Why Downey Financial is Not IndyMac

The IRA is on the road part of this week in Oslo for our talk on Monday, “Do OTC Credit Derivatives Increase or Reduce Risk?” But we wanted to comment on Downey Financial (NASDAQ:DSL) before we head to EWR.

We’ve been getting lots of “oh no” calls from the print and broadcast media about DSL. Our response is very simple: calm down.

Yes, DSL’s loan loss rate is nasty with run-rate defaults above 300bp and an MPL calculated in The IRA Bank Monitor over 400bp. Yes, the bank’s very ample capital ratios are under some pressure, with total risk-weighted capital down to “only” 14.5% as of June 30, 2008. Tangible equity to tangible assets was 7.5% as of the same date, according to data from the FDIC.

But the thing we have stressed with members of the “oh no” club is that whereas thrifts such as Countrywide, IndyMac and even the giant lake trout, Washington Mutual (NYSE:WM), have excessive liquidity risk in their dependence upon brokered funds (as manifest by rising advances from the FHLBs), two key red flags in the IRA world view, DSL does not.

DSL has almost 80% core funding for its assets and shows no brokered deposits in its latest report to regulators. Only 10% of total assets are funded off the FHLBs, meaning DSL is below the level considered “excessive” by regulators and has access to ample additional liquidity if needed.

At a market cap of $61 million, DSL is trading at 6% of book. Given the premium being paid for deposits in the market today, at some point we see DSL getting bought. Indeed, it would not be impossible for a fund to take DSL private at current levels. That’s a hint, BTW.

Remember that DSL is a lot like the old GoldenWest business, basically a loan portfolio with an in-house origination, servicing and funding operation. Yes, loss rates may remain high through 2008 for the type of exotic CA collateral found on DSL’s loan book, but the value of this collateral is not 6% of par, in our humble view.

We have told and are telling our advisory clients that it may not yet be time to pull the trigger but it is certainly time to shop. Evaluating situations like DSL is going to require steel nerves and creative thinking for investors on both sides of the table to extract value. As of friend David Kotok said in our interview earlier this year (“Sleepless in MuniLand: Interview With David Kotok” ), if the act of pulling the trigger makes you sick to your stomach, then there is probably value to be had.

We believe that current market valuations for banks like DSL are silly, even assuming a worst case, 2x 1990 loss rate scenario as we postulated last week. Indeed, even were the bank’s capital wiped out by losses of say 2x current default rates, a remote possibility in our view, the loan portfolio would still be worth north of 60-70% of par. Right?

Strategic acquirers are well aware of the value locked-up inside both sides of the balance sheet at strong retail banking franchises such as DSL. While the continued mark-to-market self-immolation still has much of the Street distracted, there is a growing crowd of investors evaluating bank valuations from Reykjavik to DSL’s home in Newport Beach, CA, down the road from IRA’s HQ. In both cases, hysteria and media hype may be obscuring value.

As and when more chum hits the water in terms of further confirmation that bank loan loss rates are slowing, the fish will start to feed in earnest. We’ll have more to say about that when the FDIC releases the Q2 data the week of August 25th.

Originally published at Institutional Risk Analysis and reproduced here with the author’s permission.

6 Responses to "Why Downey Financial is Not IndyMac"

  1. Anonymous   August 25, 2008 at 10:35 am

    On paper, DSL might look good, but the fact is management is sorely lacking. When Mac left, it will only get worse.I have to question the paper aspect as well. 80% of their depositors are elderly people who like simple things like passbooks for savings. As they get older and pass away, there is no (relatively) new depositor to pick up the slack. DSL needs to go the way of the dinosaur, and the sooner the better.

  2. Guest   August 25, 2008 at 3:16 pm

    The majority of the book is option ARM. This asset class is worse than subprime. The loans are not worth 60.00 they are trading in the teens. Real losses are going to wipe them out. Just a quick lesson on option ARM: they allow the borrow to pay the minimum payment (which they all do) which adds the difference of the full index rate onto the balance of the loans. All of the option ARM are located in CA which is having sever house price decline. Most of the borrowers are investors or had limited documentation. So you have a loan that is increase, home price decrease, little incentive to pay (because you don’t live there), and all this setsup for a perfect storm. In the next six month this company will be worth zero. No byout – no one will take on future losses for this paper. Do your homework and good luck.

  3. Guest   August 25, 2008 at 3:36 pm

    Thornburg Mortgage got crushed and they originated mostly clean fixed rate paper. Unless a miracle happens DSL is toast. We should all note that these products don’t work, Pay Option Arms and COFI loans, and should be retied permanently

  4. Roo   August 25, 2008 at 7:07 pm

    I’m extremely confused by this post. If an entity’s assets fell to .60/dollar, anyone leveraged at greater than 2.5 to 1 would see their equity wiped out. The book value is the difference b/w the assets and the liabilities. So when the stock is trading at 6% of book value, that means that the market places a small chance on the assets being worth more than the liabilities. It doesn’t mean that the market thinks that the assets are worth 6% of their face value. This is pretty basic accounting.

  5. Guest   September 8, 2008 at 11:42 am

    Institutional Risk Analysis is a smart organization, but this article makes no sense, as Roo explains cogently. I would add that even sedate senior citizens will extract their cash when they think a bank is on the brink. What is Chris Whalen thinking? There are a lot of solid undervalued companies out there, so why on earth would anyone focus on an insolvent trash heap like Downey?

  6. Mike Lomio   October 20, 2008 at 9:43 pm

    How is it that Golden West oringinated and serviced COFI Option Arms for three DECADES while returning 20% ROE for shareholders every year for twenty years? Maybe it was their prudent approach to underwriting (90% of the loans were single family owner occupied, 70% or lower LTV, 700+ credit scores). Or maybe it was because they did their own appraisals with no conflicts of interest. When run by the Sandlers their delinquency never rose above 1%. Maybe they knew that most borrowers made only the minimum payment so the set higher minimum payment rates, biweekly payments for extra amortization and offered an easy conversion to a fixed rate for a nominal fee. Then never used volatile indicies but rather stable savings based ones that were easy for cutomers to understand an track. The reason GW wrote ARMs was to offset the risk of rising rates that caused the Savings and Loan crisis in the 1980s. These are just a few reasons why Golden West was the envy of the industry. Many competitors tried unsuccessfully to copy their formula. Wachovia’s biggest mistake was changing the underwriting after the aquisition. It was the equivalent of paying 25 Billion for McDonald’s then changing the Big Mac’s secret sauce. Dumb move.