,238

Provision (reduction) 34,888 38,052 33,900 48,602 (412 )

TDR yield adjustment (a) (3,352 ) (2,670 ) (1,461 ) (483 ) –

Charge-offs (409 ) (170 ) (10,704 ) (3,917 ) (105 )

Recoveries – – – 143 –

Balance at end of period $ 133,140 $ 102,013 $ 66,801 $ 45,066 $ 721

Nine Months Ended September 30,

(In Thousands) 2008

2007

Balance at beginning of period $ 45,066 $ 601

Provision 106,840 772

TDR yield adjustment (a) (7,483 ) –

Charge-offs (11,283 ) (652 )

Recoveries – –

Balance at end of period $ 133,140 $ 721

Page 69 Navigation LinksThe following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the quarters indicated.

The following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the year-to-date periods

indicated.

The following table summarizes the activity in our allowance for real estate acquired in settlement of loans for the quarters indicated.

The following table summarizes the activity in our allowance for real estate acquired in settlement of loans for the year-to-date periods indicated.

We value real estate acquired through foreclosure at fair value less cost to sell, with any subsequent losses recorded as a direct write-off to net

operations. Given the decline in home values in the residential market, we had a valuation allowance at quarter end of $11 million for our one-to-four unit

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 11,867 $ 413 $ 422 $ 432 $ 456

Provision (reduction) 8,053 11,454 (9 ) (10 ) (24 )

Charge-offs – – – – –

Recoveries – – – – –

Balance at end of period $ 19,920 $ 11,867 $ 413 $ 422 $ 432

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Balance at beginning of period $ 422 $ 103

Provision 19,498 329

Charge-offs – –

Recoveries – –

Balance at end of period $ 19,920 $ 432

Three Months Ended

September 30, June 30, March 31, December 31, September 30,

(In Thousands) 2008 2008 2008 2007 2007

 

Balance at beginning of period $ 17,592 $ 12,334 $ – $ – $ –

Provision 19,329 14,712 19,892 1,118 2,058

Charge-offs (25,850 ) (9,454 ) (7,558 ) (1,118 ) (2,058 )

Recoveries – – – – –

Balance at end of period $ 11,071 $ 17,592 $ 12,334 $ – $ –

Nine Months Ended September 30,

(In Thousands) 2008 2007

 

Balance at beginning of period $ – $ –

Provision 53,933 2,621

Charge-offs (42,862 ) (2,621 )

Recoveries – –

Balance at end of period $ 11,071 $ –

residential properties acquired through foreclosure. This valuation allowance reflects recent loss experience from sales compared to their fair value prior

to sale. As that loss experience changes over time, our estimate of this valuation allowance will be reassessed.

Capital Resources and Liquidity

 

Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, available for sale

securities, and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments. Interest rates, real

estate sales activity and general economic conditions significantly affect repayments on loans and deposit inflows and outflows.

Page 70 Navigation LinksOur primary sources of funds generated in the third quarter of 2008 were from:

l maturities or calls of $14.2 billion of U.S. Treasury, government sponsored entities and other investment securities available for sale;

l a net increase of $487 million in borrowings;

l principal repayments of $274 million on loans held for investment, including prepayments but excluding refinances of our existing loans; and

l Sales of wholly owned real estate, real estate acquired in settlement of loans and real estate related contracts of $195 million.

We used these funds to:

l purchase $13.7 billion of government sponsored entities investment securities available for sale;

l originate and purchase $613 million of loans held for investment, excluding refinances of our existing loans; and

l absorb a $263 million reduction in deposits, primarily higher cost certificates of deposit.

In addition to its deposits, our principal source of liquidity is our ability to utilize borrowings, as needed. The Bank’s primary source of

borrowings is the FHLB. At September 30, 2008, the Bank’s FHLB borrowings totaled $2.1 billion, representing 16.5% of total assets. The Bank currently

is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional

$0.9 billion of borrowing capacity from the FHLB as of September 30, 2008. The amount the FHLB is willing to advance differs based on the quality and

character of qualifying collateral offered by the Bank, and the advance rates for the same collateral may be adjusted upwards or downwards by the

FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to

the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank of San Francisco as a back-up source of liquidity. As of

September 30, 2008 the Bank had no outstanding borrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying

collateral would have permitted it to borrow up to an additional $1.1 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is

obligated to lend to us under these loan facilities. To the extent deposit renewals and deposit growth are not sufficient to fund maturing and

withdrawable deposits, repay maturing borrowings, fund existing and future loans and investment securities and otherwise fund working capital needs

and capital expenditures, the Bank may utilize additional borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements.

However, if elevated levels of net deposit outflows occur, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required

to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no

assurances that we would be able to raise additional capital or enter into additional financing arrangements. As a result of being deemed to be

“adequately capitalized” rather than “well capitalized,” the Bank is subject to restrictions on accepting brokered deposits, which have not historically

been a significant part of the Bank’s deposit base, and upper limits on interest rates the Bank may pay on deposits. For further information, see Note 11

of Notes to the Consolidated Financial Statements on page 24.

As of September 30, 2008, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $216

million, of which $38 million were related to residential one-to-four unit loans being originated for sale in the secondary market. We also had

undisbursed loan funds and unused lines of credit of $268 million, loan forward purchase contracts of $21 million and operating leases of $16 million.

For further information, see Note 5 of Notes to the Consolidated Financial Statements on page 15.

Subsequent to September 30, 2008, we closed our Wholesale Loan Department and the loan processing centers supporting that Department, and

began contracting our Retail Loan Department. The Wholesale lending channel has traditionally provided about 80% of our single family loan

originations. Therefore, loan origination volumes will decline in future periods.

Page 71 Navigation LinksLimitations imposed by the OTS currently prohibit the Bank from providing a dividend to the Holding Company without the prior written approval

of the OTS, and currently prohibit the Holding Company from paying a dividend without the prior non-objection of the OTS. At September 30, 2008, the

Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million, down from $102 million at the end of 2007 due

primarily to $80 million in capital contributions made to the Bank. In addition, the Holding Company may not issue new debt or renew existing debt

without the prior non-objection of the OTS. At the moment there is no other source of repayment of the senior notes. Absent additional capital, the

Holding Company will default on the notes within a year.

Subsequent to the end of the quarter, Moody’s Investors Service and Standards & Poor’s Ratings Services lowered their ratings for the Holding

Company and the Bank on August 12, 2008 and September 11, 2008, respectively. For further information, see Risk Factors, on page 77.

Downey’s stockholders’ equity totaled $772 million at September 30, 2008, down from $1.3 billion at December 31, 2007 and $1.4 billion at

September 30, 2007. No future dividends will be paid without the prior non-objection of the OTS.

Contractual Obligations and Other Commitments

 

Through the normal course of operations, we have entered into contractual obligations and other commitments. Our obligations generally relate to

funding of our operations through deposits and borrowings as well as leases for premises and equipment, and our commitments generally relate to our

lending operations.

We have obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period,

with options to extend, and are non-cancelable. Currently, we have no material contractual vendor obligations.

We have executed interest rate swap contracts to change interest rate characteristics of a portion of our FHLB advances to better manage interest

rate risk. The contracts have notional amounts totaling $430 million of receive-fixed, pay 3-month LIBOR variable interest and serve as a permitted fair

value hedge.

Our commitments to originate fixed and variable rate mortgage loans are agreements to lend to a customer as long as there is no violation of any

condition established in the commitment. Undisbursed loan funds on construction projects and unused lines of credit on home equity and commercial

loans include committed funds not disbursed. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to

a third party.

Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire

without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The credit risk involved in issuing

lines and letters of credit requires the same creditworthiness evaluation as that involved in extending loan facilities to customers. We evaluate each

customer’s creditworthiness.

We receive collateral to support commitments when deemed necessary. The most significant categories of collateral include real estate properties

underlying mortgage loans, liens on personal property and cash on deposit with us.

We enter into derivative financial instruments as part of our interest rate risk management process, including loan forward sale and purchase

contracts related to our sale of loans in the secondary market. The associated fair value changes to the notional amount of the derivative instruments

are recorded on-balance sheet. The total notional amount of our derivative financial instruments does not represent future cash requirements. At

September 30, 2008, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of

$26 million, with a change in fair value resulting in a recorded gain of $0.1 million, compared with a notional amount of interest rate lock commitments of

$93 million with a change in fair value resulting in a recorded loss of less than $0.1 million at September 30, 2007. For further information, see

Asset/Liability Management and Market Risk on page 56 and Note 5 of Notes to the Consolidated Financial Statements on page 15.

We sell all loans without recourse. When a loan sold to an investor without recourse fails to perform according to the contractual terms, the

investor will typically review the loan file to determine whether defects in the origination process occurred and whether such defects give rise to a

violation of a representation or warranty we made to the investor in connection with the sale. If such a defect is identified, we may be required to either

repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, we have no commitment to repurchase the loan. During

the first nine months of 2008, we repurchased $6 million of loans and $2 million of real estate acquired in settlement of loans and recorded $0.7 million of

repurchase or indemnification losses related to defects in the origination process.

Page 72 Navigation LinksThese loan and servicing sale contracts may also contain provisions to refund sale price premiums to the purchaser if the related loans prepay

during a period typically 90 days, but not to exceed 120 days from the sale’s settlement date. We reserved less than $1 million at September 30, 2008,

December 31, 2007 and September 30, 2007 to cover the estimated loss exposure related to early payoffs. However, if all the loans related to those sales

prepaid within the refund period, as of September 30, 2008, our maximum sales price premium refund would be $1.9 million. See Note 5 of Notes to the

Consolidated Financial Statements on page 15.

Servicing loans for others includes managing foreclosed loans through the sale of the properties. Advances made for principal and interest

remittances as well as foreclosure costs are recorded in the balance sheet as other assets and are expected to ultimately be recovered from the related

investor.

At September 30, 2008, scheduled maturities of obligations and commitments, excluding accrued interest, were as follows:

(a) Amount represents the notional amount of the commitments or contracts. The notional amount for interest rate lock commitments before the

reduction of expected fallout was $38 million.

After 1 After 3

Within Through 3 Through 5 Beyond Total

(In Thousands) 1 Year Years Years 5 Years Balance

 

Certificates of deposit $ 6,865,770 $ 614,856 $ 110,554 $ – $ 7,591,180

Securities sold under agreements to repurchase – – – – –

FHLB advances 935,061 500,000 675,000 – 2,110,061

Senior notes – – – 198,593 198,593

Secondary marketing activities:

Non-qualifying hedge transactions:

Interest rate lock commitments (a) 25,963 – – – 25,963

Associated loan forward sale contracts (a) 47,392 – – – 47,392

Associated loan forward purchase contracts 21,000 21,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value 7,673 – – – 7,673

Associated loan forward sale contracts (a) 6,608 – – – 6,608

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed 430,000 – – – 430,000

Associated interest rate swap contracts –

pay-variable, receive-fixed (a) 430,000 – – – 430,000

Commitments to originate adjustable rate loans held

for investment 138,092 – – – 138,092

Undisbursed loan funds and unused lines of credit 30,381 35,694 22,372 179,272 267,719

Operating leases 5,473 7,542 2,386 344 15,745

Page 73 Navigation LinksAt September 30, 2008, the Bank was above the minimum capital ratios required by its Consent Order, with core and tangible capital ratios of

7.48% and a total risk-based capital ratio of 14.50%. For further information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

The following table is a reconciliation of the Bank’s stockholder’s equity to federal regulatory capital as of September 30, 2008.

(a) Limited to 1.25% of risk-weighted assets.

(b) From orders issued by the OTS, the Bank is required to maintain minimum capital ratios for core and tangible capital of 7.00% and risk-based

capital of 14.00%, both of which were exceeded at quarter end.

(c) Represents the minimum requirement for tangible capital, as no “well capitalized” requirement has been established for this category.

(d) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%, which the Bank met and exceeded with a ratio of 13.17%.

Tangible Capital Core Capital Risk-Based Capital

(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio

 

Stockholder’s equity $ 958,298 $ 958,298 $ 958,298

Adjustments:

Deductions:

Investment in real estate subsidiary (7,038 ) (7,038 ) (7,038 )

Non-permitted mortgage servicing rights (2,281 ) (2,281 ) (2,281 )

Additions:

Unrealized losses on investment securities

available for sale 6,231 6,231 6,231

Allowance for credit losses, net of specific

allowances (a) – – 96,015

Regulatory capital 955,210 7.48% 955,210 7.48% 1,051,225 14.50%

Well capitalized requirement (b) 191,650 1.50 (c) 638,833 5.00 725,109 10.00 (d)

Excess $ 763,560 5.98% $ 316,377 2.48% $ 326,116 4.50%

Page 74 Navigation LinksFor information regarding quantitative and qualitative disclosures about market risk, see Asset/Liability Management and Market Risk on page 56.

ITEM 4. – CONTROLS AND PROCEDURES

 

As of September 30, 2008, Downey carried out an evaluation, under the supervision and with the participation of Downey’s management,

including Downey’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Downey’s disclosure

controls and procedures pursuant to Securities and Exchange Commission (“SEC”) rules. Based upon that evaluation, the Chief Executive Officer and

Chief Financial Officer concluded Downey’s disclosure controls and procedures were effective as of the end of the period covered by this report. There

have been no significant changes during the most recent quarter in Downey’s internal controls over financial reporting or in other factors that could

significantly affect these controls subsequent to the evaluation date.

Disclosure controls and procedures are defined in SEC rules as controls and other procedures designed to ensure that information required to be

disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Downey’s disclosure controls and procedures were designed to ensure that material information related to Downey is made known to management,

including the Chief Executive Officer and Chief Financial Officer, in a timely manner.

Page 75 Navigation LinksOn October 29, 2004, two former traditional branch employees brought an action in Los Angeles County Superior Court, Case No. BC323796,

entitled Margie Holman and Alice A. Mesec, et al. v. Downey Savings and Loan Association. The first amended complaint seeks unspecified damages

for alleged unpaid regular and overtime wages, inadequate meal breaks, failure to pay split-shift and reporting time wages, and related claims. The

plaintiffs are seeking class action status to represent all other current and former Bank employees who held the position of Customer Service Supervisor

and/or Customer Service Representative at the Bank’s in-store branches at any time from October 29, 2000 to date. The Bank has opposed the claim and

asserted all appropriate defenses, and has provided for what is believed to be a reasonable estimate of exposure for this matter in the event of loss.

While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of this matter will not have a material adverse effect

on Downey’s operations, cash flows or financial position.

Two purported shareholder class actions, one brought on behalf of Waterford Township General Employees Retirement System, Case No. CV-08-

03261, and the other brought on behalf of Stephen J. Mihalacki, Case No. SACV08-00609, were filed on May 16, 2008 and June 2, 2008, respectively, in

the United States District Court for the Central District of California against the Holding Company and certain of its current and former officers and

certain former directors. The complaints, filed on behalf of all persons who purchased Holding Company common stock during October 16, 2006 to

March 14, 2008, seek unspecified damages for alleged violation of federal securities laws, claiming that the defendants made misleading statements and

omissions regarding Downey’s business and financial results, thereby artificially inflating the common stock price. Specifically, the plaintiffs contend

that the defendants concealed that (a) the Bank’s portfolio of option ARMs contained millions of dollars worth of impaired and risky securities; (b) the

Bank had been aggressive in acquiring loans from mortgage brokers that were highly risky; (c) the Bank had failed to properly account for highly

leveraged loans; (d) the Bank had inadequate underwriting practices, which led to large numbers of loan defaults; and (e) the Bank had not adequately

reserved for option ARM loans. A motion to consolidate the two actions was granted on August 14, 2008 with Waterford Township General Employees

Retirement System as lead plaintiff. The plaintiffs filed a consolidated complaint on September 30, 2008 and, pursuant to a stipulation between the

parties, have until November 12, 2008 to file a first amended consolidated complaint.

Related to the shareholder class actions, two purported shareholder derivative lawsuits, one entitled Michael L. McDougall v. Daniel D., Case No. 30-2008-00180029, and the other entitled Joyce Mendlin v. Maurice L. McAlister, et al., Case No. 30-2008-00087854, were

Rosenthal, et al.

filed on June 10, 2008 and July 28, 2008, respectively, in Orange County Superior Court, in California. The plaintiffs, who purport to bring the lawsuits

on behalf of the Holding Company against certain of its current and former officers, its current directors and certain former directors, allege that

commencing in October 2006, the defendants caused or allowed Downey to issue a series of press releases and other statements that significantly

overstated Downey’s business prospects and financial results; that the statements failed to disclose that Downey was more exposed to the subprime

market crisis than it had disclosed; that Downey’s portfolio of subprime and option ARM mortgage-related assets was overvalued; and that as a result,

Downey’s reported earnings and business prospects were inaccurate. The plaintiffs allege that the defendants’ action constitutes breaches of fiduciary

duty, waste of corporate assets and unjust enrichment, and seek, among other relief, unspecified damages to be paid to the Holding Company,

corporate governance reforms, and equitable and injunctive relief, including restitution and the creation of a constructive trust.

Downey has been named as a defendant in other legal actions arising in the ordinary course of business, none of which, in the opinion of

management, will have a material adverse effect on its operations, cash flows or financial position.

Consent Orders

 

On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. For

more information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

Page 76 Navigation LinksDowney’s 2007 Form 10-K presents, on pages 22 to 27, a comprehensive set of risk factors that may impact Downey’s future results. Given recent

developments, we are adding the following:

If we do not raise additional capital by December 31, 2008, it is highly unlikely that we will be in compliance with the capital requirements

of the Bank Consent Order at year-end, which could have a material adverse effect upon us.

 

The Bank Consent Order requires the Bank to maintain a minimum Tier I Core Capital ratio of 7% and a minimum Total Risk-Based Capital ratio of

14% at each quarter-end. While the Bank was in compliance with this requirement at September 30, 2008, based on the Bank’s current and projected

levels of capital, the Bank anticipates that it will not be able to satisfy the Tier I Core Capital and Total Risk-Based Capital minimum ratios of its Consent

Order as of December 31, 2008, unless it raises additional capital on or prior to that date. In the current economic environment, there is a significant risk

that the Bank will not be able to raise sufficient additional capital to ensure compliance with the capital requirements of the Bank Consent Order by

year-end. If the Bank does not comply with the Consent Order, without a waiver by the OTS or amendment of the Consent Order, the Bank could be

subject to further regulatory enforcement action, including, without limitation, the issuance of additional cease and desist orders (which may, among

other things, further restrict the Bank’s business activities, the imposition of civil money penalties against the Bank, and placing the Bank into a

conservatorship or receivership). Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by

no later than December 31, 2008, bank regulators could take enforcement action before that date, which could include placing the Bank into

receivership. If the Bank is placed into a conservatorship or receivership, it is highly likely that this will lead to a complete loss of all value of the

Holding Company’s ownership interest in the Bank, and the Holding Company subsequently may be exposed to significant claims by the Federal

Deposit Insurance Corporation or OTS. In addition, further restrictions will be placed on the Bank following a determination that the Bank is

undercapitalized, significantly undercapitalized, or critically undercapitalized, with increasingly greater restrictions being imposed as the level of

undercapitalization increases. Further, the failure to comply with the Consent Order could result in the termination of the Bank’s federal deposit

insurance, subject to a number of other conditions.

The Consent Orders that the Bank and the Holding Company entered into with the OTS restrict the Bank’s operations and may adversely

affect our ability to pay dividends or service our debt; and there is substantial doubt concerning the ability of the Holding Company and the Bank

to continue as going concerns for a reasonable period of time.

 

The ability of the Holding Company to pay regular quarterly dividends to its stockholders and to pay interest on its debt depends to a large extent

upon the dividends it receives from the Bank. The Consent Orders entered into by the Bank and the Holding Company with the OTS prohibit the Bank

from paying dividends to the Holding Company without the prior approval of the OTS, and which further prohibits the Holding Company from paying

dividends without the prior non-objection of the OTS.

At September 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million. However, in the

longer term, the Holding Company’s ability to service its senior debt depends on its ability to receive dividends from the Bank and, when the notes

mature, on its ability to renew or refinance the senior debt. However, pursuant to the Holding Company’s Consent Order, the OTS has prohibited the

Holding Company from issuing or renewing debt without its prior approval. We cannot predict whether the OTS will approve payments of dividends by

the Bank to the Holding Company, or will object to the payment of future Holding Company dividends, or how long these restrictions will remain in

effect. At the moment, there is no other source of repayment of the senior notes. Absent additional capital, the Holding Company will default on the

notes within a year.

As a result of the circumstances described above and in the other Risk Factors herein, there is substantial doubt concerning the ability of the

Holding Company and the Bank to continue as going concerns for a reasonable period of time.

Difficult market conditions have adversely affected our industry.

 

Downey is particularly exposed to downturns in the U.S. housing market. Dramatic declines in the housing market over the past year, with falling

home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans

and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities, major commercial and

investment banks, and regional financial institutions such as Downey. Reflecting concern about the stability of the financial markets generally and the

strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers,

Page 77 Navigation Linksincluding to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer

delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting

economic pressure on consumers and lack of confidence in the financial markets have adversely affected our business, financial condition and results

of operations. For example, on October 16, 2008, we announced the closing of our Wholesale Loan Department, the loan processing centers supporting

that Department, and a contraction of our Retail Loan Department, which affected approximately 200 employees. We do not expect that the difficult

conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects

of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection

with these events:

l We expect to face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue

business opportunities.

l Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage and

underwrite our customers become less predictive of future behaviors.

l The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts

of economic conditions and how these economic predictions might impair the ability of our borrowers to repay their loans, which may no longer

be capable of accurate estimation which may, in turn, impact the reliability of the process.

l Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by further disruptions in the capital

markets or other events, including actions by rating agencies and deteriorating investor expectations.

l Competition in our industry could intensify as a result of the increasing consolidation of financial services companies in connection with

current market conditions.

l We may be required to pay significantly higher Federal Deposit Insurance Corporation premiums because market developments have

significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

l Our liquidity could be negatively impacted by an inability to access the capital markets, unforeseen or extraordinary demands on cash, or

regulatory restrictions, which could, among other things, materially and adversely affect our business prospects and financial condition, result

in the loss of servicing rights (and the value of those rights) and negatively impact our debt ratings.

Current levels of market volatility are unprecedented.

 

The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent weeks, the volatility and disruption

has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain

issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can

be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial

condition and results of operations.

There can be no assurance that recently enacted legislation and other measures undertaken by the Treasury, the Federal Reserve and other

governmental agencies will help stabilize the U.S. financial system, improve the housing market or be of specific benefit to Downey.

 

On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 or “EESA,” which, among other measures,

authorized the Treasury Secretary to establish the Troubled Asset Relief Program (“TARP”). EESA gives broad authority to Treasury to purchase,

manage, modify, sell and insure the troubled mortgage related assets that triggered the current economic crisis as well as other “troubled assets.” EESA

includes additional provisions directed at bolstering the economy, including

l Authority for the Federal Reserve to pay interest on depository institution balances;

l Mortgage loss mitigation and homeowner protection;

l Temporary increase in FDIC insurance coverage from $100,000 to $250,000 through December 31, 2009; and

l Authority to the SEC to suspend mark-to-market accounting requirements for any issuer or class of category of transactions.

Page 78 Navigation LinksPursuant to the TARP, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion (of which $250 billion is currently

available) of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and

providing liquidity to the U.S. financial markets. Shortly following the enactment of EESA, the Treasury announced the creation of specific TARP

programs to purchase mortgage-backed securities and whole mortgage loans. In addition, under the TARP, the Treasury has created a capital purchase

program, pursuant to which it proposes to provide access to capital to financial institutions through a standardized program to acquire preferred stock

(accompanied by warrants) from eligible financial institutions that will serve as Tier I capital.

EESA also contains a number of significant employee benefit and executive compensation provisions, some of which apply to employee benefit

plans generally, and others which impose on financial institutions that participate in the TARP program restrictions on executive compensation.

EESA followed, and has been followed by, numerous actions by the Federal Reserve, Congress, Treasury, the SEC and others to address the

current liquidity and credit crisis that has followed the subprime meltdown that commenced in 2007. These measures include homeowner relief that

encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment

banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds;

the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; coordinated international efforts to

address illiquidity and other weaknesses in the banking sector;

In addition, the IRS has issued an unprecedented wave of guidance in response to the credit crisis, including a relaxation of limits on the ability of

financial institutions that undergo an “ownership change” to utilize their pre-change net operating losses and net unrealized built-in losses. The

relaxation of these limits may make significantly more attractive the acquisition of financial institutions whose tax basis in their loan portfolios

significantly exceeds the fair market value of those portfolios.

On October 14, 2008, the FDIC announced the establishment of a temporary liquidity guarantee program to provide insurance for all non-interest

bearing transaction accounts and guarantees of certain newly issued senior unsecured debt issued by financial institutions (such as the Bank), bank

holding companies and savings and loan holding companies (such as the Holding Company). Financial institutions are automatically covered by this

program commencing October 14, 2008. Any eligible entity that opts out of the Program on or before December 5, 2008, will not pay any assessment

under the Program. Any eligible entity that does not opt out on or before December 5, 2008, will be required to pay related assessment fees. Under the

program, newly issued senior unsecured debt issued on or before June 30, 2009 will be insured in the event the issuing institution subsequently fails, or

its holding company files for bankruptcy. The debt includes all newly issued unsecured senior debt (e.g., promissory notes, commercial paper and interbank

funding). The aggregate coverage for an institution may not exceed 125% of its debt outstanding on September 30, 2008 that was scheduled to

mature before June 30. 2009. The guarantee will extend to June 30, 2012 even if the maturity of the debt is after that date. Many details of the program

still remain to be worked out.

There can be no assurance as to the actual impact that EESA and such related measures undertaken to alleviate the credit crisis will have

generally on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced The failure of such

measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely

affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.

Finally, there can be no assurance regarding the specific impact that such measures may have on Downey-or whether (or to what extent)

Downey will be able to benefit from such programs and, in particular, whether Downey will be eligible to obtain capital from the Treasury under the

TARP program.

Downey’s access to liquidity may be negatively impacted if market conditions and regulatory restrictions persist or if further ratings

downgrades occur.

 

While Downey actively manages its liquidity risk and maintains liquidity at least sufficient to cover all maturing debt obligations or other

forecasted funding requirements, Downey’s liquidity may be affected by an inability to access the capital markets or by unforeseen or extraordinary

demands on cash. This situation may arise due to circumstances beyond Downey’s control, and is subject to the Holding Company’s and the Bank’s

credit ratings as assigned by nationally recognized statistical rating organizations. Recent disruptions in the capital markets have substantially limited

the ability of mortgage originators, including Downey, to sell mortgage loans to the capital markets through whole loan sales or securitization. As a

result, Downey has experienced a general loss of liquidity in most secondary markets for its loans.

Page 79 Navigation LinksDowney cannot forecast if or when market liquidity conditions will improve from current stresses, although it is Downey’s expectation that the

existing turmoil in the financial and credit markets may continue to affect its performance at least throughout 2008.

On August 12, 2008, Moody’s Investors Service downgraded the Holding Company’s senior unsecured debt rating to “B3” from “B1.” In

addition, the Bank’s financial strength was downgraded to “E+” from “D” and its long term deposit rating was downgraded to “B1” from “Ba2.” Its

short term deposit rating remains “Not Prime.” On September 11, 2008, Standard & Poor’s Ratings Services lowered its senior unsecured credit rating on

the Holding Company to “B-” from “B+/Watch Neg” and its counterparty credit rating on the Holding Company to “B-/Negative/C” from “B+/Watch

Neg/C.” In addition, the Bank’s counterparty and deposit ratings were lowered to “B/Negative/C” from “BB-/Watch Neg/B.”

In addition, the Holding Company may not issue new debt or renew existing debt without prior non-objection of the OTS.

Current market conditions have also limited the Bank’s liquidity sources principally to secured funding outlets such as the FHLB and, as back-up,

the Federal Reserve Bank of San Francisco, and to FDIC-insured deposits originated through the Bank’s branch network. Other sources of funding,

such as medium-term notes and uninsured institutional deposits, may not be available to the Bank. There can be no assurance that actions by the FHLB

or the Federal Reserve Bank would not reduce or eliminate our borrowing capacity or that we would be able to continue to attract deposits at

competitive rates. Such events could have a material adverse impact on our results of operations and financial condition.

Future regulatory actions may also adversely impact our ability to raise funds through deposits. For example, as a result of the September 5, 2008

Consent Order, the Bank is required to meet and maintain specific capital levels, it is deemed “adequately capitalized” under OTS regulations even

though it exceeds minimum regulatory capital ratios that would otherwise qualify it to be “well capitalized.” As a result, the Bank is subject to

restrictions on accepting brokered deposits and upper limits on interest rates the Bank may pay on deposits.

After the end of the second quarter, the Bank experienced elevated levels of deposit withdrawals. More recently, in response to steps taken by

management to address the situation, the deposit flows have seemed to stabilize more to historical levels. If the Bank’s deposit levels remain stabilized

at historical levels, we believe our current sources of funds, including deposits; advances from the FHLB and other borrowings; proceeds from the sale

of loans and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments would enable us to meet

our obligations while maintaining liquidity at appropriate levels. However, if elevated levels of net deposit outflows occur, the Bank’s usual sources of

liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its

liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional

financing or other arrangements.

ITEM 2. – Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

ITEM 3. – Defaults Upon Senior Securities

 

None.

ITEM 4. – Submission of Matters to a Vote of Security Holders

 

None.

Page 80 Navigation LinksThe following disclosure would otherwise be filed on Form 8-K under the heading “Item 5.02. Departure of Directors or Certain Officers; Election

of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers.” On August 27, 2008, the Company’s Board of

Directors determined to move certain members of the Board from one Class of directors to another Class. In connection with this determination,

effective as of August 27, 2008:

l Brent McQuarrie resigned as a Class 2 director and was immediately appointed by the Board as a Class 3 director;

l James H. Hunter resigned as a Class 3 director and was immediately appointed by the Board as a Class 1 director; and

l Jane Wolfe resigned as a Class 3 director and was immediately appointed by the Board as a Class 1 director.

Following these changes to the Board, and the appointment of Thomas E. Prince to the Board effective July 21, 2008, Paul M. Homan to the Board

effective August 18, 2008, and Charles R. Rinehart to the Board effective September 23, 2008, the Company’s Board is comprised as follows:

Class 1, 2 and 3 directors will continue to hold office until the Company’s 2011, 2009 and 2010 Annual Meetings of Stockholders, respectively, and

until their respective successors are duly elected and qualified.

ITEM 6. – Exhibits

Class 1 Class 2 Class 3

 

Gary W. Brummett Michael B. Abrahams Michael D. Bozarth

James H. Hunter Thomas E. Prince Paul M. Homan

Jane Wolfe Lester C. Smull Brent McQuarrie

Charles R. Rinehart

Exhibit

Number Description

 

10.1 Employment Agreement (which also includes the Change in Control Agreement), dated as of September 26,

2008, by and between the Bank and Charles R. Rinehart (incorporated by reference to Exhibit 10.1 of the

Company’s Current Report on Form 8-K, filed with the SEC on October 2, 2008).

10.2 OTS Order to Cease and Desist with the Company dated September 5, 2008 (incorporated by reference to

Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed with the SEC on September 5, 2008)

10.3 Stipulation and Consent to Issuance of Order to Cease and Desist with the Company dated September 5, 2008

(incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed with the SEC

on September 5, 2008)

10.4 OTS Order to Cease and Desist with the Bank dated September 5, 2008 (incorporated by reference to Exhibit

10.3 of the Company’s Current Report on Form 8-K, filed with the SEC on September 5, 2008)

10.5 Stipulation and Consent to Issuance of Order to Cease and Desist with the Bank dated September 5, 2008 on

(incorporated by reference to Exhibit 10.4 of the Company’s Current Report on Form 8-K, filed with the SEC

September 5, 2008)

 

 

 

31.1

Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1

Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2

Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

Page 81 Navigation LinksCorporate governance guidelines, charters for the audit, compensation, and nominating and corporate governance committees of the Board of

Directors and codes of business conduct and ethics are available free of charge from our internet site, http://www.downeysavings.com by clicking on

“Investor Relations” on our home page and proceeding to “Corporate Governance.” Annual reports on Form 10-K, quarterly reports on Form 10-Q,

current reports on Form 8-K and all amendments to those reports are posted on our internet site as soon as reasonably practical after we file them with

the SEC and available free of charge under “Corporate Filings” on our “Investor Relations” page.

We will furnish any or all of the non-confidential exhibits upon payment of a reasonable fee. Please send request for exhibits and/or fee

information to:

Downey Financial Corp.

3501 Jamboree Road

Newport Beach, California 92660

Attention: Corporate Secretary

SIGNATURES

 

Pursuant to the requirements 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.

/s/ Charles R. Rinehart

 

Date: November 10, 2008 Charles R. Rinehart

Chief Executive Officer

/s/ Brian E. Côté

 

Date: November 10, 2008 Brian E. Côté

Chief Financial Officer

Page 82 Navigation LinksITEM 1. – FINANCIAL STATEMENTS

l CONSOLIDATED BALANCE SHEETS (unaudited)

l CONSOLIDATED STATEMENTS OF INCOME (LOSS) (unaudited)

l CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (unaudited)

l CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

l NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

l NOTE (1) – Basis of Financial Statement Presentation

l NOTE (2) – Loans

l NOTE (3) – Real Estate Acquired in Settlement of Loans

l NOTE (4) – Mortgage Servicing Rights (“MSRs”)

l NOTE (5) – Derivatives, Hedging Activities, Financial Instruments with Off-Balance Sheet Risk and Other Contractual Obligations (Risk

Management)

l NOTE (6) – Income Taxes

l NOTE (7) – Employee Stock Option Plans and Restricted Stock Grant

l NOTE (8) – Earnings (Loss) Per Share

l NOTE (9) – Fair Value of Financial Instruments

l NOTE (10) – Business Segment Reporting

l NOTE (11) – Regulatory Consent Orders, Liquidity and Capital Adequacy

l NOTE (12) – Recently Issued Accounting Standards

l NOTE (13) – Subsequent Event

ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

l OVERVIEW

l CRITICAL ACCOUNTING POLICIES

l RESULTS OF OPERATIONS

l Net Interest Income

l Provision for Credit Losses

l Other Income

l Loan and Deposit Related Fees

l Real Estate and Joint Ventures Held for Investment

l Secondary Marketing Activities

l Operating Expense

l Provision for Income Taxes

l Business Segment Reporting

l Banking

l Real Estate Investment

l FINANCIAL CONDITION

l Loans and Mortgage-Backed Securities

l Investment Securities

l Deposits

l Borrowings

l Off-Balance Sheet Arrangements

l Transactions with Related Parties

l Asset/Liability Management and Market Risk

l Problem Loans and Real Estate

l Non-Performing Assets and TDRs

l Delinquent Loans

l Allowance for Credit and Real Estate Losses

l Capital Resources and Liquidity

l Contractual Obligations and Other Commitments

l Regulatory Capital Compliance

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 4. – CONTROLS AND PROCEDURES

PART II – OTHER INFORMATION

 

ITEM 1. – Legal Proceedings

ITEM 1A. – Risk Factors

ITEM 2. – Unregistered Sales of Equity Securities and Use of Proceeds

ITEM 3. – Defaults Upon Senior Securities

ITEM 4. – Submission of Matters to a Vote of Security Holders

ITEM 5. – Other Information

ITEM 6. – Exhibits

l 31.1 Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002l 31.2 Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002l 32.1 Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002l 32.2 Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002AVAILABILITY OF REPORTS

SIGNATURES

NAVIGATION LINKS

FORM 10-Q COVER

PART I – FINANCIAL INFORMATION

AVAILABILITY OF REPORTS

ITEM 5. – Other Information

ITEM 1A. – Risk Factors

PART II – OTHER INFORMATION

ITEM 1. – Legal Proceedings

Judicial Proceedings

 

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Regulatory Capital Compliance

Allowance for Credit and Real Estate Losses

 

Problem Loans and Real Estate

Non-Performing Assets and TDRs

 

Off-Balance Sheet Arrangements

Investment Securities

FINANCIAL CONDITION

Loans and Mortgage-Backed Securities

RESULTS OF OPERATIONS

Net Interest Income

CRITICAL ACCOUNTING POLICIES

ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

NOTE (12) – Recently Issued Accounting Standards

Statement of Financial Accounting Standards No. 161

 

NOTE (11) – Regulatory Consent Orders, Liquidity and Capital Adequacy

NOTE (10) – Business Segment Reporting

NOTE (8) – Earnings (Loss) Per Share

Consent Orders

 

Derivative Hedging Activities

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE (1) – Basis of Financial Statement Presentation

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss) (unaudited)

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income (Loss) (unaudited)

PART I – FINANCIAL INFORMATION

ITEM 1. – FINANCIAL STATEMENTS

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)

DOWNEY FINANCIAL CORP.

September 30, 2008 QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

1934

Delaware

1934

DOWNEY FINANCIAL CORP.

A Hardship Letter to Countrywide – A Family on the Brink of Disaster

Folow-up to No Hope for Homeowners – Foreclosure Prevention Program Falters

Will Countrywide and Bank of America Please Step Up?

In the last week of October I ran an article about the government’s lack of any significant efforts to stop the tsunami of foreclosures that are supposedly responsible for the current economic crisis, titled No hope for Homeowners: Foreclosure Prevention Program Falters, which explored evidence the government seems determined to merely pay lip service to the foreclosure problem, while letting another million-plus families linger in a state of insecurity and despair as they rapidly approach foreclosure.

Many people these days are quick to peg people under the threat of foreclosure as being irresponsible, overly-optimistic, or just plain greedy – assuming everyone tried to buy too much house for too little down in the hopes they might be the next Donald Trump. 

The truth is that the majority of homeowners facing foreclosure were not investors or property flippers looking for an easy buck.  And those that did get in over their head did so at the advice and urging of under-supervised or unethical loan officers and brokers – which amounted to only a small number compared to all of the hardworking, honest folks who made a living and a career in the mortgage business – many of whom worked for decades in the business and did not get rich.  

One reader – who we will call “Kitty” – has volunteered her to share her story, recounting the chain of events that has thrust her family from the comfort of middle-class security to the brink of bankruptcy and foreclosure in the span of about one year.

“Kitty’s” story demonstrates the very precarious nature of America’s middle class, especially in the face of a contracting economy, increased competition from overseas, and a government determined to drive it to into extinction.

Read ‘Kitty’s” story and be warned that this could easily happen to any of us, and sooner than we could ever imagine.

How many paychecks, illnesses and credit rating hits are you from being kicked out of your home and onto the streets?

How secure is your place in the middleclass?

“Kitty” is actively seeking assistance in her efforts to avoid foreclosure, and she and her family are running out of time.

If you are in the position to help “Kitty” PLEASE CONTACT ME IMMIDIATELY and I will pass your information on immediately.

If you can not help “Kitty” yourself, please post or pass on this article – the more people who see it, the more likely we can help.

If we can not find some help for “Kitty” this week (first week of November, 2008) they may find themselves on the street for Thanksgiving.

I will keep you updated on “Kitty’s” situation.

Thank you, and have the Happiest of Holidays.

Anthony

anthonymfreed@gmail.com

 

“Kitty’s” Hardship Letter to Countrywide:

To Whom it may concern:

I would like to humbly submit my letter of explanation to you for my current credit situation and financial hardship.

My husband and I have both enjoyed the same careers for the last 20 years, during that time we have seen our share of ups and downs. We planned carefully. As you can see by my credit report, we did not incur huge amounts of credit card debt, and we only recently acquired auto loans, always paying cash for our vehicles in the past. In fact my credit history over the last 7 years has been good; my prior mortgage history was perfect.

In the spring of 2007 I was a victim of credit fraud. Someone applied for and obtained a credit card with Premier credit in my name, shortly there after I saw several charges on my Providian card that were not mine, while I was in dispute with them they sold my card off to another company, I am still disputing several of the charges.

I was cleared of the Premier credit card account the fraud department determined it was not my account. I can provide a letter from them to that effect if needed. It should have been noted and cleared off of my credit report.

About the same time the employer of both myself and my husband laid off 5,500 people on August 16th 2007. Over night we became a no income family. We were assured that we would receive our final paychecks, the coveted bonus checks we had all worked so hard for on the 20th.

On the 21st of August the company filed for Bankruptcy. Over night we lost our paychecks, our long awaited bonus checks, our health insurance, vacation pay…..and our 401k plan was frozen. Our health insurance and 401k plan were funded and managed by our employer. In short we were left with nothing.

We were devastated financially and emotionally.

We had just paid for our sons first year of college, we did not want to finance it, since we knew that our bonus checks were on the way, depleting our cash reserves and, if you will, wrongly betting on my bonus which I qualified for.

We also felt confident with our earnings even without my bonus. It took us months to get our funds out of the 401k plan by then we had lost a substantial amount of money due to the upheaval of the markets in the wake of the mortgage crisis that was just then coming to a boil. And our “vested” matching funds were not honored, or employer had withdrew those funds prior to filing Bankruptcy.

They also absconded with all of our Cafeteria funds, and stopped paying our “self funded” insurance premiums in May, which left us with unpaid medical bills that we thought were covered because we were gainfully employed and our employer was deducting the premiums from our pay check….wrong. We are responsible for all of those bills because they did not pay any premiums from May until they filed for bankruptcy in August.

In short, losing our jobs was just the beginning of the nightmare.

Our employer owed my husband several thousand in expense funds and as a manager, none of his funds were protected or considered earnings because they had not yet paid them to him. All of the branch managers lost their funds and have little to no recourse.

My husband and I tried to find any kind of employment possible. In November I got a job offer as an Operations Manager. I worked there for about 10 days when the owner’s son came to me and said that because of their own financial problems they could not afford to pay me…..he then gave me a check for 1/2 of what they owed me and that check bounced.

It took me weeks to collect the pay they owed me.

Then I took a temp job for a local business…..the owner went to Mexico for Christmas and failed to tell us that he was not coming back…. I was never paid for my work.

I also took another job as a pet sitter, I did get paid for that job. Not enough to have any effect on my unemployment but enough to keep current on my car notes and put some food on the table.

On February 18, 2008 I was hired by an insurance company as an Underwriter. 5 weeks later March 28th all 16 of us who were hired for the same position with the same start date around the country were let go.

Unemployment ran out for both my husband and I in mid February. We were left penniless, were forced to sell what we could to survive., and borrowing from family.

My son got a part time job at college and sent money home to us.

April 15th I started with a company in a position with a bank in Westchester Illinois. Since my sister lives in the area I was able to stay with her while on assignment, leaving my family behind in Houston.

May 20th my husband was admitted into the hospital after being ill for several months. The diagnosis was pulmonary edema and congestive heart failure.  We have no medical insurance.

This diagnosis is life threatening and another devastating blow to our family. His heart was functioning at just 20% of it’s capacity.

His prognosis is uncertain at this point as it is still early and we don’t know how well the medications will work. We have incurred yet another $20,000 in hospital bills, not to mention the cost of his follow up care and medications. We are uncertain if he will be able to go back to work on a full time basis.

June 9th I started a position with a large national insurance company that will allow me to work from home in Houston and to care for my husband. After being stuck in Chicago for the last 2 months it was good to finally return home

I fully understood the precarious financial position we were in.

I paid who I could, borrowed what I could from family, and called my creditors to try and work out payment plans. I also knew that I would have been able to file for protection under chapter 7 bankruptcy laws. However, I did not want to do that, nor do I want to file bankruptcy, although my attorney advises I do so.

To this end we respectfully request that you allow us to be considered for a loan modification. The only way I can stay employed in my current line of work is to avoid foreclosure or bankruptcy. 

Thank you for your consideration; I am attaching documentation to support some of these hardships. I am sorry this is such a long letter. If I have failed to address anything please give me opportunity to do so

Sincerely,

“Kitty”

Live simply. Love generously. Care deeply. Speak kindly. Leave the rest to God.

We walk by faith not by sight….. Faith is knowledge of that which can not be seen.

 

Bail-Outs and Buy-Ins vs A Sustainable Economy

Guest Editorial by George LoBuono 

You may wonder where will all that taxpayer bail-out / buy-in money go in the end?  Major interests in two of the three big banks that benefit most by the Paulson plan to give nearly a trillion to failing banks have a history of strange moves against popular government. JPMorgan-Chase is what’s left of the old J.P. Morgan monopoly (Morgan’s only son had no direct heirs), and Citicorp was until recently the repository of many billions in Du Pont family cash accounts.

Ironically, JP Morgan’s Guaranty National Bank and DuPont family interests were two of the most visible supporters of an avowedly “fascist” 1934 plan to overthrow newly-elected President Franklin D. Roosevelt in a coup by impoverished veterans of World War I. War hero Gen. Smedley Butler was asked to lead the coup but exposed it, instead. The plan was to have 1 million angry veterans descend on Washington DC and occupy it, then force Roosevelt to install a “Secretary of General Affairs” who would really run the White House. Morgan supplied money and the DuPont’s Remington Arms company was to supply the weapons. The plan was modeled on the fascist veterans organizations in Europe, at the time. A Congressional investigation chaired by later-Speaker of the House John McCormack largely substantiated Butler’s charges.

Also ironic is that fact that both Morgan-Chase and Citicorp have a long history of involvement in both the origin and the ownership of the Federal Reserve Bank. A Chase-owning Rockefeller pushed the legislation that created the Fed back in 1913. And who actually owns the Fed? Not the US government.

Two internet articles, WHO OWNS THE FEDERAL RESERVE and THE FED NOW OWNS THE WORLD’S , argue that only US banks own the Fed, yet as the first article indicates we see Deutsche Bank’s NY subsidiary listed as one of the Fed’s owners. So, those Rothschild-Warburg interests often, if not erroneously decried as prime Fed owners can simply use their financial ins at Lehman, Morgan-Rockefeller and Goldman Sachs, etc. to manipulate the Federal Reserve Bank. Paul Warburg was the Fed’s first chairman.

Some on the internet argue that the Rothschild interests that President Andrew Jackson ousted by ending the Second Bank of the United States in 1836 were allowed back into power in 1913 when a Rockefeller and Rothschild-associate Paul Warburg pushed for the Jekyll Island conference that created the Fed. Was it, as some allege, a scheme to hijack the US economy at its source: the currency printing press? The question revolves around the fact that when the US government needs money, the US Treasury sends bonds to a relatively small group of private dealers who auction them to investors. As Congressman Wright Patman said, “When the Federal Reserve writes a check for any government bond it does exactly what any bank does, it creates money, it created money simply by writing a check.” In her book Web of Debt, Ellen Brown notes that “The bonds then become the “reserves” that the banking establishment uses to back its loans. In addition to (a) guaranteed 6% (paid by the Fed to its member banks), the banks will now be getting interest from the taxpayers on their “reserves.”

So for those banks, it’s like getting money for nothing and it’s all funneled into the hands of a relatively small group of private bankers. By effectively ceding them the power to create and distribute new money, is the US government really working toward a sustainable kind of economy? Recent events suggest otherwise, of course. Are there any alternatives on the horizon?

The 21st century will require a safer, more reliable approach, and that will require some thinking. So, here are some ideas for a system that might work better.

First, phase out the Federal Reserve bank (and the dollar). Replace it with a fractionally-integrated “eco.” How would it be fractionally-integrated? In the “eco” plan, the prime determining number is the sustainable resource of your planet–it’s the whole number 1 and all of your economy is based on fractions of that most important whole. The economy of the future will probably be mostly about electronic values (computerized accounts), but if you want to supplement that with some currency in order have the privacy to buy things without an electronic Big Brother watching your every move, then issue currency (i.e. the eco) that’s based on fractions or decimals of that sustainable whole quantity. That way, you won’t ruin your ecology or deplete its resources and have to seek them elsewhere (other planets?) at horrendous energy expense. This new kind of fractionally-integrated economy may be the only way to protect our planet’s ecology.

In order to both accommodate and adequately reflect the nature of 21st century energy technologies like so-called “scalar electromagnetism” and other energy drawn from the vacuum of empty space, the eco must have alternate-cycle numerical values written into all of it’s (fractions-of-the-whole) calculations. And just what are those “alternate cycle” numerical values?

They’re numbers that have two characteristics at the same time: they’re always mirrored by positive decimals (fractions of that ecologically sustainable whole), and they’re mirrored by the large whole number value (the energy universe) within which they are merely a fraction. As such, they resonate, precisely and predictably. When the new, non-polluting technologies that various official whistle-blowers say now exist in black budget programs are mainstreamed due to need and the rising costs of petroleum, the new economy must reflect the ecologically sustainable limits of the energy we draw from the vacuum. This may sound futuristic to some readers, yet according to numerous current and former official whistleblowers, such technologies are already a reality.

In order to correlate our energy use to the safe limits of the vacuum of “empty” space, the new eco economy would use extra-dimensional values. Here’s how that looks in real life: There’s a limited amount of energy that can be safely pulled out of the vacuum of empty space, and if we exceed that, as Nikola Tesla reportedly once did in New York City, we could cause earthquakes or even solar flares that can damage our atmosphere and our electronics. Such dangers are due to what Tom Bearden calls “delta t,” the marginal change of time involved in all “scalar” energy usage. “Scalar” energy draws from energy on a larger “scale,” across a larger range (or scale) of energy values extending both more deeply down into the atom and farther out into space, at the same time. Scalar electromagnetism, a technology already used in black budget industrial projects, is also called “zero point energy,” or electro-gravity, or negative energy technology–they’re all the same thing.

So, to be safe-especially during the first half of the 21st century, under the new “eco” we won’t burn so much fossil fuel because fossil fuels are used up in a mere flash of historical time. Instead, our energy increasingly becomes either simple conventional wind, hydroelectric (wireless distribution), or solar—plus some “scalar” energy.

Because the mistakes of a single, sitting government could endanger the lives of all of humankind for centuries, we must finally devise an ecologically realistic economy. So, the eco would be based on energy credits and sustainable resources. You can see the logic in that: equality and sustainability–all of it is rated per the planet’s resources. With the eco and the new 21st century technologies, we must use innovative math that always computes more than one numerical value or equation at a given time. Rather than use the simple linear math of old, we should use a non-linear math that has converging, or co-existing multiple fractional values (fractions of the sustainable whole). So whenever we use a whole number, it must be counter-balanced by the larger, determining fractions or decimals that rate it to larger cosmic/ecological quantities. We don’t just dream up whatever cosmic quantity we choose. Cosmic values are pre-determined and are explicit in the all the quanta and the energy fluctuations in the vacuum all around us. *This is a binding constraint in using the new “scalar” energy.

Technically speaking, our electronic calculation of a new “eco” economy has negative exponential numbers and decimals fluctuating with every use of energy. Such numbers must correlate to a clearly defined, “negative cycle” that manifests both in the gravity and the scalar energy around us, and also in the resonant ecology of nature around us. **A “negative cycle” is negative because it pulls and cycles inwardly like atomic gravity and the strong force, while normal energy like light and heat curves and bends outward.

In other words, given the new technological reality now upon us, we must begin to rate our energy and resource use directly to a negative cycle (or better yet a mutiply-shelled counterbalance of alternate cycles) because scalar energy, which is an “open secret” now shared by numerous industrial nations, is directly premised on such a cycle. Way back in the 1950’s Nikita Kruschev openly proclaimed his nation’s involvement in such technologies. More recently, Bill Clinton’s Secretary of Defense William Cohen publicly stated that there are already international agreements about the use of such technologies. Two noted researchers, ret. Navy Col. Tom Bearden and physicist Mark Comings have reported that for decades there has been a system both here in the United States (and likely elsewhere) than can instantly detect and triangulate the location of anyone who uses the new “scalar” energies. So, a kind of safety network is already in place, according to informed researchers.

To be most effective, the new eco economy must use new, alternative values in order to work correctly. Its math must put extra-dimensional values in very equation. Instead of a whole number sitting alone, you may see a floating value–like an exponent that we use but the eco economy will use an extra exponent sitting to the left of the number (a subscript), for example, to represent the scalar, negative cycle relationship of that number to the larger energy ecology. It’s a very real, binding kind of equation. That new negative-cycle value doesn’t sit still but is smeared out into space-time and is nearly always in more than one place at a given time. So it’s extra-dimensional. It is spread out on a greater scale.

I would argue that once we take the first necessary steps, the rest of world will soon recognize the logic of the “eco,” which intrinsically pays its benefits forward.

Along with the eco, we must end the Federal Reserve Bank. We can replace it with an international currency commission and the new, globally integrated electronic values. At the same time, in the US and in other participating countries, we can allow for adjusted internal market values-rated at their technology and planned resource futures. No outside dictatorship of internal values would arise, only basic global ratings per the eco–to assure a sustainable ecology (isn’t the lack of that why the current crisis is now occurring?)

The new “eco” economy would feel like a mildly humbling pinch in the short-term but should create a vigorous boost of activity within 3-5 years. It is real money-it’s faster and is fractionally integrated, as is the energy/resource reality; it’s not a fiction. The eco would require a public education campaign regarding the humbler, better reality that will begin to replace those “disaster capitalism” pyramid schemes.

If we choose to do so, we could phase in the new scalar energy sciences with the new plan, which would phase out fossil fuel dictatorships. The strength of the new system would be within it, hence the example would challenge other nations to be equally sustainable. It would always work within the nations that first adopt it because it is resonant ecology in motion. It immediately binds us to a survivable ecology. During early phases, we would confer with big lender nations about the value owed them by participating eco plan states. So we would reward green incentives in all states, with no exclusion. High tech can be exported to reverse China’s environmental disaster, infra-structural commitments can be made to Russia and India, Brazil, etc. Rainforests won’t be cut down in desperation.

Ideally, because of its popularity the eco should plan for a universal value of labor, so we should keep that in our overall goals.

In short, a sustainable system like that of the eco is very real and must either be considered or we will suffer systemic failures like the current one, over and over again. In the short-term, we would do well to adopt universal healthcare, essentially de-monetarize the medical care but not the med-tech industry just yet (it’s global).

And why not couple the eco with a global food plan, thus phasing out starvation due to monetary insularity. How do you do that? Export reproducable, self-sustaining agriculture systems to needy nations, i.e. simple irrigation projects are prioritized over Monsanto-like disaster predations.

Innovative new tech freedoms must be encouraged in an eco system. Green alternatives would inherently be prioritized per the eco plan. Educational credit programs for participating populations would be less elitist, more widespread among those populations and could be mixed with work offered to students, also. That much is easy.

Priority would be given to conventional “green” energy systems. Meanwhile, to be safe during early phases, scalar energy technology should be limited to micro-scale research (physics, genetics) and globally-networked outer space or medical projects, and such. The eco would offer exchange education programs for nations where religions seem reluctant to admit the new technological reality of the “new physics” universe.

And, finally, we would allow for innovation and adaptations required by participating societies. Using the eco, we wouldn’t tread on peoples’ freedoms. Instead, we would increase them because the eco is premised on a greater 21st century kind of realism and efficiency that would make work days shorter. As a result, hence there would be more free-time and time for study. 

–George LoBuono is a writer and investigative researcher living in Davis, CA