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Downey Financial 10-Q 2008 Navigation Links Click here to quickly move through the content of the Form 10-Q filing. UNITED STATES ___________________________ FORM 10-Q (Mark One)
For the quarterly period ended June 30, 2008 OR
For the transition period from __________ to __________ Commission File Number 1-13578 DOWNEY FINANCIAL CORP.
N/A 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):
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 June 30, 2008, 27,853,783 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.
DOWNEY FINANCIAL CORP.
PART I – FINANCIAL INFORMATION ITEM 1. – FINANCIAL STATEMENTS DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
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 June 30, 2008, December 31, 2007 and June 30, 2007, the results of operations and comprehensive income (loss) for the three months and six months ended June 30, 2008 and 2007, and changes in cash flows for the six months ended June 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) – 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.
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.
(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.
The following table summarizes the activity in MSRs and its related allowance for the year-to-date periods indicated.
(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.
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.
(b) The weighted-average expected life of the MSRs portfolio becomes 36 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.
(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.
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.
(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. 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 June 30, 2008, Downey had a notional amount of interest rate lock commitments identified to sell as part of its secondary marketing activities of $54 million, with a change in fair value resulting in a recorded gain of $0.7 million. Downey does not generally enter into derivative transactions for purely speculative purposes. 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 June 30, 2008, the notional amount of loan forward sale contracts amounted to $130 million, with a change in fair value resulting in a gain of $0.8 million, of which $72 million were designated as cash flow hedges. The notional amount of loan forward purchase contracts at June 30, 2008 amounted to $4 million, with less than $0.1 million change in fair value. 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 June 30, 2008, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value gain of $0.4 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 June 30, 2008.
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.
The following table shows the impact from non-qualifying hedges and the ineffectiveness of cash flow hedges on net gains (losses) on sales of loans and mortgage-backed securities (i.e., SFAS 133 effect), as well as the impact to other comprehensive income (loss) from qualifying cash flow transactions for the year-to-date periods indicated.
These loan forward sale and swap contracts expose Downey to credit risk in the event of nonperformance by the other parties—primarily government-sponsored enterprises such as Federal National Mortgage Association, securities firms and the FHLB. This risk consists primarily of the termination value of agreements where Downey is in an unfavorable position. Downey manages the credit risk associated with its other parties to the various derivative agreements through credit review, exposure limits and monitoring procedures. Downey does not anticipate nonperformance by the other parties. Financial Instruments with Off-Balance Sheet Risk Downey utilizes financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to originate fixed and variable rate mortgage loans held for investment, undisbursed loan funds, lines and letters of credit, commitments to purchase loans and mortgage-backed securities for portfolio and commitments to invest in community development funds. The contract or notional amounts of those instruments reflect the extent of involvement Downey has in particular classes of financial instruments.
Commitments to originate fixed and variable rate mortgage loans held for investment are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Undisbursed loan funds on construction projects and unused lines of credit on home equity and commercial loans include committed funds not disbursed. Letters of credit are conditional commitments issued by Downey to guarantee the performance of a customer to a third party. Downey also enters into commitments to purchase loans and mortgage-backed securities, investment securities and to invest in community development funds. The following is a summary of commitments with off-balance sheet risk at the dates indicated.
Downey uses the same credit policies in making commitments to originate loans held for investment and lines and letters of credit as it does for on-balance sheet instruments. For commitments to originate loans held for investment, the commitment amounts represent exposure to loss from market fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. Downey manages the credit risk of its commitments to originate loans held for investment through credit approvals, limits and monitoring procedures. The credit risk involved in issuing lines and letters of credit requires the same creditworthiness evaluation as that involved in extending loan facilities to customers. Downey evaluates each customer’s creditworthiness. Downey receives collateral to support commitments when deemed necessary. The most significant categories of collateral include real estate properties underlying mortgage loans, liens on personal property and cash on deposit with Downey. Downey maintains an allowance for losses to provide for inherent losses for loan-related commitments associated with undisbursed loan funds and unused lines of credit. The allowance for losses on loan-related commitments was $1 million at June 30, 2008, December 31, 2007 and June 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 six months of 2008, Downey recorded repurchase or indemnification losses related to defects in the origination process of $0.2 million and repurchased $2 million of loans and $1 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 June 30, 2008, December 31, 2007 and June 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 June 30, 2008, Downey’s maximum sales price premium refund would be $1.4 million. Through the normal course of operations, Downey has entered into certain contractual obligations. Downey’s obligations generally relate to the funding of operations through deposits and borrowings, loan servicing, as well as leases for premises and equipment. Downey has obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period, with options to extend, and are non-cancelable. Downey also has vendor contractual relationships, but the contracts are not considered to be material.
At June 30, 2008, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, senior notes and future operating minimum lease commitments were as follows:
Litigation 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 is pending, after which it is expected that the plaintiffs will file a 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.
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. During the quarter, the Internal Revenue Service (“IRS”) completed its examination of Downey’s tax returns for 2003, 2004 and 2005. Tax years subsequent to 2005 remain subject to federal examination, while state tax returns for years subsequent to 2002 are subject to examination by taxing authorities. During 2007, Downey determined that its treatment of certain loan origination costs for the years under examination was improper and filed amended tax returns for those years and paid tax and interest to federal and state taxing authorities in the amount of $144.7 million to resolve this issue. 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 $182.8 million against its deferred tax asset of $239.9 million as of June 30, 2008, after considering all available evidence and potential tax-planning strategies 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 June 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 in future periods, but, as explained above, at much smaller levels than in prior periods. NOTE (5) – Employee Stock Option Plans 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 June 30, 2008, options for 52,914 shares were outstanding, all of which were exercisable at a weighted average option price per share of $25.44, which represented at least the fair market value of such shares on the date the options were granted and expire at December 31, 2008. At June 30, 2008, 381,239 shares of treasury stock existed that may be used to satisfy the exercise of the options or for payment of other awards. No other stock based plan exists. NOTE (6) – 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.
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.
NOTE (7) – 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.
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.
The following table summarizes the activity in the Level 3 fair value category for the year-to-date period indicated.
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.
NOTE (8) – Business Segment Reporting The following table presents the operating results and selected financial data by business segments for the periods indicated.
NOTE (9) – 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. On July 25, 2008, following Downey’s second quarter earnings release on July 24, 2008, Moody’s Investors Service downgraded the Holding Company’s senior unsecured debt rating to “B1” from “Ba1.” In addition, the Bank’s financial strength was downgraded to “D” from the previous rating of a “D+,” long-term deposit rating to “Ba2” from “Baa3” and short-term deposits to “Not Prime” from “Prime-3,” with the ratings of both the Holding Company and the Bank under review for downgrade. On July 26, 2008, Standard & Poor’s Ratings Services lowered its senior unsecured and counterparty credit rating on the Holding Company to “BB+/B” from “BBB-/A-3.” In addition, the Bank’s counterparty and deposit ratings were lowered to “BBB-/A-3” from “BBB/A-2,” with the ratings of both the Holding Company and the Bank on negative watch. These lower ratings, and any further ratings downgrades, could make it more difficult for the Holding Company and the Bank to access the capital markets going forward, as the cost to borrow or raise capital would most likely become more expensive. The cost of the Bank’s primary funding sources (deposits and FHLB borrowings) is not influenced directly by the Bank’s credit ratings. In addition, the Holding Company may not issue new debt or renew existing debt without prior non-objection of the OTS. In addition to its deposits, Downey’s principal source of liquidity is its ability to utilize borrowings, as needed. The Bank’s primary source of borrowings is the FHLB. At June 30, 2008, the Bank’s FHLB borrowings totaled $1.5 billion, representing 12.1% of total assets. As of August 8, 2008, the Bank’s FHLB borrowings totaled $2.8 billion. Approximately half of the Bank’s increase in FHLB borrowings subsequent to June 30, 2008 is being held in cash equivalents and short-term investment securities to meet our liquidity needs. 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 $0.2 billion of borrowing capacity from the FHLB as of August 8. 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 qualifying 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 as a back-up source of liquidity. As of August 8, 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 $1.5 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.
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 Bank has experienced net deposit inflows. If the Bank’s deposit levels continue to stabilize with withdrawals at historical levels, Downey believes its 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 Downey to meet its obligations while maintaining liquidity at appropriate levels. However, if elevated levels of net deposit outflows resume, 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. Management believes that the Holding Company, on a stand-alone basis, currently has adequate liquid assets to meet its current obligations, which are primarily interest payments on $199 million of senior notes. Limitations imposed by the Office of Thrift Supervision (“OTS”) discussed below currently prohibit the Bank from providing a dividend to the Holding Company without prior OTS approval, and the Holding Company from paying dividends (other than the quarterly dividend payable in August 2008), and incurring and renewing debt, without prior non-objection of the OTS. At June 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $53 million, down from $102 million at the end of 2007 due primarily to a $50 million capital contribution to the Bank. Downey’s stockholders’ equity totaled $0.9 billion at June 30, 2008, down from $1.3 billion at December 31, 2007 and $1.5 billion at June 30, 2007. The Board reduced the quarterly per share dividend payment from $0.12 to $0.01 for the dividend payable in August 2008, after which no future dividends will be paid without prior non-objection of the OTS. In light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have been working closely with the Bank’s federal banking regulators. In that regard, the OTS, the Bank’s principal regulator, has also imposed the following limitations on the Holding Company and the Bank: the Bank may not pay dividends to the Holding Company without prior OTS approval, and the Holding Company may not pay dividends without prior non-objection of the OTS; the Bank may not increase its assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities without prior OTS approval; the Holding Company may not issue or renew debt without the prior non-objection of the OTS; the Holding Company and the Bank must provide prior notice to the OTS regarding any additions or changes to directors or senior executive officers (or changes in the responsibilities of senior executive officers); the Holding Company and the Bank may not pay certain kinds of severance and other forms of compensation without regulatory approval; the Bank may not enter into, renew, extend or revise any contract related to compensation or benefits with any director or senior executive officer without prior regulatory approval; the Bank must provide prior notice to the OTS (and not receive any objection) before engaging in transactions with any affiliate or subsidiary. In addition, Downey is subject to higher regulatory assessments and FDIC deposit insurance premiums than those prevailing in prior periods. In response to the challenges facing Downey in the current operating environment, Downey has formed a special Board committee to explore a range of strategic alternatives, including the raising of additional capital to levels deemed by the Board to be appropriate under the circumstances.
ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 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 by regulatory and taxing authorities and government regulation and factors, identified under part II – Other Information Item 1A. Risk Factors on page 67. 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, the percentage of unsold homes in escrow or under negotiation will be representative of the number or percentage of homes sold in future periods, the improved quality of our loan portfolio will continue in future periods, we will have adequate liquidity in future periods, or our capital levels will exceed “well-capitalized” levels in future periods. A net loss was recorded for the second quarter of 2008 of $218.9 million or $7.86 per share on a diluted basis, compared with net income of $32.7 million or $1.17 per share in the second quarter of 2007. The $309.5 million unfavorable change in pre-tax income/(loss) between second quarters was due primarily to:
For the first six months of 2008, the net loss totaled $466.6 million or $16.75 per share on a diluted basis, compared with net income of $75.6 million or $2.71 per share for the first six 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 second quarter, our return on average assets was a negative 6.76%, and our return on average equity was a negative 85.33%. These compare to year-ago positive returns of 0.87% on average assets and 9.01% on average equity. For the six months ended June 30, 2008, our return on average assets was a negative 7.08%, and our return on average equity was a negative 80.67%. These compare to year-ago positive returns of 0.98% on average assets and 10.54% on average equity. At June 30, 2008, assets totaled $12.632 billion, down $2.271 billion or 15.2% from a year ago. During the current quarter, assets declined $499 million due primarily to a decline of $605 million in investment securities. That decline was partially offset by a $72 million increase in real estate acquired in settlement of loans, net, and a $64 million increase in income tax receivable. Although gross loans held for investment increased by $231 million, this growth was substantially offset by a $186 million increase in the allowance for loan losses. Included within loans held for investment at quarter end were $6.242 billion of single family adjustable rate mortgages subject to negative amortization, down $721 million from March 31, 2008. These loans comprised 57% of the single family residential loan portfolio held for investment at quarter end, compared with 76% a year ago. The amount of negative amortization included in loan balances declined $31 million during
the current quarter to $344 million or 5.5% of loans subject to negative amortization. During the current quarter, approximately 15% of loan interest income represented negative amortization, down from 20% in the first quarter 2008 and 29% in the year-ago second quarter. Loan originations (including purchases) totaled $1.027 billion in the current quarter, down $182 million or 15.0% from $1.209 billion a year ago, but up from $676 million in the first quarter of 2008. Loans originated for sale declined $283 million or 57.2% to $212 million, while single family residential loans originated for portfolio increased $52 million or 7.4% to $751 million from a year ago. In addition to single family residential loans, $65 million of other loans were originated in the current quarter, up from $15 million a year ago. For the first six months of 2008, loan originations totaled $1.703 billion, down $767 million or 31.0% from the same period a year-ago. Not included in the above originations are loans for which we modified the terms of a borrower’s loan. During the current quarter, we modified $320 million of loans associated with our portfolio 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 $79 million of loans at below market interest rates in loan workout situations. Most of the 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. Deposits totaled $9.881 billion at quarter end, down $1.366 billion or 12.1% from a year ago. Although deposits declined from a year ago, the number of checking accounts was up modestly over a year ago. At quarter end, the number of branches totaled 174 (169 in California and five in Arizona). At quarter end, the average deposit size of our 84 traditional branches was $94 million, while the average deposit size of our 90 in-store branches was $22 million. During the current quarter, borrowings increased by $85 million and represented 14% of total assets at quarter end. Non-performing assets increased during the quarter by $395 million to $1.958 billion and represented 15.50% of total assets, compared with 7.77% at year-end 2007 and 1.53% 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 loans 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 June 30, 2008, 82% of such borrowers had made all loan payments due. Accordingly, the 15.50% ratio of non-performing assets to total assets includes 4.34% related to performing troubled debt restructurings resulting in an adjusted ratio of 11.16%. At June 30, 2008, Downey Savings and Loan Association, F.A. (the “Bank”), our primary subsidiary, had capital-to-asset ratios of 7.57% for both tangible and core capital, and 14.31% for total risk-based capital. As previously reported, the Bank’s regulatory capital position was enhanced by $62 million during the second quarter from a contribution of $50 million of equity from the Holding Company and a $12 million dividend paid by DSL Service Company, the Bank’s wholly-owned real estate subsidiary. This was more than offset by the net loss recorded in the current quarter. In light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have been working closely with the Bank’s federal banking regulators. In that regard, the OTS, the Bank’s principal regulator, has also imposed the following limitations on the Bank: the Bank may not pay dividends to the Holding Company without prior OTS approval; the Bank may not increase its assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities without prior OTS approval; the Bank must provide prior notice to the OTS regarding any additions or changes to directors or senior executive officers (or changes in the responsibilities of senior executive officers); the Bank may not pay certain kinds of severance and other forms of compensation without regulatory approval; the Bank may not enter into, renew, extend or revise any contract related to compensation or benefits with any director or senior executive officer without prior regulatory approval; and the Bank must provide prior notice to the OTS (and not receive any objection) before engaging in transactions with any affiliate or subsidiary. In addition, the Bank is subject to higher regulatory assessments and FDIC deposit insurance premiums than those prevailing in prior periods. In response to the challenges facing Downey in the current operating environment, Downey has formed a special Board committee to explore a range of strategic alternatives, including the raising of additional capital to levels deemed by the Board to be appropriate under the circumstances.
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.
RESULTS OF OPERATIONS 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 $82.9 million in the second quarter of 2008, down $28.5 million or 25.6% from a year ago, reflecting a $2.367 billion or 16.3% decline in average interest-earning assets to $12.168 billion and a decline in the effective interest rate spread. The average effective interest rate spread was 2.73% in the current quarter, down 0.34% from a year ago but up 0.10% from the first 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. Although non-performing assets increased in the current quarter from the first quarter of 2008, the earning asset yield did not decline as rapidly as the cost of funds resulting in an increase in the effective interest rate spread. For the first six months of 2008, net interest income totaled $166.7 million, down $69.9 million or 29.6% 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:
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.
(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.
(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.
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.
During the current quarter, our provision for credit losses totaled $258.9 million, up $249.4 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 six months of 2008, the provision for credit losses totaled $495.7 million, compared with $10.1 million a year ago. For further information, see Allowance for Credit and Real Estate Losses on page 57. Other income totaled $12.1 million in the current quarter, down $5.5 million or 31.2% from a year ago. Primary contributors to the decline between second quarters were:
These unfavorable items were partially offset by a $4.8 million increase in income from loan servicing fees due primarily to a favorable change in the fair value of mortgage servicing rights as a result of slower prepayment speeds.
For the first six months of 2008, other income totaled $21.0 million, down $14.2 million or 40.4% from a year ago. The decline primarily reflected lower net gains from the sale of loans and mortgage-backed securities as well as an unfavorable change in income from real estate and joint ventures held for investment. Below is a further detailed discussion of the major other income categories. Our loan and deposit related fees totaled $8.2 million in the current quarter, down $1.1 million from a year ago. The decline was primarily related to lower automated teller machine fees of $0.6 million and loan related fees of $0.4 million. The following table presents a breakdown of loan and deposit related fees during the quarters indicated.
For the first six months of 2008, loan and deposit related fees totaled $16.4 million, down $1.7 million from the same period of 2007. Both automated teller machine fees and loan related fees declined by $0.9 million each. The following table presents a breakdown of loan and deposit related fees during the year-to-date periods indicated.
Real Estate and Joint Ventures Held for Investment A loss of $5.3 million was recorded from our real estate and joint ventures held for investment, compared to a loss of $0.1 million a year ago. Although net gains from sales increased $5.8 million from a year ago to $6.2 million, that improvement was more than offset by a current quarter provision for losses of $11.1 million to reflect declines in the value of single family lots in which we are a joint venture partner. The following table sets forth the key components comprising our income from real estate and joint venture operations during the quarters indicated.
For the first six months of 2008, a loss of $5.9 million was recorded from real estate and joint ventures held for investment, compared to income of $0.4 million a year ago. The unfavorable change primarily reflected an increase in the provision for losses in the current period which were only partially offset by net gains from sales.
The following table sets forth the key components comprising our income from real estate and joint venture operations during the year-to-date periods indicated.
Secondary Marketing Activities We service loans for others and those activities generated a gain of $4.0 million in the current quarter, up from a loss of $0.8 million in the year-ago quarter. This primarily reflected a $3.6 million favorable change from the measurement of MSRs to fair value and a $1.0 million favorable change in payoff and curtailment interest cost. 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 2 of Notes to Consolidated Financial Statements on page 6. At June 30, 2008, MSRs totaled $23.6 million or 0.95% of the $2.471 billion of associated loans serviced for others, up $1.9 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 June 30, 2008, we serviced $2.961 billion of loans on a sub-servicing basis where we receive a fixed fee per loan, with no risk associated with changing MSR values. The following table presents a breakdown of the components of our loan servicing income (loss), net for the quarters indicated.
(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 six months of 2008, income of $2.8 million was recorded from loan servicing activities, compared to a loss of $1.2 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.
(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 $4.6 million in the current quarter, down $4.4 million from a year ago, reflecting both a decline in loans sold and a lower gain per dollar of loan sold. The current quarter included a $2.1 million gain due to the SFAS 133 impact of valuing derivatives associated with the sale of loans, compared with a SFAS 133 gain of $0.9 million in the year-ago quarter. Excluding the impact of SFAS 133, a gain was realized equal to 1.05% on secondary market sales of $235 million, compared with the year-ago gain of 1.42% on secondary market sales of $570 million. 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.
For the first six months of 2008, our sales of loans and mortgage-backed securities totaled $464 million, down from $1.3 billion a year ago. Net gains associated with these sales totaled $6.2 million, or $11.5 million lower than the prior year amount. Excluding the impact of SFAS 133, a gain equal to 0.90% per dollar of loan sold was realized in the current year, down from the year-ago gain of 1.29%. 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.
Our operating expense totaled $88.5 million in the current quarter, up $26.2 million or 42.0% from a year ago. The increase primarily reflected an increase of $23.2 million in net operations of real estate acquired in the settlement of loans due to a higher number of foreclosed properties. General and administrative expense increased $3.0 million or 4.8% between second quarters, due primarily to an increase in the other general and administrative expense category, which was up $2.8 million. That increase was primarily attributable to an adjustment in the prior year period related to liabilities associated with workers’ compensation insurance claims. Also contributing to the increase between second quarters was a $1.2 million increase in regulatory assessments due primarily to a special credit received in the prior period. Partially offsetting these unfavorable items was a $1.1 million decline in advertising expense. Although salaries and related costs were essentially unchanged between second quarters, the current quarter included severance costs of approximately $1.0 million associated with the previously announced departure of Downey’s former President. The following table presents a breakdown of key components comprising operating expense for the quarters indicated.
For the first six months of 2008, operating expense totaled $177.5 million, up $49.5 million or 38.7% from a year ago. The increase primarily reflected higher net operations of real estate acquired in the settlement of loans, deposit insurance premiums, a goodwill impairment charge during the first quarter of 2008 and other general and administrative expenses. 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.
A tax benefit of $33.5 million was recorded in the current quarter, reflecting an effective tax rate of 13.3%, compared with the year-ago effective tax rate of 42.7%. For the first six months of 2008, the effective tax rate was 3.9%, compared with 43.4% a year ago. For further information, see Note 4 of Notes to Consolidated Financial Statements on page 15.
The previous discussion and analysis of the Results of Operations pertained to our consolidated results. This section discusses and analyzes the results of operations of our two business segments: banking and real estate investment. For further information, see Note 8 of Notes to Consolidated Financial Statements on page 18. The following table presents by business segment our net income (loss) for the periods indicated.
The following table presents by business segment our net income for the year-to-date periods indicated.
A net loss of $215.7 million was recorded in the current quarter related to our banking operations, compared with income of $32.6 million a year ago. The unfavorable change between second quarters primarily reflected:
The following table sets forth our banking operational results and selected financial data for the quarters indicated.
For the first six months of 2008, our net loss from our banking operations totaled $463.0 million, compared to income of $75.0 million a year ago. The unfavorable change primarily reflected a higher provision for credit losses, lower net interest income, and higher operating expense.
The following table sets forth our banking operational results for the year-to-date periods indicated.
A net loss of $3.2 million was recorded in the current quarter from our real estate investment operations, compared to net income of $0.1 million a year ago. Although net gains from sales increased $5.8 million between second quarters, that was more than offset by a $11.1 million provision for losses in the current quarter to reflect declines in the value of single family lots in which we are a joint venture partner. The following table sets forth real estate investment operational results and selected financial data for the quarters indicated.
For the first six months of 2008, a net loss of $3.7 million was recorded related to our real estate investment operations, compared to income of $0.6 million a year ago. The unfavorable change primarily reflected higher provision for losses in the current period, partially offset by higher gains from sales. The following table sets forth our real estate investment operational results for the year-to-date periods indicated.
Our investments in real estate and joint ventures amounted to $63 million at June 30, 2008, down from $69 million at December 31, 2007, and $65 million at June 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 57.
FINANCIAL CONDITION Loans and Mortgage-Backed Securities Total loans and mortgage-backed securities, including those we hold for sale, were virtually unchanged during the current quarter at $10.7 billion or 84.8% of total assets at June 30, 2008. During the quarter loans held for investment increased $15 million while loans held for sale declined $24 million. Our loan originations, including loans purchased, totaled $1.027 billion in the current quarter, down $182 million or 15.0% from the $1.209 billion we originated in the year-ago second quarter but 51.9% above the $676 million we originated in the first quarter of 2008. Loans originated for sale declined $283 million or 57.2% from a year ago to $212 million, while single family loans originated for portfolio increased $52 million or 7.4% to $751 million. Our prepayment speed, which measures the annualized percentage of loans repaid, for residential one-to-four unit loans held for investment declined from 37% a year ago to 13% in the current quarter and was down from 16% in the first quarter of 2008. During the current quarter, 61% 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 78% in the first quarter of 2008 and down from 88% in the year-ago second 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 $320 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 $79 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 $748 million in the current quarter, up from $699 million in the year-ago quarter and $435 million in the first quarter of 2008. Of the current quarter total:
The following table sets forth loans originated, including purchases, for investment and for sale during the periods indicated.
(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.
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.
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.
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 June 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 51% 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 June 30, 2008, $6.2 billion or 57% 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 $31 million during the quarter to $344 million or 5.5% of loans subject to negative amortization. During current quarter, approximately 15% of our loan interest income represented negative amortization, down from 20% in first quarter and 29% in year-ago second quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%. In addition, $3.9 billion or 36% 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.
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.
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.
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 two consecutive quarters starting with the third quarter of 2008 and annually thereafter through 2011. 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 first quarter of 2008, we forecasted that $825 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 $521 million did recast while:
At June 30, 2008, 11% of our residential one-to-four unit loans were originated in 2008, with an additional 16% 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.
At June 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.
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