Edgar Filing: DOWNEY FINANCIAL CORP

Securities and Exchange Commission Form 10-Q dated March 31, 2007

Navigation Links Click here to quickly move through the content of the Form 10-Q filing.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

___________________________

FORM 10-Q

(Mark One)

[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

[ ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________

Commission File Number 1-13578

DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)

Delaware (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) 854-0300

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 X No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated file X Accelerated filer Non-accelerated filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X

At March 31, 2007, 27,853,783 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.

Page

Navigation Links

DOWNEY FINANCIAL CORP.

March 31, 2007 QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

ITEM 1. –

FINANCIAL STATEMENTS

Consolidated Balance Sheets at March 31, 2007 and 2006 and December 31, 2006

Consolidated Statements of Income for the three months ended

March 31, 2007 and 2006

Consolidated Statements of Comprehensive Income for the three months ended

March 31, 2007 and 2006

Consolidated Statements of Cash Flows for the three months ended

March 31, 2007 and 2006

Notes To Consolidated Financial Statements

ITEM 2. –

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 SECURITIY HOLDERS

ITEM 5. –

OTHER INFORMATION

ITEM 6. –

EXHIBITS

AVAILABILITY OF REPORTS

SIGNATURES

Page i

Navigation Links

PART I – FINANCIAL INFORMATION

ITEM 1. – FINANCIAL STATEMENTS

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

		March 31,			December 31,			March 31,
(Dollars in Thousands, Except Per Share Data)		2007			2006			2006

Assets
Cash		$	157,084		$	124,865		$	168,822
Federal funds			-			1			-

	Cash and cash equivalents		157,084			124,866			168,822
U.S. Treasury, government sponsored entities and other investment
	securities available for sale, at fair value		1,411,258			1,433,176			730,402
Loans held for sale, at lower of cost or fair value			267,862			363,215			561,511
Mortgage-backed securities available for sale, at fair value			117			251			271
Loans held for investment			13,002,795			13,868,227			15,912,318
Allowance for loan losses			(60,758	)		(60,943	)		(44,504	)

	Loans held for investment, net		12,942,037			13,807,284			15,867,814
Investments in real estate and joint ventures			61,663			59,843			49,182
Real estate acquired in settlement of loans			17,212			8,524			385
Premises and equipment			115,534			114,052			110,595
Federal Home Loan Bank stock, at cost			126,125			152,953			182,557
Mortgage servicing rights, net			20,689			21,196			20,165
Other assets			118,288			122,022			111,055

		$	15,237,869		$	16,207,382		$	17,802,759

Liabilities and Stockholders’ Equity
Deposits		$	11,647,431		$	11,784,869		$	12,198,903
Securities sold under agreements to repurchase			546,870			469,971			-
Federal Home Loan Bank advances			1,298,197			2,140,785			3,825,811
Senior notes			198,305			198,260			198,129
Accounts payable and accrued liabilities			93,977			220,262			317,976
Deferred income taxes			13,626			-			17,301

	Total liabilities		13,798,406			14,814,147			16,558,120

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 28,235,022 shares at March 31, 2007, December 31, 2006 and
	March 31, 2006; outstanding 27,853,783 shares at March 31, 2007,
	December 31, 2006 and March 31, 2006		282			282			282
Additional paid-in capital			93,792			93,792			93,792
Accumulated other comprehensive loss			(1,676	)		(5,204	)		(6,196	)
Retained earnings			1,363,857			1,321,157			1,173,553
Treasury stock, at cost, 381,239 shares at March 31, 2007,
	December 31, 2006 and March 31, 2006		(16,792	)		(16,792	)		(16,792	)

	Total stockholders’ equity		1,439,463			1,393,235			1,244,639

		$	15,237,869		$	16,207,382		$	17,802,759

See accompanying notes to consolidated financial statements.

Page 1

Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income

		Three Months Ended
		March 31,

(Dollars in Thousands, Except Per Share Data)		2007			2006

Interest income
Loans		$	252,172		$	255,345
U.S. Treasury and government sponsored entities securities			19,174			7,336
Mortgage-backed securities			3			3
Other investment securities			2,471			2,279

	Total interest income		273,820			264,963

Interest expense
Deposits			113,575			91,835
Federal Home Loan Bank advances and other borrowings			31,830			43,914
Senior notes			3,301			3,298

	Total interest expense		148,706			139,047

Net interest income			125,114			125,916
Provision for credit losses			617			10,057

	Net interest income after provision for credit losses		124,497			115,859

Other income, net
Loan and deposit related fees			8,836			8,558
Real estate and joint ventures held for investment, net			476			2,289
Secondary marketing activities:
	Loan servicing income (loss), net		(436	)		189
	Net gains on sales of loans and mortgage-backed securities		8,740			11,654
Other			72			520

	Total other income, net		17,688			23,210

Operating expense
Salaries and related costs			42,234			40,780
Premises and equipment costs			8,809			8,538
Advertising expense			1,191			1,242
Deposit insurance premiums and regulatory assessments			2,764			1,014
Professional fees			559			792
Other general and administrative expense			9,795			9,175

	Total general and administrative expense		65,352			61,541
Net operation of real estate acquired in settlement of loans			291			(9	)

	Total operating expense		65,643			61,532

Income before income taxes			76,542			77,537
Income taxes			33,679			33,840

	Net income	$	42,863		$	43,697

Per share information
Basic		$	1.54		$	1.57
Diluted		$	1.54		$	1.57
Cash dividends declared and paid		$	0.12		$	0.10
Weighted average shares outstanding
Basic		27,853,783			27,853,783
Diluted		27,884,030			27,883,221

See accompanying notes to consolidated financial statements.

Page 2

Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

			Three Months Ended
			March 31,

(In Thousands)			2007			2006

Net income			$	42,863		$	43,697

Other comprehensive income (loss), net of income taxes (benefits)
Unrealized gains (losses) on securities available for sale:
	U.S. Treasury, government sponsored entities and other investment
		securities available for sale, at fair value		3,587			(1,367	)
	Mortgage-backed securities available for sale, at fair value			1			-
	Reclassification of realized amounts included in net income			-			-
Unrealized gains (losses) on cash flow hedges:
	Net derivative instruments			154			503
	Reclassification of realized amounts included in net income			(214	)		76

Total other comprehensive income (loss), net of income taxes (benefits)				3,528			(788	)

Comprehensive income			$	46,391		$	42,909

See accompanying notes to consolidated financial statements.

Page 3

Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

			Three Months Ended
			March 31,

(In Thousands)			2007			2006

Cash flows from operating activities
Net income			$	42,863		$	43,697
Adjustments to reconcile net income to net cash used for operating activities:
	Depreciation			3,475			3,285
	Amortization			30,523			26,076
	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		692			10,018
	Net gains on sales of loans and mortgage-backed securities, mortgage servicing rights,
		investment securities, real estate and other assets		(8,921	)		(12,618	)
	Interest capitalized on loans (negative amortization)			(77,796	)		(64,827	)
	Federal Home Loan Bank stock dividends			(2,413	)		(2,274	)
Loans originated and purchased for sale				(640,669	)		(980,164	)
Proceeds from sales of loans held for sale, including those sold
	as mortgage-backed securities			721,268			887,037
Other, net				(113,184	)		(17,817	)

Net cash used by operating activities				(44,162	)		(107,587	)

Cash flows from investing activities
Proceeds from:
	Sales of Federal Home Loan Bank stock			29,241			-
	Maturities or calls of U.S. Treasury, government sponsored entities
		and other investment securities available for sale		128,150			4,750
	Sales of wholly owned real estate and real estate acquired in settlement of loans			2,871			681
Purchase of:
	U.S. Treasury, government sponsored entities and other investment securities
		available for sale		(100,000	)		(61,225	)
	Loans held for investment			-			(12,218	)
	Premises and equipment			(5,455	)		(9,902	)
	Federal Home Loan Bank stock			-			(439	)
Originations of loans held for investment (net of refinances of $229,941 for the
	three months ended March 31, 2007 and $199,203 for the three months ended
	March 31, 2006)			(390,457	)		(1,621,617	)
Principal payments on loans held for investment and mortgage-backed securities
	available for sale			1,330,381			1,194,760
Net change in undisbursed loan funds				(12,537	)		(2,881	)
Other, net				610			6,496

Net cash provided by (used for) investing activities				982,804			(501,595	)

See accompanying notes to consolidated financial statements.

Page 4

Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

			Three Months Ended
			March 31,

(In Thousands)			2007			2006

Cash flows from financing activities
Net increase (decrease) in deposits			$	(137,438	)	$	322,055
Proceeds from Federal Home Loan Bank advances and other borrowings				5,276,899			7,148,170
Repayments of Federal Home Loan Bank advances and other borrowings				(6,045,000	)		(6,877,100	)
Cash dividends				(3,342	)		(2,785	)
Other, net				2,457			(2,732	)

Net cash provided by (used for) financing activities				(906,424	)		587,608

Net increase (decrease) in cash and cash equivalents				32,218			(21,574	)
Cash and cash equivalents at beginning of period				124,866			190,396

Cash and cash equivalents at end of period			$	157,084		$	168,822

Supplemental disclosure of cash flow information:
	Cash paid during the period for:
		Interest	$	154,771		$	151,688
		Income taxes		119,608			393
Supplemental disclosure of non-cash investing:
	Loans transferred to held for investment from held for sale			17,545			4,006
	Loans transferred from held for investment to held for sale			1,311			166
	U.S. Treasury, government sponsored entities and other investment securities
		available for sale, purchased and not settled		-			49,996
	Loans exchanged for mortgage-backed securities			283,691			213,980
	Real estate acquired in settlement of loans			11,881			104

See accompanying notes to consolidated financial statements.

Page 5

Navigation Links

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE (1) – Basis of Financial Statement Presentation

In 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 March 31, 2007, December 31, 2006 and March 31, 2006, the results of operations and comprehensive income for the three months ended March 31, 2007 and 2006, and changes in cash flows for the three months ended March 31, 2007 and 2006. During the quarter ended March 31, 2007, Downey discovered that it had under reported income taxes for 2004 through 2006 by immaterial amounts. However, since the correction of our income taxes would be material to the current quarter, Downey has adjusted its previously reported results in the accompanying financial statements. For a discussion and summary of the impact of the amounts related to Downey’s adjustment of prior period data see Note (4) – Income Taxes on page 12 and Note (9) – Adjustment of Prior and Beginning Period Amounts on page 15.

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 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, 2006, 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, 2006 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.

Page 6

Navigation Links

NOTE (2) – Mortgage Servicing Rights (“MSRs”)

The following table summarizes the activity in MSRs and its related allowance for the periods indicated and other related financial data.

			Three Months Ended

			March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)			2007			2006			2006			2006			2006

Gross balance at beginning of period			$	21,435		$	20,483		$	20,665		$	20,420		$	21,157
Additions ^(a)				1,341			2,122			896			1,285			1,022
Amortization				(1,024	)		(1,087	)		(1,056	)		(1,029	)		(1,198	)
Sales				(868	)		-			-			-			-
Impairment write-down				(13	)		(83	)		(22	)		(11	)		(561	)

	Gross balance at end of period			20,871			21,435			20,483			20,665			20,420

Allowance balance at beginning of period				239			173			104			255			855
Provision for (reduction of) impairment				(44	)		149			91			(140	)		(39	)
Impairment write-down				(13	)		(83	)		(22	)		(11	)		(561	)

	Allowance balance at end of period			182			239			173			104			255

		Total mortgage servicing rights, net	$	20,689		$	21,196		$	20,310		$	20,561		$	20,165

As a percentage of associated mortgage loans				0.88	%		0.89	%		0.87	%		0.87	%		0.85	%
Estimated fair value ^(b)			$	22,461		$	22,828		$	22,383		$	23,644		$	21,894
Weighted average expected life (in months)				56			54			51			56			51
Custodial account earnings rate				5.26	%		5.28	%		5.28	%		5.39	%		4.90	%
Weighted average discount rate				10.27			10.28			9.41			9.39			9.45

At period end
Mortgage loans serviced for others:
	Total		$	6,021,673		$	5,908,233		$	6,595,462		$	6,377,737		$	5,794,067
	With capitalized mortgage servicing rights:^(b)
		Amount		2,348,060			2,394,754			2,345,880			2,369,543			2,372,534
		Weighted average interest rate		5.77	%		5.75	%		5.70	%		5.66	%		5.63	%
	Total loans sub-serviced without mortgage
		servicing rights: ^(c)
		Term – less than six months	$	125,425		$	93,074		$	981,883		$	228,455		$	153,655
		Term – indefinite		3,533,200			3,404,342			3,249,905			3,760,642			3,248,012

Custodial account balances			$	176,171		$	172,462		$	171,481		$	147,831		$	124,324

^(a) Included minor amounts repurchased.
^(b) The estimated fair value may exceed book value for certain asset strata and excluded loans sold or securitized prior to 1996 and loans sub-serviced without capitalized MSRs.
^(c) Servicing is performed for a fixed fee per loan each month.

Downey capitalizes MSRs at fair value for residential one-to-four unit mortgage loans we originate and sell with servicing rights retained and at the lower of cost or fair value for MSRs 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. MSRs are amortized over the estimated servicing period as a component of loan servicing income (loss), net. Downey recognizes impairment losses on the MSRs through a valuation allowance and records any associated provision 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. 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; and the discount rate used in valuing future cash flows. Impairment is 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 are recognized through a valuation allowance for each impaired stratum. Certain stratum may have impairment, while other stratum may not. Therefore, changes in overall fair value may not equal provisions for or reductions of the valuation allowance. Once a quarter, Downey conducts model validation procedures by obtaining three independent broker results for the fair value of MSRs and comparing them to the results of its MSR model.

Page 7

Navigation Links

The following table summarizes the estimated changes in the fair value of mortgage servicing rights for changes in those assumptions individually and in combination associated with an immediate 100 basis point increase or decrease in market rates. The table also summarizes the earnings impact associated with provisions for or reductions of the valuation allowance for mortgage servicing rights. 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.

		Expected			Custodial
		Prepayment			Accounts			Discount
(Dollars in Thousands)		Speeds			Rate			Rate			Combination

Increase rates 100 basis points:^(a)
	Increase (decrease) in fair value	$	2,207		$	1,120		$	(805	)	$	2,446
	Reduction of (increase in) valuation allowance		98			64			(102	)		117

Decrease rates 100 basis points:^(b)
	Increase (decrease) in fair value		(5,844	)		(1,143	)		832			(6,833	)
	Reduction of (increase in) valuation allowance		(5,024	)		(224	)		40			(5,704	)

^(a) The weighted-average expected life of the MSRs portfolio becomes 67 months.
^(b) The weighted-average expected life of the MSRs portfolio becomes 32 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.

		Three Months Ended

		March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)		2007			2006			2006			2006			2006

Net cash servicing fees		$	1,607		$	1,647		$	1,583		$	1,574		$	1,566
Payoff and curtailment interest cost ^(a)			(1,063	)		(1,269	)		(813	)		(233	)		(218	)
Amortization of mortgage servicing rights			(1,024	)		(1,087	)		(1,056	)		(1,029	)		(1,198	)
(Provision for) reduction of impairment of
	mortgage servicing rights		44			(149	)		(91	)		140			39

	Total loan servicing income (loss), net	$	(436	)	$	(858	)	$	(377	)	$	452		$	189

^(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.

NOTE (3) – 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. Associated fair value adjustments to the notional amount of interest rate lock commitments 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. 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 from the date of rate lock to the date of funding. At March 31, 2007, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $225 million, with a change in fair value resulting in a recorded loss of $0.8 million.

Downey does not generally enter into derivative transactions for purely speculative purposes.

Page 8

Navigation Links

Derivative Hedging Activities

As 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 that are not perfectly correlated 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 March 31, 2007, the notional amount of loan forward sale contracts amounted to $464 million, with a change in fair value resulting in a gain of $1.3 million, of which $254 million were designated as cash flow hedges. There were no loan forward purchase contracts at March 31, 2007.

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 (“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 of 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 March 31, 2007, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value loss of $12 million recorded on the balance sheet in accounts payable and accrued liabilities and as a decrease to the advances being hedged.

The following table summarizes Downey’s interest rate swap contracts at March 31, 2007.

				Weighted
	Notional			Average
(Dollars in Thousands)	Amount			Interest Rate		Term

Pay – Variable (3-month LIBOR)	$	(100,000	)	5.36	%	March 2004 – October 2008
Receive – Fixed		100,000		3.20

Pay – Variable (3-month LIBOR)		(130,000	)	5.36		March 2004 – October 2008
Receive – Fixed		130,000		3.21

Pay – Variable (3-month LIBOR)		(100,000	)	5.36		March 2004 – November 2008
Receive – Fixed		100,000		3.26

Pay – Variable (3-month LIBOR)		(100,000	)	5.36		March 2004 – November 2008
Receive – Fixed		100,000		3.27

Page 9

Navigation Links

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 periods indicated. Also shown is the notional amount or balance for Downey’s non-qualifying and qualifying hedge transactions.

					Three Months Ended

					March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)					2007			2006			2006			2006			2006

Net gains (losses) on non-qualifying hedge transactions					$	251		$	(309	)	$	(304	)	$	(733	)	$	238
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)		251			(309	)		(304	)		(733	)		238
Other comprehensive income (loss)						(60	)		434			(201	)		(385	)		579

Notional amount or balance at period end
Non-qualifying hedge transactions:
	Interest rate lock commitments^(a)				$	224,546		$	196,751		$	236,435		$	237,867		$	307,635
	Associated loan forward sale contracts					209,818			187,804			213,783			209,815			261,359
Qualifying cash flow hedge transactions:
	Loans held for sale, at lower of cost or fair value					267,862			363,215			323,428			417,691			561,511
	Associated loan forward sale contracts					254,260			341,696			307,982			398,741			544,141
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

^(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 $290 million.

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 controls 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 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.

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. 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.

		March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)		2007		2006		2006		2006		2006

Commitments to originate adjustable rate loans
	held for investment	$	340,849	$	139,145	$	201,662	$	338,222	$	508,426
Undisbursed loan funds and unused lines of credit			334,803		347,338		370,159		391,395		406,675

Page 10

Navigation Links

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 controls 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 March 31, 2007, December 31, 2006 and March 31, 2006.

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 three months of 2007, Downey recorded repurchase or indemnification losses related to defects in the origination process of $0.3 million and repurchased $9 million of loans. Included in the repurchased loans were $8 million of one-to-four single family residential loans from Fannie Mae, due to the loans being outside Fannie Mae’s underwriting guidelines.

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 typically 90 days, but not to exceed 120 days from the sale’s settlement date. Downey reserved less than $1 million at March 31, 2007, December 31, 2006 and March 31, 2006 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 March 31, 2007, Downey’s maximum sales price premium refund would be $7.2 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 non-cancelable. Downey also has vendor contractual relationships, but the contracts are not considered to be material.

At March 31, 2007, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, senior notes and future operating minimum lease commitments were as follows:

				After 1		After 3
		Within		Through 3		Through 5		Beyond		Total
(In Thousands)		1 Year		Years		Years		5 Years		Balance

Certificates of deposit		$	8,541,202	$	280,898	$	106,693	$	-	$	8,928,793
Securities sold under agreements to repurchase			546,870								546,870
FHLB advances			880,000		418,197		-		-		1,298,197
Senior notes			-		-		-		198,305		198,305
Operating leases			5,259		7,901		3,613		760		17,533

	Total other contractual obligations	$	9,973,331	$	706,996	$	110,306	$	199,065	$	10,989,698

Page 11

Navigation Links

Litigation

On October 29, 2004, two former traditional branch employees brought an action in Los Angeles Superior Court, Case No. BC323796, entitled “Margie Holman and Alice A. Mesec, et al. v. Downey Savings and Loan Association.” The complaint seeks unspecified damages for alleged unpaid regular and overtime wages and bonuses, inadequate meal and rest breaks, and related claims. The plaintiffs are seeking class action status to represent all other current and former Downey Savings employees who held the position of Customer Service Supervisor and/or Customer Service Representative at any time during the four years prior to October 29, 2004. Based on a review of the current facts and circumstances with retained outside counsel, (i) Downey Savings plans to oppose the claim and assert all appropriate defenses and (ii) management 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.

On June 21, 2005, a former loan underwriting employee brought an action in Contra Costa Superior Court, Case No. C05-01293, entitled "Teresa Sims, et al. v. Downey Savings and Loan Association." The complaint seeks unspecified damages for alleged unpaid overtime wages and bonuses, inadequate meal and rest breaks, and related claims. The plaintiff is seeking class action status to represent all other current and former Downey Savings employees that held the position of loan underwriter, including, but not limited to, the job title of Senior Loan Underwriter within the State of California (a) at any time during the four years prior to June 21, 2005 and/or (b) who was employed by Downey Savings on or about September 30, 2002, when Downey Savings terminated an annual bonus program. Based on a review of the current facts and circumstances with retained outside counsel, (i) Downey Savings plans to oppose the claim and assert all appropriate defenses and (ii) management 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.

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.

NOTE (4) – Income Taxes

During the first quarter of 2007, FIN 48 was adopted. FIN 48 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. The impact of adoption resulted in an increase to the opening balance of retained earnings of $3.2 million, relating to the recognition of a previously unrecognized tax benefit associated with bad debt reserves for tax purposes. There are no other unrecognized tax benefits to be reported in Downey’s financial statements, and none are anticipated during the next 12 months. Accordingly, Downey’s effective tax rate has not been impacted by the adoption of FIN 48.

The Internal Revenue Service ("IRS") is currently examining Downey’s tax returns for 2004. All tax years subsequent to 2002 are subject to federal examination, while state tax returns for years subsequent to 2001 are subject to examination by taxing authorities. Downey has determined there is ambiguity surrounding the treatment of certain loan origination costs on its tax returns for 2003 through 2005. Since year-end 2006, Downey has made payments of taxes (previously accrued in prior periods) and interest to federal and state taxing authorities in the amount of $88.9 million for the purpose of avoiding penalties and further interest pending resolution of this ambiguity. The potential after-tax interest assessment related to Downey’s tax returns for 2003 through 2005 totals $10.8 million through the first quarter of 2007. Of this amount, $1.6 million has been accrued and reflected as additional income taxes in the accompanying consolidated statement of income for the current quarter and $9.2 million has been reflected as additional income taxes for 2004 through 2006 in this Form 10-Q and will be reflected in subsequent SEC filings. When applicable, Downey classifies interest (net of tax) and penalties on the underpayment of taxes as income tax expense.

While the IRS may assert a $9.2 million penalty (including penalty interest) against Downey related to its 2004 tax return, Downey has determined it is unlikely any such penalty would be sustained and it would vigorously contest any penalty that would be proposed, and, accordingly, has not accrued this amount.

Page 12

Navigation Links

The following table sets forth the impact on beginning and ending retained earnings for the first quarter of 2007 from the prior period adjustments related to interest on taxes for the treatment of certain loan origination costs and the beginning of period adjustment related to bad debt reserves from the adoption of FIN 48.

		Retained
(Dollars in Thousands, Except Per Share Data)		Earnings

Balance at December 31, 2006, as previously reported		$	1,330,379
Prior period adjustment related to interest on taxes for the treatment of certain loan origination costs			(9,222)
Beginning of period adjustment for taxes related to tax bad debt reserves			3,179

	Adjusted balance at January 1, 2007		1,324,336
Cash dividends on common stock—$0.12 per share			(3,342	)
Net income for the quarter ending March 31, 2007			42,863

Balance at March 31, 2007		$	1,363,857

For discussion and summary of the amounts related to Downey’s adjustment of prior period data for the above mentioned tax matters, see Note (9) – Adjustment of Prior and Beginning Period Amounts.

NOTE (5) – Employee Stock Option Plans

During 1994, Downey Savings and Loan Association ("Bank") adopted and the 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, Downey Financial Corp. and the Bank executed an amendment to the LTIP by which Downey Financial Corp. adopted and ratified the LTIP such that shares of Downey Financial Corp. 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 March 31, 2007, options for 52,914 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. At March 31, 2007, 381,239 shares of treasury stock existed that may be used to satisfy the exercise of the options or for payment of other awards. No other stock based plan exists.

Downey historically measured its employee stock-based compensation arrangements under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Accordingly, no compensation expense has been recognized for the stock option plan, as stock options were granted at fair value at the date of grant. Had compensation expense for Downey’s stock option plan been determined based on the fair value estimated using the Black-Scholes model at the grant date for previous awards, stock-based compensation would have been fully expensed over the vesting period as of December 31, 2002. Therefore, for the three months ended March 31, 2007 and 2006, Downey’s net income and income per share would not have been reduced.

NOTE (6) – Earnings Per Share

Earnings 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.

Page 13

Navigation Links

The following table presents a reconciliation of the components used to derive basic and diluted earnings per share for the periods indicated.

		Three Months Ended March 31,

		2007					2006

				Weighted					Weighted
				Average					Average
		Net		Shares	Per Share		Net		Shares	Per Share
(Dollars in Thousands, Except Per Share Data)		Income		Outstanding	Amount		Income		Outstanding	Amount

Basic earnings per share		$	42,863	27,853,783	$	1.54	$	43,697	27,853,783	$	1.57
Effect of dilutive stock options			-	30,247		-		-	29,438		-

	Diluted earnings per share	$	42,863	27,884,030	$	1.54	$	43,697	27,883,221	$	1.57

There were no options excluded from the computation of earnings per share due to anti-dilution.

NOTE (7) – Business Segment Reporting

The 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 March 31, 2007
Net interest income			$	124,752	$	362		$	-		$	125,114
Provision for credit losses				617		-			-			617
Other income				16,932		756			-			17,688
Operating expense				65,275		368			-			65,643
Net intercompany income (expense)				12		(12	)		-			-

Income before income taxes				75,804		738			-			76,542
Income taxes				33,381		298			-			33,679

	Net income		$	42,423	$	440		$	-		$	42,863

At March 31, 2007
Assets:
	Loans and mortgage-backed securities, net		$	13,210,016	$	-		$	-		$	13,210,016
	Investments in real estate and joint ventures			-		61,663			-			61,663
	Other			2,015,777		28,402			(77,989	)		1,966,190

		Total assets		15,225,793		90,065			(77,989	)		15,237,869

Equity			$	1,439,463	$	77,989		$	(77,989	)	$	1,439,463

Three months ended March 31, 2006
Net interest income			$	125,632	$	284		$	-		$	125,916
Provision of credit losses				10,057		-			-			10,057
Other income				20,671		2,539			-			23,210
Operating expense				60,797		735			-			61,532
Net intercompany income (expense)				87		(87	)		-			-

Income before income taxes				75,536		2,001			-			77,537
Income taxes				33,020		820			-			33,840

	Net income		$	42,516	$	1,181		$	-		$	43,697

At March 31, 2006
Assets:
	Loans and mortgage-backed securities, net		$	16,429,596	$	-		$	-		$	16,429,596
	Investments in real estate and joint ventures			-		49,182			-			49,182
	Other			1,364,430		29,974			(70,423	)		1,323,981

		Total assets		17,794,026		79,156			(70,423	)		17,802,759

Equity			$	1,244,639	$	70,423		$	(70,423	)	$	1,244,639

Page 14

Navigation Links

NOTE (8) – Recently Issued Accounting Standards

Statement of Financial Accounting Standards No. 157

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, ("SFAS 157"), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. Downey is currently evaluating the impact, if any, that SFAS 157 will have on its financial condition and results of operations.

Statement of Financial Accounting Standards No. 158

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, "Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106, and 132(R), ("SFAS 158"), which requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS 158 requires employers to measure the funded status of a plan as of the date of its year-end statement of financial position. The new reporting requirements and related new footnote disclosure rules of SFAS No. 158 are effective for fiscal years ending after December 15, 2006. The new measurement date requirement applies for fiscal years ending after December 15, 2008. Adoption of SFAS 158 is not expected to have a material impact on Downey.

Statement of Financial Accounting Standards No. 159

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("SFAS 159"), which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to more easily understand the effect of the company’s choice to use fair value on its earnings. SFAS 159 also requires entities to display the fair value of the selected assets and liabilities on the face of the balance sheet. SFAS 159 does not eliminate disclosure requirements of other accounting standards, including fair value measurement disclosures in SFAS 157. This Statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157. Adoption of SFAS 159 is not expected to have a material impact on Downey.

NOTE (9) – Adjustment of Prior and Beginning Period Amounts

Adjustments have been made to prior period financial statements for the tax matters discussed in Note (4) – Income Taxes.

Page 15

Navigation Links

The following table sets forth the impact to net income and earnings per share for financial statement purposes of the change in treatment of certain loan origination costs in Downey’s tax returns for 2003 through 2005. This table reflects by quarter for 2006 and by year for 2004 through 2006 the after-tax interest assessment that is recorded as additional income taxes, as interest begins accruing after the due date for filing each year’s tax return.

			Net Income										Earnings Per Share (diluted)

(Dollars in Thousands, Except Per			Previously										Previously
	Share Data)		Reported		Adjusted		Change						Reported		Adjusted		Change

2006:
	1^st quarter		$	44,757	$	43,697	$	(1,060	)	(2.4	)	%	$	1.61	$	1.57	$	(0.04	)	(2.7	)	%
	2^nd quarter			49,540		48,224		(1,316	)	(2.7	)			1.77		1.73		(0.04	)	(2.3	)
	3^rd quarter			57,176		55,620		(1,556	)	(2.7	)			2.05		1.99		(0.06	)	(2.7	)
	4^th quarter			53,701		52,115		(1,586	)	(3.0	)			1.93		1.87		(0.06	)	(3.2	)

		Total 2006		205,174		199,656		(5,518	)	(2.7	)			7.36		7.16		(0.20	)	(2.7	)
2005				217,434		214,477		(2,957	)	(1.4	)			7.80		7.69		(0.11	)	(1.4	)
2004				107,662		106,915		(747	)	(0.7	)			3.85		3.83		(0.02	)	(0.6	)

Grand Total			$	530,270	$	521,048	$	(9,222	)	(1.7	)	%	$	19.01	$	18.68	$	(0.33	)	(1.7	)	%

The following table sets forth the impact on the balance sheet as of December 31, 2006, September 30, 2006, June 30, 2006 and March 31, 2006 for the immaterial corrections.

(Dollars in Thousands)		As Reported			Adjustments				As Adjusted

Consolidated Balance Sheet at December 31, 2006
Assets:
	Other assets	$		124,029	$		(2,007	)	$		122,022
	Total assets			16,209,389			(2,007	)			16,207,382
Liabilities and Stockholders’ Equity:
	Accounts payable and accrued liabilities			109,797			110,465				220,262
	Deferred income taxes			103,250			(103,250	)			-
	Total liabilities			14,806,932			7,215				14,814,147
	Retained earnings			1,330,379			(9,222	)			1,321,157
	Total stockholders’ equity			1,402,457			(9,222	)			1,393,235
	Total liabilities and stockholders’ equity	$		16,209,389	$		(2,007	)	$		16,207,382

Consolidated Balance Sheet at September 30, 2006
Assets:
	Other assets	$		120,493	$		(1,236	)	$		119,257
	Total assets			16,982,793			(1,236	)			16,981,557
Liabilities and Stockholders’ Equity:
	Accounts payable and accrued liabilities			220,497			118,317				338,814
	Deferred income taxes			121,869			(111,917	)			9,952
	Total liabilities			15,630,564			6,400				15,636,964
	Retained earnings			1,279,463			(7,636	)			1,271,827
	Total stockholders’ equity			1,352,229			(7,636	)			1,344,593
	Total liabilities and stockholders’ equity	$		16,982,793	$		(1,236	)	$		16,981,557

Consolidated Balance Sheet at June 30, 2006
Liabilities and Stockholders’ Equity:
	Accounts payable and accrued liabilities	$		201,714	$		125,467		$		327,181
	Deferred income taxes			132,498			(119,387	)			13,111
	Total liabilities			16,174,615			6,080				16,180,695
	Retained earnings			1,225,072			(6,080	)			1,218,992
	Total stockholders’ equity	$		1,290,165	$		(6,080	)	$		1,284,085

Consolidated Balance Sheet at March 31, 2006
Liabilities and Stockholders’ Equity:
	Accounts payable and accrued liabilities	$	189,552		$	128,424			$	317,976
	Deferred income taxes		140,961			(123,660		)		17,301
	Total liabilities		16,553,356			4,764				16,558,120
	Retained earnings		1,178,317			(4,764		)		1,173,553
	Total stockholders’ equity	$	1,249,403		$	(4,764		)	$	1,244,639

The immaterial adjustments to the balance sheet and income statement had no impact on total cash flows from operating investing or financing activities.

Page 16

Navigation Links

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

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 forward-looking 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 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, fluctuations in interest rates, credit quality, the outcome of the IRS audit currently underway and government regulation and factors, identified under Part II – Other Information Item 1A. – Risk Factors on page 50. 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.

OVERVIEW

Our net income for the first quarter of 2007 totaled $42.9 million or $1.54 per share on a diluted basis, down $0.8 million or 1.9% from $43.7 million or $1.57 per share in the first quarter of 2006. For a discussion regarding revisions to prior period results, see Note (4) – Income Taxes on page 12 and Note (9) – Adjustment of Prior and Beginning Period Amounts on page 15 of Notes to Consolidated Financial Statements.

The decline in our net income between first quarters primarily reflected:

a $3.8 million or 6.2% increase in general and administrative expense;
A $2.9 million decline in net gains on sales of loans and mortgage-backed securities, primarily due to a lower volume of loans sold and, to a lesser extent, a lower gain per dollar of loan sold;
A $1.8 million decline in income from real estate and joint ventures held for investment;
A $0.8 million decline in net interest income due to a lower level of interest-earning assets; and
A $0.6 million unfavorable change in income from loan servicing activities.

Those unfavorable items were partially offset by a $9.4 million decline in provision for credit losses.

For the first quarter, our return on average assets was 1.09%, up from 1.00% a year ago, while our return on average equity was 12.10%, down from 14.28% a year ago.

At March 31, 2007, assets totaled $15.238 billion, down $2.565 billion or 14.4% from a year ago. During the current quarter, assets declined $970 million or 6.0 % due primarily to declines of $865 million in loans held for investment and $95 million in loans held for sale. Included within loans held for investment at quarter end were $10.055 billion of one-to-four unit adjustable rate mortgages subject to negative amortization, down $1.145 billion from year-end 2006. These loans comprised 81% of the residential one-to-four unit adjustable rate portfolio at quarter end, compared to 92% a year ago. The amount of negative amortization included in loan balances increased $37 million during the current quarter to $358 million or 3.56% of loans subject to negative amortization. During the current quarter, approximately 31% of loan interest income represented negative amortization, up from both 29% in the fourth quarter of 2006 and 25% in the year-ago first quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%.

Loan originations (including purchases) totaled $1.261 billion in the current quarter, down $1.552 billion or 55.2% from $2.813 billion a year ago. Loans originated for sale declined $339 million or 34.6% to $641 million, while single family loans originated for portfolio declined $1.116 billion or 64.9% to $603 million. In addition to single family loans, $17 million of other loans were originated in the current quarter.

Deposits totaled $11.647 billion at quarter end, down 4.5% from a year ago and down $137 million or 1.2% from year-end 2006. During the current quarter, one traditional branch was opened. At quarter end, the number of branches totaled 173 (169 in California and four in Arizona), up one branch from December 31, 2006. At quarter end, the average deposit size of our 82 traditional branches was $112 million, while the average deposit size of our 91 in-store branches was $27 million. Since the end of 2006, borrowings declined $766 million and represented 13.4% of total assets.

Non-performing assets increased during the quarter by $33 million to $143 million and represented 0.94% of total assets, compared with 0.68% at year-end 2006 and 0.22% a year ago. The increase occurred in our residential loan category.

Page 17

Navigation Links

At March 31, 2007, Downey Savings and Loan Association, F.A. (the “Bank”), our primary subsidiary, exceeded all regulatory capital requirements, with capital-to-asset ratios of 9.64% for both tangible and core capital and 19.57% for risk-based capital. These capital levels are significantly above the “well capitalized” standards defined by the federal banking regulators of 5% for core capital and 10% for risk-based capital.

Page 18

Navigation Links

CRITICAL ACCOUNTING POLICIES

We 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. Our significant accounting policies are described in Downey’s Annual Report on Form 10-K for the year ended December 31, 2006. 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. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors.

We believe the following are critical accounting policies that require the most judicious estimates and assumptions, which are particularly susceptible to significant change in the preparation of our financial statements:

The valuation of interest rate lock commitments. We enter into commitments to make loans that we intend to sell to investors whereby the interest rate on the loan is set prior to funding. These interest rate lock commitments are considered to be derivatives and are recorded at fair value. This value is calculated using market sources, reduced by an anticipated fallout factor for interest rate lock commitments that are not expected to fund. At March 31, 2007, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $225 million, with a change in fair value resulting in a loss of $0.8 million, compared with a notional amount of interest rate lock commitments of $308 million with a change in fair value resulting in a loss of $0.8 million at March 31, 2006. For further information, see Note 3 on page 8 of Notes to Consolidated Financial Statements.
The allowance for credit and real estate losses. The allowance for credit losses, which includes an allowance for loan losses reported as a reduction of outstanding loans and an allowance for loan-related commitments included in accounts payable and accrued liabilities, and the allowance for real estate losses reported as a reduction to real estate held for investment are maintained at amounts management deems adequate to cover inherent losses in the portfolios at the balance sheet date. We use an internal asset review system and credit loss allowance methodology designed to provide for the detection of problem assets and an adequate allowance to cover credit and real estate losses. In determining the allowance for credit losses related to loan relationships of $5 million or more, we evaluate the loans on an individual basis, including an analysis of the borrower’s creditworthiness, cash flows and financial status, and the condition and the estimated value of the collateral. Unless an individual loan or borrower relationship warrants separate analysis, we generally determine the allowance for credit losses related to loans under $5 million through a statistical analysis of the expected performance of each loan based on historical trends for similar types of borrowers, loans, collateral and economic circumstances. Those amounts may be adjusted based upon an analysis of macro-economic and other trends that are likely to affect a borrower’s ability to repay their loan according to their loan terms. The allowance for credit and real estate losses totaled $62 million at March 31, 2007, compared with $46 million at March 31, 2006. For further information, see Allowance for Credit and Real Estate Losses on page 43.
The valuation of mortgage servicing rights (“MSRs”). The fair value of MSRs is measured using a discounted cash flow analysis based on available market quotes, anticipated prepayment speeds, a custodial account rate and market-adjusted discount rates. Market sources are used to determine prepayment speeds, the net cost of servicing per loan, inflation rate, and default and interest rates for mortgage loans. MSRs are reviewed for impairment based on their fair value. Impairment is 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 at 50 basis point increments. Impairment losses are recognized through a valuation allowance for each impaired stratum, with any associated provision recorded as a component of loan servicing income (loss), net. The MSR valuation allowance totaled less than $1 million at March 31, 2007 and March 31, 2006. For further information, see Note 2 on page 7 of Notes to Consolidated Financial Statements.
The prepayment reserves related to sales of loans and MSRs. The gains on sales of loans and of MSRs are recorded net of reserves for anticipated prepayments. These loans and MSR sales contracts typically 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. Loan and MSR sales reserves are estimated using the prepayment experience of similar products. The estimates are updated during the applicable period for actual payoffs. The reserve was less than $1 million at both March 31, 2007 and March 31, 2006. For further information, see Note 2 on page 7 and Note 3 on page 8 of Notes to Consolidated Financial Statements and Secondary Marketing Activities on page 23.

Page 19

Navigation Links

RESULTS OF OPERATIONS

Net Interest Income

Net 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 interest-earning 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 $125.1 million in the first quarter of 2007, down $0.8 million or 0.6% from a year ago, reflecting a $1.7 billion or 10.2% decline in average interest-earning assets. The effective interest rate spread averaged 3.28% in the current quarter, up 0.31% from 2.97% a year ago, and up 0.06% from 3.22% in the fourth quarter of 2006. The increase in the effective interest rate spread between first quarters was primarily the result of two factors. First, interest-earning assets in the current quarter were funded with a higher proportion of interest free funds (the excess of interest-earning assets over interest-bearing deposits and borrowings), and the value of those funds was worth more due to the higher interest rate levels prevalent in the current quarter. Second, the yield on interest-earning assets rose more between first quarters than did the cost of interest-bearing liabilities. Those two favorable items were partially offset by a lower proportion of loan prepayment fees to the amount of deferred loan origination costs written-off as a result of those payoffs. Loan prepayment fees in the first quarter of 2007 represented 84.5% of deferred loan origination costs written-off, compared to 97.4% a year ago. The decline was the result of a higher proportion of loans being repaid that were no longer subject to a prepayment fee.

The following table presents for the periods indicated the total dollar amount of:

interest income from average interest-earning assets and resultant yields; and
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:

the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities, divided by
average interest-earning assets for the period.

The table also sets forth our net interest-earning balance—the difference between the average balance of interest-earning assets and the average balance of total deposits and borrowings—for the quarters indicated. We included non-accrual loans in the average interest-earning assets balance. We included interest from non-accrual loans in interest income only to the extent we received payments and believe we will recover the remaining principal balance of the loans. We computed average balances for the quarter using the average of each month’s daily average balance during the periods indicated.

Page 20

Navigation Links

				Three Months Ended

				March 31, 2007							December 31, 2006							March 31, 2006

									Average							Average							Average
				Average					Yield/		Average					Yield/		Average					Yield/
(Dollars in Thousands)				Balance		Interest			Rate		Balance		Interest			Rate		Balance		Interest			Rate

Average balance sheet data
Interest-earning assets:
	Loans:
		Loan prepayment fees					21,804		0.64					27,409		0.75					21,471		0.53
		Write-off of deferred costs and
			premiums from loan payoffs				(25,814	)	(0.76	)				(27,893	)	(0.76	)				(22,044	)	(0.54	)
		All other					256,182		7.49					272,723		7.42					255,918		6.34

			Total loans	$	13,678,775	$	252,172		7.37	%	$	14,703,050	$	272,239		7.41	%	$	16,137,510	$	255,345		6.33	%
	Mortgage-backed securities				152		3		5.80			254		4		5.60			276		3		4.35
	Investment securities ^(a)				1,578,946		21,645		5.56			1,472,000		18,390		4.96			848,460		9,615		4.60

		Total interest-earnings assets			15,257,873		273,820		7.18			16,175,304		290,633		7.19			16,986,246		264,963		6.24
Non-interest-earning assets					469,512							450,768							419,058

	Total assets			$	15,727,385						$	16,626,072						$	17,405,304

Transaction accounts:
	Non-interest-bearing checking			$	755,063	$	-		-	%	$	776,986	$	-		-	%	$	699,971	$	-		-	%
	Interest-bearing checking ^(b)				488,174		395		0.33			488,383		418		0.34			515,516		435		0.34
	Money market				150,385		385		1.04			146,991		384		1.04			164,212		423		1.04
	Regular passbook				1,243,823		2,949		0.96			1,311,124		3,225		0.98			1,727,033		4,384		1.03

		Total transaction accounts			2,637,445		3,729		0.57			2,723,484		4,027		0.59			3,106,732		5,242		0.68
Certificates of deposit					9,004,183		109,846		4.95			9,117,252		111,897		4.87			8,904,238		86,593		3.94

	Total deposits				11,641,628		113,575		3.96			11,840,736		115,924		3.88			12,010,970		91,835		3.10
FHLB advances and other borrowings ^(c)					2,227,592		31,830		5.79			2,867,151		41,234		5.71			3,689,386		43,914		4.83
Senior notes					198,289		3,301		6.66			198,245		3,300		6.66			198,112		3,298		6.66

	Total deposits and borrowings				14,067,509		148,706		4.29			14,906,132		160,458		4.27			15,898,468		139,047		3.55
Other liabilities					243,070							351,312							283,060
Stockholders’ equity					1,416,806							1,368,628							1,223,776

	Total liabilities and stockholders’ equity			$	15,727,385						$	16,626,072						$	17,405,304

Net interest income/interest rate spread						$	125,114		2.89	%			$	130,175		2.92	%			$	125,916		2.69	%
Excess of interest-earning assets over
	deposits and borrowings			$	1,190,364						$	1,269,172						$	1,087,778
Effective interest rate spread									3.28							3.22							2.97

^(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.

Page 21

Navigation Links

Changes 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 interest-earning assets and interest-bearing liabilities, we have provided information on changes attributable to:

changes in volume: changes in volume multiplied by comparative period rate;
changes in rate: changes in rate multiplied by comparative period volume; and
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.

				Three Months Ended March 31,
				2007 Versus 2006
				Changes Due To

										Rate/
(In Thousands)				Volume			Rate			Volume			Net

Interest income:
	Loans			$	(38,893	)	$	42,141		$	(6,421	)	$	(3,173	)
	Mortgage-backed securities				(1	)		1			-			-
	Investment securities				8,278			2,016			1,736			12,030

		Change in interest income			(30,616	)		44,158			(4,685	)		8,857

Interest expense:
	Transaction accounts:
		Interest-bearing checking			(23	)		(18	)		1			(40	)
		Money market			(38	)		-			-			(38	)
		Regular passbook			(1,227	)		(289	)		81			(1,435	)

			Total transaction accounts		(1,288	)		(307	)		82			(1,513	)
	Certificates of deposit				972			22,034			247			23,253

		Total interest-bearing deposits			(316	)		21,727			329			21,740
	FHLB advances and other
		borrowings			(17,400	)		8,804			(3,488	)		(12,084	)
	Senior notes				3			-			-			3

		Change in interest expense			(17,713	)		30,531			(3,159	)		9,659

Change in net interest income				$	(12,903	)	$	13,627		$	(1,526	)	$	(802	)

Provision for Credit Losses

During the current quarter, the provision for credit losses totaled $0.6 million, down $9.4 million from a year ago. Although the California residential real estate market continued to show signs of weakening during the current quarter, a $823 million or 6.2% drop in the single-family residential loan portfolio mitigated the need to increase the associated allowance for loan losses. For further information, see Allowance for Credit and Real Estate Losses on page 43.

Other Income

Our total other income was $17.7 million in the current quarter, down $5.5 million from a year ago. Contributing to the decline between first quarters was:

A $2.9 million decline in net gains on sales of loans and mortgage-backed securities, primarily due to a lower volume of loans sold.
A $1.8 million decline in income from real estate and joint ventures held for investment, primarily due to higher operating charges from investments in joint ventures and lower gains from sales.
A $0.6 million unfavorable change in income from loan servicing activities.

Below is a further detailed discussion of the major other income categories.

Page 22

Navigation Links

Loan and Deposit Related Fees

Loan and deposit related fees totaled $8.8 million in the current quarter, up $0.3 million from a year ago. Loan related fees were down $0.2 million or 21.0%, while deposit related fees were up $0.5 million or 6.7%. Within deposit related fees, automated teller machine fees increased 7.3%, while other fees increased 6.5%.

The following table presents a breakdown of loan and deposit related fees during the quarters indicated.

			Three Months Ended

			March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)			2007		2006		2006		2006		2006

Loan related fees			$	842	$	918	$	901	$	1,009	$	1,066
Deposit related fees:
	Automated teller machine fees			2,305		2,346		2,419		2,410		2,149
	Other fees			5,689		5,879		5,959		5,752		5,343

		Total loan and deposit related fees	$	8,836	$	9,143	$	9,279	$	9,171	$	8,558

Real Estate and Joint Ventures Held for Investment

Income from our real estate and joint ventures held for investment totaled $0.5 million in the current quarter, down $1.8 million from the year-ago quarter due primarily to higher operating charges from investments in joint ventures and lower gains from sales. The current quarter included gains of $0.5 million, compared with gains of $1.0 million a year ago.

The following table sets forth the key components comprising our income from real estate and joint venture operations during the quarters indicated.

			Three Months Ended

			March 31,			December 31,		September 30,		June 30,		March 31,
(In Thousands)			2007			2006		2006		2006		2006

Net rental operations			$	545		$	20	$	124	$	240	$	487
Net gains on sales of wholly owned real estate				22					3,051		-		-
Equity (deficit) in net income (loss) from
joint ventures				(91	)		760		2,156		2,313		1,802
Provision for losses on real estate and joint ventures				-			-		-		-		-

	Total income from real estate and
		joint ventures held for investment, net	$	476		$	780	$	5,331	$	2,553	$	2,289

Secondary Marketing Activities

We service loans for others and those activities generated a loss of $0.4 million in the current quarter, compared with income of $0.2 million in the year-ago quarter. The primary reason for the unfavorable change was an increase in payoff and curtailment interest costs of $0.8 million.

At March 31, 2007, MSRs, net of a $0.2 million valuation allowance, totaled $20.7 million or 0.88% of the $2.348 billion of associated loans serviced for others, little changed from a year ago. In addition to the loans we serviced for others with capitalized MSRs, at March 31, 2007, we serviced $3.659 billion of loans on a sub-servicing basis where we receive a fixed fee per loan, with no risk associated with changing MSR values.

Page 23

Navigation Links

The following table presents a breakdown of the components of our loan servicing income (loss), net for the quarters indicated.

			Three Months Ended

			March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)			2007			2006			2006			2006			2006

Net cash servicing fees			$	1,607		$	1,647		$	1,583		$	1,574		$	1,566
Payoff and curtailment interest cost ^(a)				(1,063	)		(1,269	)		(813	)		(233	)		(218	)
Amortization of mortgage servicing rights				(1,024	)		(1,087	)		(1,056	)		(1,029	)		(1,198	)
(Provision for) reduction of impairment of
	mortgage servicing rights			44			(149	)		(91	)		140			39

		Total loan servicing income (loss), net	$	(436	)	$	(858	)	$	(377	)	$	452		$	189

For further information regarding mortgage servicing rights, see Note 2 on page 7 of Notes to Consolidated Financial Statements.

Net gains on sales of loans and mortgage-backed securities totaled $8.7 million in the current quarter, down $2.9 million from a year ago. The decline primarily reflected a lower volume of loans sold, as sales of loans and mortgage-backed securities we originated for sale declined from $876 million a year ago to $714 million in the current quarter. The current quarter included a $0.3 million gain due to the SFAS 133 impact of valuing derivatives associated with the sale of loans, compared with a SFAS 133 gain of $0.2 million in the year-ago quarter. Excluding the impact of SFAS 133, a gain equal to 1.19% on secondary market sales was realized in the current quarter, down from the year-ago gain of 1.30%.

The following table presents a breakdown of the components of our net gains on sales of loans and mortgage-backed securities for the quarters indicated.

			Three Months Ended

			March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)			2007			2006			2006			2006			2006

Mortgage servicing rights			$	1,341		$	2,122		$	837		$	1,285		$	1,022
All other components excluding SFAS 133				7,148			6,682			14,314			8,067			10,394
SFAS 133				251			(309	)		(304	)		(733	)		238

	Total net gains on sales of loans
		and mortgage-backed securities	$	8,740		$	8,495		$	14,847		$	8,619		$	11,654

Secondary marketing gain excluding SFAS
	133 as a percentage of associated sales			1.19	%		1.23	%		1.68	%		0.91	%		1.30	%

Operating Expense

Operating expense totaled $65.6 million in the current quarter, up $4.1 million or 6.7% from a year ago. The increase primarily reflected a $1.8 million increase associated with higher deposit insurance premiums and regulatory assessments and a $1.5 million or 3.6% increase in salaries and related costs.

Page 24

Navigation Links

The following table presents a breakdown of key components comprising operating expense for the quarters indicated.

		Three Months Ended

		March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)		2007		2006		2006		2006		2006

Salaries and related costs		$	42,234	$	40,464	$	38,943	$	40,873	$	40,780
Premises and equipment costs			8,809		9,207		8,804		8,410		8,538
Advertising expense			1,191		1,895		1,211		1,879		1,242
Deposit insurance premiums and regulatory
	assessments		2,764		2,193		2,224		1,008		1,014
Professional fees			559		297		254		450		792
Other general and administrative expense			9,795		7,920		7,087		8,295		9,175

	Total general and administrative expense		65,352		61,976		58,523		60,915		61,541
Net operation of real estate acquired in
	settlement of loans		291		65		166		28		(9	)

	Total operating expense	$	65,643	$	62,041	$	58,689	$	60,943	$	61,532

Provision for Income Taxes

Our effective tax rate was 44.0% for the current quarter, compared with 43.6% a year ago. The difference in effective tax rates was due primarily to interest associated with a potential underpayment of taxes, as discussed in more detail below.

The Internal Revenue Service ("IRS") is currently examining Downey’s tax return for 2004. Downey has determined there is substantial ambiguity surrounding the treatment of certain loan origination costs on its tax returns for 2003 through 2005. The potential after-tax interest assessment related to Downey’s tax returns for 2003 through 2005 totals $10.8 million. Of that amount, $1.6 million was accrued for 2007 and has been recorded as additional income taxes in the current quarter, and $9.2 million was accrued for 2004 through 2006 and will be reflected in income taxes in those prior periods in future SEC filings (including this Form 10-Q). For further information on the impact of these prior period adjustments on previously filed financial statements, see Note (4) – Income Taxes on page 12 and Note (9) – Adjustment of Prior and Beginning Period Amounts on page 15 of Notes to Consolidated Financial Statements.

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 further information, see Note 7 of Notes to Consolidated Financial Statements on page 14.

The following table presents by business segment our net income for the periods indicated.

		Three Months Ended

		March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)		2007		2006		2006		2006		2006

Banking net income		$	42,423	$	50,907	$	51,432	$	46,494	$	42,516
Real estate investment net income			440		1,208		4,188		1,730		1,181

	Total net income	$	42,863	$	52,115	$	55,620	$	48,224	$	43,697

Banking

Net income from our banking operations for the current quarter totaled $42.4 million, down slightly from a year ago. The decline between first quarters primarily reflected:

a $4.5 million or 7.4% increase in operating expense;
A $2.9 million decline in net gains on sales of loans and mortgage-backed securities, primarily due to a lower volume of loans sold and, to a lesser extent, a lower gain per dollar of loan sold;
A $0.9 million decline in net interest income due to a lower level of interest-earning assets; and
A $0.6 million unfavorable change in income from loan servicing activities.

Page 25

Navigation Links

Those unfavorable items were mostly offset by a $9.4 million decline in provision for credit losses.

The following table sets forth our banking operational results and selected financial data for the quarters indicated.

			Three Months Ended

			March 31,		December 31,			September 30,			June 30,			March 31,
(In Thousands)			2007		2006			2006			2006			2006

Net interest income			$	124,752	$	129,798		$	129,870		$	132,021		$	125,632
Provision for credit losses				617		245			9,640			6,662			10,057
Other income				16,932		16,549			25,090			18,188			20,671
Operating expense				65,275		61,995			59,801			60,652			60,797
Net intercompany income (expense)				12		(29	)		(38	)		(54	)		87

Income before income taxes				75,804		84,078			85,481			82,841			75,536
Income taxes				33,381		33,171			34,049			36,347			33,020

	Net income		$	42,423	$	50,907		$	51,432		$	46,494		$	42,516

At period end
Assets:
	Loans and mortgage-backed securities, net		$	13,210,016	$	14,170,750		$	15,135,543		$	15,938,573		$	16,429,596
	Other			2,015,777		2,025,790			1,837,714			1,517,582			1,364,430

		Total assets		15,225,793		16,196,540			16,973,257			17,456,155			17,794,026

Equity			$	1,439,463	$	1,393,235		$	1,344,593		$	1,284,085		$	1,244,639

Real Estate Investment

Net income from real estate investment operations totaled $0.4 million in the current quarter, down from $1.2 million a year ago. The decrease primarily reflected higher operating charges from investments in joint ventures and lower gains from sales, partially offset by lower operating expense. Gains from sales totaled $0.5 million in the current quarter, compared to $1.0 million a year ago.

The following table sets forth real estate investment operational results and selected financial data for the quarters indicated.

			Three Months Ended

			March 31,			December 31,		September 30,			June 30,		March 31,
(In Thousands)			2007			2006		2006			2006		2006

Net interest income			$	362		$	377	$	369		$	326	$	284
Other income				756			1,685		5,579			2,842		2,539
Operating expense				368			46		(1,112	)		291		735
Net intercompany income (expense)				(12	)		29		38			54		(87	)

Income before income taxes				738			2,045		7,098			2,931		2,001
Income taxes				298			837		2,910			1,201		820

	Net income		$	440		$	1,208	$	4,188		$	1,730	$	1,181

At period end
Assets:
	Investments in real estate and joint ventures		$	61,663		$	59,843	$	55,663		$	49,237	$	49,182
	Other			28,402			28,548		28,978			31,541		29,974

		Total assets		90,065			88,391		84,641			80,778		79,156

Equity			$	77,989		$	77,549	$	76,341		$	72,153	$	70,423

Our investments in real estate and joint ventures amounted to $62 million at March 31, 2007, up from $60 million at December 31, 2006 and $49 million at March 31, 2006.

For information on valuation allowances associated with real estate and joint venture loans, see Allowance for Credit and Real Estate Losses on page 43.

Page 26

Navigation Links

FINANCIAL CONDITION

Loans and Mortgage-Backed Securities

Total loans and mortgage-backed securities, including those we hold for sale, declined $961 million during the current quarter to a total of $13.2 billion or 86.7% of total assets at March 31, 2007. Loans held for investment declined $865 million, as loan payoffs exceeded originations and loans held for sale declined $95 million.

Our loan originations, including loans purchased, totaled $1.261 billion in the current quarter, down $1.552 billion or 55.2% from the $2.813 billion we originated in the year-ago first quarter and 5.9% below the $1.340 billion we originated in the fourth quarter of 2006. Loans originated for sale declined $339 million or 34.6% from a year ago to $641 million, while single family loans originated for portfolio declined $1.116 billion or 64.9% to $603 million. Our prepayment speed, which measures the annualized percentage of loans repaid, for one-to-four unit residential loans held for investment increased from 34% a year ago to 44% in the current quarter and was up slightly from 43% in the fourth quarter of 2006. During the current quarter, 89% 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 91% from the fourth quarter of 2006 but up from 87% in the year-ago first quarter.

We originate one-to-four unit residential 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 fees. In addition, a prepayment fee on loans with no origination fees is generally required if prepaid within the first three years. These loans generally result in deferrable loan origination costs exceeding loan origination fees.

Originations of adjustable rate residential one-to-four unit loans for portfolio, including loans purchased, totaled $603 million in the current quarter, down from $1.719 billion in the year-ago quarter but up from $555 million in the fourth quarter of 2006. Of the current quarter total:

57% were adjustable – fixed for 3-5 years, compared with 11% in the year-ago quarter;
25% were adjustable rate loans tied to either the LIBOR index, which typically adjust every six months, or the Constant Maturity Treasury ("CMT") index; and
18% 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 88% in the year-ago quarter. Of the current quarter total, loans tied to the COFI index represented 94% of these originations, compared with 86% of originations in the year-ago quarter.

Page 27

Navigation Links

The following table sets forth loans originated, including purchases, for investment and for sale during the periods indicated.

				Three Months Ended

				March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)				2007		2006		2006		2006		2006

Loans originated and purchased
Investment portfolio:
	Residential one-to-four units:
		Adjustable by index:
			COFI	$	99,782	$	170,394	$	339,128	$	612,586		$	1,309,298
			MTA		6,838		44,200		11,820		3,206			209,134
			LIBOR		123,226		70,457		69,768		77,753			11,396
			CMT		31,047		28,175		53,633		43,975			-
		Adjustable – fixed for 3-5 years			342,005		241,347		290,397		392,126			189,385
		Fixed			-		-		-		69			155

		Total residential one-to-four units			602,898		554,573		764,746		1,129,715			1,719,368
	Other				17,500		6,605		15,744		49,059			113,670

	Total for investment portfolio				620,398		561,178		780,490		1,178,774			1,833,038
Sale portfolio ^(a)					640,669		779,002		824,072		892,314			980,164

	Total for investment and sale portfolios			$	1,261,067	$	1,340,180	$	1,604,562	$	2,071,088	$		2,813,202

^(a) All residential one-to-four unit loans.

The 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.

			March 31, 2007				December 31, 2006				September 30, 2006				June 30, 2006				March 31, 2006

					% 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	$	8,365,223	77	%	$	9,231,837	77	%	$	10,107,839	78	%	$	10,770,739	77	%		11,172,831	77	%
		MTA		1,807,965	17			2,094,828	18			2,353,639	18			2,636,804	19			2,841,747	20
		LIBOR		435,132	4			364,537	3			366,907	3			359,752	3			351,128	2
		Other, primarily CMT		228,260	2			209,191	2			191,542	1			138,488	1			151,003	1

	Total adjustable loans ^(a)		$	10,836,580	100	%	$	11,900,393	100	%	$	13,019,927	100	%	$	13,905,783	100	%	$	14,516,709	100	%

^(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:

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;
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
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.

Most of our adjustable rate mortgage loans are option ARM products with an interest rate that adjusts monthly and a minimum monthly loan payment that adjusts annually. The start rate is lower than the fully-indexed rate and is the effective interest rate 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, or the addition to loan principal of accrued interest that exceeds the required minimum monthly loan payment. If the borrower chooses to make the required 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 are clearly defined in the loan documents signed by the borrower at funding and explained again on the borrower’s monthly statement.

Page 28

Navigation Links

More particularly, these loans currently:

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%, 115% if the loan-to-value ratio is 75% or less and up to 120% for certain salable loans;
have a lifetime interest rate cap, but no periodic cap on interest rate adjustments; and
include a payment cap that limits the change in required 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 at the earlier of every five years or when the loan balance reaches the maximum level of loan balance permitted.

The maximum home loan we make, except for a limited amount related to Community Reinvestment Act ("CRA") activities, is equal to 97% of a property’s appraised value; however, any loan in excess of 80% of appraised value generally requires private mortgage insurance. Typically, this insures the loan down to a 75% loan-to-value ratio, consistent with secondary marketing requirements. 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. 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.

Our loan portfolio held for investment does contain loans previously originated with a limit on the maximum loan balance of 125% of the original loan amount. At March 31, 2007, loans with the higher 125% limit on the maximum loan balance represented only 3% of our adjustable rate one-to-four unit residential loan portfolio, while those with the 115% limit represented only 2% and those with the 110% limit represented 76%. 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:

lower risk applicants:
- 6.00% for owner occupied; or
- 6.25% for non-owner occupied.
higher risk applicants:
- 7.00% for owner occupied; or
- 7.25% for non-owner occupied.

For interest-only loans, we qualify applicants at the interest-only payment amount based on the interest rate applicable to the fixed rate period of the loan program.

Page 29

Navigation Links

As set forth in the following table, $10.1 billion or 81% of our residential one-to-four unit adjustable rate loans held for investment were subject to negative amortization at March 31, 2007, of which $358 million or 3.6% represented the amount of negative amortization included in the loan balance. The amount of negative amortization had a net increase of $37 million during the current quarter, as borrowers took advantage of the flexibility of this product. During the current quarter, approximately 31% of our loan interest income represented negative amortization, up from 29% in the fourth quarter of 2006 and 25% in the year-ago first quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%. In addition, $1.9 billion or 15% of our residential one-to-four unit adjustable rate loans held for investment represented loans requiring interest only payments over the initial terms of the loans, generally the first three to five years.

										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 March 31, 2007:
		With negative amortization:
			Balance less than or equal to original loan amount		$	365,466		3	%	$	1,740	70	%	69	%	34
			Balance greater than original loan amount			8,608,796		86			355,890	74		77		23

				Total with negative amortization		8,974,262		89			357,630	73		76		23
		Not utilizing negative amortization				1,080,655		11			-	69		65		48

			Total loans subject to negative amortization		$	10,054,917		100	%	$	357,630	73	%	75	%	26
		As a percentage of total residential one-to-four unit
			adjustable rate loans			81	%

	Total loans with interest only payments				$	1,876,201						68	%	68	%	11
	As a percentage of total residential one-to-four unit
		adjustable rate loans				15	%

	At December 31 2006:
		With negative amortization:
			Balance less than or equal to original loan amount		$	477,873		4	%	$	1,933	70	%	69	%	31
			Balance greater than original loan amount			9,320,945		83			318,533	73		76		20

				Total with negative amortization		9,798,818		87			320,466	73		75		21
		Not utilizing negative amortization				1,401,052		13			-	69		65		41

			Total loans subject to negative amortization		$	11,199,870		100	%	$	320,466	73	%	74	%	23
		As a percentage of total residential one-to-four unit
			adjustable rate loans			85	%

	Total loans with interest only payments				$	1,578,202						69	%	68	%	12
	As a percentage of total residential one-to-four unit
		adjustable rate loans				12	%

	At March 31, 2006:
		With negative amortization:
			Balance less than or equal to original loan amount		$	1,011,396		7	%	$	2,772	70	%	70	%	20
			Balance greater than original loan amount			9,953,964		72			178,787	73		74		15

				Total with negative amortization		10,965,360		79			181,559	73		74		16
		Not utilizing negative amortization				2,900,585		21			-	71		69		24

			Total loans subject to negative amortization		$	13,865,945		100	%	$	181,559	72	%	73	%	17
		As a percentage of total residential one-to-four unit
			adjustable rate loans			92	%

	Total loans with interest only payments				$	723,108						70	%	70	%	22
	As a percentage of total residential one-to-four unit
		adjustable rate loans				5	%

^(a) Based on current loan balance relative to the lower of the appraised value or sales price at time of origination.

Page 30

Navigation Links

We have other credit risk elements within our real estate loans held for investment besides loans subject to negative amortization or loans with interest-only payments. At March 31, 2007, these other credit risks included:

88% of our real estate loans were concentrated and secured by properties located in California, principally in Los Angeles, San Diego, Orange, Santa Clara and Riverside counties;
81% of our residential one-to-four unit loans were underwritten based on borrower stated income and asset verification and an additional 9% were underwritten with no verification of either borrower income or assets; and
the loans are relatively new and unseasoned, as 5% of our residential one-to-four unit loans were originated in the current quarter, with an additional 29% originated in 2006 and 34% in 2005.

Those risks are mitigated primarily by various minimum borrower credit requirements and maximum loan-to-value limitations. For example, at March 31, 2007, 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. For example, while residential property values have increased over the past several years thereby further reducing our exposure to credit risk, home value declines emerged in certain markets we lend to in 2006. The uncertainty of future home value changes may materially impact the risk associated with our loan portfolio since 68% of these loans were originated since year-end 2004.

While our historic credit experience has been good, option ARMs can present greater credit risk in sustained periods of rising interest rates, as borrowers may see their loan payments increase significantly when their payments recast to fully-amortizing payments. In addition, credit risk increases if home values decline. In light of continued increases in market interest rates and other unfavorable changes in the residential housing market, we increased the start rate on option ARM loans originated for portfolio beginning in March of 2006 in order to reduce the potential for negative amortization. Since our start rate remained higher than that of many of our competitors, our production of option ARM loans for portfolio did not offset loan payoffs for the last year. In September of 2006, we increased the competitiveness of our option ARM pricing by lowering the start rate for borrowers who have high FICO credit scores and low loan-to-value ratios, with the goal of stimulating additional loan production for our portfolio, while at the same time limiting our portfolio credit exposure. However, this pricing change has not resulted in loan production completely offsetting portfolio payoffs.

In September, 2006, the federal banking agencies issued final guidance on non-traditional mortgage loan products that allow borrowers to defer repayment of principal and sometimes interest, including "interest-only" mortgage loans, and "payment option" adjustable rate mortgage loans where a borrower has flexible payment options, including payments that have the potential for negative amortization. While acknowledging that innovations in mortgage lending can benefit some consumers, the final guidance states that management should (1) assess a borrower’s ability to repay the loan, including any principal balances added through negative amortization, at the fully indexed rate that would apply after the incentive interest rate period, (2) recognize that certain nontraditional mortgage loans are untested in a stressed environment and warrant strong risk management standards as well as appropriate capital and loan loss reserves, and (3) ensure that borrowers have sufficient information to clearly understand loan terms and associated risks prior to making a product or payment choice. We have instituted some disclosure changes and are assessing what impact, if any, this new lending guidance will have on our loan underwriting guidelines; and we continue to closely monitor trends in residential housing and lending markets and will make adjustments, as deemed necessary.

We also offer other types of adjustable rate product for portfolio that do not permit negative amortization and do not fall in the scope of the guidance, but those products are currently not as popular with borrowers.

Page 31

Navigation Links

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.

			March 31, 2007				December 31, 2006				September 30, 2006				June 30, 2006				March 31, 2006

					% 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	$	564,407	5	%	$	645,004	5	%	$	741,310	5	%	$	855,396	6	%	$	984,652	7	%
		621 to 659		3,104,677	25			3,344,594	25			3,601,342	25			3,755,084	25			3,788,331	25
		660 to 719		4,721,195	38			5,095,599	39			5,469,547	39			5,736,445	39			5,861,341	39
		720 and above		3,848,112	31			3,964,348	30			4,184,865	30			4,295,868	29			4,306,399	28
		Not available		165,629	1			177,459	1			186,141	1			196,686	1			210,006	1

	Total residential one-to-four units		$	12,404,020	100	%	$	13,227,004	100	%	$	14,183,205	100	%	$	14,839,479	100	%	$	15,150,729	100	%

Weighted average FICO score for
	loan investment portfolio of
	residential one-to-four units			694				692				692				691				690

The 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 appraisal if private mortgage insurance has been removed.

				March 31, 2007				December 31, 2006				September 30, 2006				June 30, 2006				March 31, 2006

						% 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		$	1,839,882	15	%	$	1,940,772	15	%	$	2,048,086	14	%	$	2,148,624	14	%	$	2,187,876	14	%
		61% to 70%			2,176,103	18			2,349,016	18			2,505,972	18			2,628,314	18			2,717,204	18
		71% to 80%			7,763,469	63			8,271,605	62			8,877,059	63			9,225,868	62			9,313,806	62

			Total 80% or below		11,779,454	95			12,561,393	95			13,431,117	95			14,002,806	94			14,218,886	94
	81% to 85%:
		With private mortgage insurance			90,228	1			96,683	1			110,452	1			124,623	1			143,620	1
		Without private mortgage insurance			1,210	-			1,789	-			2,319	-			3,293	-			4,243	-

			Total 81% to 85%		91,438	1			98,472	1			112,771	1			127,916	1			147,863	1
	86% to 89%:
		With private mortgage insurance			218,546	2			231,471	2			261,422	2			291,605	2			331,008	2
		Without private mortgage insurance			5,005	-			5,960	-			6,687	-			6,603	-			6,328	-

			Total 86% to 89%		223,551	2			237,431	2			268,109	2			298,208	2			337,336	2
	90% and above:
		With private mortgage insurance			281,334	2			300,546	2			341,158	2			380,351	3			417,974	3
		Without private mortgage insurance ^(a)			24,948	-			25,569	-			26,405	-			26,491	-			24,693	-

			Total 90% and above		306,282	2			326,115	2			367,563	2			406,842	3			442,667	3
	Not available				3,295	-			3,593	-			3,645	-			3,707	-			3,977	-
	Total residential one-to-four units			$	12,404,020	100	%	$	13,227,004	100	%	$	14,183,205	100	%	$	14,839,479	100	%	$	15,150,729	100	%

Weighted average loan-to-value ratio
	for loan investment portfolio of
	residential one-to-four units					72				72				72				72				72

^(a) Primarily related to Community Reinvestment Act activities.

We continue to originate residential fixed interest rate mortgage loans to meet consumer demand, but we intend to sell the majority of these loans. We expect to sell some of our production of adjustable rate loans into the secondary market to the extent we can do so profitably. We sold $714 million of loans and mortgage-backed securities in the current quarter, unchanged from the fourth quarter of 2006 but down from $876 million in the year-ago first quarter. All amounts were secured by residential one-to-four unit property, and at March 31, 2007, loans held for sale totaled $268 million.

In addition to single family loans, $17 million of other loans were originated in the current quarter, up from $7 million in the fourth quarter of 2006, but down from $114 million in the year-ago quarter.

Page 32

Navigation Links

At March 31, 2007, our unfunded loan application pipeline totaled $1.3 billion. Within that pipeline, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $630 million, of which $290 million were related to residential one-to-four unit loans being originated for sale in the secondary market. Furthermore, at March 31, 2007, we had commitments for undrawn lines of credit of $292 million and loans in process of $43 million. We believe our current sources of funds will be adequate relative to these obligations.

The 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

					March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)					2007			2006			2006			2006			2006

Investment Portfolio
Loans originated:
	Loans secured by real estate:
		Residential one-to-four units:
			Adjustable		$	260,893		$	313,226		$	473,072		$	729,413		$	1,517,610
			Adjustable – fixed for 3-5 years			342,005			241,347			290,397			392,126			189,385
			Fixed			-			-			-			-			155

				Total residential one-to-four units		602,898			554,573			763,469			1,121,539			1,707,150
		Home equity loans and lines of credit				2,812			3,018			6,388			8,313			8,793
		Residential five or more units – adjustable				435			-			560			525			68,583

			Total residential			606,145			557,591			770,417			1,130,377			1,784,526
		Commercial real estate				-			-			-			-			630
		Construction				12,897			1,730			7,516			4,458			19,863
		Land				-			71			313			33,903			15,102
	Non-mortgage:
		Commercial				-			-			-			-			-
		Consumer				1,356			1,786			967			1,860			699

			Total loans originated			620,398			561,178			779,213			1,170,598			1,820,820
Residential one-to-four unit loans purchased						-			-			1,277			8,176			12,218

	Total loans originated and purchased					620,398			561,178			780,490			1,178,774			1,833,038
Loan repayments						(1,560,187	)		(1,661,536	)		(1,563,517	)		(1,596,002	)		(1,393,957	)
Other net changes ^(a)						74,542			95,784			74,266			70,033			71,575

	Increase (decrease) in loans held for investment, net					(865,247	)		(1,004,574	)		(708,761	)		(347,195	)		510,656

Sale Portfolio
Residential one-to-four unit loans:
	Originated					631,268			778,519			823,656			890,191			979,000
	Purchased					9,401			483			416			2,123			1,164
Loans transferred to the investment portfolio ^(a)						(16,234	)		(22,819	)		(10,722	)		(6,782	)		(3,840	)
Originated whole loans sold						(430,739	)		(474,578	)		(699,664	)		(751,702	)		(662,306	)
Loans exchanged for mortgage-backed securities						(283,691	)		(239,396	)		(203,492	)		(276,292	)		(213,980	)
Capitalized basis adjustment ^(b)						(754	)		(270	)		815			1,254			(1,066	)
Other net changes ^(c)						(4,604	)		(2,152	)		(5,272	)		(2,612	)		(1,949	)

	Increase (decrease) in loans held for sale, net					(95,353	)		39,787			(94,263	)		(143,820	)		97,023

Mortgage-backed securities, net:
	Received in exchange for loans					283,691			239,396			203,492			276,292			213,980
	Sold					(283,691	)		(239,396	)		(203,492	)		(276,292	)		(213,980	)
	Repayments					(135	)		(6	)		(6	)		(8	)		(6	)
	Other net changes					1			-			-			-			-

		Decrease in mortgage-backed securities
			available for sale			(134	)		(6	)		(6	)		(8	)		(6	)

		Increase (decrease) in loans held for sale and
			mortgage-backed securities available for sale			(95,487	)		39,781			(94,269	)		(143,828	)		97,017

		Total increase (decrease) in loans and
			mortgage-backed securities, net		$	(960,734	)	$	(964,793	)	$	(803,030	)	$	(491,023	)	$	607,673

^(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) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding.
^(c) Primarily included repayments and the change in net deferred costs and premiums.

Page 33

Navigation Links

The following table sets forth the composition of our loan and mortgage-backed securities portfolios at the dates indicated.

				March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)				2007			2006			2006			2006			2006

Investment Portfolio
Loans secured by real estate:
	Residential one-to-four units:
		Adjustable		$	10,715,218		$	11,786,038		$	12,896,352		$	13,774,904		$	14,375,672
		Adjustable – fixed for 3-5 years			1,639,381			1,397,516			1,240,644			1,017,059			724,442
		Fixed			49,421			43,450			46,209			47,516			50,615

			Total residential one-to-four units		12,404,020			13,227,004			14,183,205			14,839,479			15,150,729
	Home equity loans and lines of credit				168,442			187,939			211,713			232,746			250,804
	Residential five or more units:
		Adjustable			109,330			112,580			115,174			117,060			134,340
		Fixed			898			908			936			1,040			1,092
	Commercial real estate:
		Adjustable			23,580			23,943			24,117			24,254			25,967
		Fixed			2,716			2,757			2,793			2,837			2,879
	Construction				61,955			52,922			58,157			67,609			78,095
	Land				58,795			58,910			59,394			59,682			27,379
Non-mortgage:
	Commercial				2,200			2,400			3,400			3,400			3,481
	Consumer				6,143			6,778			6,073			6,303			6,658

		Total loans held for investment			12,838,079			13,676,141			14,664,962			15,354,410			15,681,424
Increase (decrease) for:
	Undisbursed loan funds				(43,709	)		(40,208	)		(48,635	)		(58,390	)		(59,222	)
	Net deferred costs and premiums				208,425			232,294			256,315			275,797			290,116
	Allowance for losses				(60,758	)		(60,943	)		(60,784	)		(51,198	)		(44,504	)

		Total loans held for investment, net			12,942,037			13,807,284			14,811,858			15,520,619			15,867,814

Sale Portfolio
Loans held for sale:
	Residential one-to-four units				266,162			358,128			318,414			411,086			556,365
	Net deferred costs and premiums				2,156			4,789			4,445			6,851			6,646
	Capitalized basis adjustment ^(a)				(456	)		298			569			(246	)		(1,500	)

		Total loans held for sale, net			267,862			363,215			323,428			417,691			561,511
Mortgage-backed securities available for sale:
	Adjustable				117			251			257			263			271
	Fixed				-			-			-			-			-

		Total mortgage-backed securities available for sale			117			251			257			263			271

		Total loans held for sale and mortgage-backed
			securities available for sale		267,979			363,466			323,685			417,954			561,782

		Total loans and mortgage-backed securities, net		$	13,210,016		$	14,170,750		$	15,135,543		$	15,938,573		$	16,429,596

^(a) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding.

We carry loans for sale at the lower of cost or fair value. At March 31, 2007, 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 March 31, 2007, was essentially equal to our cost basis.

Page 34

Navigation Links

Investment Securities

The following table sets forth the composition of our investment securities portfolios at the dates indicated.

			March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)			2007		2006		2006		2006		2006

Federal funds			$	-	$	1	$	1	$	2	$	-
Investment securities available for sale:
	U.S. Treasury			-		-		-		-		-
	Government sponsored entities			1,411,196		1,433,113		1,162,551		892,109		730,338
	Other			62		63		63		63		64

		Total investment securities	$	1,411,258	$	1,433,177	$	1,162,615	$	892,174	$	730,402

The fair value of temporarily impaired investment securities, the amount of unrealized losses and the length of time these unrealized losses existed as of March 31, 2007 are presented in the following table. The $1 million unrealized loss on investment securities that have been in a loss position for less than 12 months and the $3 million unrealized loss on investment securities that have been in a loss position for more than 12 months are due to changes in market interest rates and are not considered to be other than temporary. We have the intent and ability to hold the securities until that temporary impairment is eliminated.

			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			599,196		804		661,943		2,621		1,261,139		3,425
	Other			-		-		-		-		-		-

		Total temporarily impaired securities	$	599,196	$	804	$	661,943	$	2,621	$	1,261,139	$	3,425

The following table sets forth the maturities of our investment securities and their weighted average yields at March 31, 2007.

				Amount Due as of March 31, 2007

				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				$	-		$	-		$	-		$	-		$	-
	Weighted average yield				-	%		-	%		-	%		-	%		-	%
Investment securities available for sale:
	U.S. Treasury				-			-			-			-			-
		Weighted average yield			-	%		-	%		-	%		-	%		-	%
	Government sponsored entities ^(a)				41,531			987,680			381,985			-			1,411,196
		Weighted average yield			4.24	%		5.56	%		5.01	%		-	%		5.37	%
	Other				-			-			-			62			62
		Weighted average yield			-	%		-	%		-	%		6.25	%		6.25	%

		Total investment securities		$	41,531		$	987,680		$	381,985		$	62		$	1,411,258
			Weighted average yield		4.24	%		5.56	%		5.01	%		6.25	%		5.37	%

^(a) At March 31, 2007, 35% of our investment securities had step-up provisions that stipulate increases in the coupon rate ranging from 0.50% to 2.00% at various specified dates ranging from June 2007 to December 2012. In addition, at March 31, 2007, all of these investment securities contained call provisions from April 2007 to August 2015. 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.

Page 35

Navigation Links

Deposits

At March 31, 2007, our deposits totaled $11.6 billion, down $551 million or 4.5% from the year-ago level and $137 million or 1.2% from year-end 2006. Compared with the year-ago period, our transaction accounts (i.e., checking, money market and regular passbook) declined $384 million or 12.4% due to a decline of $425 million in regular passbook accounts. Given the relatively low level of interest rates in prior periods, certain of our depositors moved monies from certificates of deposit to transaction accounts, primarily regular passbook accounts, as they seemed more interested in liquidity. As market interest rates have risen, monies have flowed back into certificates of deposit. Checking accounts have increased $54 million or 4.2% from a year ago.

During the current quarter, one traditional branch was opened. This brings our total number of branches to 173, of which 91 were in-store and four were located in Arizona. At March 31, 2007, the average deposit size of our 82 traditional branches was $112 million, while the average deposit size of our 91 in-store branches was $27 million.

The following table sets forth information concerning our deposits and weighted average rates paid at the dates indicated.

				March 31, 2007				December 31, 2006				September 30, 2006				June 30, 2006				March 31, 2006

				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		-	%	$	831,708	-	%	$	769,086	-	%	$	776,696	-	%	$	751,446	-	%	$	758,055
	Interest-bearing
		checking ^(a)		0.28			505,975	0.28			493,620	0.28			486,226	0.29			497,313	0.29			525,564
	Money market			1.05			153,291	1.04			148,448	1.04			147,812	1.05			162,213	1.05			166,496
	Regular passbook			0.95			1,227,664	0.97			1,269,420	0.98			1,355,595	1.00			1,483,890	1.02			1,652,549

		Total transaction
			accounts	0.54			2,718,638	0.57			2,680,574	0.58			2,766,329	0.62			2,894,862	0.65			3,102,664
Certificates of deposit:
	Less than 2.00%			1.30			24,106	1.29			22,566	1.28			22,484	1.31			29,690	1.49			47,149
	2.00-2.49			2.29			686	2.29			686	2.46			11,567	2.37			24,559	2.37			81,014
	2.50-2.99			2.80			11,062	2.80			25,375	2.84			51,185	2.87			92,839	2.81			159,742
	3.00-3.49			3.29			99,309	3.30			128,294	3.27			153,871	3.28			176,414	3.34			368,255
	3.50-3.99			3.89			144,544	3.89			237,155	3.87			267,610	3.89			1,190,947	3.86			2,681,838
	4.00-4.49			4.25			271,609	4.31			692,386	4.26			1,574,479	4.24			3,765,400	4.23			4,422,839
	4.50-4.99			4.90			4,235,873	4.82			2,722,829	4.74			3,340,812	4.72			3,408,252	4.68			1,320,831
	5.00-5.49			5.17			3,871,787	5.19			5,008,378	5.20			3,514,530	5.08			304,776	5.07			14,571
	5.50 and greater			5.55			269,817	5.54			266,626	5.54			242,891	-			-	-			-

		Total certificates
			of deposit	4.97			8,928,793	4.94			9,104,295	4.78			9,179,429	4.36			8,992,877	4.10			9,096,239

			Total deposits	3.94	%	$	11,647,431	3.95	%	$	11,784,869	3.81	%	$	11,945,758	3.45	%	$	11,887,739	3.22	%	$	12,198,903

^(a) Included amounts swept into money market deposit accounts.

Page 36

Navigation Links

Borrowings

At March 31, 2007, our borrowings totaled $2.0 billion, down $2.0 billion from a year ago and $766 million from year-end 2006. At quarter end, we borrowed $547 million of funds through transactions in which securities are sold under agreements to repurchase. These repurchase agreements are entered into with selected major securities dealers, using securities of government sponsored entities from our portfolio as collateral.

The following table sets forth information concerning our FHLB advances and other borrowings at the dates indicated.

		March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)		2007			2006			2006			2006			2006

Securities sold under agreements to repurchase		$	546,870		$	469,971		$	463,678		$	255,042		$	-
Federal Home Loan Bank advances ^(a)			1,298,197			2,140,785			2,680,546			3,499,450			3,825,811
Senior notes			198,305			198,260			198,216			198,172			198,129

	Total borrowings	$	2,043,372		$	2,809,016		$	3,342,440		$	3,952,664		$	4,023,940

Weighted average rate on borrowings during
	the quarter ^(a)		5.86	%		5.77	%		5.71	%		5.33	%		4.92	%
Total borrowings as a percentage of total assets			13.41			17.33			19.68			22.63			22.60

^(a) 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.

Off-Balance Sheet Arrangements

We 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 also 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 38 and Note 3 of Notes to the Consolidated Financial Statements on page 8.

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 troubled loans or problem 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.

Page 37

Navigation Links

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 government-sponsored enterprises and whole loan sale contracts with various parties. These contracts are typically obtained at 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.

Changes 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 38

Navigation Links

One 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 March 31, 2007, 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. We assume prepayment rates on substantially all of our loan portfolio based upon our historical loan prepayment experience to anticipate future prepayments. 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.

					March 31, 2007

								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)				$	859,672		$	237,260		$	440,451		$	-		$	-		$	1,537,383
	Loans and mortgage-backed securities, net: ^(b)
		Loans secured by real estate:
			Residential one-to-four units:
				Adjustable		11,231,923			319,673			1,078,964			-			-			12,630,560
				Fixed		150,040			4,091			22,132			11,945			6,529			194,737
			Home equity loans and lines of credit			166,639			133			692			85			-			167,549
			Residential five or more units:
				Adjustable		71,118			17,091			6,687			-			-			94,896
				Fixed		100			94			461			193			43			891
			Commercial real estate			18,173			2,749			4,491			25			-			25,438
			Construction			42,246			-			-			-			-			42,246
			Land			46,600			-			-			-			-			46,600
		Non-mortgage loans:
			Commercial			1,128			-			-			-			-			1,128
			Consumer			5,851			3			-			-			-			5,854
		Mortgage-backed securities				117			-			-			-			-			117

	Total loans and mortgage-backed securities, net					11,733,935			343,834			1,113,427			12,248			6,572			13,210,016

		Total interest-earning assets			$	12,593,607		$	581,094		$	1,553,878		$	12,248		$	6,572		$	14,747,399

Transaction accounts:
	Non-interest-bearing checking				$	831,708		$	-		$	-		$	-		$	-		$	831,708
	Interest-bearing checking ^(c)					505,975			-			-			-			-			505,975
	Money market ^(d)					153,291			-			-			-			-			153,291
	Regular passbook ^(d)					1,227,664			-			-			-			-			1,227,664

		Total transaction accounts				2,718,638			-			-			-			-			2,718,638
Certificates of deposit ^(e)						6,697,300			1,843,902			387,591			-			-			8,928,793

	Total deposits					9,415,938			1,843,902			387,591			-			-			11,647,431
FHLB advances and other borrowings						1,426,870			-			418,197			-			-			1,845,067
Senior notes						-			-			-			198,305			-			198,305
Impact of swap contracts hedging borrowings						430,000			-			(430,000	)		-			-			-

	Total deposits and borrowings				$	11,272,808		$	1,843,902		$	375,788		$	198,305		$	-		$	13,690,803

Excess (shortfall) of interest-earning assets
	over deposits and borrowings				$	1,320,799		$	(1,262,808	)	$	1,178,090		$	(186,057	)	$	6,572		$	1,056,596
Cumulative gap						1,320,799			57,991			1,236,081			1,050,024			1,056,596
Cumulative gap – as a percentage of total assets:
	March 31, 2007					8.67	%		0.38	%		8.11	%		6.89	%		6.93	%
	December 31, 2006					10.86			0.92			8.29			7.14			7.18
	March 31, 2006					19.61			8.60			7.27			6.24			6.29

^(a) Includes FHLB stock and is based on contractual maturity and repricing date.
^(b) Based on contractual maturity, repricing date and projected repayment and prepayments of principal.
^(c) Included amounts swept into money market deposit accounts and is subject to immediate repricing.
^(d) Subject to immediate repricing.
^(e) Based on contractual maturity and repricing date.

Page 39

Navigation Links

Our six-month gap at March 31, 2007 was a positive 8.67%. This means that more interest-earning assets mature or reprice within six months than total deposits and borrowings. This compares to our positive six-month gap of 10.86% at December 31, 2006 and 19.61% a year ago, which reflected a larger repricing mismatch between interest-earning assets and deposits and borrowings.

We continue to emphasize the origination of adjustable rate mortgages for our investment portfolio. For the twelve months ended March 31, 2007, we originated and purchased for investment $3.1 billion of adjustable rate loans which represented essentially all of the loans we originated and purchased for investment during the period.

At March 31, 2007, December 31, 2006 and March 31, 2006 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 $12.8 billion at March 31, 2007, compared with $13.6 billion at December 31, 2006 and $15.6 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.

				March 31,		December 31,		September 30,		June 30,		March 31,
				2007		2006		2006		2006		2006

Weighted average yield: ^(a)
	Loans and mortgage-backed securities			7.61	%	7.59	%	7.38	%	6.99	%	6.52	%
	Investment securities ^(b)			5.37		5.38		5.26		4.97		4.66

		Interest-earning assets yield		7.40		7.38		7.22		6.88		6.44

Weighted average cost:
	Deposits			3.94		3.95		3.81		3.45		3.22
	Borrowings:
		Securities sold under agreements to repurchase		5.29		5.30		5.27		5.30		-
		Federal Home Loan Bank advances ^(c)		6.15		5.87		5.75		5.57		4.94
		Senior notes		6.50		6.50		6.50		6.50		6.50

			Total borrowings	5.95		5.82		5.73		5.60		5.02

		Combined funds cost		4.24		4.31		4.23		3.99		3.67

			Interest rate spread	3.16	%	3.07	%	2.99	%	2.89	%	2.77	%

^(a) Excludes adjustments for non-accrual loans, amortization of net deferred costs to originate loans, premiums and discounts, prepayment and late fees and FHLB stock dividends.
^(b) 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 increased to 7.61% at March 31, 2007, up from 7.59% at December 31, 2006 and 6.52% a year ago. At March 31, 2007, our adjustable rate mortgage portfolio of single family residential loans, including mortgage-backed securities, totaled $12.6 billion with a weighted average rate of 7.60%, compared with $13.5 billion with a weighted average rate of 7.56% at December 31, 2006, and $15.6 billion with a weighted average rate of 6.48% at March 31, 2006.

Page 40

Navigation Links

Problem Loans and Real Estate

Non-Performing Assets

Non-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. Our non-performing assets totaled $143 million at March 31, 2007, up from $110 million at December 31, 2006 and $39 million at March 31, 2006. The increase in our non-performing assets during the current quarter was primarily due to an increase in our residential one-to-four unit category of $25 million. The non-performing land category consists of a single loan to develop residential lots. While this loan is deemed collateral dependent and value impaired, no significant loss is anticipated at this time. Of the total non-performing assets, real estate acquired in settlement of loans represented $17 million at March 31, 2007, up from $9 million at December 31, 2006 and less than $1 million at March 31, 2006. Our non-performing assets as a percentage of total assets was 0.94% at March 31, 2007, up from 0.68% at year-end 2006 and 0.22% at March 31, 2006.

The following table summarizes our non-performing assets at the dates indicated.

			March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)			2007			2006			2006			2006			2006

Non-accrual loans:
	Residential one-to-four units		$	114,833		$	90,218		$	60,461		$	38,074		$	38,503
	Land			11,345			11,345			-			-			-
	Other			28			275			306			-			1

		Total non-accrual loans		126,206			101,838			60,767			38,074			38,504
Real estate acquired in settlement of loans				17,212			8,524			5,761			1,254			385

	Total non-performing assets		$	143,418		$	110,362		$	66,528		$	39,328		$	38,889

Allowance for loan losses:
	Amount		$	60,758		$	60,943		$	60,784		$	51,198		$	44,504
	As a percentage of non-accrual loans			48.14	%		59.84	%		100.03	%		134.47	%		115.58	%
Non-performing assets as a percentage of total assets				0.94			0.68			0.39			0.23			0.22

At March 31, 2007, $26 million of our non-performing assets were located outside of California, compared with $10 million a year ago.

Delinquent Loans

At March 31, 2007, loans delinquent 30 days or more as a percentage of total loans was 1.32%, up from 1.03% at December 31, 2006 and 0.37% at March 31, 2006. The increase from the prior year-ago quarter occurred primarily in our residential one-to-four units and land classifications. As a percentage of its loan category, delinquent residential one-to-four units increased from 0.38% at March 31, 2006 and 1.05% at December 31, 2006 to 1.27% at March 31, 2007. A higher incidence of delinquency is expected when the minimum payments on our option ARM and hybrid ARM loans reset, particularly when our option ARM loans reach their maximum loan balance permitted under the terms of the loan. Our land delinquency category consists of a single loan to develop residential lots. While this loan is deemed collateral dependent and value impaired, no significant loss is anticipated at this time. These increases in delinquency are considered when we analyze the adequacy of our loan loss allowance.

Page 41

Navigation Links

The following table indicates the amounts of our past due loans at the dates indicated.

			March 31, 2007												December 31, 2006

			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	$	47,770		$	31,510		$	82,091		$	161,371		$	56,962		$	24,100		$	62,887		$	143,949
		Home equity loans and lines of credit		256			32			15			303			20			212			259			491
		Five or more units		-			-			-			-			-			-			-			-
	Commercial real estate			-			-			-			-			-			-			-			-
	Construction			-			-			-			-			-			-			-			-
	Land			-			-			11,345			11,345			-			-			-			-

		Total real estate loans		48,026			31,542			93,451			173,019			56,982			24,312			63,146			144,440
Non-mortgage:
	Commercial			-			-			-			-			-			-			-			-
	Consumer			6			50			13			69			60			1			16			77

		Total delinquent loans	$	48,032		$	31,592		$	93,464		$	173,088		$	57,042		$	24,313		$	63,162		$	144,517

Delinquencies as a percentage of total loans				0.37	%		0.24	%		0.71	%		1.32	%		0.41	%		0.17	%		0.45	%		1.03	%


			September 30, 2006												June 30, 2006

Loans secured by real estate:
	Residential:
		One-to-four units	$	42,522		$	20,872		$	37,214		$	100,608		$	28,007		$	11,877		$	23,879		$	63,763
		Home equity loans and lines of credit		-			173			297			470			400			-			-			400
		Five or more units		-			-			-			-			-			-			-			-
	Commercial real estate			-			-			-			-			-			-			-			-
	Construction			-			-			-			-			-			-			-			-
	Land			-			-			-			-			-			-			-			-

		Total real estate loans		42,522			21,045			37,511			101,078			28,407			11,877			23,879			64,163
Non-mortgage:
	Commercial			-			-			-			-			-			-			-			-
	Consumer			63			10			9			82			13			31			-			44

		Total delinquent loans	$	42,585		$	21,055		$	37,520		$	101,160		$	28,420		$	11,908		$	23,879		$	64,207

Delinquencies as a percentage of total loans				0.28	%		0.14	%		0.25	%		0.68	%		0.18	%		0.08	%		0.15	%		0.41	%


			March 31, 2006

Loans secured by real estate:
	Residential:
		One-to-four units	$	26,669		$	10,491		$	22,110		$	59,270
		Home equity loans and lines of credit		61			-			-			61
		Five or more units		-			-			-			-
	Commercial real estate			-			-			-			-
	Construction			-			-			-			-
	Land			-			-			-			-

		Total real estate loans		26,730			10,491			22,110			59,331
Non-mortgage:
	Commercial			-			-			-			-
	Consumer			61			6			1			68

		Total delinquent loans	$	26,791		$	10,497		$	22,111		$	59,399

Delinquencies as a percentage of total loans				0.17	%		0.06	%		0.14	%		0.37	%

^(a) All 90 day or greater delinquencies are on non-accrual status and reported as part of non-performing assets.

Page 42

Navigation Links

Allowance for Credit and Real Estate Losses

We maintain a valuation allowance for credit and real estate losses to provide for losses inherent in those portfolios. 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 an unallocated allowance. General valuation allowances relate to assets and loan-related commitments with no well-defined deficiency or weakness and take into consideration losses that are imbedded within the portfolio but have not yet been realized. Allocated allowances relate to assets with well-defined deficiencies or weaknesses. 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 unallocated allowance is more subjective and is reviewed quarterly to take into consideration estimation errors and economic trends that are not captured in determining the general valuation and allocated allowances.

Provision for credit losses totaled $0.6 million in the first quarter of 2007, compared with $10.1 million a year ago. The California residential real estate market continued to show signs of weakening, with a decline in prices and an increase in loan defaults. In addition, capitalized interest balances continued to increase on negative amortizing loans. If this tendency continues, certain borrowers may reach their limit of negative amortization permitted under the terms of their loan, thereby resulting in an increase in their minimum monthly loan payment and the potential for higher delinquencies. Despite these trends, an $823 million or 6.2% drop in the single-family residential loan portfolio in the current quarter mitigated the need to increase the associated allowance for loan losses. The allowance declined $0.1 million in the current quarter, reflecting a decrease of $4.9 million in the general valuation allowance and an increase of $4.8 million in the allocated allowance. At March 31, 2007, the allowance for credit losses was $62 million, comprised of $61 million for loan losses and $1 million for unfunded loan commitments virtually unchanged from year-end. Unfunded loan commitments are reported in the category accounts payable and accrued liabilities. There was no change in our unallocated allowance of $2.8 million.

The following table summarizes the activity in our allowance for losses on loans and loan-related commitments for the quarters indicated.

		Three Months Ended

		March 31,			December 31,			September 30,			June 30,			March 31,
(In Thousands)		2007			2006			2006			2006			2006

Allowance for loan losses
Balance at beginning of period		$	60,943		$	60,784		$	51,198		$	44,504		$	34,601
Provision			507			411			9,777			6,701			9,974
Charge-offs			(843	)		(376	)		(197	)		(12	)		(76	)
Recoveries			151			124			6			5			5

	Balance at end of period	$	60,758		$	60,943		$	60,784		$	51,198		$	44,504

Allowance for loan-related commitments
Balance at beginning of period		$	1,055		$	1,221		$	1,358		$	1,397		$	1,314
Provision (reduction)			110			(166	)		(137	)		(39	)		83

	Balance at end of period	$	1,165		$	1,055		$	1,221		$	1,358		$	1,397

Total allowance for credit losses
Balance at beginning of period		$	61,998		$	62,005		$	52,556		$	45,901		$	35,915
Provision			617			245			9,640			6,662			10,057
Charge-offs			(843	)		(376	)		(197	)		(12	)		(76	)
Recoveries			151			124			6			5			5

	Balance at end of period	$	61,923		$	61,998		$	62,005		$	52,556		$	45,901

Page 43

Navigation Links

The following table presents gross charge-offs, gross recoveries and net charge-offs by category of loan for the periods indicated.

				Three Months Ended

				March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)				2007			2006			2006			2006			2006

Gross loan charge-offs
Loans secured by real estate:
	Residential:
		One-to-four units		$	823		$	358		$	166		$	-		$	25
		Home equity loans and lines of credit			-			-			-			-			-
		Five or more units			-			-			-			-			-
	Commercial real estate				-			-			-			-			-
	Construction				-			-			-			-			-
	Land				-			-			-			-			-
Non-mortgage:
	Commercial				-			-			-			-			-
	Consumer				20			18			31			12			51

		Total gross loan charge-offs			843			376			197			12			76

Gross loan recoveries
Loans secured by real estate:
	Residential:
		One-to-four units			150			120			-			-			-
		Home equity loans and lines of credit			-			-			-			-			-
		Five or more units			-			-			-			-			-
	Commercial real estate				-			-			-			-			-
	Construction				-			-			-			-			-
	Land				-			-			-			-			-
Non-mortgage:
	Commercial				-			-			-			-			-
	Consumer				1			4			6			5			5

		Total gross loan recoveries			151			124			6			5			5

Net loan charge-offs
	(recoveries)
Loans secured by real estate:
	Residential:
		One-to-four units			673			238			166			-			25
		Home equity loans and lines of credit			-			-			-			-			-
		Five or more units			-			-			-			-			-
	Commercial real estate				-			-			-			-			-
	Construction				-			-			-			-			-
	Land				-			-			-			-			-
Non-mortgage:
	Commercial				-			-			-			-			-
	Consumer				19			14			25			7			46

			Total net loan charge-offs	$	692		$	252		$	191		$	7		$	71

Net loan charge-offs as a percentage
	of average loans				0.02	%		0.01	%		-	%		-	%		-	%

Page 44

Navigation Links

The following table indicates our allocation of the allowance for loan losses to the various categories of loans at the dates indicated.

			March 31,		December 31,		September 30,		June 30,		March 31,
(Dollars in Thousands)			2007		2006		2006		2006		2006

Loans secured by real estate:
	Residential:
		One-to-four units	$	53,931	$	53,918	$	53,918	$	44,518	$	37,874
		Home equity loans and lines of credit		857		999		1,124		1,192		1,288
		Five or more units		1,006		1,030		1,049		1,064		1,194
	Commercial real estate			266		267		302		304		298
	Construction			574		581		454		455		487
	Land			1,025		1,016		838		570		251
Non-mortgage:
	Commercial			11		14		14		14		16
	Consumer			288		318		285		281		296
Not specifically allocated				2,800		2,800		2,800		2,800		2,800

		Total for loans held for investment	$	60,758	$	60,943	$	60,784	$	51,198	$	44,504

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.

			March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)			2007			2006			2006			2006			2006

Loans secured by real estate:
	Residential:
		One-to-four units		0.43	%		0.41	%		0.38	%		0.30	%		0.25	%
		Home equity loans and lines of credit		0.51			0.53			0.53			0.51			0.51
		Five or more units		0.91			0.91			0.90			0.90			0.88
	Commercial real estate			1.01			1.00			1.12			1.12			1.03
	Construction			0.93			1.10			0.78			0.67			0.62
	Land			1.74			1.72			1.41			0.96			0.92
Non-mortgage:
	Commercial			0.50			0.58			0.41			0.41			0.46
	Consumer			4.69			4.70			4.69			4.46			4.45

		Total for loans held for investment		0.47	%		0.45	%		0.41	%		0.33	%		0.28	%

The following table indicates by loan category the percentage mix of our total loans held for investment at the dates indicated.

			March 31,			December 31,			September 30,			June 30,			March 31,
(Dollars in Thousands)			2007			2006			2006			2006			2006

Loans secured by real estate:
	Residential:
		One-to-four units		96.62	%		96.71	%		96.72	%		96.65	%		96.62	%
		Home equity loans and lines of credit		1.31			1.37			1.44			1.51			1.60
		Five or more units		0.86			0.83			0.79			0.77			0.86
	Commercial real estate			0.20			0.20			0.18			0.18			0.18
	Construction			0.48			0.39			0.40			0.44			0.50
	Land			0.46			0.43			0.41			0.39			0.18
Non-mortgage:
	Commercial			0.02			0.02			0.02			0.02			0.02
	Consumer			0.05			0.05			0.04			0.04			0.04

		Total for loans held for investment		100.00	%		100.00	%		100.00	%		100.00	%		100.00	%

At March 31, 2007, the recorded investment in loans for which we recognized impairment totaled $12 million, up from $11 million at December 31, 2006 and no loans at March 31, 2006. The allowance for losses related to these loans was less than $1 million at March 31, 2007 and December 31, 2006, with no allowance for losses at March 31, 2006. During the current quarter there was no interest recognized on the impaired loan portfolio.

Page 45

Navigation Links

The following table summarizes the activity in our allowance for credit losses associated with impaired loans for the quarters indicated.

		Three Months Ended

		March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)		2007		2006		2006		2006		2006

Balance at beginning of period		$	601	$	-	$	-	$	-	$	-
Provision			56		601		-		-		-
Charge-offs			-		-		-		-		-
Recoveries			-		-		-		-		-

	Balance at end of period	$	657	$	601	$	-	$	-	$	-

The following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the quarters indicated.

		Three Months Ended

		March 31,		December 31,		September 30,		June 30,		March 31,
(In Thousands)		2007		2006		2006		2006		2006

Balance at beginning of period		$	103	$	103	$	103	$	103	$	103
Provision			-		-		-		-		-
Charge-offs			-		-		-		-		-
Recoveries			-		-		-		-		-

	Balance at end of period	$	103	$	103	$	103	$	103	$	103

Capital Resources and Liquidity

Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, mortgage-backed securities and real estate; payments of loans and mortgage-backed securities 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 mortgage-backed securities and deposit inflows and outflows.

Our primary sources of funds generated in the first quarter of 2007 were from:

principal repayments of $1.3 billion on loans held for investment and mortgage-backed securities available for sale, including prepayments but excluding refinances of our existing loans;
maturities or calls of $128 million of U.S. Treasury, government sponsored entities and other investment securities available for sale; and
a net decline of $95 million in our loans held for sale.

We used these funds to:

reduce borrowings by $766 million;
originate and purchase $390 million of loans held for investment, excluding refinances of our existing loans;
absorb a $137 million reduction in deposits; and
purchase $100 million of investment securities of government sponsored entities available for sale.

Our principal source of liquidity is our ability to utilize borrowings, as needed. Our primary source of borrowings is the FHLB. At March 31, 2007, our FHLB borrowings totaled $1.3 billion, representing 8.5% of total assets. We currently are approved by the FHLB to borrow up to 50% of total assets to the extent we provide qualifying collateral and hold sufficient FHLB stock. That approved limit would have permitted us, as of quarter end, to borrow an additional $6.3 billion. To the extent deposit growth over the remainder of 2007 falls short of satisfying ongoing commitments to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans, make investments and continue branch improvement programs, we may utilize the additional capacity from our FHLB borrowing arrangement or other sources. As of March 31, 2007, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $630 million, of which $290 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 $335 million and operating leases of $18 million. We believe our current sources of funds, including repayments of existing loans, enable us to meet our obligations while maintaining liquidity at appropriate levels.

Page 46

Navigation Links

The holding company currently has adequate liquid assets to meet its obligations and can obtain further funds by means of dividends from subsidiaries, subject to certain limitations, or issuance of further debt or equity. As of March 31, 2007, the Bank had the capacity to declare a dividend totaling $366 million subject to filing an application with the Office of Thrift Supervision (“OTS”) at least 30 days prior to the distribution and the OTS approve the dividend. At March 31, 2007, the holding company’s liquid assets, including due from Bank—interest bearing balances, totaled $99 million down from $108 million at the end of 2006.

Stockholders’ equity totaled $1.4 billion at March 31, 2007, up $46 million from December 31, 2006 and up $195 million from March 31, 2006.

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 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 do not represent future cash requirements. For further information, see Asset/Liability Management and Market Risk on page 38 and Note 3 of Notes to the Consolidated Financial Statements on page 8.

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 required us 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 three months of 2007, we recorded a $0.3 million repurchase or indemnification losses related to defects in the origination process and repurchased $9 million of loans. Included in the repurchased loans was $8 million of one-to-four single family residential loans from Fannie Mae, due to the loans being outside Fannie Mae’s underwriting guidelines.

These 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 March 31, 2007, December 31, 2006 and March 31, 2006 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 March 31, 2007, our maximum sales price premium refund would be $7.2 million. See Note 3 of Notes to the Consolidated Financial Statements on page 8.

Page 47

Navigation Links

At March 31, 2007, scheduled maturities of obligations and commitments were as follows:

					After 1		After 3
			Within		Through 3		Through 5		Beyond		Total
(In Thousands)			1 Year		Years		Years		5 Years		Balance

Certificates of deposit			$	8,541,202	$	280,898	$	106,693	$	-	$	8,928,793
Securities sold under agreements to repurchase				546,870		-		-		-		546,870
FHLB advances and other borrowings				880,000		418,197		-		-		1,298,197
Senior notes				-		-		-		198,305		198,305
Secondary marketing activities:
	Non-qualifying hedge transactions:
		Interest rate lock commitments ^(a)		224,546		-		-		-		224,546
		Associated loan forward sale contracts ^(a)		209,818		-		-		-		209,818
	Qualifying cash flow hedge transactions:
		Loans held for sale, at lower of cost or fair value		267,862		-		-		-		267,862
		Associated loan forward sale contracts ^(a)		254,260		-		-		-		254,260
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			340,849		-		-		-		340,849
Undisbursed loan funds and unused lines of credit				18,514		25,375		4,413		286,501		334,803
Operating leases				5,259		7,901		3,613		760		17,533

^(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 $290 million.

Regulatory Capital Compliance

The Bank’s core and tangible capital ratios were both 9.64% and its risk-based capital ratio was 19.57% at March 31, 2007. The Bank’s capital ratios compare favorably with the “well capitalized” standards of 5.00% for core capital and 10.00% for risk-based capital, as defined by regulation.

The following table is a reconciliation of the Bank’s stockholder’s equity to federal regulatory capital as of March 31, 2007.

				Tangible Capital						Core Capital					Risk-Based Capital

(Dollars in Thousands)				Amount			Ratio			Amount			Ratio		Amount			Ratio

Stockholder’s equity				$	1,540,947					$	1,540,947				$	1,540,947
Adjustments:
	Deductions:
		Investment in real estate subsidiary			(77,314	)					(77,314	)				(77,314	)
		Excess cost over fair value of branch acquisitions			(3,150	)					(3,150	)				(3,150	)
		Non-permitted mortgage servicing rights			(2,069	)					(2,069	)				(2,069	)
	Additions:
		Unrealized losses on investment securities
			available for sale		1,676						1,676					1,676
		Allowance for credit losses, net of specific
			allowances ^(a)		-						-					61,698

Regulatory capital					1,460,090		9.64	%			1,460,090		9.64	%		1,521,788		19.57	%
Well capitalized requirement					227,291		1.50		^(b)		757,636		5.00			777,740		10.00		^(c)

Excess				$	1,232,799		8.14	%		$	702,454		4.64	%	$	744,048		9.57	%

^(a) Limited to 1.25% of risk-weighted assets.
^(b) Represents the minimum requirement for tangible capital, as no “well capitalized” requirement has been established for this category.
^(c) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%, which the Bank met and exceeded with a ratio of 18.77%.

Page 48

Navigation Links

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For information regarding quantitative and qualitative disclosures about market risk, see Asset/Liability Management and Market Risk on page 38.

ITEM 4. – CONTROLS AND PROCEDURES

As of March 31, 2007, 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 changes during the most recent fiscal quarter in Downey’s internal controls over financial reporting that has materially affected, or is reasonably likely to materially affect Downey’s internal controls over financial reporting.

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, including subsidiaries, is made known to management, including the Chief Executive Officer and Chief Financial Officer, in a timely manner.

Page 49

Navigation Links

PART II – OTHER INFORMATION

ITEM 1. – Legal Proceedings

ITEM 1A. – Risk Factors

There have been no other material changes in our risk factors since December 31, 2006, except that the IRS may assert a $9.2 million penalty (including penalty interest) against Downey related to its 2004 tax return. Downey has determined it is unlikely any such penalty would be sustained and it would vigorously contest any penalty that would be proposed. See Note (4) – Income Taxes on page 12 and Note (9) – Adjustment of Prior and Beginning Period Amounts on page 15 of Notes to Consolidated Financial Statements.

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

ITEM 5. – Other Information

None.

Page 50

Navigation Links

ITEM 6. – Exhibits

Exhibit

Number

Description

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.

AVAILABILITY OF REPORTS

Corporate 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, 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 Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

DOWNEY FINANCIAL CORP.

/s/ Daniel D. Rosenthal

Date: May 4, 2007

Daniel D. Rosenthal

President and Chief Executive Officer

/s/ Brian E. Côté

Date: May 4, 2007

Brian E. Côté

Chief Financial Officer

Page 51

Navigation Links

NAVIGATION LINKS