Securities and Exchange Commission Form 10-Q dated September 30, 2008

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)

þ

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

For the quarterly period ended September 30, 2008

OR

o 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  þ    No  o

          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

  Large accelerated filer  þ   Accelerated filer  o  
  Non-accelerated filer  o (Do not check if a smaller reporting company)   Smaller reporting company o  

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

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


Page
Navigation Links

DOWNEY FINANCIAL CORP.

September 30, 2008 QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

ITEM 1. –

FINANCIAL STATEMENTS           

1

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

1

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

September 30, 2008 and 2007          

2

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

September 30, 2008 and 2007          

3

Consolidated Statements of Cash Flows for the nine months ended

September 30, 2008 and 2007          

4

Notes To Consolidated Financial Statements           

6

ITEM 2. –

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

27

ITEM 3. –

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK           

75

ITEM 4. –

CONTROLS AND PROCEDURES           

75

PART II – OTHER INFORMATION

ITEM 1. –

LEGAL PROCEEDINGS           

76

ITEM 1A. –

RISK FACTORS           

77

ITEM 2. –

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS           

80

ITEM 3. –

DEFAULTS UPON SENIOR SECURITIES           

80

ITEM 4. –

SUBMISSION OF MATTERS TO A VOTE OF SECURITIY HOLDERS           

80

ITEM 5. –

OTHER INFORMATION           

81

ITEM 6. –

EXHIBITS           

81

AVAILABILITY OF REPORTS           

82

SIGNATURES           

82


Page i
Navigation Links

PART I – FINANCIAL INFORMATION

ITEM 1. – FINANCIAL STATEMENTS

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)

September 30,

December 31,

September 30,

(Dollars in Thousands, Except Per Share Data)

2008

2007

2007


Assets

Cash

$

451,815

$

83,840

$

86,072

Federal funds and interest earning due from banks

101,129

5,900

1,551


Cash and cash equivalents

552,944

89,740

87,623

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

securities available for sale, at fair value

592,542

1,549,879

2,142,278

Loans held for sale, at lower of cost or fair value

7,673

103,384

90,228

Mortgage-backed securities available for sale, at fair value

104

111

112

Loans held for investment

11,511,330

11,381,327

11,744,063

Allowance for loan losses

(761,824

)

(348,167

)

(142,218

)


Loans held for investment, net

10,749,506

11,033,160

11,601,845

Investments in real estate and joint ventures

15,606

68,679

58,715

Real estate acquired in settlement of loans, net

278,091

115,623

59,773

Premises and equipment, net

113,663

115,846

117,535

Federal Home Loan Bank stock, at cost

133,255

70,964

70,058

Mortgage servicing rights:

Measured at fair value

22,814

-

-

Amortized

-

19,512

21,849

Other assets

161,884

113,761

130,889

Income tax receivable

133,852

6,312

27,900

Deferred tax asset

19,265

122,086

8,912


$

12,781,199

$

13,409,057

$

14,417,717


Liabilities and Stockholders’ Equity

Deposits

$

9,618,384

$

10,496,041

$

10,662,618

Securities sold under agreements to repurchase

-

-

566,350

Federal Home Loan Bank advances

2,110,061

1,197,100

1,308,867

Senior notes

198,593

198,445

198,398

Accounts payable and accrued liabilities

82,447

183,054

237,258


Total liabilities

12,009,485

12,074,640

12,973,491


Stockholders’ equity

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

outstanding none

-

-

-

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

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

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

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

September 30, 2007

291

282

282

Additional paid-in capital

93,835

93,792

93,792

Accumulated other comprehensive income (loss)

(6,231

)

2,768

388

Retained earnings

683,819

1,254,367

1,366,556

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

September 30, 2007

-

(16,792

)

(16,792

)


Total stockholders’ equity

771,714

1,334,417

1,444,226


$

12,781,199

$

13,409,057

$

14,417,717


See accompanying notes to consolidated financial statements.

Page 1
Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income (Loss) (unaudited)

Three Months Ended

Nine Months Ended

September 30,

September 30,


(Dollars in Thousands, Except Per Share Data)

2008

2007

2008

2007


Interest income

Loans

$

154,479

$

208,314

$

493,193

$

690,869

U.S. Treasury and government sponsored entities securities

12,977

26,350

49,330

65,644

Mortgage-backed securities

2

3

8

9

Other investment securities

1,610

1,207

3,713

5,396


Total interest income

169,068

235,874

546,244

761,918


Interest expense

Deposits

67,726

108,514

243,047

333,977

Federal Home Loan Bank advances and other borrowings

22,010

26,088

50,601

83,494

Senior notes

3,305

3,302

9,913

9,904


Total interest expense

93,041

137,904

303,561

427,375


Net interest income

76,027

97,970

242,683

334,543

Provision for credit losses

130,291

81,562

626,035

91,684


Net interest income (loss) after provision for credit losses

(54,264

)

16,408

(383,352

)

242,859


Other income, net

Loan and deposit related fees

8,152

8,913

24,595

27,087

Real estate and joint ventures held for investment, net

(10,749

)

(7,892

)

(16,625

)

(7,527

)

Net gain on sale of real estate related contracts

69,972

-

69,972

-

Secondary marketing activities:

Loan servicing income (loss), net

(56

)

(294

)

2,724

(1,519

)

Net gains on sales of loans and mortgage-backed securities

677

2,506

6,898

20,224

Net gains on sales of investment securities

-

-

837

-

Other

219

(197

)

817

(16

)


Total other income, net

68,215

3,036

89,218

38,249


Operating expense

Salaries and related costs

37,611

36,699

118,197

119,931

Premises and equipment costs

9,224

9,736

27,402

27,667

Advertising expense

1,473

1,400

2,750

4,469

Deposit insurance premiums and regulatory assessments

8,117

2,413

15,509

7,659

Professional fees

3,000

489

4,146

1,779

Impairment writedown of goodwill

-

-

3,149

-

Other general and administrative expense

11,802

8,275

29,256

24,271


Total general and administrative expense

71,227

59,012

200,409

185,776

Net operation of real estate acquired in settlement of loans

31,428

3,664

79,763

4,903


Total operating expense

102,655

62,676

280,172

190,679


Income (loss) before income taxes (tax benefits)

(88,704

)

(43,232

)

(574,306

)

90,429

Income taxes (tax benefits)

(7,634

)

(19,871

)

(26,620

)

38,183


Net income (loss)

$

(81,070

)

$

(23,361

)

$

(547,686

)

$

52,246


Per share information

Basic

$

(2.89

)

$

(0.84

)

$

(19.64

)

$

1.87

Diluted

$

(2.89

)

$

(0.84

)

$

(19.64

)

$

1.87

Cash dividends declared and paid

$

0.01

$

0.12

$

0.25

$

0.36

Weighted average shares outstanding

Basic

27,960,478

27,853,783

27,889,608

27,853,783

Diluted

27,960,478

27,853,783

27,889,608

27,882,804


See accompanying notes to consolidated financial statements.

Page 2
Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss) (unaudited)

Three Months Ended

Nine Months Ended

September 30,

September 30,


(In Thousands)

2008

2007

2008

2007


Net income (loss)

$

(81,070

)

$

(23,361

)

$

(547,686

)

$

52,246


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

(6,054

)

6,644

(9,113

)

5,926

Mortgage-backed securities available for sale, at fair value

-

1

-

1

Unrealized gains (losses) on cash flow hedges:

Net derivative instruments

(175

)

(216

)

(390

)

609

Reclassification of realized amounts included in net income

302

27

504

(944

)


Total other comprehensive income (loss), net of income tax benefits

(5,927

)

6,456

(8,999

)

5,592


Comprehensive income (loss)

$

(86,997

)

$

(16,905

)

$

(556,685

)

$

57,838


See accompanying notes to consolidated financial statements.

Page 3
Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

Nine Months Ended

September 30,


(In Thousands)

2008

2007


Cash flows from operating activities

Net income (loss)

$

(547,686

)

$

52,246

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

Depreciation

10,744

10,811

Amortization

10,963

79,541

Impairment writedown of goodwill

3,149

-

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

real estate and joint ventures, mortgage servicing rights,

real estate acquired in settlement of loans, and other assets

699,465

94,833

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

investment securities, real estate and other assets

(84,947

)

(21,952

)

Interest capitalized on loans (negative amortization)

(74,013

)

(199,382

)

Changes in fair value of mortgage servicing rights due to:

Changes in valuation model inputs or assumptions

(536

)

-

Other changes

2,095

-

Federal Home Loan Bank stock dividends

(3,142

)

(5,185

)

Loans originated or purchased for sale

(596,374

)

(1,380,371

)

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

as mortgage-backed securities

687,875

1,635,997

Other, net

(157,175

)

(196,610

)


Net cash provided by (used for) operating activities

(49,582

)

69,928


Cash flows from investing activities

Proceeds from:

Sales of wholly owned real estate and real estate acquired in settlement of loans

204,122

20,560

Real estate related contracts

69,972

-

Redemption of Federal Home Loan Bank stock

2,400

95,046

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

and other investment securities available for sale

14,958,610

276,200

Purchase of:

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

available for sale

(14,011,366

)

(825,030

)

Premises and equipment

(8,469

)

(17,134

)

Federal Home Loan Bank stock

(61,549

)

(6,967

)

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

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

September 30, 2007)

(1,744,354

)

(1,209,487

)

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

available for sale

1,120,183

3,457,620

Net change in undisbursed loan funds

(38,056

)

(36,655

)

Investments in real estate held for investment

(9,368

)

2,061

Other, net

2,171

4,293


Net cash provided by investing activities

$

484,296

$

1,760,507


See accompanying notes to consolidated financial statements.

Page 4
Navigation Links

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

Nine Months Ended

September 30,


(In Thousands)

2008

2007


Cash flows from financing activities

Net decrease in deposits

$

(877,657

)

$

(1,122,251

)

Proceeds from Federal Home Loan Bank advances and other borrowings

12,995,860

12,583,559

Repayments of Federal Home Loan Bank advances and other borrowings

(12,086,350

)

(13,326,330

)

Cash dividends

(6,962

)

(10,027

)

Other, net

3,599

7,371


Net cash provided by (used for) financing activities

28,490

(1,867,678

)


Net increase (decrease) in cash and cash equivalents

463,204

(37,243

)

Cash and cash equivalents at beginning of period

89,740

124,866


Cash and cash equivalents at end of period

$

552,944

$

87,623


Supplemental disclosure of cash flow information:

Interest paid

$

307,498

$

431,774

Income taxes paid

1,599

186,100

Income tax refund

(4,872

)

-

Supplemental disclosure of non-cash investing:

Loans transferred to held for investment from held for sale

7,177

26,417

Loans transferred from held for investment to held for sale

1,723

2,856

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

available for sale, purchased and not settled

-

150,000

Real estate acquired in settlement of loans

403,297

74,886

Loans to facilitate the sale of real estate acquired in settlement of loans

22,601

1,413


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 September 30, 2008, December 31, 2007 and September 30, 2007, the results of operations and comprehensive income (loss) for the three months and nine months ended September 30, 2008 and 2007, and changes in cash flows for the nine months ended September 30, 2008 and 2007. Certain prior period amounts have been reclassified to conform to the current period presentation.

          The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial statements and are in compliance with the instructions for Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial condition, results of operations, comprehensive income (loss) and cash flows. The information under the heading Management’s Discussion and Analysis of Financial Condition and Results of Operations presumes that the interim consolidated financial statements will be read in conjunction with Downey’s Annual Report on Form 10-K for the year ended December 31, 2007, which contains among other things, a description of the business, the latest audited consolidated financial statements and notes thereto, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2007 and for the year then ended. Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Part I.

NOTE (2) – Loans

          Loans are summarized as follows:

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Loans held for investment

Loans secured by real estate:

Residential:

One-to-four units

$

10,959,601

$

10,894,889

$

10,712,235

$

10,877,228

$

11,227,561

Home equity loans and lines of credit

132,907

131,531

133,338

138,305

143,948

Five or more units

204,172

121,403

100,374

100,963

104,672

Commercial real estate

29,838

22,633

24,749

26,427

26,598

Construction

97,907

105,991

74,730

81,098

58,231

Land

10,708

10,524

10,373

49,521

50,864

Non-mortgage:

Commercial

5,305

5,505

5,305

5,000

5,000

Consumer

5,993

5,823

5,934

5,989

6,057


Total loans held for investment

11,446,431

11,298,299

11,067,038

11,284,531

11,622,931

Increase (decrease) for:

Undisbursed loan funds and net

deferred costs and premiums

64,899

65,067

96,216

96,796

121,132

Allowance for losses

(761,824

)

(732,354

)

(546,751

)

(348,167

)

(142,218

)


Total loans held for investment, net

$

10,749,506

$

10,631,012

$

10,616,503

$

11,033,160

$

11,601,845


Loans held for sale

Residential one-to-four units

$

7,624

$

85,854

$

110,685

$

103,320

$

89,794

Net deferred costs and premiums

(16

)

(146

)

(362

)

(109

)

53

Capitalized basis adjustment (a)

65

(150

)

(1,070

)

173

381


Total loans held for sale, net

$

7,673

$

85,558

$

109,253

$

103,384

$

90,228


(a) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we included the fair value of MSRs in the fair value of the interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan Commitments Recorded at Fair Value Through Earnings.

          At September 30, 2008, approximately 90% of the real estate securing Downey’s loans was located in California. As a result, the value of the underlying collateral for a significant portion of our loans may be unfavorably impacted by adverse changes in the California economy and real estate market.

Page 6
Navigation Links

          The combined weighted average interest rate on loans held for investment and sale was 6.26% at September 30, 2008, 7.41% at December 31, 2007, and 7.45% at September 30, 2007. These rates exclude adjustments for non-accrual loans; amortization of net deferred costs to originate loans, premiums and discounts, troubled debt restructuring (“TDR”) yield adjustments; and prepayment and late fees.

          Most of Downey’s adjustable rate mortgages adjust the interest rate monthly and the payment amount annually. These monthly adjustable rate mortgages allow for negative amortization, which is the addition to loan principal of accrued interest that exceeds the required monthly loan payments. At September 30, 2008, loans subject to negative amortization represented 52% of Downey’s residential one-to-four unit adjustable rate portfolio held for investment, of which $318 million represented the amount of negative amortization included in the loan balance. This compares to 69% and $379 million, respectively, at December 31, 2007. During the third quarter of 2008, approximately 10% of our loan interest income represented negative amortization, down from 15% in the second quarter of 2008 and 26% from the year-ago third quarter.

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

Real

(In Thousands)

Estate

Commercial

Consumer

Total


Balance at June 30, 2007

$

68,794

$

11

$

302

$

69,107

Provision

81,356

1

78

81,435

TDR yield adjustment (a)

-

-

-

-

Charge-offs

(8,323

)

-

(45

)

(8,368

)

Recoveries

40

-

4

44


Balance at September 30, 2007

141,867

12

339

142,218

Provision

218,603

24

23

218,650

TDR yield adjustment (a)

(483

)

-

-

(483

)

Charge-offs

(12,185

)

-

(35

)

(12,220

)

Recoveries

-

-

2

2


Balance at December 31, 2007

347,802

36

329

348,167

Provision

237,052

3

32

237,087

TDR yield adjustment (a)

(1,461

)

-

-

(1,461

)

Charge-offs

(37,015

)

-

(28

)

(37,043

)

Recoveries

-

-

1

1


Balance at March 31, 2008

546,378

39

334

546,751

Provision

258,490

1

26

258,517

TDR yield adjustment (a)

(2,670

)

-

-

(2,670

)

Charge-offs

(70,219

)

-

(26

)

(70,245

)

Recoveries

-

-

1

1


Balance at June 30, 2008

731,979

40

335

732,354

Provision (reduction)

130,400

(5

)

35

130,430

TDR yield adjustment (a)

(3,352

)

-

-

(3,352

)

Charge-offs

(97,586

)

-

(27

)

(97,613

)

Recoveries

-

-

5

5


Balance at September 30, 2008

$

761,441

$

35

$

348

$

761,824


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.
Page 7
Navigation Links

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

Real

(In Thousands)

Estate

Commercial

Consumer

Total


Balance at December 31, 2006

$

60,611

$

14

$

318

$

60,943

Provision (reduction)

91,228

(2

)

95

91,321

TDR yield adjustment (a)

-

-

-

-

Charge-offs

(10,263

)

-

(81

)

(10,344

)

Recoveries

291

-

7

298


Balance at September 30, 2007

$

141,867

$

12

$

339

$

142,218


Balance at December 31, 2007

$

347,802

$

36

$

329

$

348,167

Provision (reduction)

625,942

(1

)

93

626,034

TDR yield adjustment (a)

(7,483

)

-

-

(7,483

)

Charge-offs

(204,820

)

-

(81

)

(204,901

)

Recoveries

-

-

7

7


Balance at September 30, 2008

$

761,441

$

35

$

348

$

761,824


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

          During the current quarter, our provision for loan losses totaled $130.4 million, up $49.0 million from a year ago. The increase in our provision for loan losses reflects continued weakening and uncertainty relative to the housing market and disruption in the secondary markets which have unfavorably impacted our borrowers and the value of their loan collateral. As a result, an increase in the allowance for loan losses was deemed appropriate. Included within the current quarter provision for loan losses was $25.7 million related to the specific allowance associated with certain troubled debt restructurings resulting from a borrower retention program. The allowance related to the troubled debt restructurings that are not collateral dependent is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for loan losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield, thereby decreasing the allowance balance, or as a reduction of the provision if the loan is prepaid.

          Net charge-offs to average loans was 3.62% in the current quarter, higher than the 0.43% in the fourth quarter of 2007 and 0.28% in the year-ago third quarter. The current quarter net charge-offs primarily related to residential one-to-four unit loans.

          For the first nine months of 2008, the provision for loan losses totaled $626.0 million and net charge-offs were $204.9 million. This compares with a $91.3 million provision for loan losses and net charge-offs of $10.0 million a year ago. The increase in the year-to-date provision for loan losses reflected the same underlying weaknesses as mentioned above.

          A summary of activity in the allowance for loan-related commitment losses for loans held for investment, included in accounts payable and accrued liabilities, during the quarters indicated follows:

Real

(In Thousands)

Estate

Commercial

Consumer

Total


Balance at June 30, 2007

$

1,244

$

4

$

43

$

1,291

Provision for (reduction of) estimated losses

125

6

(4

)

127


Balance at September 30, 2007

1,369

10

39

1,418

Reduction of estimated losses

(195

)

(7

)

(1

)

(203

)


Balance at December 31, 2007

1,174

3

38

1,215

Reduction of estimated losses

(217

)

-

-

(217

)


Balance at March 31, 2008

957

3

38

998

Provision for (reduction of) estimated losses

357

1

(1

)

357


Balance at June 30, 2008

1,314

4

37

1,355

Provision for (reduction of) estimated losses

(139

)

1

(1

)

(139

)


Balance at September 30, 2008

$

1,175

$

5

$

36

$

1,216


Page 8
Navigation Links

          A summary of activity in the allowance for loan-related commitment losses for loans held for investment, included in accounts payable and accrued liabilities, for the year-to-date periods indicated follows:

Real

(In Thousands)

Estate

Commercial

Consumer

Total


Balance at December 30, 2006

$

1,011

$

3

$

41

$

1,055

Provision for (reduction of) estimated losses

358

7

(2

)

363


Balance at September 30, 2007

$

1,369

$

10

$

39

$

1,418


Balance at December 31, 2007

$

1,174

$

3

$

38

$

1,215

Provision for (reduction of) estimated losses

1

2

(2

)

1


Balance at September 30, 2008

$

1,175

$

5

$

36

$

1,216


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

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

Investment

Specific

Carrying

(In Thousands)

Value

Allowance

Value


September 30, 2007:

Loans with specific allowances

$

8,201

$

(721

)

$

7,480

Loans without specific allowances

3,316

-

3,316


Total impaired loans

$

11,517

$

(721

)

$

10,796


December 31, 2007:

Loans with specific allowances

$

485,017

$

(45,066

)

$

439,951

Loans without specific allowances

676

-

676


Total impaired loans

$

485,693

$

(45,066

)

$

440,627


March 31, 2008:

Loans with specific allowances

$

778,728

$

(66,801

)

$

711,927

Loans without specific allowances

636

-

636


Total impaired loans

$

779,364

$

(66,801

)

$

712,563


June 30, 2008:

Loans with specific allowances

$

1,177,801

$

(102,013

)

$

1,075,788

Loans without specific allowances

-

-

-


Total impaired loans

$

1,177,801

$

(102,013

)

$

1,075,788


September 30, 2008:

Loans with specific allowances

$

1,476,573

$

(133,140

)

$

1,343,433

Loans without specific allowances

-

-

-


Total impaired loans

$

1,476,573

$

(133,140

)

$

1,343,433


          At September 30, 2008, the recorded investment in loans for which we recognized impairment totaled $1.477 billion, up from $486 million at December 31, 2007 and $12 million at September 30, 2007. Of the current quarter total, $1.464 billion related to residential one-to-four unit loan TDRs with an allowance for loss of $131 million and $12 million related to two construction loans with an allowance for loss of $2 million. This is up from 2007 year-end totals of $441 million related to residential one-to-four unit loan TDRs with an allowance for loss of $39 million, $29 million related to one land loan with an allowance for loss of $4 million, $15 million related to two construction loans with an allowance for loss of $2 million, and $1 million related to one residential one-to-four unit loan with no allowance for loss; and up from the year-ago quarter total of $12 million with an allowance of less than $1 million. During the current quarter, the total interest recognized on the impaired portfolio was $27.0 million, compared to $19.9 million in the second quarter of 2008 and no interest recognized in the year-ago quarter.

          The aggregate amount of non-accrual loans that are in the foreclosure process, restructured, contractually past due 90 days or more as to principal or interest, or upon which interest collection is doubtful was $1.723 billion and $364 million at September 30, 2008 and 2007, respectively. Downey had $578 million of commitments to lend additional funds to borrowers whose loans were on non-accrual status. At September 30, 2008, Downey’s troubled debt restructurings were $1.452 billion, of which, $831 million were on non-accrual status, compared with troubled debt restructurings of $432 million with $432 million on non-accrual status at year end and $102 million troubled debt restructurings at September 30, 2007 all of which are on non-accrual status.

Page 9
Navigation Links

          Interest due on non-accrual loans, but excluded from interest income, was approximately $47.6 million at September 30, 2008, compared with $21.0 million at December 31, 2007 and $10.4 million at September 30, 2007.

          Downey has had, and expects in the future to have, transactions in the ordinary course of business with executive officers, directors and their associates on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other non-related parties. In the opinion of management, those transactions neither involve more than the normal risk of collectibility nor present any unfavorable features. At September 30, 2008, the Bank had extended loans to one director and his associates totaling $17.3 million, compared with $18.8 million and $16.7 million at December 31, 2007 and September 30, 2007, respectively. All such loans are performing in accordance with their loan terms.

          Presented below is a summary of activity with respect to such loans during the quarters indicated:

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

18,250

$

18,579

$

18,769

$

16,713

$

16,852

Additions

-

-

-

2,142

-

Repayments

(1,000

)

(329

)

(190

)

(86

)

(139

)


Balance at end of period

$

17,250

$

18,250

$

18,579

$

18,769

$

16,713


          Presented below is a summary of activity with respect to such loans for the year-to-date periods indicated:

Nine Months Ended September 30,


(In Thousands)

2008

2007


Balance at beginning of period

$

18,769

$

20,674

Additions

-

-

Repayments

(1,519

)

(3,961

)


Balance at end of period

$

17,250

$

16,713


NOTE (3) – Real Estate Acquired in Settlement of Loans

          Real estate acquired in settlement of loans was $278 million at September 30, 2008, compared to $116 million and $60 million at December 31, 2007 and September 30, 2007, respectively.

          A summary of net operation of real estate acquired in settlement of loans included in Downey’s results of operations during the quarters indicated follows:

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net (gains) losses on sales

$

2,508

$

760

$

205

$

739

$

(392

)

Net operating expense

9,591

8,667

4,099

2,726

1,998

Provision for estimated losses

19,329

14,712

19,892

1,118

2,058


Net operations of real estate acquired in


settlement of loans

$

31,428

$

24,139

$

24,196

$

4,583

$

3,664


          A summary of net operation of real estate acquired in settlement of loans included in Downey’s results of operations for the year-to-date periods indicated follows:

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net (gains) losses on sales

$

3,473

$

(797

)

Net operating expense

22,357

3,079

Provision for estimated losses

53,933

2,621


Net operations of real estate acquired in settlement of loans

$

79,763

$

4,903


Page 10
Navigation Links

          Downey values real estate acquired through foreclosure at fair value less cost to sell, with any subsequent losses recorded as a direct write-off to net operations. Given the decline in home values in the residential market, we had a valuation allowance at quarter end of $11 million for our one-to-four unit residential properties acquired through foreclosure. This valuation allowance reflects recent loss experience from sales compared to their fair value prior to sale. As that loss experience changes over time, our estimate of this valuation allowance will be reassessed.

          The following table summarizes the activity in Downey’s allowance for real estate acquired in settlement of loans for the quarters indicated.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

17,592

$

12,334

$

-

$

-

$

-

Provision

19,329

14,712

19,892

1,118

2,058

Charge-offs

(25,850

)

(9,454

)

(7,558

)

(1,118

)

(2,058

)

Recoveries

-

-

-

-

-


Balance at end of period

$

11,071

$

17,592

$

12,334

$

-

$

-


          The following table summarizes the activity in Downey’s allowance for real estate acquired in settlement of loans for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Balance at beginning of period

$

-

$

-

Provision

53,933

2,621

Charge-offs

(42,862

)

(2,621

)

Recoveries

-

-


Balance at end of period

$

11,071

$

-


NOTE (4) – Mortgage Servicing Rights (“MSRs”)

          Effective January 1, 2008, Downey adopted the fair value provision of Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets – an amendment of Financial Accounting Standards Board (“FASB”) Statement No. 140 (“SFAS 156”) and remeasured its mortgage servicing rights ("MSRs") at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity. The following table shows the adjustment recorded to the opening balance of MSRs, income taxes, and retained earnings for the remeasurement of Downey’s MSRs at fair value.

(Dollars in Thousands)

MSRs

Deferred Tax Asset

Retained Earnings


Balance at December 31, 2007

$

19,512

$

122,086

$

1,254,367

Remeasurement of MSRs upon adoption of SFAS 156

1,543

(651

)

892


Balance at January 1, 2008

$

21,055

$

121,435

$

1,255,259


Page 11
Navigation Links

          The following table summarizes the activity in MSRs using the fair value method and, prior to 2008, using the amortized cost method for the periods indicated.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

23,558

$

19,425

$

21,973

$

22,114

$

21,707

Remeasurement of mortgage servicing rights

to fair value (a)

-

-

(918

)

-

-


Adjusted balance at beginning of period

23,558

19,425

21,055

22,114

21,707

Additions (b)

901

1,557

1,122

945

1,394

Amortization

-

-

-

(1,085

)

(950

)

Sales

-

-

(262

)

-

-

Impairment write-down

-

-

-

(1

)

(37

)

Changes in fair value due to:

Changes in valuation model inputs or

assumptions (c)

(1,038

)

3,325

(1,751

)

-

-

Other changes (d)

(607

)

(749

)

(739

)

-

-


Balance at end of period

22,814

23,558

19,425

21,973

22,114


Allowance balance at beginning of period

-

-

2,461

265

88

Remeasurement of mortgage servicing rights

to fair value (a)

-

-

(2,461

)

-

-


Adjusted balance at beginning of period

-

-

-

265

88

Provision for impairment

-

-

-

2,197

214

Impairment write-down

-

-

-

(1

)

(37

)


Allowance balance at end of period

-

-

-

2,461

265


Total mortgage servicing rights, net

$

22,814

$

23,558

$

19,425

$

19,512

$

21,849


As a percentage of associated mortgage loans

0.91

%

0.95

%

0.80

%

0.80

%

0.90

%

Fair value (e)

$

22,814

$

23,558

$

19,425

$

20,991

$

23,935

Weighted average expected life (in months)

67

69

50

53

69

Custodial account earnings rate

3.23

%

3.75

%

3.72

%

4.53

%

4.57

%

Weighted average discount rate

11.74

11.78

11.47

11.45

11.63


At period end

Mortgage loans serviced for others:

Total

$

5,347,377

$

5,435,529

$

5,431,475

$

5,525,357

$

5,622,331

With capitalized mortgage servicing rights:(e)

Amount

2,495,492

2,471,000

2,428,098

2,436,278

2,419,432

Weighted average interest rate

5.89

%

5.87

%

5.88

%

5.88

%

5.83

%

Total loans sub-serviced without mortgage

servicing rights: (f)

Term – less than six months

$

96,428

$

103,972

$

69,810

$

81,123

$

76,870

Term – indefinite

2,751,711

2,857,191

2,933,567

2,995,119

3,112,895


Custodial account balances

$

75,452

$

67,710

$

71,479

$

81,778

$

84,819


(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(b) Included minor amounts repurchased.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.
(e) Excludes loans sub-serviced without capitalized mortgage servicing rights. The estimated fair values for periods presented prior to 2008 may exceed book value for certain asset strata and excluded loans sold or securitized prior to 1996.
(f) Servicing is performed for a fixed fee per loan each month.
Page 12
Navigation Links

          The following table summarizes the activity in MSRs and its related allowance for the year-to-date periods indicated.

Nine Months Ended September 30,


(Dollars in Thousands)

2008

2007


Balance at beginning of period

$

21,973

$

21,435

Remeasurement of mortgage servicing rights to fair value (a)

(918

)

-


Adjusted balance at beginning of period

21,055

21,435

Additions (b)

3,580

4,661

Amortization

-

(2,941

)

Sales

(262

)

(868

)

Impairment write-down

-

(173

)

Changes in fair value due to:

Changes in valuation model inputs or assumptions (c)

536

-

Other changes (d)

(2,095

)

-


Balance at end of period

22,814

22,114


Allowance balance at beginning of period

2,461

239

Remeasurement of mortgage servicing rights to fair value (a)

(2,461

)

-


Adjusted balance at beginning of period

-

239

Provision for impairment

-

199

Impairment write-down

-

(173

)


Allowance balance at end of period

-

265


Total mortgage servicing rights, net

$

22,814

$

21,849


(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(b) Included minor amounts repurchased.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.

          Upon adoption in 2008 of the fair value provision of SFAS 156, Downey capitalizes MSRs at fair value for residential one-to-four unit mortgage loans we originate and sell with servicing rights retained or acquired through purchase. Downey discloses MSRs associated with the origination and sale of loans in the financial statements as a component of the net gains on sales of loans and mortgage-backed securities. MSR fair value adjustments are recorded as a component of loan servicing income (loss), net. Prior to 2008, Downey capitalized MSRs at fair value except for those acquired through purchase, which were recorded at the lower of cost or fair value. MSRs were amortized over the estimated servicing period with impairment losses recorded through a valuation allowance with both the associated provisions and amortization recorded as a component of loan servicing income (loss), net category.

           Downey’s loan servicing portfolio normally increases in value as interest rates rise and loan prepayments decrease and declines in value as interest rates fall and loan prepayments increase. The change in fair value for MSRs reflects changes in assumptions and changes due to the realization of expected cash flows over time. Key assumptions used to determine the fair value of MSRs, which vary due to changes in market interest rates, include: expected prepayment speeds, which impact the average life of the portfolio; the earnings rate on custodial accounts, which impacts the value of custodial accounts; expected delinquencies and losses, which impact the servicing income (loss); and the discount rate used in valuing future cash flows. Once a quarter, Downey conducts model validation procedures by obtaining three independent broker results for the fair value of MSRs and compares them to the results of its MSR model.

          Prior to 2008, under the amortization method of recording MSRs, impairment was measured on a disaggregated basis based upon the predominant risk characteristics of the underlying mortgage loans, which include loans by loan term and coupon rate (stratified in 50 basis point increments). Impairment losses were recognized through a valuation allowance for each impaired stratum. Certain strata may have impairment, while other strata may not. Therefore, changes in overall fair value may not equal provisions for or reductions of the valuation allowance.

Page 13
Navigation Links

          The following table summarizes the estimated changes in the fair value of MSRs for changes in those assumptions individually and in combination associated with an immediate 100 basis point increase or decrease in market rates. The sensitivity analysis in the table below is hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 100 basis point variation in assumptions generally cannot be easily extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumptions. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

Expected

Custodial

Prepayment

Accounts

Discount

(Dollars in Thousands)

Speeds

Rate

Rate

Combination


Increase rates 100 basis points: (a)

Increase (decrease) in fair value

$

3,797

$

1,419

$

(541

)

$

3,795

Decrease rates 100 basis points: (b)

Increase (decrease) in fair value

(7,705

)

(1,521

)

552

(8,789

)


(a) The weighted-average expected life of the MSRs portfolio becomes 88 months.
(b) The weighted-average expected life of the MSRs portfolio becomes 34 months.

          The following table presents a breakdown of the components of loan servicing income (loss), net included in Downey’s results of operations for the periods indicated.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net cash servicing fees

$

1,797

$

1,750

$

1,765

$

2,166

$

1,657

Payoff and curtailment interest cost (a)

(208

)

(350

)

(471

)

(544

)

(787

)

Change in fair value of mortgage servicing

rights due to:(b)

Change in valuation model inputs or

assumptions (c)

(1,038

)

3,325

(1,751

)

-

-

Other changes (d)

(607

)

(749

)

(739

)

-

-

Amortization of mortgage servicing rights

-

-

-

(1,085

)

(950

)

Provision for impairment of mortgage

servicing rights

-

-

-

(2,197

)

(214

)


Total loan servicing income (loss), net

$

(56

)

$

3,976

$

(1,196

)

$

(1,660

)

$

(294

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. However, loan servicing income (loss), net does not reflect interest income derived from the use of loan repayments which is included in net interest income.
(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.
Page 14
Navigation Links

          The following table presents a breakdown of the components of loan servicing income (loss), net included in Downey’s results of operations for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net cash servicing fees

$

5,312

$

4,862

Payoff and curtailment interest cost (a)

(1,029

)

(3,241

)

Change in fair value of mortgage servicing rights due to:(b)

Change in valuation model inputs or assumptions (c)

536

-

Other changes (d)

(2,095

)

-

Amortization of mortgage servicing rights

-

(2,941

)

Provision for impairment of mortgage servicing rights

-

(199

)


Total loan servicing income (loss), net

$

2,724

$

(1,519

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. However, loan servicing income (loss), net does not reflect interest income derived from the use of loan repayments which is included in net interest income.
(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.

NOTE (5) – Derivatives, Hedging Activities, Financial Instruments with Off-Balance Sheet Risk and Other Contractual Obligations (Risk Management)

Derivatives

          Downey offers short-term interest rate lock commitments to help attract potential home loan borrowers. The commitments guarantee a specified interest rate for a loan if underwriting standards are met, but do not obligate the potential borrower. Accordingly, some commitments never become loans and merely expire. The residential one-to-four unit interest rate lock commitments Downey ultimately expects to result in loans and sell in the secondary market are treated as derivatives. Consequently, as derivatives, the hedging of the interest rate lock commitments does not qualify for hedge accounting. Effective January 1, 2008, Downey adopted the Securities and Exchange Commission Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings, that specifically states the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. Associated fair value adjustments to the notional amount of interest rate lock commitments and, beginning in 2008, the associated MSRs are recorded in current earnings under net gains on sales of loans and mortgage-backed securities with an offset to the balance sheet in either other assets, or accounts payable and accrued liabilities. Fair values for the notional amount of interest rate lock commitments are based on dealer quoted market prices acquired from third parties. Fair values for the associated MSRs are determined by computing the present value of the expected net servicing income from the portfolio by strata, determined by key characteristics of the underlying loans, primarily coupon interest rate and whether the loans have a fixed or variable rate. The carrying amount of loans held for sale includes a basis adjustment to the loan balance at funding resulting from the change in fair value of the interest rate lock derivative and, beginning in 2008, the associated MSRs from the date of rate lock to the date of funding. At September 30, 2008, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $26 million, with a change in fair value resulting in a recorded gain of $0.1 million.

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

Page 15
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 are recorded in net gains on sales of loans and mortgage-backed securities. Changes in expected future cash flows related to the fair value of the notional amount of loan forward sale contracts designated as cash flow hedges for the forecasted sale of loans held for sale are recorded in other comprehensive income (loss), net of tax, provided cash flow hedge requirements are met. The offset to these changes are recorded in the balance sheet as either other assets, or accounts payable and accrued liabilities. The amounts recorded in accumulated other comprehensive income (loss) will be recognized in the income statement when the hedged forecasted transactions impact earnings. Downey estimates that all of the related unrealized gains or losses in accumulated other comprehensive income will be reclassified into earnings within the next three months. Fair values for the notional amount of loan forward sale contracts are based on dealer quoted market prices acquired from third parties. At September 30, 2008, the notional amount of loan forward sale contracts amounted to $54 million, with a change in fair value resulting in a loss of $0.2 million, of which $7 million were designated as cash flow hedges. The notional amount of loan forward purchase contracts at September 30, 2008 amounted to $21 million, with a change in fair value resulting in a loss of $0.1 million.

          Downey has not discontinued any designated derivative instruments associated with loans held for sale due to a change in the probability of settling a forecasted transaction.

          In connection with its interest rate risk management, Downey from time to time enters into interest rate exchange agreements (“swap contracts”) with certain national investment banking firms or the Federal Home Loan Bank of San Francisco (“FHLB”) under terms that provide mutual payment of interest on the outstanding notional amount of swap contracts. These swap contracts help Downey manage the effects of adverse changes in interest rates on net interest income. Downey has interest rate swap contracts on which it pays variable interest based on the 3-month London Inter-Bank Offered Rate (“LIBOR”) while receiving fixed interest. The swaps were designated as a hedge against changes in the fair value of certain FHLB fixed rate advances due to changes in market interest rates. The payment and maturity dates of the swap contracts match those of the advances. This hedge effectively converts fixed interest rate advances into debt that adjusts quarterly to movements in 3-month LIBOR. Because the terms of the swap contracts match those of the advances, the hedge has no ineffectiveness and results are reported in interest expense. The fair value of interest rate swap contracts is based on dealer quoted market prices acquired from third parties and represents the estimated amount Downey would receive or pay upon terminating the contracts, taking into consideration current interest rates and the remaining contract terms. The fair value of the swap contracts is recorded on the balance sheet in either other assets or accounts payable and accrued liabilities. With no ineffectiveness, the recorded swap contract values will essentially act as fair value adjustments to the advances being hedged. At September 30, 2008, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value gain of $0.1 million recorded on the balance sheet in other assets and as an increase to the advances being hedged.

          The following table summarizes Downey’s interest rate swap contracts at September 30, 2008.

Weighted

Notional

Average

(Dollars in Thousands)

Amount

Interest Rate

Term


Pay – Variable (3-month LIBOR)

$

(100,000

)

2.50

%

March 2004 – October 2008

Receive – Fixed

100,000

3.20

Pay – Variable (3-month LIBOR)

(130,000

)

2.58

March 2004 – October 2008

Receive – Fixed

130,000

3.21

Pay – Variable (3-month LIBOR)

(100,000

)

2.73

March 2004 – November 2008

Receive – Fixed

100,000

3.26

Pay – Variable (3-month LIBOR)

(100,000

)

2.78

March 2004 – November 2008

Receive – Fixed

100,000

3.27


Page 16
Navigation 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 are the notional amounts or balances for Downey’s non-qualifying and qualifying hedge transactions.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net gains (losses) on non-qualifying hedge transactions

$

(1,601

)

$

2,099

$

(69

)

$

(460

)

$

(553

)

Net gains on qualifying cash flow hedge transactions:

Unrealized hedge ineffectiveness

-

-

-

-

-

Less reclassification of realized hedge ineffectiveness

-

-

-

-

-


Total net gains (losses) recognized in sales of loans and

mortgage-backed securities (SFAS 133 effect)

(1,601

)

2,099

(69

)

(460

)

(553

)

Other comprehensive income (loss)

127

593

(606

)

(101

)

(189

)


Notional amount or balance at period end

Non-qualifying hedge transactions:

Interest rate lock commitments (a)

$

25,963

$

54,095

$

78,131

$

53,250

$

92,742

Associated loan forward sale contracts

47,392

57,837

94,676

57,924

94,567

Associated loan forward purchase contracts

21,000

4,000

13,000

-

10,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value

7,673

85,558

109,253

103,384

90,228

Associated loan forward sale contracts

6,608

72,163

96,868

93,576

77,433

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed

430,000

430,000

430,000

430,000

430,000

Associated interest rate swap contracts –

pay-variable, receive-fixed

430,000

430,000

430,000

430,000

430,000


(a) Amount represents the notional amount of the commitments or contracts reduced by an anticipated fallout factor for those commitments not expected to fund. The notional amount for interest rate lock commitments before the reduction of expected fallout was $38 million.

          The following table shows the impact from non-qualifying hedges and the ineffectiveness of cash flow hedges on net gains (losses) on sales of loans and mortgage-backed securities (i.e., SFAS 133 effect), as well as the impact to other comprehensive income (loss) from qualifying cash flow transactions for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net gains on non-qualifying hedge transactions

$

429

$

564

Net gains on qualifying cash flow hedge transactions:

Unrealized hedge ineffectiveness

-

-

Less reclassification of realized hedge ineffectiveness

-

-


Total net gains recognized in sales of loans and

mortgage-backed securities (SFAS 133 effect)

429

564

Other comprehensive income (loss)

114

(335

)


          These loan forward sale and swap contracts expose Downey to credit risk in the event of nonperformance by the other parties—primarily government-sponsored enterprises such as Federal National Mortgage Association, securities firms and the FHLB. This risk consists primarily of the termination value of agreements where Downey is in an unfavorable position. Downey manages the credit risk associated with its other parties to the various derivative agreements through credit review, exposure limits and monitoring procedures. Downey does not anticipate nonperformance by the other parties.

Financial Instruments with Off-Balance Sheet Risk

          Downey utilizes financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to originate fixed and variable rate mortgage loans held for investment, undisbursed loan funds, lines and letters of credit, commitments to purchase loans and mortgage-backed securities for portfolio and commitments to invest in community development funds. The contract or notional amounts of those instruments reflect the extent of involvement Downey has in particular classes of financial instruments.

Page 17
Navigation Links

          Commitments to originate fixed and variable rate mortgage loans held for investment are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Undisbursed loan funds on construction projects and unused lines of credit on home equity and commercial loans include committed funds not disbursed. Letters of credit are conditional commitments issued by Downey to guarantee the performance of a customer to a third party. Downey also enters into commitments to purchase loans and mortgage-backed securities, investment securities and to invest in community development funds.

          The following is a summary of commitments with off-balance sheet risk at the dates indicated.

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Commitments to originate adjustable rate loans

held for investment

$

138,092

$

362,317

$

524,978

$

196,471

$

211,277

Undisbursed loan funds and unused lines of credit

267,719

277,757

265,493

306,532

310,677


          Downey uses the same credit policies in making commitments to originate loans held for investment and lines and letters of credit as it does for on-balance sheet instruments. For commitments to originate loans held for investment, the commitment amounts represent exposure to loss from market fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. Downey manages the credit risk of its commitments to originate loans held for investment through credit approvals, limits and monitoring procedures. The credit risk involved in issuing lines and letters of credit requires the same creditworthiness evaluation as that involved in extending loan facilities to customers. Downey evaluates each customer’s creditworthiness.

          Downey receives collateral to support commitments when deemed necessary. The most significant categories of collateral include real estate properties underlying mortgage loans, liens on personal property and cash on deposit with Downey.

          Downey maintains an allowance for losses to provide for inherent losses for loan-related commitments associated with undisbursed loan funds and unused lines of credit. The allowance for losses on loan-related commitments was $1 million at September 30, 2008, December 31, 2007 and September 30, 2007.

Other Contractual Obligations

          Downey sells all loans without recourse. When a loan sold to an investor without recourse fails to perform according to the contractual terms of the note, the investor will typically review the loan file to determine whether defects in the origination process occurred and whether such defects give rise to a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, Downey may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, Downey has no commitment to repurchase the loan. During the first nine months of 2008, Downey recorded repurchase or indemnification losses related to defects in the origination process of $0.7 million and repurchased $6 million of loans and $2 million of real estate acquired in settlement of loans.

          The loan and servicing sale contracts may also contain provisions to refund sales price premiums to the purchaser if the related loans prepay during a period of typically 90 days, but never more than 120 days, from the sale’s settlement date. Downey reserved less than $1 million at September 30, 2008, December 31, 2007 and September 30, 2007 to cover the estimated loss exposure related to early payoffs. However, if all the loans related to those sales prepaid within the refund period, as of September 30, 2008, Downey’s maximum sales price premium refund would be $1.9 million.

          Through the normal course of operations, Downey has entered into certain contractual obligations. Downey’s obligations generally relate to the funding of operations through deposits and borrowings, loan servicing, as well as leases for premises and equipment. Downey has obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period, with options to extend, and are non-cancelable. Downey also has vendor contractual relationships, but the contracts are not considered to be material.

Page 18
Navigation Links

          At September 30, 2008, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, senior notes and future operating minimum lease commitments were as follows:

After 1

After 3

Within

Through 3

Through 5

Beyond

Total

(In Thousands)

1 Year

Years

Years

5 Years

Balance


Certificates of deposit

$

6,865,770

$

614,856

$

110,554

$

-

$

7,591,180

FHLB advances

935,061

500,000

675,000

-

2,110,061

Senior notes

-

-

-

198,593

198,593

Operating leases

5,473

7,542

2,386

344

15,745


Total other contractual obligations

$

7,806,304

$

1,122,398

$

787,940

$

198,937

$

9,915,579


Litigation

Judicial Proceedings

          On October 29, 2004, two former traditional branch employees brought an action in Los Angeles County Superior Court, Case No. BC323796, entitled Margie Holman and Alice A. Mesec, et al. v. Downey Savings and Loan Association. The first amended complaint seeks unspecified damages for alleged unpaid regular and overtime wages, inadequate meal breaks, failure to pay split-shift and reporting time wages, and related claims. The plaintiffs are seeking class action status to represent all other current and former Downey Savings and Loan Association, F.A. (“Bank”) employees who held the position of Customer Service Supervisor and/or Customer Service Representative at the Bank’s in-store branches at any time from October 29, 2000 to date. The Bank has opposed the claim and asserted all appropriate defenses, and has provided for what is believed to be a reasonable estimate of exposure for this matter in the event of loss. While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of this matter will not have a material adverse effect on Downey’s operations, cash flows or financial position.

          Two purported shareholder class actions, one brought on behalf of Waterford Township General Employees Retirement System, Case No. CV-08-03261, and the other brought on behalf of Stephen J. Mihalacki, Case No. SACV08-00609, were filed on May 16, 2008 and June 2, 2008, respectively, in the United States District Court for the Central District of California against Downey Financial Corp. (“Holding Company”) and certain of its current and former officers and certain former directors. The complaints, filed on behalf of all persons who purchased Holding Company common stock during October 16, 2006 to March 14, 2008, seek unspecified damages for alleged violation of federal securities laws, claiming that the defendants made misleading statements and omissions regarding Downey’s business and financial results, thereby artificially inflating the common stock price. Specifically, the plaintiffs contend that the defendants concealed that (a) the Bank’s portfolio of option ARMs contained millions of dollars worth of impaired and risky securities; (b) the Bank had been aggressive in acquiring loans from mortgage brokers that were highly risky; (c) the Bank had failed to properly account for highly leveraged loans; (d) the Bank had inadequate underwriting practices, which led to large numbers of loan defaults; and (e) the Bank had not adequately reserved for option ARM loans. A motion to consolidate the two actions was granted on August 14, 2008 with Waterford Township General Partnership Employees Retirement System as lead plaintiff. The plaintiffs filed a consolidated complaint on September 30, 2008 and, pursuant to a stipulation between the parties, have until November 12, 2008 to file a first amended consolidated complaint.

          Related to the shareholder class actions, two purported shareholder derivative lawsuits, one entitled Michael L. McDougall v. Daniel D. Rosenthal, et al., Case No. 30-2008-00180029, and the other entitled Joyce Mendlin v. Maurice L. McAlister, et al., Case No. 30-2008-00087854, were filed on June 10, 2008 and July 28, 2008, respectively, in Orange County Superior Court, in California. The plaintiffs, who purport to bring the lawsuits on behalf of the Holding Company against certain of its current and former officers, its current directors and certain former directors, allege that commencing in October 2006, the defendants caused or allowed Downey to issue a series of press releases and other statements that significantly overstated Downey’s business prospects and financial results; that the statements failed to disclose that Downey was more exposed to the subprime market crisis than it had disclosed; that Downey’s portfolio of subprime and option ARM mortgage-related assets was overvalued; and that as a result, Downey’s reported earnings and business prospects were inaccurate. The plaintiffs allege that the defendants’ action constitutes breaches of fiduciary duty, waste of corporate assets and unjust enrichment, and seek, among other relief, unspecified damages to be paid to the Holding Company, corporate governance reforms, and equitable and injunctive relief, including restitution and the creation of a constructive trust.

          Downey has been named as a defendant in other legal actions arising in the ordinary course of business, none of which, in the opinion of management, will have a material adverse effect on its operations, cash flows or financial position.

Page 19
Navigation Links

Consent Orders

          On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. For more information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

NOTE (6) – Income Taxes

          FASB Interpretation 48: Accounting for Uncertainty in Income Taxes requires the affirmative evaluation that it is more likely than not, based on the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements. Management has determined that there are no unrecognized tax benefits to be reported in Downey’s financial statements, and none are anticipated during the next 12 months.

          Downey’s federal tax returns have been examined by the Internal Revenue Service (“IRS”) through 2005. Tax years subsequent to 2005 remain subject to federal examination, while state tax returns for years subsequent to 2003 are subject to examination by taxing authorities. When applicable, Downey classifies interest (net of tax) and penalties on the underpayment of taxes as income tax expense.

          SFAS 109, Accounting for Income Taxes, requires that when determining the need for a valuation allowance against a deferred tax asset, management must assess both positive and negative evidence with regard to the realizability of the tax losses represented by that asset. To the extent available sources of taxable income are insufficient to absorb tax losses, a valuation allowance is necessary. Sources of taxable income for this analysis include prior years’ tax returns, the expected reversals of taxable temporary differences between book and tax income, prudent and feasible tax-planning strategies, and future taxable income.

          Downey has recorded a valuation allowance of $216 million against its deferred tax asset of $235 million as of September 30, 2008, after considering all available evidence related to the amount of the tax asset that is more likely than not to be realized.

          Downey’s deferred tax asset resulted from a significant increase in its loan loss allowance. To the extent the loan loss allowance is not allocable to specific loans, it represents future tax benefits which would be realized when actual charge-offs are made against the allowance. Given Downey’s recent operating losses, the valuation allowance recorded at September 30, 2008 reduces the deferred tax asset to the amount management deems more likely than not to be realized only through the carry back of tax losses to prior years’ federal tax returns.

          Since generally accepted accounting principles require Downey to spread its expected annual tax benefit across the entire year through an effective tax rate, we expect to continue realizing a tax benefit for the remainder of 2008, but at a lower-than-normal effective tax rate, due to the effect of the valuation allowance discussed above.

NOTE (7) – Employee Stock Option Plans and Restricted Grant

          During 1994, the Bank adopted and Downey’s stockholders approved the Downey Savings and Loan Association 1994 Long Term Incentive Plan (“LTIP”). The LTIP provided for the granting of stock appreciation rights, restricted stock, performance awards and other awards. The LTIP specified an authorization of 434,110 shares (adjusted for stock dividends and splits) of the Bank’s common stock available for issuance under the LTIP. Effective January 23, 1995, the Holding Company and the Bank executed an amendment to the LTIP by which the Holding Company adopted and ratified the LTIP such that shares of the Holding Company shall be issued upon exercise of options or payment of other awards, for which payment is to be made in stock, in lieu of the Bank’s common stock. The LTIP terminated in 2004; however, options granted and outstanding at termination remain exercisable until the specific termination date of the option. At September 30, 2008, options for 23,430 shares were outstanding, all of which were exercisable at a weighted average option price per share of $25.44, which represented at least the fair market value of such shares on the date the options were granted and expire at December 31, 2008. No other stock based plan exists.

          On September 16, 2008, in connection with the Chief Executive Officer’s commencement of employment at Downey, 1,226,994 shares of restricted stock in Downey were granted him by the Board of Directors. At the grant date, the stock had a fair value of $3.71 per share, which resulted in compensation expense for the current quarter of $52,000. During September 2008, all of Downey’s treasury stock of 381,239 was reissued at below cost to satisfy part of the stock grant. As of the date of the grant, the restricted stock was unvested. The CEO shall vest in the restricted stock at a rate of 25% each year and be fully vested in the restricted stock upon the fourth anniversary of the grant date.

Page 20
Navigation Links

NOTE (8) – Earnings (Loss) Per Share

          Earnings (loss) per share of common stock is calculated on both a basic and diluted basis based on the weighted average number of common and common equivalent shares outstanding, excluding common shares in treasury. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted from the issuance of common stock that then shared in earnings.

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

Three Months Ended September 30,


2008

2007


Weighted

Weighted

Average

Average

Net

Shares

Per Share

Net

Shares

Per Share

(Dollars in Thousands, Except Per Share Data)

Loss

Outstanding

Amount

Loss

Outstanding

Amount


Basic loss per share

$

(81,070

)

27,960,478

$

(2.89

)

$

(23,361

)

27,853,783

$

(0.84

)

Effect of dilutive stock options (a)

-

-

-

-

-

-


Diluted loss per share

$

(81,070

)

27,960,478

$

(2.89

)

$

(23,361

)

27,853,783

$

(0.84

)


(a) For the three months ended September 30, 2008, there was no dilutive effect from our 23,430 outstanding stock options.

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

Nine Months Ended September 30,


2008

2007


Weighted

Weighted

Average

Average

Net

Shares

Per Share

Net

Shares

Per Share

(Dollars in Thousands, Except Per Share Data)

Loss

Outstanding

Amount

Income

Outstanding

Amount


Basic earnings (loss) per share

$

(547,686

)

27,889,608

$

(19.64

)

$

52,246

27,853,783

$

1.87

Effect of dilutive stock options (a)

-

-

-

-

29,021

-


Diluted earnings (loss) per share

$

(547,686

)

27,889,608

$

(19.64

)

$

52,246

27,882,804

$

1.87


(a) For the nine months ended September 30, 2008, there was no dilutive effect from our 23,430 outstanding stock options.

NOTE (9) – Fair Value of Financial Instruments

          Fair value measurements for Downey’s financial instruments are determined at a specific point in time based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we have established a fair value hierarchy as required by the FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements, ("SFAS 157"). The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of Downey (observable inputs) and (2) Downey’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs allows for situations in which there is little, if any, market activity for the asset or liability at the measurement date. Because no active market exists for a portion of Downey’s financial instruments, fair value estimates are subjective in nature. Additionally, the fair value estimates do not necessarily reflect the price Downey might receive if it were to sell at one time its entire holding of a particular financial instrument.

          Fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The highest priority (Level 1 inputs) is for quoted prices (unadjusted) in active markets for identical assets or liabilities, the next priority (Level 2 inputs) is for other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, and the lowest priority (Level 3 inputs) is for unobservable inputs. In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment considering factors specific to the asset or liability and could significantly affect the fair value estimate.

Page 21
Navigation Links

          Downey’s valuation techniques used to measure fair value are as follows:

          The following table presents for each of these hierarchy levels, Downey’s assets and liabilities that are measured at fair value on a recurring basis at the date indicated.

September 30,

(In Thousands)

Level 1

Level 2

Level 3

2008


U.S. Treasury, government sponsored entities and other

investment securities, available for sale

$

592,481

$

-

$

61

$

592,542

Mortgage-backed securities available for sale

-

-

104

104

Mortgage servicing rights

-

-

22,814

22,814

Net derivative assets (liabilities)

-

(261

)

135

(126

)


Total

$

592,481

$

(261

)

$

23,114

$

615,334


          The following table summarizes the activity in the Level 3 fair value category for the year-to-date period indicated.

Net Unrealized

Gains/(Losses)

Net

At

Gains/(Losses)

In Other

Purchases

Transfers

At

Net

December 31,

In Net

Comprehensive

Sales and

In/out of

September 30,

Unrealized

(In Thousands)

2007

Income (a)

Income

Settlements

Level 3

2008

Gains/(Losses)


U.S. Treasury, government sponsored

entities and other investment

securities, available for sale

$

61

$

-

$

-

$

-

$

-

$

61

$

-

Mortgage-backed securities

available for sale

111

-

-

(7

)

-

104

-

Mortgage servicing rights

19,512

5,659

-

(2,357

)

-

22,814

536

Net derivative assets (liabilities)

198

(63

)

-

-

-

135

135


Total

$

19,882

$

5,596

$

-

$

(2,364

)

$

-

$

23,114

$

671


(a) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity. Amount in Net Unrealized Gains/(Losses) column excludes changes in fair value due to changes from the realization of expected cash flows over time.

          Also, we may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with U. S. generally accepted accounting principles. The adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

          The following table provides a level of valuation assumptions used to determine each adjustment and the carrying value of assets measured at fair value on a nonrecurring basis at the date and for the period indicated.

Gains/(Losses)

for the Nine

Months Ended

At

September 30,

(In Thousands)

Level 1

Level 2

Level 3

September 30,

2008


Loans held for investment

$

-

$

-

$

48,728

$

48,728

$

(11,871

)

Real estate acquired in settlement of loans (a)

-

-

278,091

278,091

(57,406

)

Investment in real estate and joint ventures

-

-

13,661

13,661

(19,899

)


Total

$

-

$

-

$

340,480

$

340,480

$

(89,176

)


(a) Amount at September 30, 2008 is net of an $11 million valuation allowance related to Downey’s single family residential properties which reflects recent loss experience from sales compared to their fair value prior to sale.
Page 22
Navigation Links

NOTE (10) – 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 September 30, 2008

Net interest income

$

75,998

$

29

$

-

$

76,027

Provision for credit losses

130,291

-

-

130,291

Other income (loss)

78,820

(10,605

)

-

68,215

Operating expense

102,325

330

-

102,655

Net intercompany income (expense)

3

(3

)

-

-


Loss before income tax benefits

(77,795

)

(10,909

)

-

(88,704

)

Income taxes (tax benefits)

(8,769

)

1,135

-

(7,634

)


Net loss

$

(69,026

)

$

(12,044

)

$

-

$

(81,070

)


At September 30, 2008

Assets:

Loans and mortgage-backed securities, net

$

10,757,283

$

-

$

-

$

10,757,283

Investments in real estate and joint ventures

-

15,606

-

15,606

Other

2,004,305

11,356

(7,351

)

2,008,310


Total assets

12,761,588

26,962

(7,351

)

12,781,199


Equity

$

771,714

$

7,351

$

(7,351

)

$

771,714


Three months ended September 30, 2007

Net interest income

$

97,656

$

314

$

-

$

97,970

Provision of credit losses

81,562

-

-

81,562

Other income (loss)

10,756

(7,720

)

-

3,036

Operating expense

62,365

311

-

62,676

Net intercompany income (expense)

22

(22

)

-

-


Loss before income tax benefits

(35,493

)

(7,739

)

-

(43,232

)

Income tax benefits

(16,642

)

(3,229

)

-

(19,871

)


Net loss

$

(18,851

)

$

(4,510

)

$

-

$

(23,361

)


At September 30, 2007

Assets:

Loans and mortgage-backed securities, net

$

11,692,185

$

-

$

-

$

11,692,185

Investments in real estate and joint ventures

-

58,715

-

58,715

Other

2,710,006

30,420

(73,609

)

2,666,817


Total assets

14,402,191

89,135

(73,609

)

14,417,717


Equity

$

1,444,226

$

73,609

$

(73,609

)

$

1,444,226


Real Estate

(In Thousands)

Banking

Investment

Elimination

Totals


Nine months ended September 30, 2008

Net interest income

$

242,465

$

218

$

-

$

242,683

Provision for credit losses

626,035

-

-

626,035

Other income (loss)

105,483

(16,265

)

-

89,218

Operating expense

279,204

968

-

280,172

Net intercompany income (expense)

71

(71

)

-

-


Loss before income tax benefits

(557,220

)

(17,086

)

-

(574,306

)

Income tax benefits

(25,229

)

(1,391

)

-

(26,620

)


Net loss

$

(531,991

)

$

(15,695

)

$

-

$

(547,686

)


Nine months ended September 30, 2007

Net interest income

$

333,505

$

1,038

$

-

$

334,543

Provision for credit losses

91,684

-

-

91,684

Other income (loss)

45,056

(6,807

)

-

38,249

Operating expense

189,700

979

-

190,679

Net intercompany income (expense)

53

(53

)

-

-


Income (loss) before income taxes (tax benefits)

97,230

(6,801

)

-

90,429

Income taxes (tax benefits)

41,044

(2,861

)

-

38,183


Net income (loss)

$

56,186

$

(3,940

)

$

-

$

52,246


Page 23
Navigation Links

NOTE (11) – Regulatory Consent Orders, Liquidity and Capital Adequacy

          On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. The Bank Order requires the Bank to, among other things:

          In light of the capital directive set forth in the Bank Consent Order, the Bank is deemed to be “adequately capitalized” rather than “well capitalized” despite exceeding all “well capitalized” regulatory ratios.

          Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by no later than December 31, 2008, bank regulators could take enforcement action before that date, which could include placing the Bank into receivership.

          The Consent Order that the Holding Company entered into requires it to notify, or in certain cases receive the approval or non-objection of, the OTS prior to (i) accepting or requesting that the Bank pay or make, or commit to pay or make, any dividends or other capital distributions; (ii) making certain changes to its directors or senior executive officers; (iii) entering into, renewing, extending or revising any contractual arrangement related to compensation or benefits with any director or senior executive officer of the Holding Company; (iv) making any golden parachute payments or prohibited indemnification payments; and (v) incurring, issuing, renewing or rolling over any debt, increasing any current lines of credit or guaranteeing the debt of any entity.

Liquidity

          Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, available for sale securities, and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments. Interest rates, real estate sales activity and general economic conditions significantly affect repayments on loans and deposit inflows and outflows.

          In addition to its deposits, our principal source of liquidity is our ability to utilize borrowings, as needed. The Bank’s primary source of borrowings is the FHLB. At September 30, 2008, the Bank’s FHLB borrowings totaled $2.1 billion, representing 16.5% of total assets. The Bank currently is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional $0.9 billion of borrowing capacity from the FHLB as of September 30, 2008. The amount the FHLB is willing to advance differs based on the quality and character of qualifying collateral offered by the Bank, and the advance rates for the same collateral may be adjusted upwards or downwards by the FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank of San Francisco as a back-up source of liquidity. As of September 30, 2008 the Bank had no outstanding

Page 24
Navigation Links

borrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying collateral would have permitted it to borrow up to an additional $1.1 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is obligated to lend to us under these loan facilities. To the extent deposit renewals and deposit growth are not sufficient to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans and investment securities and otherwise fund working capital needs and capital expenditures, the Bank may utilize additional borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements. However, if elevated levels of net deposit outflows occur, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional financing arrangements. As a result of being “adequately capitalized” rather than “well capitalized,” the Bank is subject to restrictions on accepting brokered deposits, which have not historically been a significant part of the Bank’s deposit base, and upper limits on interest rates the Bank may pay on deposits.

          As of September 30, 2008, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $216 million, of which $38 million were related to residential one-to-four unit loans being originated for sale in the secondary market. We also had undisbursed loan funds and unused lines of credit of $268 million, loan forward purchase contracts of $21 million and operating leases of $16 million. Subsequent to September 30, 2008, we closed our wholesale lending channel which traditionally provided about 80% of our single family loan originations and scaled back our retail loan channel. Therefore, loan origination volumes will decline in future periods. For further information, see Note 5 of Notes to the Consolidated Financial Statements on page 15.

          Limitations imposed by the OTS currently prohibit the Bank from providing a dividend to the Holding Company without the prior written approval of the OTS, and currently prohibit the Holding Company from paying a dividend without the prior non-objection of the OTS. At September 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million, down from $102 million at the end of 2007 due primarily to $80 million in capital contributions made to the Bank. In addition, the Holding Company may not issue new debt or renew existing debt without the prior non-objection of the OTS. At this time, there is no other source of repayment of the senior notes. Absent additional capital, the Holding Company will default on the notes within a year.

          Downey’s stockholders’ equity totaled $772 million at September 30, 2008, down from $1.3 billion at December 31, 2007 and $1.4 billion at September 30, 2007. No future dividends will be paid without the prior non-objection of the OTS.

Capital Adequacy

          At September 30, 2008, the Bank was above the minimum capital ratios required by its Consent Order, with core and tangible capital ratios of 7.48% and a total risk-based capital ratio of 14.50%. In addition, the Bank’s Consent Order requires the Bank to complete a capital raising initiative by December 31, 2008. As a direct result of these requirements, during the quarter, we sold certain non-core real estate assets to a third party resulting in an enhancement to the Bank’s regulatory capital of $109 million and the Holding Company made a capital contribution of $30 million. These capital enhancements were more than offset by the net loss recorded in the current quarter. Based on the Bank’s current and projected levels of capital, the Bank anticipates that it will not be able to satisfy the Tier I Core Capital and Total Risk-Based Capital minimum ratios of its Consent Order as of December 31, 2008, unless it raises additional capital on or prior to that date. In the current economic environment, there is a significant risk that the Bank will not be able to raise sufficient additional capital to ensure compliance with the capital requirements of the Bank Consent Order by year-end. For more information, see “Part II – Other Information – Item 1A. – Risk Factors – If we do not raise additional capital by December 31, 2008, it is highly unlikely that we will be in compliance with the capital requirements of the Bank Consent Order at year-end, which could have a material adverse effect upon us.” on page 77.

Going Concern

          The circumstances described above, raise substantial doubt concerning the ability of the Holding Company and the Bank to continue as going concerns for a reasonable period of time.

Page 25
Navigation Links

NOTE (12) – Recently Issued Accounting Standards

Statement of Financial Accounting Standards No. 161

          In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). This standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. Downey is currently evaluating the impact, if any, that this statement will have on its disclosures related to hedging activities.

Statement of Financial Accounting Standards No. 162

          In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted Accounting Principles, (“SFAS 162”). This standard is intended to improve financial reporting by identifying the sources of accounting principles and a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. GAAP for nongovernmental entities. SFAS 162 will be effective 60 days after the U.S. Securities and Commission approves the Public Company Accounting Oversight Board’s amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” Adoption of SFAS 162 is not expected to have a material impact on Downey.

NOTE (13) – Subsequent Event

          On October 16, 2008, the Bank closed its Wholesale Loan Department and the loan processing centers supporting that Department, and began contracting its Retail Loan Department. For more information, see “Capital Resources and Liquidity” on page 70.

Page 26
Navigation Links

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 or outcomes may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include, but are not limited to, economic conditions, competition in the geographic and business areas in which we conduct our operations, new, changed or increased regulatory restrictions, pending or threatened litigation, a decrease in our customers, including a decrease in our deposit base, the possible loss of key personnel, the inability to successfully implement strategic initiatives, changes in deposit flows and loan demand, limitations on our ability to borrow to fund our assets and operations, risk of credit losses, risk associated with residential mortgage lending, risk associated with a slowdown in the housing market or high interest rates, fluctuations in interest rates, credit quality, the outcome of ongoing audits, taxing authorities and government regulation and factors, identified under part II – Other Information Item 1A. Risk Factors on page77 and in our other current and periodic reports filed from time to time with the SEC. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made, except as required by law. We are not able to make any assurances, including but not limited to any assurances that the increased rate of sale of foreclosed homes will continue in future periods, that the rate of deposit withdrawals will not increase in future periods, that the percentage of unsold homes in escrow or under negotiation will be representative of the number or percentage of homes sold in future periods, we will have adequate liquidity in future periods, capital levels will exceed levels required by our regulators in future periods or that we will be able to meet other requirements imposed by our regulators.

OVERVIEW

          A net loss was recorded for the third quarter of 2008 of $81.1 million or $2.89 per share on a diluted basis, compared with a net loss of $23.4 million or $0.84 per share in the year-ago third quarter.

          The $45.5 million unfavorable change in pre-tax loss between third quarters was due primarily to:

These unfavorable items were partially offset by an increase in other income of $65.2 million primarily due to the sale of non-core real estate related contracts.

          For the first nine months of 2008, the net loss totaled $547.7 million or $19.64 per share on a diluted basis, compared with net income of $52.2 million or $1.87 per share on a diluted basis for the first nine months of 2007. The decline primarily reflected an increase in our provision for credit losses, lower net interest income and higher operating expenses.

          For the third quarter, our return on average assets was a negative 2.42%, and our return on average equity was a negative 39.04%. These compare to year-ago negative returns of 0.64% on average assets and 6.36% on average equity. For the nine months ended September 30, 2008, our return on average assets was a negative 5.51%, and our return on average equity was a negative 69.68%. These compare to year-ago positive returns of 0.46% on average assets and 4.82% on average equity.

Page 27
Navigation Links

          At September 30, 2008, assets totaled $12.781 billion, down $1.637 billion or 11.4% from a year ago. During the current quarter, assets increased $149 million. Our cash and cash equivalents increased $460 million during the quarter reflecting a cautionary measure relative to our liquidity given depositor and market place concerns as various banks failed during the period. In addition, the increase in total assets reflected an increase of $118 million in loans held for investment, $54 million in Federal Home Loan Bank stock, and $33 million in other assets. Those asset increases were partially offset by declines of $406 million in investment securities, $78 million in loans held for sale and $48 million in investments in real estate and joint ventures. Included within loans held for investment at quarter end were $5.715 billion of single family adjustable rate mortgages subject to negative amortization, down $527 million from June 30, 2008. These loans comprised 52% of the single family residential loan portfolio held for investment at quarter end, compared with 74% a year ago. The amount of negative amortization included in loan balances declined $27 million during the current quarter to $318 million or 5.6% of loans subject to negative amortization. During the current quarter, approximately 10% of loan interest income represented negative amortization, down from 15% in the second quarter 2008 and 26% in the year-ago third quarter.

          Loan originations (including purchases) totaled $804 million in the current quarter, up $110 million or 15.8% from $694 million originated a year ago but down from $1.027 billion originated in the second quarter of 2008. Single family residential loans originated for portfolio increased $128 million or 29.6% from a year ago to $560 million, while other loans originated for portfolio increased $79 million to $96 million in the current quarter. Those increases were partially offset by a decline in loans originated for sale, which declined $98 million or 39.8% to $147 million.

          Not included in the above originations are loans for which we modify the terms of a borrower’s loan. During the current quarter, we modified $157 million of loans associated with our borrower retention program, wherein the borrower was current with their loan payments and the new interest rate was no less than that afforded new borrowers, and an additional $149 million of loans at below market interest rates in loan workout situations. All of the portfolio retention modifications were adjustable rate loans, which permitted negative amortization, that were modified into five-year interest-only adjustable rate loans with interest rates that adjust semi-annually but do not permit negative amortization. Most of the other modifications were modified for a two year period into a fixed rate interest-only product.

          Deposits totaled $9.618 billion at quarter end, down $1.044 billion or 9.8% from a year ago. At quarter end, the number of branches totaled 175 (170 in California and five in Arizona). At quarter end, the average deposit size of our 85 traditional branches was $89 million, while the average deposit size of our 90 in-store branches was $23 million. During the current quarter, borrowings increased by $487 million and represented 18% of total assets at quarter end.

          Non-performing assets increased during the quarter by $44 million to $2.002 billion and represented 15.66% of total assets, compared with 7.77% at year-end 2007 and 2.94% a year ago. Virtually all of the increase in the current quarter was related to our single family residential lending activity. Included in non-performing assets are loans modified pursuant to our borrower retention program. This program was initiated at the beginning of the third quarter of 2007 to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loan that permitted negative amortization to a less costly financing alternative. To the extent borrowers whose loans were modified as part of this program are current with their loan payments and included in non-performing assets, it is relevant to distinguish those from total non-performing assets because, unlike other loans classified as non-performing assets, these loans are paying interest at interest rates no less than those afforded new borrowers. At September 30, 2008, 72% of such borrowers had made all loan payments due. Accordingly, the 15.66% ratio of non-performing assets to total assets includes 3.20% related to performing troubled debt restructurings resulting in an adjusted ratio of 12.46%.

          At September 30, 2008, Downey Financial Corp.’s primary subsidiary, Downey Savings and Loan Association, F.A. (the “Bank”), had core and tangible capital ratios of 7.48%, and a total risk-based capital ratio of 14.50%. In each case, these ratios exceeded the minimum regulatory capital ratios required to be maintained by the Bank of 7.00% for core and tangible and 14.00% for risk-based. The Bank’s regulatory capital position was enhanced during the current quarter by $109 million from the sale of certain non-core real estate assets, and a $30 million contribution of equity from Downey Financial Corp. (the “Holding Company”). These were more than offset by the net loss recorded in the current quarter. For more information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

 

Page 28
Navigation Links

 

          In light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have continued to work closely with the Bank’s federal banking regulators. On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. The Bank Order requires the Bank to, among other things:

          In light of the capital directive set forth in the Bank Consent Order, the Bank is deemed to be “adequately capitalized” rather than “well capitalized” despite exceeding all “well capitalized” regulatory ratios.

          Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by no later than December 31, 2008, bank regulators could take enforcement action before that date, which could include placing the Bank into receivership.

          The Consent Order that the Holding Company entered into requires it to notify, or in certain cases receive the approval or non-objection of, the OTS prior to (i) accepting or requesting that the Bank pay or make, or commit to pay or make, any dividends or other capital distributions; (ii) making certain changes to its directors or senior executive officers; (iii) entering into, renewing, extending or revising any contractual arrangement related to compensation or benefits with any director or senior executive officer of the Holding Company; (iv) making any golden parachute payments or prohibited indemnification payments; and (v) incurring, issuing, renewing or rolling over any debt, increasing any current lines of credit or guaranteeing the debt of any entity.

          The circumstances described in Note 11 (page 24) and in Risk Factors (page 77), raise substantial doubt concerning the ability of the Holding Company and the Bank to continue as going concerns for a reasonable period of time.

Page 29
Navigation 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. Certain accounting policies require us to make significant estimates and assumptions which could have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions which could have a material impact on the future carrying value of assets and liabilities and our results of operations for the reporting periods. We believe the following four critical accounting policies require the most judicious estimates and assumptions, which are particularly susceptible to significant change in the preparation of our financial statements:

The nature of these judgments, estimates and assumptions are described in greater detail in Downey’s Annual Report on Form 10-K for the year ended December 31, 2007 in the "Critical Accounting Policies" section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

          In addition to those critical accounting policies addressed in Downey’s Annual Report on Form 10-K for the year ended December 31, 2007, we have added:

          Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors.

Page 30
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 $76.0 million in the third quarter of 2008, down $21.9 million or 22.4% from a year ago, reflecting a $1.828 billion or 13.0% decline in average interest-earning assets to $12.214 billion and a decline in our effective interest rate spread. The average effective interest rate spread was 2.49% in the current quarter, down 0.30% from a year ago and 0.24% from the second quarter of 2008. The decline in the current quarter effective interest spread from a year ago primarily reflected the negative impact of a higher proportion of non-performing assets. The decline in our effective interest spread from the second quarter of 2008 reflected both a higher level of non-performing assets as well as an increase in non-interest bearing cash related assets for liquidity purposes funded with interest-bearing liabilities.

          For the first nine months of 2008, net interest income totaled $242.7 million, down $91.9 million or 27.5% from the year-ago period. The decline was due to lower interest-earning assets and a lower effective interest rate spread in the current period.

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

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:

Page 31
Navigation Links

The table also sets forth the difference between the average balance of interest-earning assets and the average balance of total deposits and borrowings for the quarters indicated. While we included non-accrual loans in the average interest-earning assets balance, interest from non-accrual loans has not been included in interest income unless we received payments and we believe the remaining principal balance of the loans will be recovered. We computed average balances for the quarter using the average of each month’s daily average balance during the periods indicated.

Three Months Ended September 30,


2008

2007


Average

Average

Average

Average

(Dollars in Thousands)

Balance

Interest

Yield/Rate

Balance

Interest

Yield/Rate


Average balance sheet data

Interest-earning assets:

Loans:

Loan prepayment fees

$

463

0.02

%

$

8,542

0.29

%

Write-off of deferred costs and

premiums from loan payoffs

(3,391

)

(0.13

)

(16,315

)

(0.55

)

All other

157,407

5.84

216,087

7.22


Total loans

$

10,783,449

154,479

5.73

$

11,973,516

208,314

6.96

Mortgage-backed securities

105

2

4.78

113

3

5.77

Investment securities (a)

1,430,431

14,587

4.06

2,068,187

27,557

5.29


Total interest-earnings assets

12,213,985

$

169,068

5.54

%

14,041,816

$

235,874

6.72

%

Non-interest-earning assets

1,158,650

485,648


Total assets

$

13,372,635

$

14,527,464


Transaction accounts:

Non-interest-bearing checking (b)

$

766,544

$

-

-

%

$

730,179

$

-

-

%

Interest-bearing checking (b)

400,758

1,142

1.13

470,516

340

0.29

Money market

108,361

280

1.03

139,808

367

1.04

Regular passbook

864,663

1,952

0.90

1,117,084

2,660

0.94


Total transaction accounts

2,140,326

3,374

0.63

2,457,587

3,367

0.54

Certificates of deposit

7,564,088

64,352

3.38

8,455,461

105,147

4.93


Total deposits

9,704,414

67,726

2.78

10,913,048

108,514

3.94

FHLB advances and other borrowings (c)

2,538,497

22,010

3.45

1,766,933

26,088

5.86

Senior notes

198,565

3,305

6.66

198,381

3,302

6.66


Total deposits and borrowings

12,441,476

93,041

2.98

12,878,362

137,904

4.25

Other liabilities

100,624

179,944

Stockholders’ equity

830,535

1,469,158


Total liabilities and stockholders’ equity

$

13,372,635

$

14,527,464


Net interest income/interest rate spread

$

76,027

2.56

%

$

97,970

2.47

%

Excess of interest-earning assets over

deposits and borrowings

$

(227,491)

$

1,163,454

Effective interest rate spread

2.49

2.79


(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 32
Navigation Links

 

Nine Months Ended September 30,


2008

2007


Average

Average

Average

Average

(Dollars in Thousands)

Balance

Interest

Yield/Rate

Balance

Interest

Yield/Rate


Average balance sheet data

Interest-earning assets:

Loans:

Loan prepayment fees

$

3,632

0.04

%

$

47,937

0.50

%

Write-off of deferred costs and

premiums from loan payoffs

(15,669

)

(0.19

)

(66,454

)

(0.69

)

All other

505,230

6.21

709,386

7.37


Total loans

$

10,854,805

493,193

6.06

$

12,829,398

690,869

7.18

Mortgage-backed securities

108

8

5.45

127

9

5.85

Investment securities (a)

1,520,402

53,043

4.66

1,781,837

71,040

5.33


Total interest-earnings assets

12,375,315

$

546,244

5.89

%

14,611,362

$

761,918

6.95

%

Non-interest-earning assets

874,532

478,398


Total assets

$

13,249,847

$

15,089,760


Transaction accounts:

Non-interest-bearing checking (b)

$

704,296

$

-

-

%

$

762,050

$

-

-

%

Interest-bearing checking (b)

436,960

2,208

0.67

481,867

1,117

0.31

Money market

126,724

982

1.04

145,141

1,128

1.04

Regular passbook

973,320

6,687

0.92

1,183,810

8,423

0.95


Total transaction accounts

2,241,300

9,877

0.59

2,572,868

10,668

0.55

Certificates of deposit

7,793,586

233,170

4.00

8,742,787

323,309

4.94


Total deposits

10,034,886

243,047

3.24

11,315,655

333,977

3.95

FHLB advances and other borrowings (c)

1,832,461

50,601

3.69

1,909,513

83,494

5.85

Senior notes

198,520

9,913

6.66

198,334

9,904

6.66


Total deposits and borrowings

12,065,867

303,561

3.36

13,423,502

427,375

4.26

Other liabilities

135,922

219,667

Stockholders’ equity

1,048,058

1,446,591


Total liabilities and stockholders’ equity

$

13,249,847

$

15,089,760


Net interest income/interest rate spread

$

242,683

2.53

%

$

334,543

2.69

%

Excess of interest-earning assets over

deposits and borrowings

$

309,448

$

1,187,860

Effective interest rate spread

2.61

3.05


(a) Yields for securities available for sale are calculated using historical cost balances and are not adjusted for changes in fair value that are reflected as a separate component of stockholders’ equity.
(b) Included amounts swept into money market deposit accounts.
(c) The impact of swap contracts was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.
Page 33
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:

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 September 30,

Nine Months Ended September 30,

2008 Versus 2007

2008 Versus 2007

Changes Due To

Changes Due To


Rate/

Rate/

(In Thousands)

Volume

Rate

Volume

Net

Volume

Rate

Volume

Net


Interest income:

Loans

$

(20,705

)

$

(36,786

)

$

3,656

$

(53,835

)

$

(106,333

)

$

(107,959

)

$

16,616

$

(197,676

)

Mortgage-backed securities

(1

)

-

-

(1

)

(1

)

-

-

(1

)

Investment securities

(8,523

)

(6,429

)

1,982

(12,970

)

(10,395

)

(8,909

)

1,307

(17,997

)


Change in interest income

(29,229

)

(43,215

)

5,638

(66,806

)

(116,729

)

(116,868

)

17,923

(215,674

)


Interest expense:

Transaction accounts:

Interest-bearing checking

(50

)

1,001

(149

)

802

(104

)

1,318

(123

)

1,091

Money market

(82

)

(5

)

-

(87

)

(147

)

-

1

(146

)

Regular passbook

(605

)

(133

)

30

(708

)

(1,492

)

(297

)

53

(1,736

)


Total transaction accounts

(737

)

863

(119

)

7

(1,743

)

1,021

(69

)

(791

)

Certificates of deposit

(11,133

)

(33,159

)

3,497

(40,795

)

(35,019

)

(61,833

)

6,713

(90,139

)


Total interest-bearing deposits

(11,870

)

(32,296

)

3,378

(40,788

)

(36,762

)

(60,812

)

6,644

(90,930

)

FHLB advances and other

borrowings

11,563

(10,887

)

(4,754)

(4,078

)

(3,373

)

(30,765

)

1,245

(32,893

)

Senior notes

3

-

-

3

9

-

-

9


Change in interest expense

(304

)

(43,183

)

(1,376

)

(44,863

)

(40,126

)

(91,577

)

7,889

(123,814

)


Change in net interest income

$

(28,925

)

$

(32

)

$

7,014

$

(21,943

)

$

(76,603

)

$

(25,291

)

$

10,034

$

(91,860

)


Provision for Credit Losses

           During the current quarter, our provision for credit losses totaled $130.3 million, up $48.7 million from a year ago. The increase in our provision for credit losses reflects continued weakening and uncertainty relative to the housing market and disruption in the secondary markets which have unfavorably impacted our borrowers and the value of their loan collateral.

          For the first nine months of 2008, the provision for credit losses totaled $626.0 million, compared with $91.7 million a year ago. For further information, see Allowance for Credit and Real Estate Losses on page 65.

Other Income

          Other income totaled $68.2 million in the current quarter, up $65.2 million from a year ago primarily due to a $70.0 million gain from the sale of certain non-core real estate contracts. Offsetting contributors to this increase between third quarters was:

Page 34
Navigation Links

          For the first nine months of 2008, other income totaled $89.2 million, up $51.0 million or 133.3% from a year ago. The increase primarily reflected the current period gain from the sale of certain non-core real estate contracts, partially offset by unfavorable changes in net gains from sales of loans and mortgage-backed securities and income from real estate and joint ventures held for investment.

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

Loan and Deposit Related Fees

          Our loan and deposit related fees totaled $8.2 million in the current quarter, down $0.8 million from a year ago. The decline was primarily related to lower automated teller machine fees.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Loan related fees

$

445

$

377

$

422

$

467

$

572

Deposit related fees:

Automated teller machine fees

1,747

1,859

1,997

2,285

2,287

Other fees

5,960

5,968

5,820

6,215

6,054


Total loan and deposit related fees

$

8,152

$

8,204

$

8,239

$

8,967

$

8,913


          For the first nine months of 2008, loan and deposit related fees totaled $24.6 million, down $2.5 million from the same period of 2007. The decline was primarily related to lower automated teller machine fees of $1.4 million or 20.3% and loan related fees of $1.0 million or 44.2%.

          The following table presents a breakdown of loan and deposit related fees during the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Loan related fees

$

1,244

$

2,233

Deposit related fees:

Automated teller machine fees

5,603

7,032

Other fees

17,748

17,822


Total loan and deposit related fees

$

24,595

$

27,087


Real Estate and Joint Ventures Held for Investment

          A loss of $10.7 million was recorded from our real estate and joint ventures held for investment, compared to a loss of $7.9 million a year ago. The $2.8 million unfavorable change is primarily related to current quarter net losses from sales of wholly owned real estate of $2.4 million. Both the current quarter and the year-ago quarter included writedowns associated with declines in the value of single family lots in which we are a joint venture partner. In the current quarter, the writedown is recorded in provision for losses on real estate and joint ventures, whereas in the year-ago quarter the writedown appears in deficit in net loss from joint ventures.

Page 35
Navigation Links

          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net rental operations and income from community

development funds

$

(127

)

$

133

$

331

$

(49

)

$

576

Net gains (losses) on sales of wholly owned real estate

estate

(2,388

)

6,129

-

-

-

Equity (deficit) in net income (loss) from

joint ventures

(181

)

(79

)

(945

)

681

(8,492

)

(Provision for) reduction of losses on real estate

and joint ventures

(8,053

)

(11,454

)

9

10

24


Total income (loss) from real estate and

joint ventures held for investment, net

$

(10,749

)

$

(5,271

)

$

(605

)

$

642

$

(7,892

)


          For the first nine months of 2008, a loss of $16.6 million was recorded from real estate and joint ventures held for investment, compared to a loss of $7.5 million a year ago. The unfavorable change primarily reflected an increase in the writedowns of single family lots in which we are a joint venture partner, partially offset by net gains from sales.

          The following table sets forth the key components comprising our income from real estate and joint venture operations during the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net rental operations and income from community development funds

$

337

$

1,170

Net gains on sales of wholly owned real estate

3,741

22

Deficit in net loss from joint ventures

(1,205

)

(8,390

)

Provision for losses on real estate and joint ventures

(19,498

)

(329

)


Total loss from real estate and joint ventures held for investment, net

$

(16,625

)

$

(7,527

)


Secondary Marketing Activities

          We service loans for others and those activities generated a loss of $0.1 million in the current quarter, down from a loss of $0.3 million in the year-ago quarter. This primarily reflected a $0.6 million favorable change in payoff and curtailment interest cost, partially offset by a $0.5 million unfavorable change from the measurement of MSRs to fair value. Payoff and curtailment interest costs represent the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. Loan servicing income (loss), net does not reflect the interest income we derive from the use of those loan repayments as it is included in net interest income.

          Effective January 1, 2008, we adopted the fair value provision of Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140 (“SFAS 156”) and remeasured our MSRs at fair value. For further information regarding the adoption of SFAS 156 and our MSRs, see Note 4 of Notes to Consolidated Financial Statements on page 11.

          At September 30, 2008, MSRs totaled $23 million or 0.91% of the $2.495 billion of associated loans serviced for others, up $1 million from the year ago balance accounted for under the amortized cost method. In addition to the loans we serviced for others with capitalized MSRs, at September 30, 2008, we serviced $2.848 billion of loans on a sub-servicing basis where we receive a fixed fee per loan, with no risk associated with changing MSR values.

Page 36
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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net cash servicing fees

$

1,797

$

1,750

$

1,765

$

2,166

$

1,657

Payoff and curtailment interest cost (a)

(208

)

(350

)

(471

)

(544

)

(787

)

Changes in fair value of mortgage servicing

rights due to: (b)

Change in valuation model inputs or

assumptions (c)

(1,038

)

3,325

(1,751

)

-

-

Other changes (d)

(607

)

(749

)

(739

)

-

-

Amortization of mortgage servicing rights

-

-

-

(1,085

)

(950

)

Provision for impairment of mortgage

servicing rights

-

-

-

(2,197

)

(214

)


Total loan servicing income (loss), net

$

(56

)

$

3,976

$

(1,196

)

$

(1,660

)

$

(294

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. However, loan servicing activities do not include the benefit of the use of total loan repayments to increase net interest income.
(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.

          For the first nine months of 2008, income of $2.7 million was recorded from loan servicing activities, compared to a loss of $1.5 million for the same period of 2007. The favorable change primarily reflected a reduction in payoff and curtailment interest costs and a favorable change in the fair value of MSRs in the current period versus the amortization of MSRs a year ago.

          The following table presents a breakdown of the components of our loan servicing income (loss), net during the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net cash servicing fees

$

5,312

$

4,862

Payoff and curtailment interest cost (a)

(1,029

)

(3,241

)

Change in fair value of mortgage servicing rights due to: (b)

Changes in valuation model inputs or assumptions (c)

536

-

Other changes (d)

(2,095

)

-

Amortization of mortgage servicing rights

-

(2,941

)

Reduction of impairment of mortgage servicing rights

-

(199

)


Total loan servicing income (loss), net

$

2,724

$

(1,519

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and the actual interest received when a loan prepays prior to the end of the month. However, loan servicing activities do not include the benefit of the use of total loan repayments to increase net interest income.
(b) Effective January 1, 2008, Downey adopted the fair value provision of SFAS 156 and remeasured its MSRs at fair value. Downey recorded a pretax adjustment to increase MSRs by $1.5 million and a corresponding cumulative effect adjustment of $0.9 million, after tax, to increase the 2008 beginning balance of retained earnings in stockholders’ equity.
(c) Reflects changes in assumptions for such items as discount rates and prepayment speeds.
(d) Represents changes due to realization of expected cash flows over time.

          Our net gains on sales of loans and mortgage-backed securities totaled $0.7 million in the current quarter, down $1.8 million from a year ago, reflecting a decline in loans sold, partially offset by a higher gain per dollar of loan sold. The current quarter included a $1.6 million loss due to the SFAS 133 impact of valuing derivatives associated with the sale of loans, compared with a SFAS 133 loss of $0.6 million in the year-ago quarter. Excluding the impact of SFAS 133, a gain was realized equal to 1.03% on secondary market sales of $221 million, compared with the year-ago gain of 0.91% on secondary market sales of $337 million.

Page 37
Navigation Links

          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Mortgage servicing rights

$

901

$

1,557

$

1,122

$

945

$

1,394

All other components excluding SFAS 133

1,377

916

596

(393

)

1,665

SFAS 133

(1,601

)

2,099

(69

)

(460

)

(553

)


Total net gains on sales of loans and

mortgage-backed securities

$

677

$

4,572

$

1,649

$

92

$

2,506


Secondary marketing gain excluding SFAS

133 as a percentage of associated sales

1.03

%

1.05

%

0.75

%

0.31

%

0.91

%


          For the first nine months of 2008, our sales of loans and mortgage-backed securities totaled $685 million, down from $1.622 billion a year ago. Net gains associated with these sales totaled $6.9 million in the current period, or $13.3 million lower than the prior year amount. Excluding the impact of SFAS 133, a gain equal to 0.94% per dollar of loan sold was realized in the current year, down from the year-ago gain of 1.21%.

          The following table presents a breakdown of the components of our net gains on sales of loans and mortgage-backed securities during the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Mortgage servicing rights

$

3,580

$

4,661

All other components excluding SFAS 133

2,889

14,999

SFAS 133

429

564


Total net gains on sales of loans and mortgage-backed securities

$

6,898

$

20,224


Secondary marketing gain excluding SFAS 133 as a percentage of associated sales

0.94

%

1.21

%


Operating Expense

          Operating expense totaled $102.7 million in the current quarter, up $40.0 million or 63.8% from a year ago. The increase primarily reflected an increase of $27.8 million in net operations of real estate acquired in the settlement of loans due to a higher number of foreclosed properties and general and administrative expense of $12.2 million or 20.7%. The increase in general and administrative expense between third quarters was primarily a result of increases of:

Page 38
Navigation Links

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Salaries and related costs

$

37,611

$

40,884

$

39,702

$

38,882

$

36,699

Premises and equipment costs

9,224

9,181

8,997

10,257

9,736

Advertising expense

1,473

816

461

1,443

1,400

Deposit insurance premiums and regulatory

assessments

8,117

3,689

3,703

2,516

2,413

Professional fees

3,000

843

303

916

489

Impairment writedown of goodwill

-

-

3,149

-

-

Other general and administrative expense

11,802

8,974

8,480

8,732

8,275


Total general and administrative expense

71,227

64,387

64,795

62,746

59,012

Net operation of real estate acquired in

settlement of loans

31,428

24,139

24,196

4,583

3,664


Total operating expense

$

102,655

$

88,526

$

88,991

$

67,329

$

62,676


          For the first nine months of 2008, operating expense totaled $280.2 million, up $89.5 million or 46.9% from a year ago. The increase primarily reflected higher net operations of real estate acquired in the settlement of loans, deposit insurance premiums, other general and administrative expense category, a goodwill impairment charge during the first quarter of 2008, and professional fees. Those increases were partially offset by a decline in salaries and related costs and advertising expense.

          The following table presents a breakdown of key components comprising operating expense during the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Salaries and related costs

$

118,197

$

119,931

Premises and equipment costs

27,402

27,667

Advertising expense

2,750

4,469

Deposit insurance premiums and regulatory assessments

15,509

7,659

Professional fees

4,146

1,779

Impairment writedown of goodwill

3,149

-

Other general and administrative expense

29,256

24,271


Total general and administrative expense

200,409

185,776

Net operation of real estate acquired in settlement of loans

79,763

4,903


Total operating expense

$

280,172

$

190,679


 

Provision for Income Taxes

          A tax benefit of $7.6 million was recorded in the current quarter, reflecting an effective tax rate of 8.6%, compared with the year-ago effective tax rate of 46.0%. For the first nine months of 2008, the effective tax rate benefit was 4.6%, compared with an effective tax rate of 42.2% a year ago. For further information, see Note 6 of Notes to Consolidated Financial Statements on page 20.

Business Segment Reporting

          The previous discussion and analysis of the Results of Operations pertained to our consolidated results. This section discusses and analyzes the results of operations of our two business segments: banking and real estate investment. For more information, see Note 10 of Notes to Consolidated Financial Statements on page 23.

Page 39
Navigation Links

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Banking net loss

$

(69,026

)

$

(215,707

)

$

(247,258

)

$

(109,282

)

$

(18,851

)

Real estate investment net income (loss)

(12,044

)

(3,212

)

(439

)

437

(4,510

)


Total net loss

$

(81,070

)

$

(218,919

)

$

(247,697

)

$

(108,845

)

$

(23,361

)


          The following table presents by business segment our net income for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Banking net income (loss)

$

(531,991

)

$

56,186

Real estate investment net loss

(15,695

)

(3,940

)


Total net income (loss)

$

(547,686

)

$

52,246


Banking

          A net loss of $69.0 million was recorded in the current quarter related to our banking operations, compared with a loss of $18.9 million a year ago. The unfavorable change between second quarters primarily reflected:

These unfavorable items were partially offset by an increase in other income of $68.1 million primarily due to the sale of non-core real estate related contracts.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net interest income

$

75,998

$

82,866

$

83,601

$

89,059

$

97,656

Provision for credit losses

130,291

258,874

236,870

218,447

81,562

Other income

78,820

17,224

9,439

7,424

10,756

Operating expense

102,325

88,207

88,672

67,038

62,365

Net intercompany income

3

22

46

15

22


Loss before income taxes (tax benefits)

(77,795

)

(246,969

)

(232,456

)

(188,987

)

(35,493

)

Income taxes (tax benefits)

(8,769

)

(31,262

)

14,802

(79,705

)

(16,642

)


Net loss

$

(69,026

)

$

(215,707

)

$

(247,258

)

$

(109,282

)

$

(18,851

)


At period end

Assets:

Loans and mortgage-backed securities, net

$

10,757,283

$

10,716,676

$

10,725,865

$

11,136,655

$

11,692,185

Other

2,004,305

1,902,632

2,392,047

2,258,746

2,710,006


Total assets

12,761,588

12,619,308

13,117,912

13,395,401

14,402,191


Equity

$

771,714

$

858,937

$

1,090,484

$

1,334,417

$

1,444,226


          For the first nine months of 2008, our net loss from our banking operations totaled $532.0 million, compared to income of $56.2 million a year ago. The unfavorable change primarily reflected a higher provision for credit losses, lower net interest income and higher operating expense, partially offset by higher other income.

Page 40
Navigation Links

          The following table sets forth our banking operational results for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net interest income

$

242,465

$

333,505

Provision for credit losses

626,035

91,684

Other income

105,483

45,056

Operating expense

279,204

189,700

Net intercompany income

71

53


Income (loss) before income taxes (tax benefits)

(557,220

)

97,230

Income taxes (tax benefits)

(25,229

)

41,044


Net income (loss)

$

(531,991

)

$

56,186


Real Estate Investment

          A net loss of $12.0 million was recorded in the current quarter from our real estate investment operations, compared to a net loss of $4.5 million a year ago. The unfavorable change primarily reflects net losses from the sale of wholly owned real estate in the current quarter.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Net interest income

$

29

$

65

$

124

$

236

$

314

Other income (loss)

(10,605

)

(5,159

)

(501

)

803

(7,720

)

Operating expense

330

319

319

291

311

Net intercompany expense

(3

)

(22

)

(46

)

(15

)

(22

)


Income (loss) before income taxes (tax benefits)

(10,909

)

(5,435

)

(742

)

733

(7,739

)

Income taxes (tax benefits)

1,135

(2,223

)

(303

)

296

(3,229

)


Net income (loss)

$

(12,044

)

$

(3,212

)

$

(439

)

$

437

$

(4,510

)


At period end

Assets:

Investments in real estate and joint ventures

$

15,606

$

63,182

$

71,196

$

68,679

$

58,715

Other

11,356

8,224

15,848

19,023

30,420


Total assets

26,962

71,406

87,044

87,702

89,135


Equity

$

7,351

$

58,395

$

73,607

$

74,046

$

73,609


          For the first nine months of 2008, a net loss of $15.7 million was recorded related to our real estate investment operations, compared to a loss of $3.9 million a year ago. The unfavorable change primarily reflected an increase in the writedowns of single family lots in which we are a joint venture partner, partially offset by higher net gains from sales.

          The following table sets forth our real estate investment operational results for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Net interest income

$

218

$

1,038

Other loss

(16,265

)

(6,807

)

Operating expense

968

979

Net intercompany expense

(71

)

(53

)


Loss before income tax benefits

(17,086

)

(6,801

)

Income taxes (tax benefits)

(1,391

)

(2,861

)


Net income (loss)

$

(15,695

)

$

(3,940

)


          Our investments in real estate and joint ventures amounted to $16 million at September 30, 2008, down from $69 million at December 31, 2007, and $59 million at September 30, 2007.

          For information on valuation allowances associated with real estate and joint venture loans, see Allowance for Credit and Real Estate Losses on page 65.

Page 41
Navigation Links

FINANCIAL CONDITION

Loans and Mortgage-Backed Securities

          Total loans and mortgage-backed securities, including those we hold for sale, increased $41 million during the current quarter to $10.8 billion or 84.2% of total assets at September 30, 2008. During the quarter, loans held for investment increased $119 million while loans held for sale declined $78 million.

          Our loan originations, including loans purchased, totaled $804 million in the current quarter, up $110 million or 15.8% from the $694 million we originated in the year-ago third quarter but 21.8% less than the $1.027 billion we originated in the second quarter of 2008. Loans originated for sale declined $98 million or 39.8% from a year ago to $147 million, while single family loans originated for portfolio increased $128 million or 29.6% to $560 million. Our prepayment speed, which measures the annualized percentage of loans repaid, for residential one-to-four unit loans held for investment declined from 27% a year ago to 9% in the current quarter and was down from 13% in the second quarter of 2008. During the current quarter, 42% of our residential one-to-four unit originations represented refinance transactions, including new loans to refinance existing loans which we or other lenders originated. This is down from 61% in the second quarter of 2008 and down from 79% in the year-ago third quarter.

          Not included in the above originations are loans in which we modified the terms of the notes for borrowers. During the current quarter, we modified $157 million of loans associated with our borrower retention program. This program provided borrowers who were current with their loan payments with the opportunity to change from an adjustable rate loan subject to negative amortization to less costly financing alternatives, albeit at new interest rates that were no less than those offered new borrowers. The majority of these modifications were modified into adjustable rate loans whereby the interest rate adjusts semi-annually but does not permit negative amortization. An additional $149 million of loans were modified at below market interest rates in loan workout situations.

          We originate residential one-to-four unit mortgage loans both with and without loan origination fees. In mortgage transactions for which we charge no origination fees, we receive a higher interest rate than those for which we charge origination fees. These loans generally result in deferrable loan origination costs exceeding loan origination fees. A prepayment fee on these loans may be required if these loans are prepaid within the first three years.

          Originations of adjustable rate residential one-to-four unit loans for portfolio, including loans purchased, totaled $553 million in the current quarter, up from $432 million in the year-ago quarter but down from $748 million in the second quarter of 2008. Of the current quarter total:

Page 42
Navigation Links

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

16,587

$

1,515

$

7,170

$

77,163

$

101,698

MTA (a)

354

1,706

740

4,953

(177

)

LIBOR

8,070

6,562

490

2,102

5,968

CMT

7,169

3,677

1,285

7,572

6,415

Adjustable – fixed for 3-5 years

521,273

734,242

424,939

302,705

317,770

Fixed

6,805

2,876

702

-

588


Total residential one-to-four units

560,258

750,578

435,326

394,495

432,262

Other

95,953

64,765

3,382

31,682

16,743


Total for investment portfolio

656,211

815,343

438,708

426,177

449,005

Sale portfolio (b)

147,292

211,726

237,356

192,053

244,831


Total for investment and sale portfolios

$

803,503

$

1,027,069

$

676,064

$

618,230

$

693,836


(a) Originations for the quarter ending September 30, 2007 are net of $1.0 million of cancelled loans that were originated in the previous quarter.
(b) All residential one-to-four unit loans.

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

Nine Months Ended September 30,


(In Thousands)

2008

2007


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

25,272

$

257,201

MTA

2,800

7,621

LIBOR

15,122

383,069

CMT

12,131

66,543

Adjustable – fixed for 3-5 years

1,680,454

1,018,805

Fixed

10,383

873


Total residential one-to-four units

1,746,162

1,734,112

Other

164,100

49,119


Total for investment portfolio

1,910,262

1,783,231

Sale portfolio (a)

596,374

1,380,371


Total for investment and sale portfolios

$

2,506,636

$

3,163,602


(a) Primarily residential one-to-four unit loans.
Page 43
Navigation Links

          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.

September 30, 2008

June 30, 2008

March 31, 2008

December 31, 2007

September 30, 2007


% of

% of

% of

% of

% of

(Dollars in Thousands)

Amount

Total

Amount

Total

Amount

Total

Amount

Total

Amount

Total


Loan Investment Portfolio

Residential one-to-four units:

Adjustable by index:

COFI

$

5,342,617

75

%

$

5,599,857

75

%

$

5,893,818

74

%

$

6,383,837

75

%

$

6,899,483

76

%

MTA

950,163

13

1,047,051

14

1,163,661

15

1,256,672

15

1,398,540

15

LIBOR

255,208

4

250,271

3

274,555

3

444,483

5

586,143

7

Other, primarily CMT

579,518

8

588,571

8

595,695

8

394,829

5

204,513

2


Total adjustable loans (a)

$

7,127,506

100

%

$

7,485,750

100

%

$

7,927,729

100

%

$

8,479,821

100

%

$

9,088,679

100

%


(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:

          Our adjustable rate loans subject to negative amortization, which are no longer offered to borrowers, have an interest rate that adjusts monthly and a minimum monthly loan payment that adjusts annually. The start rate for these loans is lower than the fully-indexed rate and is the rate at which we earned interest for the loan only during the first month. After the first month, interest accrues at the fully-indexed rate. The start rate, however, is used to calculate the minimum monthly loan payment for the first twelve months. The borrower is required to make at least the minimum monthly payment, but retains the option to make a larger payment to reduce loan principal and avoid negative amortization (the addition to loan principal of accrued interest that exceeds the minimum monthly loan payment). If the borrower chooses to make the minimum monthly loan payment, and the interest accrual based on the fully-indexed rate results in monthly interest due exceeding the payment amount, the loan balance will increase by the difference. These payment options were clearly defined in the loan documents signed by the borrower at funding and are explained again on the borrower’s monthly statement.

          More particularly, our adjustable rate loans subject to negative amortization:

          The maximum home loan we currently make for our own portfolio, except for a limited amount related to Community Reinvestment Act ("CRA") activities and loans to facilitate the sale of real estate acquired in settlement of loans, is equal to 80% of a property’s appraised value. If a loan incurs negative amortization, the loan-to-value ratio could rise, which increases credit risk, and the fair value of the underlying collateral could be insufficient to satisfy fully the outstanding loan obligation in the event of a loan default. A loan-to-value ratio is the proportion of the principal amount of the loan to the lower of the sales price or appraised value of the property securing the loan at origination.

Page 44
Navigation Links

          Our loan portfolio held for investment contains loans previously originated with a limit on the maximum loan balance of 125% of the original loan amount. At September 30, 2008, loans with the higher 125% limit on the maximum loan balance represented 2% of our one-to-four unit residential loan portfolio, while those with the 115% limit represented 4% and those with the 110% limit represented 46% of that portfolio. We permit adjustable rate mortgage loans to be assumed by qualified borrowers.

          While start rates of our loan products fluctuate with the market, we do not use them to qualify a loan applicant. Rather, we qualify an applicant for adjustable rate mortgage loans using a fully-amortizing payment calculated from the higher of the fully-indexed rate or, currently, for our:

          At September 30, 2008, $5.7 billion or 52% of our total residential one-to-four unit loans held for investment were subject to negative amortization. The amount of negative amortization included in the loan balance declined $27 million during the quarter to $318 million or 5.6% of loans subject to negative amortization. During current quarter, approximately 10% of our loan interest income represented negative amortization, down from 15% in the second quarter of 2008 and 26% in year-ago third quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%. In addition, $4.4 billion or 40% of our residential one-to-four unit loans held for investment represented loans requiring interest only payments over the initial terms of the loans, generally the first three to five years.

Page 45
Navigation Links

          The following table sets forth our investment portfolio of residential one-to-four unit adjustable rate loans subject to negative amortization and with interest only payments, along with negative amortization included in the loan balance, loan to value ratio information and weighted average age of the loans, at the dates indicated.

Negative

Loan to

Current

Weighted

Amortization

Value

Loan to

Average

Loan

% of

Included in the

Ratio at

Value

Age

(Dollars in Thousands)

Balance

Total

Loan Balance

Origination

Ratio (a)

(Months)


Loan Investment Portfolio

Residential one-to-four units subject to negative amortization:

At September 30, 2008:

With negative amortization:

Balance less than or equal to original loan amount

$

126,949

2

%

$

1,063

71

%

69

%

42

Balance greater than original loan amount

4,925,666

86

316,439

74

79

37


Total with negative amortization

5,052,615

88

317,502

74

79

37

Not utilizing negative amortization

662,451

12

-

70

64

69


Total loans subject to negative amortization

$

5,715,066

100

%

$

317,502

73

%

77

%

41

As a percentage of total residential one-to-four unit loans

52

%


Total loans with interest only payments (b)

$

4,373,160

70

%

71

%

21

As a percentage of total residential one-to-four unit loans

40

%


At December 31 2007:

With negative amortization:

Balance less than or equal to original loan amount

$

189,508

3

%

$

1,253

70

%

69

%

37

Balance greater than original loan amount

6,501,649

86

377,411

74

78

29


Total with negative amortization

6,691,157

89

378,664

74

78

30

Not utilizing negative amortization

839,433

11

-

69

65

55


Total loans subject to negative amortization

$

7,530,590

100

%

$

378,664

73

%

77

%

32

As a percentage of total residential one-to-four unit loans

69

%


Total loans with interest only payments

$

2,745,117

70

%

70

%

16

As a percentage of total residential one-to-four unit loans

25

%


At September 30, 2007:

With negative amortization:

Balance less than or equal to original loan amount

$

213,427

3

%

$

1,358

70

%

69

%

36

Balance greater than original loan amount

7,104,531

86

386,626

74

78

27


Total with negative amortization

7,317,958

89

387,984

74

78

28

Not utilizing negative amortization

937,431

11

-

69

65

50


Total loans subject to negative amortization

$

8,255,389

100

%

$

387,984

73

%

76

%

30

As a percentage of total residential one-to-four unit loans

74

%


Total loans with interest only payments

$

2,456,416

69

%

69

%

13

As a percentage of total residential one-to-four unit loans

22

%


(a) Based on current loan balance relative to the lower of the appraised value or sales price at time of origination. (b) Loans with interest only payments include loans modified with previously capitalized interest due to negative amortization.

          Our adjustable rate loans subject to negative amortization require a payment recast every five years and additionally when the loan balance reaches the maximum permissible level of negative amortization, while interest only loans require a payment recast when the initial fixed rate or interest only period expires. At payment recast, the fully-indexed interest rate is used to calculate a new monthly loan payment that provides for full amortization of the loan balance over the remaining term of the loan. Generally, the new loan payment is significantly higher and therefore default risk typically increases. We have other adjustable rate loans that also are subject to payment recasts but the new loan payments are not likely to be as severe as those associated with loans subject to negative amortization or interest only payments because the original loan payments already include principal amortization.

Page 46
Navigation Links

          The following table sets forth projected first-time loan payment recasts for our investment portfolio of residential one-to-four unit adjustable rate loans subject to negative amortization and loans with interest only payments for the fourth quarter of 2008 and annually thereafter through 2012. To determine projected first-time loan payment recasts, we assumed that borrowers will continue to utilize negative amortization at the same rate as they did in the preceding 12 months and no loans prepay. Therefore, the projected recast amounts may be overstated as some portion of these loans is likely to prepay or be modified as part of our borrower retention or loan workout programs. For example, at the end of the second quarter of 2008, we forecasted that $460 million of loans subject to negative amortization and loans with interest only payments would recast for the first-time during the second quarter of 2008, of which $283 million did recast while:

Projected First-Time Loan Recasts at September 30, 2008 for


4th Quarter

Year Ended

Year Ended

Year Ended

Year Ended

(Dollars in Thousands)

2008

2009

2010

2011

2012


Loan Investment Portfolio

Residential one-to-four units:

Loans subject to negative amortization

$

287,489

$

1,244,001

$

1,412,573

$

888,950

$

430,995

Loans with interest only payments

1,905

152,819

32,397

1,437,642

1,270,105

All other loans (a)

394

87,283

45,591

302,689

50,908


Total

$

289,788

$

1,484,103

$

1,490,561

$

2,629,281

$

1,752,008

As a percentage of total residential

one-to-four unit loans

3

%

14

%

14

%

24

%

16

%


(a) Represents fully-amortizing adjustable rate loans.
Page 47
Navigation Links

          At September 30, 2008, 15% of our residential one-to-four unit loans were originated in 2008, with an additional 15% in 2007, and 25% in 2006, which are relatively new and unseasoned. The following table sets forth our investment portfolio of residential one-to-four unit loans by year of origination segregated by those subject to negative amortization, those with interest only payments and all others at the dates indicated. From year to year, loans may change categories due to modification.

Loans by Year of Origination


(Dollars in Thousands)

2004 and Prior

2005

2006

2007

2008

Balance


Loan Investment Portfolio

Residential one-to-four units:

At September 30, 2008:

Loans subject to negative amortization

$

1,486,305

$

2,181,840

$

1,599,568

$

410,262

$

37,091

$

5,715,066

Hybrid adjustable rate loans:

Interest only payments

108,108

54,633

832,998

1,015,074

1,261,526

3,272,339

Fully amortizing

84,355

73,238

60,069

78,270

332,004

627,936


Total hybrid adjustable rate loans

192,463

127,871

893,067

1,093,344

1,593,530

3,900,275

Non-hybrid interest only loans

221,647

514,022

189,100

140,168

35,884

1,100,821

All other loans (a)

145,253

29,910

15,333

34,699

18,244

243,439


Total residential one-to-four units

$

2,045,668

$

2,853,643

$

2,697,068

$

1,678,473

$

1,684,749

$

10,959,601

As a percentage of total residential

one-to-four unit loans

19

%

26

%

25

%

15

%

15

%

100

%


2004 and Prior

2005

2006

2007

2008

Balance


At September 30, 2007:

Loans subject to negative amortization

$

2,438,438

$

3,512,669

$

1,980,013

$

324,269

$

-

$

8,255,389

Hybrid adjustable rate loans:

Interest only payments

147,222

51,784

918,761

887,577

-

2,005,344

Fully amortizing

82,773

2,326

51,250

51,861

-

188,210


Total hybrid adjustable rate loans

229,995

54,110

970,011

939,438

-

2,193,554

Non-hybrid interest only loans

43,109

14,001

133,086

260,876

-

451,072

All other loans (a)

160,497

10,936

16,826

139,287

-

327,546


Total residential one-to-four units

$

2,872,039

$

3,591,716

$

3,099,936

$

1,663,870

$

-

$

11,227,561

As a percentage of total residential

one-to-four unit loans

25

%

32

%

28

%

15

%

-

%

100

%


(a) Represents fully-amortizing adjustable rate loans and fixed rate loans.
Page 48
Navigation Links

          At September 30, 2008, 90% of our residential one-to-four unit loans were concentrated and secured by properties located in California. The following table sets forth the major geographic distribution of our investment portfolio of residential one-to-four unit loans at the dates indicated.

September 30,


2008

2007


% of

% of

(Dollars in Thousands)

Amount

Total

Amount

Total


Loan Investment Portfolio

Residential one-to-four units:

California county:

Los Angeles

$

2,103,692

19

%

$

2,053,395

19

%

San Diego

1,213,173

11

1,287,091

12

Santa Clara

1,162,620

11

915,134

8

Orange

911,994

8

894,280

8

Alameda

557,382

5

569,392

5

Riverside

483,644

4

565,185

5

Contra Costa

471,255

4

493,200

4

San Mateo

356,430

3

298,290

3

San Bernardino

312,356

3

350,286

3

Sacramento

277,404

3

340,490

3

All other counties

2,038,234

19

2,172,137

19


Total California

9,888,184

90

9,938,880

89

Arizona

431,332

4

480,301

4

All other states

640,085

6

808,380

7


Total residential one-to-four units

$

10,959,601

100

%

$

11,227,561

100

%


          The following table sets forth our investment portfolio of residential one-to-four unit loans by the Fair Isaac Corporation credit score model ("FICO") of the borrower at origination at the dates indicated.

September 30, 2008

June 30, 2008

March 31, 2008

December 31, 2007

September 30, 2007


% of

% of

% of

% of

% of

(Dollars in Thousands)

Amount

Total

Amount

Total

Amount

Total

Amount

Total

Amount

Total


Loan Investment Portfolio

Residential one-to-four units:

FICO score at Origination:

620 or below

$

341,495

3

%

$

361,879

3

%

$

384,320

4

%

$

407,764

4

%

$

443,748

4

%

621 to 659

2,238,634

20

2,348,417

22

2,463,700

23

2,573,185

24

2,697,313

24

660 to 719

3,990,707

37

4,034,572

37

4,046,287

38

4,122,326

38

4,232,819

38

720 and above

4,262,804

39

4,020,953

37

3,683,490

34

3,630,721

33

3,705,685

33

Not available

125,961

1

129,068

1

134,438

1

143,232

1

147,996

1


Total residential one-to-four units

$

10,959,601

100

%

$

10,894,889

100

%

$

10,712,235

100

%

$

10,877,228

100

%

$

11,227,561

100

%


Weighted average FICO score for

loan investment portfolio of

residential one-to-four units

704

702

698

697

696


Page 49
Navigation Links

          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, if private mortgage insurance has been removed, a current appraisal.

September 30, 2008

June 30, 2008

March 31, 2008

December 31, 2007

September 30, 2007


% of

% of

% of

% of

% of

(Dollars in Thousands)

Amount

Total

Amount

Total

Amount

Total

Amount

Total

Amount

Total


Loan Investment Portfolio

Residential one-to-four units:

80% or below:

60% or less

$

1,600,167

15

%

$

1,590,553

15

%

$

1,504,295

14

%

$

1,539,989

14

%

$

1,628,047

14

%

61% to 70%

2,185,379

20

2,111,314

19

1,972,543

18

1,931,397

18

1,966,339

18

71% to 80%

6,722,658

61

6,711,241

61

6,717,851

63

6,866,261

63

7,067,710

63


Total 80% or below

10,508,204

96

10,413,108

95

10,194,689

95

10,337,647

95

10,662,096

95

81% to 85%:

With private mortgage insurance:

MGIC

8,255

8,928

8,923

7,805

7,782

RMIC

36,871

38,260

40,032

42,231

42,630

UGI

24,270

27,507

29,176

31,131

32,290

All others

1,096

1,260

1,448

1,452

1,786


Total with private mortgage

insurance

70,492

1

75,955

1

79,579

1

82,619

1

84,488

1

Without private mortgage insurance

2,971

-

2,991

-

2,805

-

1,728

-

1,145

-


Total 81% to 85%

73,463

1

78,946

1

82,384

1

84,347

1

85,633

1

86% to 89%:

With private mortgage insurance:

MGIC

19,167

20,134

20,552

19,563

21,252

RMIC

85,076

94,284

104,558

107,673

111,908

UGI

41,271

45,249

50,402

53,423

55,757

All others

4,319

4,351

4,941

4,959

6,051


Total with private mortgage

insurance

149,833

1

164,018

2

180,453

2

185,618

2

194,968

2

Without private mortgage insurance

5,195

-

4,457

-

4,532

-

4,624

-

4,355

-


Total 86% to 89%

155,028

1

168,475

2

184,985

2

190,242

2

199,323

2

90% and above:

With private mortgage insurance

MGIC

16,658

18,864

19,348

19,981

22,614

RMIC

104,696

113,895

126,184

132,823

140,568

UGI

58,670

62,172

66,047

73,066

77,989

All others

6,482

6,622

7,179

7,398

8,587


Total with private mortgage

insurance

186,506

2

201,553

2

218,758

2

233,268

2

249,758

2

Without private mortgage insurance (a)

33,808

-

30,114

-

28,534

-

28,778

-

27,786

-


Total 90% and above

220,314

2

231,667

2

247,292

2

262,046

2

277,544

2

Not available

2,592

-

2,693

-

2,885

-

2,946

-

2,965

-


Total residential one-to-four units

$

10,959,601

100

%

$

10,894,889

100

%

$

10,712,235

100

%

$

10,877,228

100

%

$

11,227,561

100

%


Weighted average loan-to-value ratio

for loan investment portfolio of

residential one-to-four units

72

72

72

72

73


(a) Primarily related to Community Reinvestment Act activities.

          In addition to the other credit risks already identified, 74% of our residential one-to-four unit loans held for investment at September 30, 2008 were underwritten based on borrower stated income and asset verification and an additional 5% were underwritten with no verification of either borrower income or assets. In April 2008, we changed our guidelines to no longer permit stated income programs for portfolio loans.

Page 50
Navigation Links

          Credit risks are mitigated primarily by various minimum borrower credit requirements and maximum loan-to-value ratio limitations. For example, at September 30, 2008, the average loan-to-value ratio at origination of our residential one-to-four unit loan portfolio was 72%. However, even with these requirements and limitations, our risk mitigation strategy is limited by potential defects in the underwriting process as well as potential changes in the loan-to-value ratio due to negative amortization and declines in home values after the loans were originated. For example, while residential property values increased in the past thereby further reducing our exposure to credit risk, home value declines emerged in 2006 and are continuing in most markets in which we lend. The uncertainty of future home value changes may materially impact the risk associated with our loan portfolio since 55% of these loans were originated after 2005.

          We originated $3 million of home equity loans and lines of credit in the current quarter, unchanged from both the second quarter of 2008 and year-ago third quarter. During the current quarter, we originated $83 million of residential five or more unit loans, compared to $24 million in the second quarter of 2008 and none in the year-ago third quarter. During the current quarter we originated less than $1 million of construction loans, down from $36 million in the second quarter of 2008 and $12 million in the year-ago third quarter. Consumer loan originations totaled $1 million in the current quarter, up from less than $1 million in the second quarter of 2008 but down from $2 million in the year-ago third quarter.

          At September 30, 2008, our unfunded loan application pipeline totaled $423 million. Within that pipeline, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $216 million, of which $38 million were related to residential one-to-four unit loans being originated for sale in the secondary market. Furthermore, we had commitments for undrawn lines of credit of $205 million and loans in process of $63 million. We believe our current sources of funds will be adequate relative to these obligations.

Page 51
Navigation Links

          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Investment Portfolio

Loans originated:

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

32,180

$

13,460

$

9,685

$

92,109

$

113,585

Adjustable – fixed for 3-5 years

521,273

734,242

424,939

302,386

318,089

Fixed

6,805

2,876

702

-

588


Total residential one-to-four units

560,258

750,578

435,326

394,495

432,262

Home equity loans and lines of credit

3,325

3,322

2,019

2,268

3,048

Residential five or more units – adjustable

82,970

24,345

-

-

-


Total residential

646,553

778,245

437,345

396,763

435,310

Commercial real estate

8,180

-

-

-

-

Construction

271

36,478

275

28,524

11,551

Land

197

161

41

103

135

Non-mortgage:

Commercial

-

-

305

-

300

Consumer

1,010

459

742

787

1,709


Total loans originated

656,211

815,343

438,708

426,177

449,005

Loan repayments

(297,790

)

(412,751

)

(552,942

)

(747,862

)

(979,625

)

Other net changes (a)

(239,927

)

(388,083

)

(302,423

)

(247,000

)

(71,735

)


Increase (decrease) in loans held for investment, net

118,494

14,509

(416,657

)

(568,685

)

(602,355

)


Sale Portfolio

Residential one-to-four unit loans:

Originated

143,610

210,055

236,568

190,816

240,423

Purchased

3,682

1,671

788

1,237

4,408

Loans transferred to the investment portfolio

(4,254

)

(1,077

)

(123

)

(579

)

(6,669

)

Originated whole loans sold

(16,548

)

(398

)

(1,505

)

(1,999

)

(93,774

)

Loans exchanged for mortgage-backed securities (b)

(204,613

)

(234,715

)

(227,482

)

(173,909

)

(243,546

)

Capitalized basis adjustment (c)

215

920

(1,243

)

(208

)

2,103

Other net changes (d)

23

(151

)

(1,134

)

(2,202

)

(469

)


Increase (decrease) in loans held for sale, net

(77,885

)

(23,695

)

5,869

13,156

(97,524

)


Mortgage-backed securities, net:

Received in exchange for loans (b)

204,613

234,715

227,482

173,909

243,546

Sold (b)

(204,613

)

(234,715

)

(227,482

)

(173,909

)

(243,546

)

Repayments

(2

)

(3

)

(2

)

(1

)

(2

)

Other net changes

-

-

-

-

-


Decrease in mortgage-backed securities

available for sale

(2

)

(3

)

(2

)

(1

)

(2

)


Increase (decrease) in loans held for sale and

mortgage-backed securities available for sale

(77,887

)

(23,698

)

5,867

13,155

(97,526

)


Total increase (decrease) in loans and

mortgage-backed securities, net

$

40,607

$

(9,189

)

$

(410,790

)

$

(555,530

)

$

(699,881

)


(a) Primarily included changes in undisbursed funds for lines of credit and construction loans, in loss allowances, in net deferred costs and premiums, in interest capitalized on loans (negative amortization), and from loans transferred to real estate acquired in settlement of loans or from (to) the held for sale portfolio.
(b) These transactions typically involve creation of an MBS by a government sponsored entity (GSE) from loans sold by, and delivered by, us to the GSE. While the GSE is obligated to provide us with the MBS in exchange for the sold loans, the GSE typically fulfills this commitment through delivery of the MBS directly to the third-party purchaser based on a forward sales commitment made by us to that third party. The sales of both the loans and MBS are settled typically on a same-day basis such that we do not retain the MBS. If the MBS were to be retained with an intent to sell, we would classify the security as held for trading and record changes in fair value in our consolidated statement of income.
(c) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we included the fair value of MSRs in the fair value of interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan Commitments Recorded at Fair Value Through Earnings.
(d) Primarily included repayments and the change in net deferred costs and premiums.
Page 52
Navigation Links

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

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Investment Portfolio

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

6,989,861

$

7,343,057

$

7,781,332

$

8,302,538

$

8,999,273

Adjustable – fixed for 3-5 years

3,916,019

3,504,702

2,884,877

2,528,287

2,180,099

Fixed

53,721

47,130

46,026

46,403

48,189


Total residential one-to-four units

10,959,601

10,894,889

10,712,235

10,877,228

11,227,561

Home equity loans and lines of credit

132,907

131,531

133,338

138,305

143,948

Residential five or more units:

Adjustable

193,914

120,565

99,522

100,098

103,798

Fixed

10,258

838

852

865

874

Commercial real estate:

Adjustable

28,796

21,562

23,651

23,837

23,966

Fixed

1,042

1,071

1,098

2,590

2,632

Construction

97,907

105,991

74,730

81,098

58,231

Land

10,708

10,524

10,373

49,521

50,864

Non-mortgage:

Commercial

5,305

5,505

5,305

5,000

5,000

Consumer

5,993

5,823

5,934

5,989

6,057


Total loans held for investment

11,446,431

11,298,299

11,067,038

11,284,531

11,622,931

Increase (decrease) for:

Undisbursed loan funds

(64,674

)

(74,228

)

(51,595

)

(60,057

)

(48,063

)

Net deferred costs and premiums

129,573

139,295

147,811

156,853

169,195

Allowance for losses

(761,824

)

(732,354

)

(546,751

)

(348,167

)

(142,218

)


Total loans held for investment, net

10,749,506

10,631,012

10,616,503

11,033,160

11,601,845


Sale Portfolio

Loans held for sale:

Residential one-to-four units

7,624

85,854

110,685

103,320

89,794

Net deferred costs and premiums

(16

)

(146

)

(362

)

(109

)

53

Capitalized basis adjustment (a)

65

(150

)

(1,070

)

173

381


Total loans held for sale, net

7,673

85,558

109,253

103,384

90,228

Mortgage-backed securities available for sale:

Adjustable

104

106

109

111

112

Fixed

-

-

-

-

-


Total mortgage-backed securities available for sale

104

106

109

111

112


Total loans held for sale and mortgage-backed

securities available for sale

7,777

85,664

109,362

103,495

90,340


Total loans and mortgage-backed securities, net

$

10,757,283

$

10,716,676

$

10,725,865

$

11,136,655

$

11,692,185


(a) Reflected the change in fair value of the interest rate lock derivative from the date of rate lock to the date of funding. Effective January 2008, we included the fair value of MSRs in the fair value of the interest rate lock derivatives in accordance with Staff Accounting Bulletin 109, Written Loan Commitments Recorded at Fair Value Through Earnings.

          We carry loans for sale at the lower of cost or fair value. At September 30, 2008, no valuation allowance was required as the fair value exceeded book value on an aggregate basis.

          We carry mortgage-backed securities available for sale at fair value which, at September 30, 2008, was essentially equal to our cost basis.

Page 53
Navigation Links

Investment Securities

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

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Federal funds and interest earning due from banks

$

101,129

$

11,060

$

-

$

5,900

$

1,551

Investment securities available for sale:

U.S. Treasury

-

-

-

-

-

Government sponsored entities

592,481

998,396

1,603,039

1,549,818

2,142,216

Other

61

61

61

61

62


Total investment securities

$

693,671

$

1,009,517

$

1,603,100

$

1,555,779

$

2,143,829


          The fair value of temporarily impaired investment securities, the amount of unrealized losses and the length of time these unrealized losses existed as of September 30, 2008 are presented in the following table. The $7 million unrealized loss on investment securities that have been in a loss position for less than 12 months is due to changes in market interest rates and is not considered to be other than temporary. We have the intent and ability to hold the securities until that temporary impairment is eliminated.

Less than 12 months

12 months or longer

Total


Unrealized

Unrealized

Unrealized

(In Thousands)

Fair Value

Losses

Fair Value

Losses

Fair Value

Losses


Investment securities available for sale:

U.S. Treasury

$

-

$

-

$

-

$

-

$

-

$

-

Government sponsored entities

243,234

6,766

-

-

243,234

6,766


Total temporarily impaired securities

$

243,234

$

6,766

$

-

$

-

$

243,234

$

6,766


          The following table sets forth the maturities of our investment securities and their weighted average yields at September 30, 2008.

Amount Due as of September 30, 2008


In 1 Year

After 1 Year

After 5 Years

After

(Dollars in Thousands)

or Less

Through 5 Years

Through 10 Years

10 Years

Total


Federal funds and interest earning due

from banks

$

101,129

$

-

$

-

$

-

$

101,129

Weighted average yield

0.77

%

-

%

-

%

-

%

0.77

%

Investment securities available for sale:

U.S. Treasury

-

-

-

-

-

Weighted average yield

-

%

-

%

-

%

-

%

-

%

Government sponsored entities (a)

-

349,247

98,124

145,110

592,481

Weighted average yield

-

%

5.09

%

4.40

%

4.68

%

4.87

%

Other

-

-

-

61

61

Weighted average yield

-

%

-

%

-

%

6.25

%

6.25

%


Total investment securities

$

101,129

$

349,247

$

98,124

$

145,171

$

693,671

Weighted average yield

0.77

%

5.09

%

4.40

%

4.68

%

4.27

%


(a) At September 30, 2008, 41% of our investment securities had step-up provisions that stipulate increases in the coupon rate ranging from 0.25% to 1.43% at various specified dates ranging from February 2011 to February 2020. In addition, at September 30, 2008, all of these investment securities contained call provisions from June 2008 to November 2022. Yields for investment securities available for sale are calculated using historical cost balances and are not adjusted for changes in fair value that are reflected as a separate component of stockholders’ equity.

Deposits

          At September 30, 2008, our deposits totaled $9.6 billion, down $1.0 billion or 9.8% from the year-ago level and $878 million or 8.4% from year-end 2007. Compared with the year-ago period, certificates of deposit declined $719 million or 8.7% and our transaction accounts (i.e., checking, money market and regular passbook) declined $325 million or 13.8%. Within our transaction accounts, regular passbook accounts declined $290 million and checking accounts declined $148 million while money market increased $113 million. Of the decline in checking, $8 million was in custodial accounts related to loan servicing, which reflected the concurrent decline in loan prepayments.

Page 54
Navigation Links

          At September 30, 2008, our total number of branches was 175, of which 170 were located in California and five were located in Arizona. The average deposit size of our 85 traditional branches was $89 million, while the average deposit size of our 90 in-store branches was $23 million.

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

September 30, 2008

June 30, 2008

March 31, 2008

December 31, 2007

September 30, 2007


Weighted

Weighted

Weighted

Weighted

Weighted

Average

Average

Average

Average

Average

(Dollars in Thousands)

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount


Transaction accounts:

Non-interest-bearing

checking (a)

-

%

$

628,492

-

%

$

664,895

-

%

$

673,717

-

%

$

645,730

-

%

$

679,148

Interest-bearing

checking (a)

0.27

365,930

0.27

443,801

0.29

467,051

0.27

464,980

0.27

462,973

Money market

2.26

251,160

1.47

185,036

1.04

137,745

1.04

134,640

1.04

138,256

Regular passbook

0.89

781,622

0.93

1,002,450

0.93

1,033,302

0.95

1,035,964

0.95

1,071,728


Total transaction

accounts

0.67

2,027,204

0.58

2,296,182

0.54

2,311,815

0.55

2,281,314

0.55

2,352,105

Certificates of deposit:

Less than 2.00%

1.26

22,805

1.27

26,765

1.28

26,374

1.25

21,915

1.28

20,070

2.00-2.49

2.45

464,836

2.45

475,931

2.44

118,716

2.31

148

2.33

163

2.50-2.99

2.94

1,532,295

2.92

1,927,169

2.90

370,206

2.83

6,889

2.83

8,068

3.00-3.49

3.15

1,880,018

3.23

1,715,721

3.29

1,094,117

3.28

72,288

3.28

87,110

3.50-3.99

3.84

1,147,577

3.76

776,072

3.75

894,761

3.86

43,481

3.84

49,390

4.00-4.49

4.17

1,552,749

4.24

557,160

4.23

618,422

4.29

306,302

4.26

189,990

4.50-4.99

4.68

924,106

4.80

1,845,236

4.81

4,061,873

4.85

6,026,108

4.91

5,225,991

5.00-5.49

5.05

66,787

5.07

260,735

5.09

747,306

5.10

1,736,673

5.11

2,728,452

5.50 and greater

6.06

7

6.06

7

6.06

699

6.00

923

5.82

1,279


Total certificates

of deposit

3.57

7,591,180

3.67

7,584,796

4.33

7,932,474

4.85

8,214,727

4.93

8,310,513


Total deposits

2.96

%

$

9,618,384

2.95

%

$

9,880,978

3.47

%

$

10,244,289

3.92

%

$

10,496,041

3.96

%

$

10,662,618


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

Borrowings

          At September 30, 2008, our borrowings totaled $2.3 billion, up $235 million from a year ago and up $913 million from year-end 2007. During the current quarter, borrowings increased by $487 million and represented 18% of total assets at quarter end. This increase is largely due to additional FHLB advances of $585 million, partially offset by the decline in securities sold under agreements to repurchase of $98 million.

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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Securities sold under agreements to repurchase

$

-

$

97,838

$

103,000

$

-

$

566,350

Federal Home Loan Bank advances (a)

2,110,061

1,525,034

1,434,602

1,197,100

1,308,867

Senior notes

198,593

198,543

198,494

198,445

198,398


Total borrowings

$

2,308,654

$

1,821,415

$

1,736,096

$

1,395,545

$

2,073,615


Weighted average rate on borrowings during

the quarter (a)

3.68

%

3.73

%

4.74

%

5.80

%

5.94

%

Total borrowings as a percentage of total assets

18.06

14.42

13.22

10.41

14.38


(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.
Page 55
Navigation Links

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 utilize financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to originate fixed and variable rate mortgage loans held for investment, undisbursed loan funds, lines and letters of credit, commitments to purchase loans and mortgage-backed securities for our portfolio and commitments to invest in community development funds. The contract or notional amounts of these instruments reflect the extent of involvement we have in particular classes of financial instruments. For further information, see Asset/Liability Management and Market Risk on page 56 and Note 5 of Notes to the Consolidated Financial Statements on page 15.

          We use the same credit policies in making commitments to originate or purchase loans, lines of credit and letters of credit as we do for on-balance sheet instruments. For commitments to originate loans held for investment, the contract amounts represent exposure to loss from market fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. We control the credit risk of our commitments to originate loans held for investment through credit approvals, limits and monitoring procedures.

          We do not dispose of loans or assets by means of unconsolidated special purpose entities.

Transactions with Related Parties

          There are no significant related party transactions required to be disclosed in accordance with FASB Statement No. 57, Related Party Disclosures. Loans to our executive officers and directors were made in the ordinary course of business and were made on substantially the same terms as comparable transactions.

Asset/Liability Management and Market Risk

          Market risk is the risk of loss or reduced earnings from adverse changes in market prices and interest rates. Our market risk arises primarily from interest rate risk in our lending and deposit taking activities. Interest rate risk primarily occurs to the degree that our interest-bearing liabilities reprice or mature on a different basis and frequency than our interest-earning assets. Since our earnings depend primarily on our net interest income, which is the difference between the interest and dividends earned on interest-earning assets and the interest paid on interest-bearing liabilities, our principal objectives are to actively monitor and manage the effects of adverse changes in interest rates on net interest income. Our primary strategy in managing interest rate risk is to emphasize the origination for investment of adjustable rate mortgage loans or loans with relatively short maturities. Interest rates on adjustable rate mortgage loans are primarily tied to COFI, MTA, LIBOR and CMT. We also may execute swap contracts to change interest rate characteristics of our interest-earning assets or interest-bearing liabilities to better manage interest rate risk.

          In addition to the interest rate risk associated with our lending for investment and deposit-taking activities, we also have market risk associated with our secondary marketing activities. Changes in mortgage interest rates, primarily fixed rate mortgage loans, impact the fair value of loans held for sale as well as our interest rate lock commitment derivatives, where we have committed to an interest rate with a potential borrower for a loan we intend to sell. Our objective is to hedge against fluctuations in interest rates through the use of loan forward sale and purchase contracts with government-sponsored enterprises and whole loan sale contracts with various other parties. These contracts are typically obtained at or about the time the interest rate lock commitments are made. Therefore, as interest rates fluctuate, the changes in the fair value of our interest rate lock commitments and loans held for sale tend to be offset by changes in the fair value of the hedge contracts. We continue to hedge as previously done before the issuance of SFAS 133. As applied to our risk management strategies, SFAS 133 may increase or decrease reported net income and stockholders’ equity, depending on interest rates and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on the overall economics of the transactions. The method used for assessing the effectiveness of a hedging derivative, as well as the measurement approach for determining the ineffective aspects of the hedge, is established at the inception of the hedge. We generally do not enter into derivative contracts for speculative purposes.

Page 56
Navigation Links

          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 57
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 September 30, 2008, as well as other information regarding the repricing and maturity differences between our interest-earning assets and total deposits and borrowings in future periods. We refer to these differences as “gap.” We have determined the repricing frequencies by reference to projected maturities, based upon contractual maturities as adjusted for scheduled repayments and “repricing mechanisms”—provisions for changes in the interest and dividend rates of assets and liabilities. Prepayment rates on substantially our entire loan portfolio are based upon anticipated future prepayment behavior as derived from external models of loans with similar characteristics. Repricing mechanisms on a number of our assets are subject to limitations, such as caps on the amount that interest rates and payments on our loans may adjust, and accordingly, these assets may not respond to changes in market interest rates as completely or rapidly as our liabilities. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if we used different assumptions or if actual experience differed from the assumptions set forth.

September 30, 2008


After 6 Months

After 1 Year

After 5 Years

Within

Through 12

Through 5

Through 10

Beyond

Total

(Dollars in Thousands)

6 Months

Months

Years

Years

10 Years

Balance


Interest-earning assets:

Investment securities and stock (a)

$

447,116

$

11,291

$

368,519

$

-

$

-

$

826,926

Loans and mortgage-backed securities: (b)

Loans secured by real estate:

Residential one-to-four units:

Adjustable

6,387,381

423,273

3,475,101

-

-

10,285,755

Fixed

7,750

2,187

15,038

13,732

19,958

58,665

Home equity loans and lines of credit

131,471

51

347

220

-

132,089

Residential five or more units:

Adjustable

69,242

14,845

68,308

30,145

-

182,540

Fixed

281

364

2,609

6,220

144

9,618

Commercial real estate

15,382

3,250

4,701

3,551

-

26,884

Construction

45,053

-

-

-

-

45,053

Land

7,463

-

-

-

-

7,463

Non-mortgage loans:

Commercial

3,451

-

-

-

-

3,451

Consumer

5,661

-

-

-

-

5,661

Mortgage-backed securities

104

-

-

-

-

104


Total loans and mortgage-backed securities, net

6,673,239

443,970

3,566,104

53,868

20,102

10,757,283


Total interest-earning assets

$

7,120,355

$

455,261

$

3,934,623

$

53,868

$

20,102

$

11,584,209


Transaction accounts:

Non-interest-bearing checking (c)

$

628,492

$

-

$

-

$

-

$

-

$

628,492

Interest-bearing checking (d)

365,930

-

-

-

-

365,930

Money market (e)

251,160

-

-

-

-

251,160

Regular passbook (e)

781,622

-

-

-

-

781,622


Total transaction accounts

2,027,204

-

-

-

-

2,027,204

Certificates of deposit (f)

5,138,288

1,727,482

725,410

-

-

7,591,180


Total deposits

7,165,492

1,727,482

725,410

-

-

9,618,384

FHLB advances and other borrowings (g)

960,061

-

1,150,000

-

-

2,110,061

Senior notes

-

-

-

198,593

-

198,593


Total deposits and borrowings

$

8,125,553

$

1,727,482

$

1,875,410

$

198,593

$

-

$

11,927,038


Excess (shortfall) of interest-earning assets

over deposits and borrowings

$

(1,005,198

)

$

(1,272,221

)

$

2,059,213

$

(144,725

)

$

20,102

$

(342,829

)

Cumulative gap

(1,005,198

)

(2,277,419

)

(218,206

)

(362,931

)

(342,829

)

Cumulative gap – as a percentage of total assets:

September 30, 2008

(7.86

)%

(17.82

)%

(1.71

)%

(2.84

)%

(2.68

)%

December 31, 2007

3.59

(2.96

)

7.85

6.46

6.50

September 30, 2007

5.89

(2.27

)

9.36

8.07

8.11


(a) Includes FHLB stock and is based on contractual maturity and repricing/call date.
(b) Based on contractual maturity, repricing date and projected repayment of principal. Prepayment rate based on speeds in September 2008 blended for entire portfolio.
(c) Even though no interest is paid on these accounts, they are classified as repricing within six months, which increases negative gap.
(d) Includes amounts swept into money market deposit accounts and is subject to immediate repricing.
(e) Subject to immediate repricing.
(f) Based on contractual maturity.
(g) Excludes embedded interest rate caps with a notional amount of $50 million and a three-month LIBOR strike rate equal to 5.50%.
Page 58
Navigation Links

          Our six-month gap at September 30, 2008 was a negative 7.86%. This means more deposits and borrowings mature or reprice within six months than total interest-earning assets. This compares to our positive six-month gap of 3.59% at December 31, 2007 and 5.89% a year ago, which reflected more interest-earning assets repricing within six months than total deposits and borrowings. The change since year-end 2007 from a positive to negative gap is primarily due to an increase of adjustable rate loans with interest rates fixed for the first 3 to 5 years without a commensurate increase in the maturities for our FHLB advances and certificates of deposit.

          We continue to emphasize the origination of adjustable rate mortgages for our investment portfolio, which includes our adjustable – fixed for 3-5 years loans that carry a fixed interest rate for a period of three to five years then adjust semi-annually or annually thereafter. For the twelve months ended September 30, 2008, we originated and purchased for investment $2.3 billion of adjustable rate loans, of which $2.0 billion or 85% were adjustable – fixed for 3-5 years loans, which represented essentially all of the loans we originated and purchased for investment during the period.

          At September 30, 2008, December 31, 2007 and September 30, 2007 essentially all of our interest-earning assets mature, reprice or are estimated to prepay within five years. Essentially all of our loans held for investment and mortgage-backed securities portfolios consisted of adjustable rate loans and loans with a due date of five years or less, and totaled $11.4 billion at September 30, 2008 compared with $11.2 billion at December 31, 2007 and $11.6 billion a year ago. During the current quarter, we continued to offer residential fixed rate loan products to our customers primarily for sale in the secondary market. We originate fixed rate loans primarily for sale in the secondary market and price them accordingly to create loan servicing income and to increase opportunities for originating adjustable rate mortgage loans. However, we may originate fixed rate loans for investment if these loans meet specific yield, interest rate risk and other approved guidelines, or to facilitate the sale of real estate acquired through foreclosure.

          The following table sets forth the interest rate spread between our interest-earning assets and interest-bearing liabilities at the dates indicated.

September 30,

June 30,

March 31,

December 31,

September 30,

2008

2008

2008

2007

2007


Weighted average yield:

Loans and mortgage-backed securities (a)

6.26

%

6.57

%

7.10

%

7.41

%

7.45

%

Investment securities (b)

4.27

4.88

5.01

5.09

5.50


Interest-earning assets yield

6.14

6.44

6.84

7.14

7.15


Weighted average cost:

Deposits

2.96

2.95

3.47

3.92

3.96

Borrowings:

Securities sold under agreements to repurchase

-

2.40

2.92

-

5.14

Federal Home Loan Bank advances (c)

3.81

3.35

3.49

5.61

5.96

Senior notes

6.50

6.50

6.50

6.50

6.50


Total borrowings

4.04

3.64

3.80

5.74

5.79


Combined funds cost

3.17

3.06

3.52

4.14

4.26


Interest rate spread

2.97

%

3.38

%

3.32

%

3.00

%

2.89

%


(a) Excludes adjustments for non-accrual loans, amortization of net deferred costs to originate loans, premiums and discounts, troubled debt restructuring (“TDR”) yield adjustments, prepayment and late fees.
(b) Excludes FHLB stock dividends and includes the yield on investment securities accounted for on a trade-date basis but for which interest income will not be recognized until settlement. Yields for investment securities available for sale are calculated using historical cost balances and are not adjusted for changes in fair value that are reflected as a separate component of stockholders’ equity.
(c) Included the impact of interest rate swap contracts, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.

          The period-end weighted average yield on our loans and mortgage-backed securities was 6.26% at September 30, 2008, down from 7.41% at December 31, 2007 and 7.45% a year ago. At September 30, 2008, our adjustable rate mortgage portfolio of single family residential loans, including mortgage-backed securities, totaled $10.9 billion with a weighted average rate of 6.24%, compared with $10.8 billion with a weighted average rate of 7.29% at December 31, 2007, and $11.2 billion with a weighted average rate of 7.41% at September 30, 2007.

Page 59
Navigation Links

Problem Loans and Real Estate

Non-Performing Assets and TDRs

          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. At the beginning of the third quarter of 2007, we initiated our borrower retention program to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loan subject to negative amortization to a less costly financing alternative. Those loans are considered TDRs and have been placed on non-accrual status even though the interest rates following modification were no less than those offered new borrowers. The reason for this is because the modified interest rate was lower than the interest rate on the original loan and the loan was not re-underwritten to prove that the new interest rate was, in fact, a market interest rate for a borrower with similar credit quality. Interest income is recorded as these borrowers make their loan payments and, in the current quarter, $8.7 million was recognized including $1.1 million of amortization of associated impairment allowance. If these borrowers perform pursuant to the modified terms for six consecutive months, the loans will be placed back on accrual status and, while still reported as TDRs, they will no longer be classified as non-performing assets because the borrower will have demonstrated an ability to perform in accordance with the loan modification and the interest rate was no less than those afforded new borrowers at the time of modification.

          Our non-performing assets totaled $2.002 billion at September 30, 2008, up from $1.042 billion at December 31, 2007 and $424 million at September 30, 2007. Virtually all of the $44 million increase in non-performing assets during the current quarter came from our single family residential loans which, in turn, reflected the following:

Those increases were partially offset by declines in performing TDR loans modified as part of our previously disclosed borrower retention program of $139 million and in our non-TDR loans of $5 million. At September 30, 2008, $621 million of TDR loans for which we have received six consecutive months of successful loan payments were removed from non-performing assets and placed on accrual status, of which $578 million were associated with our borrower retention program and $43 million were associated with loans modified in loan workout situations.

          Our non-performing assets as a percentage of total assets were 15.66% at September 30, 2008, up from 7.77% at year-end 2007 and 2.94% a year ago. To the extent borrowers whose loans were modified pursuant to the borrower retention program are current with their loan payments and included in non-performing assets, it is relevant to distinguish those from total non-performing assets because, these loans are paying interest at interest rates no less than those offered new borrowers. At September 30, 2008, $409 million or 72% of such borrowers had made all loan payments due. Accordingly, the 15.66% ratio of non-performing assets to total assets includes 3.20% related to performing TDRs, resulting in an adjusted ratio of 12.46%.

Page 60
Navigation Links

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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Non-accrual loans:

Residential one-to-four units:

Performing troubled debt restructurings (a)

$

408,976

$

548,096

$

589,304

$

400,562

$

96,984

Other troubled debt restructurings

410,260

240,775

110,368

31,218

5,173

All other

888,644

894,104

658,334

448,516

253,259

Residential five or more units

2,900

-

-

-

-

Construction

12,195

12,790

14,869

15,933

7,808

Land

-

-

-

29,080

-

Other

448

566

487

837

511


Total non-accrual loans

1,723,423

1,696,331

1,373,362

926,146

363,735

Real estate acquired in settlement of loans (b)

278,091

261,536

189,127

115,623

59,773


Total non-performing assets

$

2,001,514

$

1,957,867

$

1,562,489

$

1,041,769

$

423,508


Allowance for loan losses:

Amount

$

761,824

$

732,354

$

546,751

$

348,167

$

142,218

As a percentage of non-accrual loans

44.20

%

43.17

%

39.81

%

37.59

%

39.10

%

Non-performing assets as a percentage of total assets:

Performing troubled debt restructurings (a)

3.20

4.34

4.49

2.99

0.67

All other non-performing assets

12.46

11.16

7.41

4.78

2.27


Total non-performing assets

15.66

%

15.50

%

11.90

%

7.77

%

2.94

%


Performing troubled debt restructurings excluded

from non-performing assets (c)

$

620,903

$

354,842

$

49,141

$

-

$

-


(a) Represents TDRs associated with loans modified pursuant to our borrower retention program and all payments due have been made. These loans are considered TDRs and have been placed on non-accrual status even though the interest rate following modification was no less than that offered new borrowers at the time of loan modification. These TDR loans will be on non-accrual status until six consecutive months of successful payment history has been established, at which time they will be removed from non-accrual status and from non-performing assets; however, they will continue to be reported as TDRs. While these loans are on non-accrual status, interest income is recognized only when paid by borrowers on a cash basis.
(b) Amount is net of a valuation allowance of $11 million at September 30, 2008 and $18 million at June 30, 2008, which reflects recent loss experience from sales compared to their fair value prior to sale.
(c)
Represents loans where the borrower has made six consecutive months of successful loan payments and the loan has been placed on accrual status, including $578 million associated with our borrower retention program and $43 million related to loans modified in loan workout situations.

          We evaluate the need for property valuations of non-performing assets on a periodic basis. We generally will obtain a new property valuation when we believe there may have been an adverse change in the property operations or in the economic conditions of the geographic market of the property securing our loans. Our policy is to obtain new property valuations at least annually for all real estate acquired in settlement of loans, but in a declining real estate market such as the recent market, we typically obtain new property valuations more frequently.

Page 61
Navigation Links

          At September 30, 2008, 90% of our non-performing assets were located in California, compared with 86% a year ago. The following table summarizes by major geographical area our residential one-to-four unit non-performing assets at the dates indicated.

September 30, 2008

September 30, 2007


Non-

Non-

% of

Non-

Non-

% of

Performing

Performing

Related

Performing

Performing

Related

(Dollars in Thousands)

Loans

REO

Assets

Assets

Loans

REO

Assets

Assets


Loan Investment Portfolio

Residential one-to-four units:

California county:

Los Angeles

$

238,654

$

21,673

$

260,327

12.2

%

$

26,170

$

2,835

$

29,005

1.4

%

San Diego

237,981

45,079

283,060

22.5

38,817

10,269

49,086

3.8

Santa Clara

89,249

12,257

101,506

8.6

8,458

1,631

10,089

1.1

Orange

125,587

13,183

138,770

15.0

13,963

619

14,582

1.6

Alameda

72,096

17,112

89,208

15.5

8,915

2,329

11,244

2.0

Riverside

109,688

16,318

126,006

25.2

25,372

2,930

28,302

5.0

Contra Costa

83,095

21,427

104,522

21.2

8,874

3,286

12,160

2.5

San Mateo

39,387

3,687

43,074

12.0

3,079

1,368

4,447

1.5

San Bernardino

66,353

8,687

75,040

23.4

10,662

755

11,417

3.3

Sacramento

69,599

18,655

88,254

29.8

17,910

4,001

21,911

6.4

All other counties

388,589

80,430

469,019

22.1

56,945

15,503

72,448

3.3


Total California

1,520,278

258,508

1,778,786

17.5

219,165

45,526

264,691

2.7

Arizona

66,278

9,149

75,427

17.1

9,197

1,086

10,283

2.1

All other states

121,324

9,893

131,217

20.2

27,477

5,837

33,314

4.1

Valuation allowance

-

(11,071

)

(11,071

)

(1.0

)

-

-

-

-


Total residential

one-to-four units

$

1,707,880

$

266,479

$

1,974,359

17.6

%

$

255,839

$

52,449

$

308,288

2.7

%


Troubled Debt Restructurings

          We consider a restructuring of a debt a TDR when we, for economic or legal reasons related to the borrower’s financial difficulties, grant a concession to the borrower that we would not otherwise grant. TDRs may include changing repayment terms, reducing the stated interest rate, reducing the amounts of principal and/or interest due or extending the maturity date. The restructuring of a loan is intended to recover as much of our investment as possible and to achieve the highest yield possible. During the current quarter, the total interest recognized on the impaired portfolio was $27.0 million. At September 30, 2008, we had $1.452 billion of principal balance for TDRs of which $1.150 billion related to the borrower retention program, $290 million related to other residential one-to-four unit loans and $12 million related to two construction loans. Of those TDRs related to our borrower retention program, $578 million have demonstrated six consecutive months of successful payment history, were accruing interest and were no longer reported as a non-performing asset at September 30, 2008. During the current quarter, $8.7 million of interest income was recognized from TDR loan payments, including $1.1 million of amortization of the associated impairment allowance. There are $43 million of TDR loans modified in loan workout situations that are currently accruing interest and were no longer reported as a non-performing assets at September 30, 2008.

Real Estate Acquired in Settlement of Loans

          Real estate acquired in settlement of loans consists of real estate acquired through foreclosure or deeds in lieu of foreclosure and totaled $278 million at September 30, 2008. Of this amount, $266 million, net of a $11 million valuation allowance which reflects recent loss experience from sales compared to their fair value prior to sale, was for 1,080 residential one-to-four unit properties, $8 million represented one property consisting of raw land for approximately 545 single family lots and $4 million represented one property consisting of 113 single family lots. We generally require private mortgage insurance on loans in excess of 80% of their appraised value. In the current quarter, subsequent to our acquiring real estate in the settlement of loans, we collected $6.0 million in private mortgage insurance to mitigate any losses incurred.

Page 62
Navigation Links

          The following table summarizes the activity of our number of residential one-to-four unit properties acquired in settlement of loans and the loss given default on those sold for the quarters indicated.

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Number of residential one-to-four unit

properties acquired in settlement of loans

Count at beginning of period

888

575

326

162

90

New

596

522

316

212

109

Sold

(404

)

(209

)

(67

)

(48

)

(37

)


Count at end of period

1,080

888

575

326

162


Loss given default (a)

35.9

%

31.8

%

22.3

%

22.2

%

8.1

%


(a) Reflects the difference between the net sales proceeds and loan principal balance at foreclosure adjusted for associated deferred costs and fees, premiums and discounts, and collection of mortgage insurance as a percentage of their loan principal balance at foreclosure. The ratio does not include the cost to carry or real estate related costs, such as property taxes, which are expensed as incurred.

          At September 30, 2008, 169 properties or 15.6% of our one-to-four unit residential properties were in escrow to be sold and offers were being negotiated on an additional 91 properties.

Delinquent Loans

          At September 30, 2008, loans delinquent 30 days or more as a percentage of total loans was 12.41%, up from 6.05% at December 31, 2007 and 3.30% a year ago. The increase from the year-ago quarter occurred primarily in our residential one-to-four unit loan classification. As a percentage of its loan category, delinquent residential one-to-four units increased from 3.41% at September 30, 2007 to 12.91% at September 30, 2008, reflecting the continued weakness in the residential real estate market. A higher incidence of delinquency is expected when the minimum payments reset on our adjustable rate loans subject to negative amortization or interest only payments, whereby the interest rate is fixed for the first three to five years. For example, we had loans subject to negative amortization or with interest only payments that have not been modified within our loans held for investment, which recasted for the first time in 2007 or 2008 of $1.2 billion, of which 47.65% were delinquent 30 days or more at September 30, 2008. The increase in delinquency is considered when we analyze the adequacy of our credit loss allowance.

Page 63
Navigation Links

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

September 30, 2008

June 30, 2008


30-59

60-89

90+

30-59

60-89

90+

(Dollars in Thousands)

Days

Days

Days (a)

Total

Days

Days

Days (a)

Total


Loans secured by real estate:

Residential:

One-to-four units

$

274,844

$

200,502

$

940,731

$

1,416,077

$

269,429

$

209,610

$

796,358

$

1,275,397

Home equity loans and lines of credit

-

569

365

934

212

-

490

702

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

4,136

-

4,136

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

274,844

205,207

941,096

1,421,147

269,641

209,610

796,848

1,276,099

Non-mortgage:

Commercial

-

-

-

-

-

-

-

-

Consumer

32

5

83

120

17

5

76

98


Total delinquent loans

$

274,876

$

205,212

$

941,179

$

1,421,267

$

269,658

$

209,615

$

796,924

$

1,276,197


Delinquencies as a percentage

of total loans

2.40

%

1.79

%

8.22

%

12.41

%

2.37

%

1.84

%

7.00

%

11.21

%


March 31, 2008

December 31, 2007


Loans secured by real estate:

Residential:

One-to-four units

$

226,100

$

160,775

$

576,130

$

963,005

$

205,737

$

134,715

$

313,528

$

653,980

Home equity loans and lines of credit

131

-

422

553

-

450

776

1,226

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

33,580

-

-

33,580


Total real estate loans

226,231

160,775

576,552

963,558

239,317

135,165

314,304

688,786

Non-mortgage:

Commercial

-

-

-

-

-

-

-

-

Consumer

19

9

65

93

21

12

61

94


Total delinquent loans

$

226,250

$

160,784

$

576,617

$

963,651

$

239,338

$

135,177

$

314,365

$

688,880


Delinquencies as a percentage

of total loans

2.02

%

1.44

%

5.16

%

8.62

%

2.10

%

1.19

%

2.76

%

6.05

%


September 30, 2007


Loans secured by real estate:

Residential:

One-to-four units

$

129,329

$

75,757

$

180,422

$

385,508

Home equity loans and lines of credit

212

195

444

851

Five or more units

-

-

-

-

Commercial real estate

-

-

-

-

Construction

-

-

-

-

Land

-

-

-

-


Total real estate loans

129,541

75,952

180,866

386,359

Non-mortgage:

Commercial

-

-

-

-

Consumer

22

6

67

95


Total delinquent loans

$

129,563

$

75,958

$

180,933

$

386,454


Delinquencies as a percentage

of total loans

1.11

%

0.65

%

1.54

%

3.30

%


(a) All 90 day or greater delinquencies are on non-accrual status and reported as part of non-performing assets.
Page 64
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 at the balance sheet date. The allowance for credit losses includes an allowance for loan losses reported as a reduction of loans held for investment and the allowance for loan-related commitments reported in accounts payable and accrued liabilities. Management evaluates the adequacy of the allowance quarterly to maintain the allowance at levels sufficient to provide for inherent losses at the balance sheet date.

          We use an internal asset review system and loss allowance methodology designed to provide for timely recognition of problem assets and an adequate allowance to cover asset and loan-related commitment losses. The amount of the allowance is based upon the total of general valuation allowances, allocated allowances and specific allowances. General valuation allowances relate to assets and loan-related commitments with no well-defined deficiency or weakness and take into consideration losses that are embedded within the portfolio but have not yet been realized. Allocated allowances relate to assets segregated into different classifications with well-defined deficiencies or weaknesses. Loans evaluated individually that are deemed to be impaired are separated from our other credit loss analysis in accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan. If we determine the carrying value of our asset exceeds the net fair value and no alternative payment source exists, then a specific allowance is recorded for the amount of that difference.

          The OTS has the authority to require us to change our asset classifications. If the change results in an asset being classified in whole or in part as loss, a specific allowance must be established against the amount so classified or that amount must be charged off. The OTS generally directs its examiners to rely on management’s estimates of adequate general valuation allowances if the Bank’s process for determining adequate allowances is deemed to be sound.

          Provision for credit losses totaled $130.3 million in the third quarter of 2008, compared with $81.6 million a year ago.

          At September 30, 2008, the allowance for credit losses was $763 million, comprised of $762 million for loan losses and $1 million for loan-related commitments. That compares to an allowance for credit losses of $349 million at year-end 2007, comprised of $348 million for loan losses and $1 million for loan-related commitments. Loan-related commitments are reported on the balance sheet in the category accounts payable and accrued liabilities. The allowance for credit losses increased $29 million this quarter, of which $24 million was related to specific allowances associated with certain troubled debt restructurings pursuant to our borrower retention program. These specific allowances totaled $117 million at quarter end and will be accreted into interest income over the remaining life of the modified loans as long as they remain on accrual status. The balance of the increase in the allowance for credit losses was primarily due to loan workout modifications.

          Downey’s allowance methodology incorporates assumptions related to default probabilities, loss severities and loss horizons based on historical experience, current market conditions, and the unique characteristics of each borrower, loan and underlying collateral. On a comparative basis, these factors individually increase or decrease the amount of the allowance for loan losses from prior periods. In the current quarter, loss severities continued to increase and loss horizons continued to shorten. Further, as a result of deteriorating conditions facing the residential housing market, borrower equity continues to decline. Partially offsetting this unfavorable trend was a small decrease in default probabilities due to lower mortgage interest rates and a lower proportion of option ARM loans in our portfolio that have a higher loss experience.

Page 65
Navigation Links

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Allowance for loan losses

Balance at beginning of period

$

732,354

$

546,751

$

348,167

$

142,218

$

69,107

Provision

130,430

258,517

237,087

218,650

81,435

TDR yield adjustment (a)

(3,352

)

(2,670

)

(1,461

)

(483

)

-

Charge-offs

(97,613

)

(70,245

)

(37,043

)

(12,220

)

(8,368

)

Recoveries

5

1

1

2

44


Balance at end of period

$

761,824

$

732,354

$

546,751

$

348,167

$

142,218


Allowance for loan-related commitments

Balance at beginning of period

$

1,355

$

998

$

1,215

$

1,418

$

1,291

Provision (reduction)

(139

)

357

(217

)

(203

)

127


Balance at end of period

$

1,216

$

1,355

$

998

$

1,215

$

1,418


Total allowance for credit losses

Balance at beginning of period

$

733,709

$

547,749

$

349,382

$

143,636

$

70,398

Provision

130,291

258,874

236,870

218,447

81,562

TDR yield adjustment (a)

(3,352

)

(2,670

)

(1,461

)

(483

)

-

Charge-offs

(97,613

)

(70,245

)

(37,043

)

(12,220

)

(8,368

)

Recoveries

5

1

1

2

44


Balance at end of period

$

763,040

$

733,709

$

547,749

$

349,382

$

143,636


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

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

Nine Months Ended September 30,


(In Thousands)

2008

2007


Allowance for loan losses

Balance at beginning of period

$

348,167

$

60,943

Provision

626,034

91,321

TDR yield adjustment (a)

(7,483

)

-

Charge-offs

(204,901

)

(10,344

)

Recoveries

7

298


Balance at end of period

$

761,824

$

142,218


Allowance for loan-related commitments

Balance at beginning of period

$

1,215

$

1,055

Provision

1

363


Balance at end of period

$

1,216

$

1,418


Total allowance for credit losses

Balance at beginning of period

$

349,382

$

61,998

Provision

626,035

91,684

TDR yield adjustment (a)

(7,483

)

-

Charge-offs

(204,901

)

(10,344

)

Recoveries

7

298


Balance at end of period

$

763,040

$

143,636


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.
Page 66
Navigation Links

          Net charge-offs of loans totaled $97.6 million in the current quarter, compared to $8.3 million a year ago. The current quarter net charge-offs primarily related to residential one-to-four unit loans, with an annualized net charge-off ratio associated with these loans increasing to 3.62% from 0.28% a year ago.

          For the first nine months of 2008, the provision for credit losses totaled $626.0 million and net charge-offs were $204.9 million. This compares with a $91.7 million provision for credit losses and net charge-offs of $10.0 million a year ago.

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

Three Months Ended

Nine Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007

2008

2007


Gross loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

$

97,586

$

70,219

$

26,207

$

12,188

$

4,301

$

194,012

$

6,221

Home equity loans and lines

of credit

-

-

169

-

-

169

-

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

(3

)

-

-

20

Land

-

-

10,639

-

4,022

10,639

4,022

Non-mortgage:

Commercial

-

-

-

-

-

-

-

Consumer

27

26

28

35

45

81

81


Total gross loan charge-offs

97,613

70,245

37,043

12,220

8,368

204,901

10,344


Gross loan recoveries

Loans secured by real estate:

Residential:

One-to-four units

-

-

-

-

40

-

291

Home equity loans and lines

of credit

-

-

-

-

-

-

-

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

-

Consumer

5

1

1

2

4

7

7


Total gross loan recoveries

5

1

1

2

44

7

298


Net loan charge-offs (recoveries)

Loans secured by real estate:

Residential:

One-to-four units

97,586

70,219

26,207

12,188

4,261

194,012

5,930

Home equity loans and lines

-

-

169

-

-

of credit

-

-

-

-

-

169

-

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

(3

)

-

-

20

Land

-

-

10,639

-

4,022

10,639

4,022

Non-mortgage:

Commercial

-

-

-

-

-

-

-

Consumer

22

25

27

33

41

74

74


Total net loan charge-offs

$

97,608

$

70,244

$

37,042

$

12,218

$

8,324

$

204,894

$

10,046


Net loan charge-offs

as a percentage of average loans

3.62

%

2.60

%

1.35

%

0.43

%

0.28

%

2.52

%

0.10

%


Page 67
Navigation Links

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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Loans secured by real estate:

Residential:

One-to-four units

$

755,010

$

727,073

$

542,248

$

339,424

$

134,947

Home equity loans and lines of credit

853

828

767

1,019

850

Five or more units

1,934

1,306

1,005

976

965

Commercial real estate

290

226

247

297

298

Construction

2,569

2,348

1,916

1,857

1,726

Land

785

198

195

4,229

3,081

Non-mortgage:

Commercial

35

40

39

36

12

Consumer

348

335

334

329

339


Total for loans held for investment

$

761,824

$

732,354

$

546,751

$

348,167

$

142,218


          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.

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Loans secured by real estate:

Residential:

One-to-four units

6.89

%

6.67

%

5.06

%

3.12

%

1.20

%

Home equity loans and lines of credit

0.64

0.63

0.58

0.74

0.59

Five or more units

0.95

1.08

1.00

0.97

0.92

Commercial real estate

0.97

1.00

1.00

1.12

1.12

Construction

2.62

2.22

2.56

2.29

2.96

Land

7.33

1.88

1.88

8.54

6.06

Non-mortgage:

Commercial

0.66

0.73

0.74

0.72

0.24

Consumer

5.81

5.75

5.63

5.49

5.60


Total for loans held for investment

6.66

%

6.48

%

4.94

%

3.09

%

1.22

%


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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2008

2008

2008

2007

2007


Loans secured by real estate:

Residential:

One-to-four units

95.75

%

96.43

%

96.80

%

96.40

%

96.60

%

Home equity loans and lines of credit

1.16

1.16

1.20

1.23

1.24

Five or more units

1.78

1.08

0.91

0.89

0.90

Commercial real estate

0.26

0.20

0.22

0.23

0.23

Construction

0.86

0.94

0.68

0.72

0.50

Land

0.09

0.09

0.09

0.44

0.44

Non-mortgage:

Commercial

0.05

0.05

0.05

0.04

0.04

Consumer

0.05

0.05

0.05

0.05

0.05


Total for loans held for investment

100.00

%

100.00

%

100.00

%

100.00

%

100.00

%


Page 68
Navigation Links

          In determining impairment, we consider large non-homogeneous loans that are on non-accrual, have been restructured or are performing but exhibit, among other characteristics, high loan-to-value ratios or delinquent taxes. We base the measurement of collateral dependent impaired loans on the fair value of the loan’s collateral net of costs to sell. We value non-collateral dependent loans based on a present value calculation of expected future cash flows discounted at the loan’s effective rate or the loan’s observable market price. We generally use cash receipts on impaired loans not performing according to contractual terms to reduce the carrying value of the loan, unless we believe we will recover the remaining principal balance of the loan, in which case we may recognize interest income. We include impairment losses in the allowance for loan losses through a charge to provision for credit losses. We include adjustments to impairment losses due to changes in the fair value of the collateral of impaired loans in provision for credit losses. For TDRs of residential one-to-four unit loans, we include adjustments to impairment losses due to the change in cash flow as an adjustment to loan yield. Upon disposition of an impaired loan, we record loss of principal through a charge-off to the allowance for loan losses.

          At September 30, 2008, the recorded investment in loans for which we recognized impairment totaled $1.477 billion, up from $486 million at December 31, 2007 and $12 million at September 30, 2007. Of the current quarter total, $1.464 billion related to residential one-to-four unit loan TDRs with an allowance for loss of $131 million and $12 million related to two construction loans with an allowance for loss of $2 million. This is up from 2007 year-end totals of $441 million related to residential one-to-four unit loan TDRs with an allowance for loss of $39 million, $29 million related to one land loan with an allowance for loss of $4 million, $15 million related to two construction loans with an allowance for loss of $2 million, and $1 million related to one residential one-to-four unit loan with no allowance for loss; and up from the year-ago quarter total of $12 million with an allowance of less than $1 million. During the current quarter, the total interest recognized on the impaired portfolio was $27.0 million, compared to $19.9 million in the second quarter of 2008 and no interest recognized in the year-ago quarter.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

102,013

$

66,801

$

45,066

$

721

$

1,238

Provision (reduction)

34,888

38,052

33,900

48,602

(412

)

TDR yield adjustment (a)

(3,352

)

(2,670

)

(1,461

)

(483

)

-

Charge-offs

(409

)

(170

)

(10,704

)

(3,917

)

(105

)

Recoveries

-

-

-

143

-


Balance at end of period

$

133,140

$

102,013

$

66,801

$

45,066

$

721


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.

          The following table summarizes the activity in our allowance for credit losses associated with impaired loans for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Balance at beginning of period

$

45,066

$

601

Provision

106,840

772

TDR yield adjustment (a)

(7,483

)

-

Charge-offs

(11,283

)

(652

)

Recoveries

-

-


Balance at end of period

$

133,140

$

721


(a) For TDRs of residential one-to-four unit loans that are not collateral dependent, a specific valuation allowance is calculated as the difference between the recorded investment of the original loan and the present value of the expected cash flows of the modified loan (discounted at the effective interest rate of the original loan). This difference is recorded as a provision for credit losses in current earnings and subsequently amortized over the expected life of the loans as an adjustment to loan yield or as a reduction of the provision if the loan is prepaid.
Page 69
Navigation Links

          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

11,867

$

413

$

422

$

432

$

456

Provision (reduction)

8,053

11,454

(9

)

(10

)

(24

)

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

19,920

$

11,867

$

413

$

422

$

432


          The following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Balance at beginning of period

$

422

$

103

Provision

19,498

329

Charge-offs

-

-

Recoveries

-

-


Balance at end of period

$

19,920

$

432


          The following table summarizes the activity in our allowance for real estate acquired in settlement of loans for the quarters indicated.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2008

2008

2008

2007

2007


Balance at beginning of period

$

17,592

$

12,334

$

-

$

-

$

-

Provision

19,329

14,712

19,892

1,118

2,058

Charge-offs

(25,850

)

(9,454

)

(7,558

)

(1,118

)

(2,058

)

Recoveries

-

-

-

-

-


Balance at end of period

$

11,071

$

17,592

$

12,334

$

-

$

-


          The following table summarizes the activity in our allowance for real estate acquired in settlement of loans for the year-to-date periods indicated.

Nine Months Ended September 30,


(In Thousands)

2008

2007


Balance at beginning of period

$

-

$

-

Provision

53,933

2,621

Charge-offs

(42,862

)

(2,621

)

Recoveries

-

-


Balance at end of period

$

11,071

$

-


          We value real estate acquired through foreclosure at fair value less cost to sell, with any subsequent losses recorded as a direct write-off to net operations. Given the decline in home values in the residential market, we had a valuation allowance at quarter end of $11 million for our one-to-four unit residential properties acquired through foreclosure. This valuation allowance reflects recent loss experience from sales compared to their fair value prior to sale. As that loss experience changes over time, our estimate of this valuation allowance will be reassessed.

Capital Resources and Liquidity

          Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, available for sale securities, and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments. Interest rates, real estate sales activity and general economic conditions significantly affect repayments on loans and deposit inflows and outflows.

 

Page 70
Navigation Links

 

          Our primary sources of funds generated in the third quarter of 2008 were from:

          We used these funds to:

          In addition to its deposits, our principal source of liquidity is our ability to utilize borrowings, as needed. The Bank’s primary source of borrowings is the FHLB. At September 30, 2008, the Bank’s FHLB borrowings totaled $2.1 billion, representing 16.5% of total assets. The Bank currently is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional $0.9 billion of borrowing capacity from the FHLB as of September 30, 2008. The amount the FHLB is willing to advance differs based on the quality and character of qualifying collateral offered by the Bank, and the advance rates for the same collateral may be adjusted upwards or downwards by the FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank of San Francisco as a back-up source of liquidity. As of September 30, 2008 the Bank had no outstanding borrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying collateral would have permitted it to borrow up to an additional $1.1 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is obligated to lend to us under these loan facilities. To the extent deposit renewals and deposit growth are not sufficient to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans and investment securities and otherwise fund working capital needs and capital expenditures, the Bank may utilize additional borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements. However, if elevated levels of net deposit outflows occur, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional financing arrangements. As a result of being deemed to be “adequately capitalized” rather than “well capitalized,” the Bank is subject to restrictions on accepting brokered deposits, which have not historically been a significant part of the Bank’s deposit base, and upper limits on interest rates the Bank may pay on deposits. For further information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

          As of September 30, 2008, we had commitments to borrowers for short-term interest rate locks, before the reduction of expected fallout, of $216 million, of which $38 million were related to residential one-to-four unit loans being originated for sale in the secondary market. We also had undisbursed loan funds and unused lines of credit of $268 million, loan forward purchase contracts of $21 million and operating leases of $16 million. For further information, see Note 5 of Notes to the Consolidated Financial Statements on page 15.

          Subsequent to September 30, 2008, we closed our Wholesale Loan Department and the loan processing centers supporting that Department, and began contracting our Retail Loan Department. The Wholesale lending channel has traditionally provided about 80% of our single family loan originations. Therefore, loan origination volumes will decline in future periods.

Page 71
Navigation Links

          Limitations imposed by the OTS currently prohibit the Bank from providing a dividend to the Holding Company without the prior written approval of the OTS, and currently prohibit the Holding Company from paying a dividend without the prior non-objection of the OTS. At September 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million, down from $102 million at the end of 2007 due primarily to $80 million in capital contributions made to the Bank. In addition, the Holding Company may not issue new debt or renew existing debt without the prior non-objection of the OTS. At the moment there is no other source of repayment of the senior notes. Absent additional capital, the Holding Company will default on the notes within a year.

          Subsequent to the end of the quarter, Moody’s Investors Service and Standards & Poor’s Ratings Services lowered their ratings for the Holding Company and the Bank on August 12, 2008 and September 11, 2008, respectively. For further information, see Risk Factors, on page 77.

          Downey’s stockholders’ equity totaled $772 million at September 30, 2008, down from $1.3 billion at December 31, 2007 and $1.4 billion at September 30, 2007. No future dividends will be paid without the prior non-objection of the OTS.

Contractual Obligations and Other Commitments

          Through the normal course of operations, we have entered into contractual obligations and other commitments. Our obligations generally relate to funding of our operations through deposits and borrowings as well as leases for premises and equipment, and our commitments generally relate to our lending operations.

          We have obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period, with options to extend, and are non-cancelable. Currently, we have no material contractual vendor obligations.

          We have executed interest rate swap contracts to change interest rate characteristics of a portion of our FHLB advances to better manage interest rate risk. The contracts have notional amounts totaling $430 million of receive-fixed, pay 3-month LIBOR variable interest and serve as a permitted fair value hedge.

          Our commitments to originate fixed and variable rate mortgage loans are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Undisbursed loan funds on construction projects and unused lines of credit on home equity and commercial loans include committed funds not disbursed. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party.

          Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The credit risk involved in issuing lines and letters of credit requires the same creditworthiness evaluation as that involved in extending loan facilities to customers. We evaluate each customer’s creditworthiness.

          We receive collateral to support commitments when deemed necessary. The most significant categories of collateral include real estate properties underlying mortgage loans, liens on personal property and cash on deposit with us.

          We enter into derivative financial instruments as part of our interest rate risk management process, including loan forward sale and purchase contracts related to our sale of loans in the secondary market. The associated fair value changes to the notional amount of the derivative instruments are recorded on-balance sheet. The total notional amount of our derivative financial instruments does not represent future cash requirements. At September 30, 2008, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $26 million, with a change in fair value resulting in a recorded gain of $0.1 million, compared with a notional amount of interest rate lock commitments of $93 million with a change in fair value resulting in a recorded loss of less than $0.1 million at September 30, 2007. For further information, see Asset/Liability Management and Market Risk on page 56 and Note 5 of Notes to the Consolidated Financial Statements on page 15.

          We sell all loans without recourse. When a loan sold to an investor without recourse fails to perform according to the contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred and whether such defects give rise to a violation of a representation or warranty we made to the investor in connection with the sale. If such a defect is identified, we may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, we have no commitment to repurchase the loan. During the first nine months of 2008, we repurchased $6 million of loans and $2 million of real estate acquired in settlement of loans and recorded $0.7 million of repurchase or indemnification losses related to defects in the origination process.

Page 72
Navigation Links

          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 September 30, 2008, December 31, 2007 and September 30, 2007 to cover the estimated loss exposure related to early payoffs. However, if all the loans related to those sales prepaid within the refund period, as of September 30, 2008, our maximum sales price premium refund would be $1.9 million. See Note 5 of Notes to the Consolidated Financial Statements on page 15.

          Servicing loans for others includes managing foreclosed loans through the sale of the properties. Advances made for principal and interest remittances as well as foreclosure costs are recorded in the balance sheet as other assets and are expected to ultimately be recovered from the related investor.

          At September 30, 2008, scheduled maturities of obligations and commitments, excluding accrued interest, were as follows:

After 1

After 3

Within

Through 3

Through 5

Beyond

Total

(In Thousands)

1 Year

Years

Years

5 Years

Balance


Certificates of deposit

$

6,865,770

$

614,856

$

110,554

$

-

$

7,591,180

Securities sold under agreements to repurchase

-

-

-

-

-

FHLB advances

935,061

500,000

675,000

-

2,110,061

Senior notes

-

-

-

198,593

198,593

Secondary marketing activities:

Non-qualifying hedge transactions:

Interest rate lock commitments (a)

25,963

-

-

-

25,963

Associated loan forward sale contracts (a)

47,392

-

-

-

47,392

Associated loan forward purchase contracts

21,000

21,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value

7,673

-

-

-

7,673

Associated loan forward sale contracts (a)

6,608

-

-

-

6,608

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed

430,000

-

-

-

430,000

Associated interest rate swap contracts –

pay-variable, receive-fixed (a)

430,000

-

-

-

430,000

Commitments to originate adjustable rate loans held

for investment

138,092

-

-

-

138,092

Undisbursed loan funds and unused lines of credit

30,381

35,694

22,372

179,272

267,719

Operating leases

5,473

7,542

2,386

344

15,745


(a) Amount represents the notional amount of the commitments or contracts. The notional amount for interest rate lock commitments before the reduction of expected fallout was $38 million.
Page 73
Navigation Links

Regulatory Capital Compliance

          At September 30, 2008, the Bank was above the minimum capital ratios required by its Consent Order, with core and tangible capital ratios of 7.48% and a total risk-based capital ratio of 14.50%. For further information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

          The following table is a reconciliation of the Bank’s stockholder’s equity to federal regulatory capital as of September 30, 2008.

Tangible Capital

Core Capital

Risk-Based Capital


(Dollars in Thousands)

Amount

Ratio

Amount

Ratio

Amount

Ratio


Stockholder’s equity

$

958,298

$

958,298

$

958,298

Adjustments:

Deductions:

Investment in real estate subsidiary

(7,038

)

(7,038

)

(7,038

)

Non-permitted mortgage servicing rights

(2,281

)

(2,281

)

(2,281

)

Additions:

Unrealized losses on investment securities

available for sale

6,231

6,231

6,231

Allowance for credit losses, net of specific

allowances (a)

-

-

96,015


Regulatory capital

955,210

7.48

%

955,210

7.48

%

1,051,225

14.50

%

Well capitalized requirement (b)

191,650

1.50

(c)

638,833

5.00

725,109

10.00

(d)


Excess

$

763,560

5.98

%

$

316,377

2.48

%

$

326,116

4.50

%


(a) Limited to 1.25% of risk-weighted assets.
(b) From orders issued by the OTS, the Bank is required to maintain minimum capital ratios for core and tangible capital of 7.00% and risk-based capital of 14.00%, both of which were exceeded at quarter end.
(c) Represents the minimum requirement for tangible capital, as no “well capitalized” requirement has been established for this category.
(d) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%, which the Bank met and exceeded with a ratio of 13.17%.
Page 74
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 56.

ITEM 4. – CONTROLS AND PROCEDURES

          As of September 30, 2008, Downey carried out an evaluation, under the supervision and with the participation of Downey’s management, including Downey’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Downey’s disclosure controls and procedures pursuant to Securities and Exchange Commission (“SEC”) rules. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded Downey’s disclosure controls and procedures were effective as of the end of the period covered by this report. There have been no significant changes during the most recent quarter in Downey’s internal controls over financial reporting or in other factors that could significantly affect these controls subsequent to the evaluation date.

          Disclosure controls and procedures are defined in SEC rules as controls and other procedures designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Downey’s disclosure controls and procedures were designed to ensure that material information related to Downey is made known to management, including the Chief Executive Officer and Chief Financial Officer, in a timely manner.

Page 75
Navigation Links

PART II – OTHER INFORMATION

ITEM 1. – Legal Proceedings

Judicial Proceedings

          On October 29, 2004, two former traditional branch employees brought an action in Los Angeles County Superior Court, Case No. BC323796, entitled Margie Holman and Alice A. Mesec, et al. v. Downey Savings and Loan Association. The first amended complaint seeks unspecified damages for alleged unpaid regular and overtime wages, inadequate meal breaks, failure to pay split-shift and reporting time wages, and related claims. The plaintiffs are seeking class action status to represent all other current and former Bank employees who held the position of Customer Service Supervisor and/or Customer Service Representative at the Bank’s in-store branches at any time from October 29, 2000 to date. The Bank has opposed the claim and asserted all appropriate defenses, and has provided for what is believed to be a reasonable estimate of exposure for this matter in the event of loss. While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of this matter will not have a material adverse effect on Downey’s operations, cash flows or financial position.

          Two purported shareholder class actions, one brought on behalf of Waterford Township General Employees Retirement System, Case No. CV-08-03261, and the other brought on behalf of Stephen J. Mihalacki, Case No. SACV08-00609, were filed on May 16, 2008 and June 2, 2008, respectively, in the United States District Court for the Central District of California against the Holding Company and certain of its current and former officers and certain former directors. The complaints, filed on behalf of all persons who purchased Holding Company common stock during October 16, 2006 to March 14, 2008, seek unspecified damages for alleged violation of federal securities laws, claiming that the defendants made misleading statements and omissions regarding Downey’s business and financial results, thereby artificially inflating the common stock price. Specifically, the plaintiffs contend that the defendants concealed that (a) the Bank’s portfolio of option ARMs contained millions of dollars worth of impaired and risky securities; (b) the Bank had been aggressive in acquiring loans from mortgage brokers that were highly risky; (c) the Bank had failed to properly account for highly leveraged loans; (d) the Bank had inadequate underwriting practices, which led to large numbers of loan defaults; and (e) the Bank had not adequately reserved for option ARM loans. A motion to consolidate the two actions was granted on August 14, 2008 with Waterford Township General Employees Retirement System as lead plaintiff. The plaintiffs filed a consolidated complaint on September 30, 2008 and, pursuant to a stipulation between the parties, have until November 12, 2008 to file a first amended consolidated complaint.

          Related to the shareholder class actions, two purported shareholder derivative lawsuits, one entitled Michael L. McDougall v. Daniel D. Rosenthal, et al., Case No. 30-2008-00180029, and the other entitled Joyce Mendlin v. Maurice L. McAlister, et al., Case No. 30-2008-00087854, were filed on June 10, 2008 and July 28, 2008, respectively, in Orange County Superior Court, in California. The plaintiffs, who purport to bring the lawsuits on behalf of the Holding Company against certain of its current and former officers, its current directors and certain former directors, allege that commencing in October 2006, the defendants caused or allowed Downey to issue a series of press releases and other statements that significantly overstated Downey’s business prospects and financial results; that the statements failed to disclose that Downey was more exposed to the subprime market crisis than it had disclosed; that Downey’s portfolio of subprime and option ARM mortgage-related assets was overvalued; and that as a result, Downey’s reported earnings and business prospects were inaccurate. The plaintiffs allege that the defendants’ action constitutes breaches of fiduciary duty, waste of corporate assets and unjust enrichment, and seek, among other relief, unspecified damages to be paid to the Holding Company, corporate governance reforms, and equitable and injunctive relief, including restitution and the creation of a constructive trust.

          Downey has been named as a defendant in other legal actions arising in the ordinary course of business, none of which, in the opinion of management, will have a material adverse effect on its operations, cash flows or financial position.

Consent Orders

          On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. For more information, see Note 11 of Notes to the Consolidated Financial Statements on page 24.

Page 76
Navigation Links

ITEM 1A. – Risk Factors

          Downey’s 2007 Form 10-K presents, on pages 22 to 27, a comprehensive set of risk factors that may impact Downey’s future results. Given recent developments, we are adding the following:

          If we do not raise additional capital by December 31, 2008, it is highly unlikely that we will be in compliance with the capital requirements of the Bank Consent Order at year-end, which could have a material adverse effect upon us.

          The Bank Consent Order requires the Bank to maintain a minimum Tier I Core Capital ratio of 7% and a minimum Total Risk-Based Capital ratio of 14% at each quarter-end. While the Bank was in compliance with this requirement at September 30, 2008, based on the Bank’s current and projected levels of capital, the Bank anticipates that it will not be able to satisfy the Tier I Core Capital and Total Risk-Based Capital minimum ratios of its Consent Order as of December 31, 2008, unless it raises additional capital on or prior to that date. In the current economic environment, there is a significant risk that the Bank will not be able to raise sufficient additional capital to ensure compliance with the capital requirements of the Bank Consent Order by year-end. If the Bank does not comply with the Consent Order, without a waiver by the OTS or amendment of the Consent Order, the Bank could be subject to further regulatory enforcement action, including, without limitation, the issuance of additional cease and desist orders (which may, among other things, further restrict the Bank’s business activities, the imposition of civil money penalties against the Bank, and placing the Bank into a conservatorship or receivership). Notwithstanding that portion of the Bank Consent Order requiring the raising of new equity and a capital infusion by no later than December 31, 2008, bank regulators could take enforcement action before that date, which could include placing the Bank into receivership. If the Bank is placed into a conservatorship or receivership, it is highly likely that this will lead to a complete loss of all value of the Holding Company’s ownership interest in the Bank, and the Holding Company subsequently may be exposed to significant claims by the Federal Deposit Insurance Corporation or OTS. In addition, further restrictions will be placed on the Bank following a determination that the Bank is undercapitalized, significantly undercapitalized, or critically undercapitalized, with increasingly greater restrictions being imposed as the level of undercapitalization increases. Further, the failure to comply with the Consent Order could result in the termination of the Bank’s federal deposit insurance, subject to a number of other conditions.

          The Consent Orders that the Bank and the Holding Company entered into with the OTS restrict the Bank’s operations and may adversely affect our ability to pay dividends or service our debt; and there is substantial doubt concerning the ability of the Holding Company and the Bank to continue as going concerns for a reasonable period of time.

          The ability of the Holding Company to pay regular quarterly dividends to its stockholders and to pay interest on its debt depends to a large extent upon the dividends it receives from the Bank. The Consent Orders entered into by the Bank and the Holding Company with the OTS prohibit the Bank from paying dividends to the Holding Company without the prior approval of the OTS, and which further prohibits the Holding Company from paying dividends without the prior non-objection of the OTS.

          At September 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $11 million. However, in the longer term, the Holding Company’s ability to service its senior debt depends on its ability to receive dividends from the Bank and, when the notes mature, on its ability to renew or refinance the senior debt. However, pursuant to the Holding Company’s Consent Order, the OTS has prohibited the Holding Company from issuing or renewing debt without its prior approval. We cannot predict whether the OTS will approve payments of dividends by the Bank to the Holding Company, or will object to the payment of future Holding Company dividends, or how long these restrictions will remain in effect. At the moment, there is no other source of repayment of the senior notes. Absent additional capital, the Holding Company will default on the notes within a year.

          As a result of the circumstances described above and in the other Risk Factors herein, there is substantial doubt concerning the ability of the Holding Company and the Bank to continue as going concerns for a reasonable period of time.

          Difficult market conditions have adversely affected our industry.

          Downey is particularly exposed to downturns in the U.S. housing market. Dramatic declines in the housing market over the past year, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities, major commercial and investment banks, and regional financial institutions such as Downey. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers,

Page 77
Navigation Links

including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets have adversely affected our business, financial condition and results of operations. For example, on October 16, 2008, we announced the closing of our Wholesale Loan Department, the loan processing centers supporting that Department, and a contraction of our Retail Loan Department, which affected approximately 200 employees. We do not expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:

          Current levels of market volatility are unprecedented.

          The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent weeks, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.

          There can be no assurance that recently enacted legislation and other measures undertaken by the Treasury, the Federal Reserve and other governmental agencies will help stabilize the U.S. financial system, improve the housing market or be of specific benefit to Downey.

          On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 or “EESA,” which, among other measures, authorized the Treasury Secretary to establish the Troubled Asset Relief Program (“TARP”). EESA gives broad authority to Treasury to purchase, manage, modify, sell and insure the troubled mortgage related assets that triggered the current economic crisis as well as other “troubled assets.” EESA includes additional provisions directed at bolstering the economy, including

Page 78
Navigation Links

          Pursuant to the TARP, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion (of which $250 billion is currently available) of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Shortly following the enactment of EESA, the Treasury announced the creation of specific TARP programs to purchase mortgage-backed securities and whole mortgage loans. In addition, under the TARP, the Treasury has created a capital purchase program, pursuant to which it proposes to provide access to capital to financial institutions through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions that will serve as Tier I capital.

          EESA also contains a number of significant employee benefit and executive compensation provisions, some of which apply to employee benefit plans generally, and others which impose on financial institutions that participate in the TARP program restrictions on executive compensation.

          EESA followed, and has been followed by, numerous actions by the Federal Reserve, Congress, Treasury, the SEC and others to address the current liquidity and credit crisis that has followed the subprime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; coordinated international efforts to address illiquidity and other weaknesses in the banking sector;

          In addition, the IRS has issued an unprecedented wave of guidance in response to the credit crisis, including a relaxation of limits on the ability of financial institutions that undergo an “ownership change” to utilize their pre-change net operating losses and net unrealized built-in losses. The relaxation of these limits may make significantly more attractive the acquisition of financial institutions whose tax basis in their loan portfolios significantly exceeds the fair market value of those portfolios.

          On October 14, 2008, the FDIC announced the establishment of a temporary liquidity guarantee program to provide insurance for all non-interest bearing transaction accounts and guarantees of certain newly issued senior unsecured debt issued by financial institutions (such as the Bank), bank holding companies and savings and loan holding companies (such as the Holding Company). Financial institutions are automatically covered by this program commencing October 14, 2008. Any eligible entity that opts out of the Program on or before December 5, 2008, will not pay any assessment under the Program. Any eligible entity that does not opt out on or before December 5, 2008, will be required to pay related assessment fees. Under the program, newly issued senior unsecured debt issued on or before June 30, 2009 will be insured in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. The debt includes all newly issued unsecured senior debt (e.g., promissory notes, commercial paper and inter-bank funding). The aggregate coverage for an institution may not exceed 125% of its debt outstanding on September 30, 2008 that was scheduled to mature before June 30. 2009. The guarantee will extend to June 30, 2012 even if the maturity of the debt is after that date. Many details of the program still remain to be worked out.

          There can be no assurance as to the actual impact that EESA and such related measures undertaken to alleviate the credit crisis will have generally on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced The failure of such measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.

          Finally, there can be no assurance regarding the specific impact that such measures may have on Downey—or whether (or to what extent) Downey will be able to benefit from such programs and, in particular, whether Downey will be eligible to obtain capital from the Treasury under the TARP program.

          Downey’s access to liquidity may be negatively impacted if market conditions and regulatory restrictions persist or if further ratings downgrades occur.

          While Downey actively manages its liquidity risk and maintains liquidity at least sufficient to cover all maturing debt obligations or other forecasted funding requirements, Downey’s liquidity may be affected by an inability to access the capital markets or by unforeseen or extraordinary demands on cash. This situation may arise due to circumstances beyond Downey’s control, and is subject to the Holding Company’s and the Bank’s credit ratings as assigned by nationally recognized statistical rating organizations. Recent disruptions in the capital markets have substantially limited the ability of mortgage originators, including Downey, to sell mortgage loans to the capital markets through whole loan sales or securitization. As a result, Downey has experienced a general loss of liquidity in most secondary markets for its loans.

Page 79
Navigation Links

          Downey cannot forecast if or when market liquidity conditions will improve from current stresses, although it is Downey’s expectation that the existing turmoil in the financial and credit markets may continue to affect its performance at least throughout 2008.

          On August 12, 2008, Moody’s Investors Service downgraded the Holding Company’s senior unsecured debt rating to “B3” from “B1.” In addition, the Bank’s financial strength was downgraded to “E+” from “D” and its long term deposit rating was downgraded to “B1” from “Ba2.” Its short term deposit rating remains “Not Prime.” On September 11, 2008, Standard & Poor’s Ratings Services lowered its senior unsecured credit rating on the Holding Company to “B-“ from “B+/Watch Neg” and its counterparty credit rating on the Holding Company to “B-/Negative/C” from “B+/Watch Neg/C.” In addition, the Bank’s counterparty and deposit ratings were lowered to “B/Negative/C” from “BB-/Watch Neg/B.”

          In addition, the Holding Company may not issue new debt or renew existing debt without prior non-objection of the OTS.

          Current market conditions have also limited the Bank’s liquidity sources principally to secured funding outlets such as the FHLB and, as back-up, the Federal Reserve Bank of San Francisco, and to FDIC-insured deposits originated through the Bank’s branch network. Other sources of funding, such as medium-term notes and uninsured institutional deposits, may not be available to the Bank. There can be no assurance that actions by the FHLB or the Federal Reserve Bank would not reduce or eliminate our borrowing capacity or that we would be able to continue to attract deposits at competitive rates. Such events could have a material adverse impact on our results of operations and financial condition.

          Future regulatory actions may also adversely impact our ability to raise funds through deposits. For example, as a result of the September 5, 2008 Consent Order, the Bank is required to meet and maintain specific capital levels, it is deemed “adequately capitalized” under OTS regulations even though it exceeds minimum regulatory capital ratios that would otherwise qualify it to be “well capitalized.” As a result, the Bank is subject to restrictions on accepting brokered deposits and upper limits on interest rates the Bank may pay on deposits.

          After the end of the second quarter, the Bank experienced elevated levels of deposit withdrawals. More recently, in response to steps taken by management to address the situation, the deposit flows have seemed to stabilize more to historical levels. If the Bank’s deposit levels remain stabilized at historical levels, we believe our current sources of funds, including deposits; advances from the FHLB and other borrowings; proceeds from the sale of loans and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments would enable us to meet our obligations while maintaining liquidity at appropriate levels. However, if elevated levels of net deposit outflows occur, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional financing or other arrangements.

ITEM 2. – Unregistered Sales of Equity Securities and Use of Proceeds

          None.

ITEM 3. – Defaults Upon Senior Securities

          None.

ITEM 4. – Submission of Matters to a Vote of Security Holders

          None.

Page 80
Navigation Links

ITEM 5. – Other Information

          The following disclosure would otherwise be filed on Form 8-K under the heading “Item 5.02. Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers.” On August 27, 2008, the Company’s Board of Directors determined to move certain members of the Board from one Class of directors to another Class. In connection with this determination, effective as of August 27, 2008:

          Following these changes to the Board, and the appointment of Thomas E. Prince to the Board effective July 21, 2008, Paul M. Homan to the Board effective August 18, 2008, and Charles R. Rinehart to the Board effective September 23, 2008, the Company’s Board is comprised as follows:           

Class 1

Class 2

Class 3


Gary W. Brummett

Michael B. Abrahams

Michael D. Bozarth

James H. Hunter

Thomas E. Prince

Paul M. Homan

Jane Wolfe

Lester C. Smull

Brent McQuarrie

Charles R. Rinehart


          Class 1, 2 and 3 directors will continue to hold office until the Company’s 2011, 2009 and 2010 Annual Meetings of Stockholders, respectively, and until their respective successors are duly elected and qualified.

ITEM 6. – Exhibits

Exhibit

Number

Description


10.1

Employment Agreement (which also includes the Change in Control Agreement), dated as of September 26,

2008, by and between the Bank and Charles R. Rinehart (incorporated by reference to Exhibit 10.1 of the

Company’s Current Report on Form 8-K, filed with the SEC on October 2, 2008).

10.2

OTS Order to Cease and Desist with the Company dated September 5, 2008 (incorporated by reference to

Exhibit 10.1 of the Company’s Current Report on Form 8-K, filed with the SEC on September 5, 2008)

10.3

Stipulation and Consent to Issuance of Order to Cease and Desist with the Company dated September 5, 2008

(incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K, filed with the SEC

on September 5, 2008)

10.4

OTS Order to Cease and Desist with the Bank dated September 5, 2008 (incorporated by reference to Exhibit

10.3 of the Company’s Current Report on Form 8-K, filed with the SEC on September 5, 2008)

10.5

Stipulation and Consent to Issuance of Order to Cease and Desist with the Bank dated September 5, 2008 on

(incorporated by reference to Exhibit 10.4 of the Company’s Current Report on Form 8-K, filed with the SEC

September 5, 2008)

31.1

Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1

Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2

Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.


Page 81
Navigation Links

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 the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

DOWNEY FINANCIAL CORP.

/s/ Charles R. Rinehart


Date: November 10, 2008

Charles R. Rinehart

Chief Executive Officer

/s/ Brian E. Côté


Date: November 10, 2008

Brian E. Côté

Chief Financial Officer


Page 82
Navigation Links

 

NAVIGATION   LINKS

FORM 10-Q COVER

PART I - FINANCIAL INFORMATION

ITEM 1. – 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 Security Holders

ITEM 5. – Other Information

ITEM 6. – Exhibits

AVAILABILITY OF REPORTS

SIGNATURES