================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
- --------------------------------------------------------------------------------
FORM 10-K
- --------------------------------------------------------------------------------
(Mark One)
|X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 for the fiscal year ended December 31, 2001.
| | 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)
- --------------------------------------------------------------------------------
3501 Jamboree Road, Newport Beach, California 92660
(Address of principal executive offices) (Zip Code)
I.R.S. Employer Identification No.: 33-0633413
Registrant's telephone number, including area code: (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE
- ------------------------------ -------------------------
Common Stock, $0.01 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
- --------------------------------------------------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by a check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |_|
The aggregate market value of the voting stock held by non-affiliates of
the registrant, based upon the closing sale price of its Common Stock on
February 28, 2002, on the New York Stock Exchange was $1,018,509,053.
At February 28, 2002, 28,213,048 shares of the Registrant's Common Stock,
$0.01 par value were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's Proxy
Statement to be filed with the Securities and Exchange Commission in connection
with the Annual Meeting of Stockholders to be held April 24, 2002 are
incorporated by reference in Part III hereof.
================================================================================
TABLE OF CONTENTS
ITEM PAGE
- --------------------------------------------------------------------------------
PART I
1. BUSINESS.......................................................... 1
General........................................................ 1
Banking Activities............................................. 2
Lending Activities........................................... 2
Loan and Mortgage-Backed Securities Portfolio.............. 3
Residential Real Estate Lending............................ 3
Secondary Marketing and Loan Servicing Activities.......... 5
Commercial Real Estate and Multi-Family Lending............ 5
Construction Lending....................................... 6
Commercial Lending......................................... 6
Consumer Lending........................................... 6
Investment Activities........................................ 6
Deposit Activities........................................... 7
Borrowing Activities......................................... 7
Capital Securities........................................... 7
Asset/Liability Management................................... 8
Earnings Spread.............................................. 8
Insurance Agency Activities.................................. 8
Real Estate Investment Activities.............................. 8
Competition.................................................... 9
Employees...................................................... 9
Regulation..................................................... 9
General...................................................... 9
Regulation of Downey......................................... 9
Regulation of the Bank....................................... 10
Regulation of DSL Service Company............................ 16
Taxation....................................................... 17
Factors That May Affect Future Results......................... 17
2. PROPERTIES........................................................ 19
Branches....................................................... 19
Electronic Data Processing..................................... 19
3. LEGAL PROCEEDINGS................................................. 19
4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS................... 19
PART II
5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS............................................ 20
6. SELECTED FINANCIAL DATA........................................... 21
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS...................................... 23
Overview....................................................... 23
Results of Operations.......................................... 25
Net Interest Income......................................... 25
Provision for Loan Losses................................... 27
Other Income................................................ 28
Loan and Deposit Related Fees............................ 28
Real Estate and Joint Ventures Held for Investment....... 28
Secondary Marketing Activities .......................... 29
Other Category........................................... 29
i
TABLE OF CONTENTS
ITEM PAGE
- --------------------------------------------------------------------------------
PART II----(CONTINUED)
Operating Expense........................................... 30
Provision for Income Taxes.................................. 30
Business Segment Reporting.................................. 30
Banking.................................................. 31
Real Estate Investment................................... 32
Financial Condition............................................ 33
Loans and Mortgage-Backed Securities........................ 33
Investment Securities....................................... 37
Investments in Real Estate and Joint Ventures............... 38
Deposits.................................................... 40
Borrowings.................................................. 41
Capital Securities.......................................... 42
Asset/Liability Management and Market Risk.................. 43
Problem Loans and Real Estate............................... 48
Non-Performing Assets.................................... 48
Delinquent Loans......................................... 50
Allowance for Losses on Loans and Real Estate............ 52
Capital Resources and Liquidity............................. 58
Regulatory Capital Compliance............................... 58
Newly Adopted Accounting Principles......................... 59
Current Accounting Issues................................... 59
Sale of Subsidiary.......................................... 60
8. FINANCIAL STATEMENTS.............................................. 61
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES........................... 106
PART III
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................ 106
11. EXECUTIVE COMPENSATION............................................ 106
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT..................................................... 106
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 106
PART IV
14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K.................................................... 106
SIGNATURES ................................................................109
ii
PART I
Certain matters discussed in this Annual Report may constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 (the "Reform Act") and, as such, may involve risks
and uncertainties. These forward-looking statements relate to, among other
things, expectations of the business environment in which Downey Financial Corp.
("Downey," "we," "us" and "our") operates, projections of future performance,
perceived opportunities in the market and statements regarding Downey's mission
and vision. Downey's actual results, performance or achievements may differ
significantly from the results, performance or achievements expressed or implied
in such forward-looking statements. For discussion of the factors that might
cause such a difference, see Business--Factors That May Affect Future Results on
page 17.
ITEM 1. BUSINESS
GENERAL
We were incorporated in Delaware on October 21, 1994. On January 23, 1995,
after we obtained necessary stockholder and regulatory approvals, we acquired
100% of the issued and outstanding capital stock of Downey Savings and Loan
Association (the "Bank") and the Bank's stockholders became holders of our
stock. Downey was thereafter funded by the Bank and presently operates as the
Bank's holding company. Our stock is traded on the New York Stock Exchange and
Pacific Exchange under the trading symbol "DSL."
The Bank was formed in 1957 as a California-licensed savings and loan
association and converted to a federal charter in 1995. As of December 31, 2001,
it conducts its business through 137 retail deposit branches, including 68
full-service in-store branches. Residential loans are originated or purchased:
o by branch managers in our branches;
o by loan officers who solicit loans from realtors and other business
sources, to include via the internet from two California call centers;
o by wholesale loan representatives who obtain loans submitted by
mortgage brokers; and
o by purchases of loans from correspondent banking institutions or
mortgage bankers.
The Bank is regulated or affected by the following governmental entities
and laws:
o As a federally chartered savings association, the Bank's activities
and investments are generally governed by the Home Owners' Loan Act,
as amended, and regulations and policies of the Office of Thrift
Supervision (the "OTS").
o The Bank and Downey are subject to the primary regulatory and
supervisory jurisdiction of the OTS.
o As a federally insured depository institution, the Bank is regulated
and supervised by the Federal Deposit Insurance Corporation (the
"FDIC") with respect to some of its activities and investments.
o The Bank is a member of the Federal Home Loan Bank (the "FHLB") of San
Francisco, which is one of the 12 regional banks for federally insured
depository institutions comprising the Federal Home Loan Bank System.
o The Bank's savings deposits are insured through the Savings
Association Insurance Fund ("SAIF") of the FDIC, an instrumentality of
the United States government.
o The Bank is regulated by the Federal Reserve with respect to reserves
the Bank is required to maintain against deposits and other matters.
General economic conditions, the monetary and fiscal policies of the
federal government and the regulatory policies of governmental authorities
significantly influence our operations. Additionally, interest rates on
competing investments and general market interest rates influence our deposit
flows and the costs we incur on interest-bearing liabilities, which represents
our cost of funds. Similarly, market interest rates and other factors that
affect the supply of and demand for housing and the availability of funds affect
our loan volume and our yields on loans and mortgage-backed securities.
Our primary business is banking and we are also involved in real estate
investments, each of which we discuss further below.
1
BANKING ACTIVITIES
Our primary business is banking. Our banking activities focus on:
o attracting funds from the general public and institutions; and
o originating and investing in loans, primarily residential real estate
mortgage loans, investment securities and mortgage-backed securities.
These mortgage-backed securities include mortgage pass-through securities issued
by other entities and securities issued or guaranteed by government-sponsored
enterprises like the Federal National Mortgage Association, the Federal Home
Loan Mortgage Corporation and the Government National Mortgage Association.
Our primary sources of revenue from our banking business are:
o interest we earn on loans, investment securities and mortgage-backed
securities;
o fees we earn in connection with loans and deposits;
o gains on sales of our loans, investment securities and mortgage-backed
securities; and
o income we earn on loans and mortgage-backed securities we service for
investors.
Our principal expenses in connection with our banking business are:
o interest we incur on our interest-bearing liabilities, including
deposits, borrowings and capital securities; and
o general and administrative costs.
Our primary sources of funds from our banking business are:
o deposits;
o principal and interest payments on our loans and mortgage-backed
securities;
o proceeds from sales of our loans and mortgage-backed securities; and
o borrowings and capital securities.
Scheduled payments we receive on our loans and mortgage-backed securities are a
relatively stable source of funds. However, the funds we receive from deposits
and prepayment of loans and mortgage-backed securities vary widely. Below is a
detailed discussion of our banking activities.
LENDING ACTIVITIES
Historically, our lending activities have primarily emphasized our
origination of first mortgage loans secured by residential properties and retail
neighborhood shopping centers. To a lesser extent, our lending activities have
emphasized our origination of real estate loans secured by multi-family,
commercial and industrial properties, including office buildings, land and other
properties with income producing capabilities. In addition, we have provided
construction loan financing for single family and multi-family residential
properties and commercial retail neighborhood shopping center projects. These
construction loan financings have included loans to joint ventures, which were
being engaged in by DSL Service Company, a wholly owned subsidiary of the Bank,
with other participants. We also originate loans to businesses through our
commercial banking operations.
We originate automobile loans directly through our branch network. We also
conducted an indirect auto-lending program through our purchase of new or used
automobile sales contracts from auto dealers in California and other western
states. Downey Auto Finance Corp., a previous wholly owned subsidiary of the
Bank, operated this indirect auto-lending program, but was sold in February
2000. For more information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Sale of
Subsidiary on page 60.
Our primary focus will continue to be our origination of:
o adjustable rate single family mortgage loans, including subprime loans
which carry higher interest rates; and
o consumer loans.
2
We will also continue our secondary marketing activities of originating and
selling single family loans to various investors.
For more information, see below under the caption entitled Secondary
Marketing and Loan Servicing Activities on page 5. For additional information on
the composition of our loan and mortgage-backed securities portfolio, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Loans and Mortgage-Backed Securities on page
33.
LOAN AND MORTGAGE-BACKED SECURITIES PORTFOLIO
We carry loans receivable held for investment at cost. Our net loans
receivable are adjusted for amortization of premiums and accretion of discounts
which are recognized in interest income using the interest method. Our
investments in mortgage-backed securities represent participating interests in
pools of first mortgage loans originated and serviced by the issuers of the
securities. We carry mortgage-backed securities held to maturity at unpaid
principal balances, which are adjusted for unamortized premiums and unearned
discounts. We amortize premiums and discounts on mortgage-backed securities by
using the interest method over the remaining period to contractual maturity,
adjusted for anticipated prepayments.
We identify loans that may be sold before their maturity. In our balance
sheets, we classify these as loans held for sale and record them at the lower of
amortized cost or fair value. Amortized cost includes a basis adjustment to the
loan at funding resulting from the change in the fair value of the associated
interest rate lock derivative from the date of commitment to the date of
funding. We recognize net unrealized losses on these loans, if any, in a
valuation allowance by making charges to our income.
We carry mortgage-backed securities available for sale at fair value. We
report net unrealized gains or losses on these securities net of income taxes in
stockholders' equity and as a separate component of our other comprehensive
income until realized.
The residential mortgage loans we originate typically have contractual
maturities at origination of 15 to 40 years. To limit the interest rate risk
associated with these 15- to 40-year maturities, we, among other things,
principally originate adjustable rate mortgages for our own loan portfolio. We
originate fixed rate loans with the intention to sell the majority of them in
the secondary market on a non-recourse basis for cash. However, we occasionally
originate fixed rate loans for our own portfolio to facilitate the sale of real
estate we acquire in settlement of loans or which meet specific yield and other
approved guidelines. For more information, see Asset/Liability Management on
page 8. In addition, the average term of these fixed rate mortgage loans we
originate for our own portfolio historically has been significantly shorter than
their contractual maturity due to loan payoffs as a result of home sales or
refinancings and prepayments.
RESIDENTIAL REAL ESTATE LENDING
Our primary lending activity is our origination of mortgage loans secured
by single family residential properties consisting of one-to-four units located
primarily in California. We provide these mortgage loans for borrowers to
purchase residences or to refinance their existing mortgages at lower rates or
upon different terms. Our primary strategy is to originate adjustable rate
mortgages for our portfolio of loans we hold for investment. For more
information, see Asset/Liability Management on page 8. We also originate
residential fixed rate mortgage loans to meet consumer demand, but we intend to
sell the majority of these loans in the secondary market, rather than hold them
in our portfolio. We may, however, place residential fixed rate loans in our
portfolio of loans held for investment if these fixed rate loans are funded with
long-term funds to mitigate interest rate risk. In addition, we originate a
small volume of fixed rate loans for our own investment if they meet specific
yield and other approved guidelines, or to facilitate our sale of real estate
acquired in settlement of loans. For more information, see Secondary Marketing
and Loan Servicing Activities on page 5.
Our adjustable rate mortgages generally:
o begin with an incentive interest rate, which is an interest rate below
the current market rate, that adjusts to the applicable index plus a
defined spread, subject to periodic and lifetime caps, after one,
three, six or twelve months;
o provide that the maximum interest rate we can charge borrowers cannot
exceed the incentive rate by more than six to nine percentage points,
depending on the type of loan and the initial rate offered; and
o limit interest rate adjustments to 1% per adjustment period for those
that adjust semi-annually and 2% per adjustment period for those that
adjust annually.
3
Most of our adjustable rate mortgages adjust monthly instead of
semi-annually. These monthly adjustable rate mortgages:
o have a lifetime interest rate cap, but no specified periodic interest
rate adjustment cap;
o have a periodic cap on changes in required monthly payments, which
adjust annually; and
o allow for negative amortization, which is the addition to loan
principal of accrued interest that exceeds the required monthly loan
payments.
Regarding negative amortization, if a loan incurs significant negative
amortization, then there is an increased risk that the fair value of the
underlying collateral on the loan would be insufficient to satisfy fully the
outstanding principal and interest. We currently impose a limit on the amount of
negative amortization for loans with loan-to-value ratios of 80% or less. A
loan-to-value ratio is the ratio of the principal amount of the loan to the
lower of the sales price or appraised value at origination of the property
securing the loan. The limit on negative amortization is that the principal plus
the added amount cannot exceed 125% of the original loan amount. This limit does
not apply to subprime loans. Rather, for subprime loans the principal plus
negative amortization cannot exceed 110% of the original loan amount. At
year-end 2001, loans with the higher 125% limit on negative amortization
represented about one-fourth of our adjustable rate one-to-four unit residential
portfolio. We permit adjustable rate mortgages to be assumed by qualified
borrowers.
During 2001, approximately 78% of our one-to-four unit residential real
estate loans were obtained by our wholesale loan representatives but originated
through outside mortgage brokers. We pay our wholesale loan representatives on a
commission basis. We consider the compensation we pay outside mortgage brokers
when we set the overall price of our mortgage loan products. These mortgage
brokers do not operate from our offices and are not our employees. Our branch
mangers and residential loan officers originated approximately 22% of our
one-to-four unit residential loans during 2001. We compensate residential loan
officers located in our call centers on a salary basis plus a fixed amount per
loan they originate. Branch mangers and assistant managers are compensated a
fixed amount per loan they originate. Loan officers located outside our call
centers are compensated on a commission only basis and typically receive loan
referrals from real estate agents, builders and customers.
We require that our residential real estate loans be approved at various
levels of management, depending upon the amount of the loan. On a single family
residential loan we originate for our portfolio, the maximum amount we generally
will lend is $1 million. Our average loan size, however, is much lower. In 2001,
our average loan size was $309,000. We generally make loans with loan-to-value
ratios not exceeding 80%. We will make loans with loan-to-value ratios of over
80%, if the borrower obtains private mortgage insurance to reduce the effective
loan-to-value ratio to between 70% to 78%, consistent with secondary marketing
requirements. In addition, we require that borrowers obtain hazard insurance for
all residential real estate loans covering the lower of the loan amount or the
replacement value of the residence.
In our approval process for the loans we originate or purchase, we assess
both the value of the property securing the loan and the applicant's ability to
repay the loan. Loan underwriters analyze the loan application and the property
involved. Qualified appraisers on our staff or approved outside appraisers
establish the value of the collateral through the use of full appraisals or
alternative valuation formats that meet regulatory requirements. Appraisal
reports prepared by outside appraisers are selectively reviewed by our staff
appraisers or by approved fee appraisers. We also obtain information about the
applicant's income, financial condition, employment and credit history.
Typically, we will verify an applicant's credit information for loans originated
by our retail loan representatives. For loans submitted from outside mortgage
brokers, we require the mortgage broker to obtain, review and verify the
applicant's credit information and employment.
On our adjustable rate mortgages we offer with incentive interest rates, we
currently qualify applicants:
o for loan programs with no negative amortization at the higher of:
o the initial incentive interest rate; or
o the fully indexed interest rate.
o for loan programs that include negative amortization and are owner
occupied, at the minimum qualifying interest rate of 7.00%.
o for loan programs that include negative amortization and are non-owner
occupied, at the minimum qualifying interest rate of 7.25%.
4
Late in 1996, we began offering one-to-four unit residential loans to
borrowers who have or, in the case of purchases, will have equity in their homes
but whose credit rating contains exceptions which preclude them from qualifying
for lower or better market interest rates and terms. We refer to these lower
grade credits, which we characterize as "A-," "B" and "C" loans, as subprime
loans in our loan portfolio. Our subprime loans are characterized by lower
loan-to-value ratios and higher average interest rates than higher credit grade
loans or "A" loans. We believe these lower credit grade borrowers represent an
opportunity for us to earn a higher net return for the risks we assume. We have
developed specific underwriting guidelines for each classification of adjustable
subprime credit and qualify these applicants at the fully indexed rate. For
further information, see Regulation--Regulation of the Bank--Regulatory Capital
Requirements on page 11.
SECONDARY MARKETING AND LOAN SERVICING ACTIVITIES
As part of our secondary marketing activities, we originate some
residential real estate adjustable rate mortgages and fixed rate mortgages,
which we intend to sell. Accordingly, we classify these loans as held for sale
and carry them at the lower of cost or fair value. Amortized cost includes a
basis adjustment to the loan at funding resulting from the change in the fair
value of the associated interest rate lock derivative from the date of
commitment to the date of funding. These loans are secured by first liens on
one-to-four unit residential properties and generally have maturities of 30
years or less.
Generally, we use various hedging programs to manage the interest rate risk
of our fixed rate mortgage origination process. For further information, see
Asset/Liability Management and Market Risk on page 43.
We believe that servicing loans for others can be an important
asset/liability management tool because it produces operating results which, in
response to changes in market interest rates, tend to move opposite to changes
in net interest income. Because adjustable rate mortgages take longer to adjust
to market interest rates, net interest income associated with these loans is
expected to decline in periods of rising interest rates and increase in periods
of falling rates. In contrast, the value of a loan servicing portfolio normally:
o increases as interest rates rise and loan prepayments decrease; and
o declines as interest rates fall and loan prepayments increase.
In addition, increased levels of servicing activities and the opportunity to
offer our other financial services in servicing loans for others can provide us
with additional income with minimal additional overhead costs.
Depending upon market pricing for servicing, we sell loans either servicing
retained or servicing released. When we sell loans servicing retained, we record
gains or losses from these loans at the time of sale. We calculate gains or
losses from our sale as the difference between the net sales proceeds and the
allocated basis of the loans sold. We capitalize mortgage servicing rights we
acquire through either our purchase or origination of mortgage loans we intend
to sell with servicing rights retained. We allocate the total cost of the
mortgage loans designated for sale to both the mortgage servicing rights and to
the mortgage loans without mortgage servicing rights based on their relative
fair values. We disclose our mortgage servicing rights in our financial
statements and include them as a component of the gain on sale of loans. We
recognize impairment losses on the mortgage servicing rights through a valuation
allowance and record any associated provision as a component of loan servicing
fees. At December 31, 2001, our mortgage servicing rights totaled $57 million
and during 2001 we recorded a $10.6 million provision for impairment of our
mortgage servicing rights.
We may exchange loans we originate for sale with government agencies for
mortgage-backed securities collateralized by these loans. Our cost for the
exchange, a monthly guaranty fee, is expressed as a percentage of the unpaid
principal balance and is deducted from interest income. We can use the
securities we receive to collateralize various types of our borrowings at rates
that frequently are more favorable than rates on other types of liabilities and
also carry a lower risk-based capital requirement than whole loans. We carry
these mortgage-backed securities available for sale at fair value. However, we
record no gain or loss on the exchange in our statement of income until the
securities are sold to a third party. Before we sell these securities to third
parties, we show all changes in fair value as a separate component of
stockholders' equity as accumulated other comprehensive income, net of income
taxes.
COMMERCIAL REAL ESTATE AND MULTI-FAMILY LENDING
We have provided permanent loans secured by retail neighborhood shopping
centers and multi-family properties. Our major loan officers conduct our
commercial real estate and multi-family lending activities. We compensate these
officers on a salary basis.
5
Commercial real estate and multi-family loans generally entail additional
risks as compared to single family residential mortgage lending. We subject each
loan, including loans to facilitate the sale of real estate we own, to our
underwriting standards, which generally include:
o our evaluation of the creditworthiness and reputation of the borrower;
and
o the amount of the borrower's equity in the project as determined on
the basis of appraisal, sales and leasing information on the property
and cash flow projections.
To protect the value of the security for our loan, we require borrowers to
maintain casualty insurance for the loan amount or replacement cost. In
addition, for non-residential loans in excess of $500,000, we require the
borrower to obtain comprehensive general liability insurance. All commercial
real estate loans we originate must be approved by at least two of our officers,
one of whom must be the originating loan account officer and the other a
designated officer with appropriate loan approval authority.
CONSTRUCTION LENDING
We have provided construction loan financing for single family and
multi-family residential properties and commercial real estate projects, like
retail neighborhood shopping centers. Our major loan officers principally
originate these loans. We generally make construction loans at floating interest
rates based upon the prime or reference rate of a major commercial bank.
Generally, we require a loan-to-value ratio of 75% or less on construction
lending and we subject each loan to our underwriting standards.
Construction loans involve risks different from completed project lending
because we advance loan funds based upon the security of the completed project
under construction. If the borrower defaults on the loan, then we may have to
advance additional funds to finance the project's completion before the project
can be sold. Moreover, construction projects are affected by uncertainties
inherent in estimating:
o construction costs;
o potential delays in construction time;
o market demand; and
o the accuracy of the value on the completed project.
When providing construction loans, we require the general contractor to,
among other things, carry contractor's liability insurance equal to specific
prescribed minimum amounts, carry builder's risk insurance and have a blanket
bond against employee misappropriation.
COMMERCIAL LENDING
We originate commercial loans and revolving lines of credit and issue
standby letters of credit for our middle market commercial customers. We offer
the various credit products on both a secured and unsecured basis with interest
rates being either fixed or variable. Our portfolio emphasis is toward secured,
floating rate credit facilities. Our commercial banking group directs these
activities and focuses on our long-term, relationship-based customers. We also
utilize our retail branch network as a source of commercial customers, with the
lending to these customers being typically managed by the branch manager. We
believe our commercial borrowers are desirable because these borrowers generally
have lower cost deposit accounts.
CONSUMER LENDING
The Bank originates direct automobile loans, home equity loans and lines of
credit, and other consumer loan products. Before we make a consumer loan, we
assess the applicant's ability to repay the loan and, if applicable, the value
of the collateral securing the loan. The risk involved with home equity loans
and lines of credit is similar to the risk involved with residential real estate
loans. We offer customers a credit card through a third party, who extends the
credit and services the loans made to our customers.
INVESTMENT ACTIVITIES
As a federally chartered savings association, the Bank's ability to make
securities investments is prescribed under the OTS regulations and the Home
Owners' Loan Act. The Bank's authorized officers make investment decisions
within guidelines established by the Bank's Board of Directors. The Bank manages
these investments in an effort to produce the highest yield, while at the same
time maintaining safety of principal, minimizing interest rate risk and
complying with applicable regulations.
6
We carry securities held to maturity at amortized cost. We adjust these
costs for amortization of premiums and accretion of discounts, which we
recognize as interest income using the interest method. We carry securities
available for sale at fair value. We exclude unrealized holding gains and
losses, or valuation allowances established for net unrealized losses, from our
earnings and report them as a separate component of our stockholders' equity as
accumulated other comprehensive income, net of income taxes, unless the security
is deemed other than temporarily impaired. If the security is determined to be
other than temporarily impaired, we charge the amount of the impairment to
operations. For further information on the composition of our investment
portfolio, see Management's Discussion and Analysis of Financial Condition and
Results of Operations--Financial Condition--Investment Securities on page 37.
DEPOSIT ACTIVITIES
We prefer to use deposits as our principal source of funds for supporting
our lending activities, because the cost of these funds generally is less than
that of borrowings or other funding sources with comparable maturities. We
traditionally have obtained our savings deposits primarily from areas
surrounding the Bank's branch offices. However, we occasionally raise some
retail deposits through Wall Street activities.
General economic conditions affect deposit flows. Funds may flow from
depository institutions such as savings associations into direct vehicles like
government and corporate securities or other financial intermediaries. Our
ability to attract and retain deposits will continue to be affected by money
market conditions, prevailing interest rates and available competing investment
vehicles. Generally, state or federal regulation does not restrict interest
rates we pay on deposits.
In 1996, we began establishing full-service branch facilities in selected
supermarket locations throughout California. Each in-store branch offers a full
range of financial services including checking and savings accounts as well as
residential and consumer loans.
When consistent with our maintenance of appropriate capital levels, we may
consider opportunities to augment our retail branch system and deposit base
through our acquisition of selected branches or deposits.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Deposits on
page 40.
BORROWING ACTIVITIES
Our principal source of funds has been and continues to be deposits we
raise through our retail branch system. At various times, however, we have
utilized other sources to fund our loan origination and other business
activities. We have at times relied upon our borrowings from the FHLB of San
Francisco as an additional source of funds. The FHLB of San Francisco makes
advances to us through several different credit programs it offers.
From time to time, we obtain additional sources of funds by selling some of
our securities and mortgage loans under agreements to repurchase. These reverse
repurchase agreements are generally short-term and are collateralized by our
mortgage-backed or investment securities and our mortgage loans. We only deal
with investment banking firms that are recognized as primary dealers in U.S.
government securities or major commercial banks in connection with these reverse
repurchase agreements. In addition, we limit the amounts of our borrowings from
any single institution.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Borrowings
on page 41.
CAPITAL SECURITIES
On July 23, 1999, we issued $120 million in capital securities through
Downey Financial Capital Trust I. The capital securities pay quarterly
cumulative cash distributions at an annual rate of 10.00% of the liquidation
value of $25 per share. Of the $115 million of net proceeds, we invested $108
million as additional common stock of the Bank thereby increasing the Bank's
regulatory core/tangible capital by that same amount. The balance of the net
proceeds have been used for general corporate purposes. For further information
regarding our capital securities, see Note 18 on page 91 of Notes to
Consolidated Financial Statements.
7
ASSET/LIABILITY MANAGEMENT
Savings institutions are affected by interest rate risks to the degree that
their interest-bearing liabilities, consisting principally of customer deposits,
FHLB advances, other borrowings and capital securities, mature or reprice on a
different basis than their interest-earning assets, which consist predominantly
of intermediate or long-term real estate loans. While having liabilities that on
average mature or reprice more frequently than assets may be beneficial in times
of declining interest rates, this asset/liability structure may result in
declining net earnings during periods of rising interest rates. One of our
principal objectives is to manage the effects of adverse changes in interest
rates on our interest income while maintaining our asset quality and an
acceptable interest rate spread. To improve the rate sensitivity and maturity
balance of our interest-earning assets and liabilities, we have emphasized the
origination of loans with adjustable interest rates or relatively short
maturities. Loans with adjustable interest rates have the beneficial effect of
allowing the yield on our assets to increase during periods of rising interest
rates, although these loans have contractual limitations on the frequency and
extent of interest rate adjustments.
For further information, see Lending Activities on page 2 and Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Asset/Liability Management and Market Risk on
page 43.
EARNINGS SPREAD
We determine our net interest income or the interest rate spread by
calculating the difference between:
o the yield we earn on our interest-earning assets like loans,
mortgage-backed securities and investment securities; and
o the cost we pay on our interest-bearing liabilities like deposits,
borrowings and capital securities.
Our net interest income is also determined by the relative dollar amounts of our
interest-earning assets and interest-bearing liabilities.
Our effective interest rate spread, which reflects the relative level of
our interest-earning assets to our interest-bearing liabilities, equals:
o the difference between interest income on our interest-earning assets
and interest expense on our interest-bearing liabilities, divided by
o our average interest-earning assets for the period.
For information regarding our net income and the components thereof and for
management's analysis of our financial condition and results of operations, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations beginning on page 23. For information regarding the return on our
assets and other selected financial data, see Selected Financial Data on page
21.
INSURANCE AGENCY ACTIVITIES
Downey Affiliated Insurance Agency was incorporated on January 25, 1995, as
Downey's wholly owned subsidiary. We capitalized Downey Affiliated Insurance
Agency on February 24, 1995 with $400,000. In the 1995 second quarter, Downey
Affiliated Insurance Agency commenced operations at which time representatives
of Downey Affiliated Insurance Agency were available in our branches to offer
annuity products. During 1996, Downey Affiliated Insurance Agency began offering
forced-placed casualty insurance policies on mortgage loans and stopped offering
annuity products. The offering of forced-placed casualty insurance policies
ceased in April 1999.
REAL ESTATE INVESTMENT ACTIVITIES
In addition to our primary business of banking, which has been described
above, we are also involved in real estate investment activities, which are
conducted primarily through DSL Service Company, a wholly owned subsidiary of
the Bank. DSL Service Company is a diversified real estate development company
which was established in 1966 as a neighborhood shopping center and residential
tract developer, as well as the general contractor for the Bank's branch
locations. Today its capabilities include development, construction and property
management activities relating to its portfolio of projects primarily within
California, but also in Arizona. In addition to DSL Service Company developing
its own real estate projects, it associates with other qualified developers to
engage in joint ventures. The primary revenue sources of our real estate
investment activities include net rental
8
income and gains from the sale of real estate investments. The primary expenses
of our real estate investment activities are interest expense and general and
administrative expense.
Due to federal law, the Bank is prohibited from making new investments in
real estate development and joint venture operations and is required to deduct
the full amount of its investment in DSL Service Company in calculating its
applicable ratios under the core, tangible and risk-based capital standards.
Savings associations generally may invest in service corporation subsidiaries,
like DSL Service Company, to the extent of 2% of the association's assets, plus
up to an additional 1% of assets for investments which serve primarily
community, inner-city or community development purposes. In addition,
"conforming loans" by the Bank to DSL's joint venture partnerships are limited
to 50% of the Bank's risk-based capital. "Conforming loans" are those generally
limited to 80% of appraised value, bear a market rate of interest and require
payments sufficient to amortize the principal balance of the loan. We are in
compliance with each of these investment limitations.
To the extent Downey or a subsidiary of Downey, other than the Bank or its
subsidiaries, makes real estate investments, the above-mentioned capital
deductions and limitations do not apply, as they only pertain to the specific
investments by savings associations or their subsidiaries.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Investments
in Real Estate and Joint Ventures on page 38.
COMPETITION
We face competition both in attracting deposits and in making loans. Our
most direct competition for deposits has historically come from other savings
institutions and from commercial banks located in our principal market areas,
including many large financial institutions based in other parts of the country
or their subsidiaries. In addition, we face additional significant competition
for investors' funds from short-term money market securities and other corporate
and government securities. Our ability to attract and retain savings deposits
depends, generally, on our ability to provide a rate of return, liquidity and
risk comparable to that offered by competing investment opportunities and the
appropriate level of customer service.
We experience competition for real estate loans principally from other
savings institutions, commercial banks, mortgage banking companies and insurance
companies. We compete for loans principally through our interest rates and loan
fees we charge and our efficiency and quality of services we provide borrowers
and real estate brokers.
EMPLOYEES
At December 31, 2001, we had approximately 1,966 full-time employees and
545 part-time employees. We provide our employees with health and welfare
benefits and a retirement and savings plan. Additionally, we offer qualifying
employees participation in our stock purchase plan. Our employees are not
represented by any union or collective bargaining group, and we consider our
employee relations to be good.
REGULATION
GENERAL
Federal and state law extensively regulates savings and loan holding
companies and savings associations. This regulation is intended primarily for
the protection of our depositors and the SAIF and not for the benefit of our
stockholders. In the following information, we describe some of the regulations
applicable to us and the Bank. We do not claim this discussion is complete and
qualify our discussion in its entirety by reference to applicable statutory or
regulatory provisions.
REGULATION OF DOWNEY
General. We are a savings and loan holding company and are therefore
subject to regulatory oversight by the OTS. Thus, we are required to register
and file reports with the OTS and are regulated and examined by the OTS. In
addition, the OTS has enforcement authority over us, which also permits the OTS
to restrict or prohibit our activities that it determines to be a serious risk
to the Bank.
Activities Restrictions. As a savings and loan holding company with only
one savings and loan association subsidiary, we generally are not limited by OTS
activity restrictions, provided the Bank satisfies the qualified thrift lender
test or meets the definition of a domestic building and loan association in the
Internal Revenue Code. If we acquire control of another savings association as a
separate subsidiary of Downey, we would become a multiple
9
savings and loan holding company. As a multiple savings and loan holding
company, our activities, other than the activities of the Bank or any other
SAIF-insured savings association, would become subject to restrictions
applicable to bank holding companies unless these other savings associations
were acquired in a supervisory acquisition and each also satisfies the qualified
thrift lender test or meets the definition of a domestic building and loan
association. Furthermore, if we were in the future to sell control of the Bank
to any other company, such company would not succeed to our grandfathered status
as a unitary thrift holding company and would be subject to the same business
activity restrictions as a bank holding company. For more information, see
Restrictions on Acquisitions below and Regulation of the Bank--Qualified Thrift
Lender Test on page 13.
Restrictions on Acquisitions. We must obtain approval from the OTS before
acquiring control of any other SAIF-insured association. The OTS generally
prohibits these types of acquisitions if they result in a multiple savings and
loan holding company controlling savings associations in more than one state.
However, the OTS permits interstate acquisitions if the acquisition is
authorized by specific state authorization or a supervisory acquisition of a
failing savings association.
Federal law generally provides that no "person," acting directly or
indirectly or through or in concert with one or more other persons, may acquire
"control" of a federally insured savings association unless the person gives at
least 60 days written notice to the OTS. The OTS then has the opportunity to
disapprove the proposed acquisition. In addition, no company may acquire control
of this type of an institution without prior OTS approval. These provisions also
prohibit, among other things, any director or officer of a savings and loan
holding company, or any individual who owns or controls more than 25% of the
voting shares of a savings and loan holding company, from acquiring control of
any savings association not a subsidiary of the savings and loan holding
company, unless the acquisition is approved by the OTS.
Furthermore, no company may acquire control of an insured savings
association, unless that company engages, and continues to engage, only in the
financial activities permissible for a Financial Holding Company, unless
grandfathered as a unitary savings and loan holding company. Downey is a
grandfathered unitary savings and loan holding company.
Financial Holding Company Legislation. On November 12, 1999, the
Gramm-Leach-Bliley Act of 1999 (the "Act") was signed into law. This law
established a comprehensive framework to permit affiliations among commercial
banks, insurance companies, securities firms and other financial service
providers by revising and expanding the Bank Holding Company Act framework to
permit a holding company to engage in a full range of financial activities
through a new entity known as a "Financial Holding Company." "Financial
activities" is broadly defined to include not only banking, insurance and
securities activities, but also merchant banking and additional activities that
the Federal Reserve Board, in consultation with the Secretary of the Treasury,
determines to be financial in nature, related or incidental to such financial
activities, or complementary activities that do not pose a substantial risk to
the safety and soundness of depository institutions or the financial system
generally.
The Act provided that no company may acquire control of an insured savings
association, unless that company engages, and continues to engage, only in the
financial activities permissible for a Financial Holding Company, unless
grandfathered as a unitary savings and loan holding company. Downey is a
grandfathered unitary savings and loan holding company and we may continue to
operate under present law as long as we continue to control only the Bank and
the Bank continues to meet the qualified thrift lender test.
We do not believe that this law will have a material adverse effect on our
operations in the near-term. However, to the extent that the Act permits banks,
securities firms and insurance companies to affiliate, the financial services
industry may experience further consolidation. The Act is intended to grant to
community banks certain powers as a matter of right that larger institutions
have accumulated on an ad hoc basis and which unitary savings and loan holding
companies, such as Downey, already possess. Nevertheless, this Act may have the
result of increasing the amount of competition that we face from larger
institutions and other types of companies offering financial products, many of
which may have greater financial resources than we do. In addition, the Act may
have an anti-takeover effect because it may tend to limit the range of potential
acquirers of Downey to other savings and loan holding companies and Financial
Holding Companies.
REGULATION OF THE BANK
General. The OTS and the FDIC extensively regulate the Bank because the
Bank is a federally chartered, SAIF-insured savings association. The Bank must
ensure that its lending activities and its other investments comply with various
statutory and regulatory requirements. The Bank is also regulated by the Federal
Reserve.
10
The OTS, in conjunction with the FDIC, regularly examines the Bank and
prepares reports for the Bank's Board of Directors to consider with respect to
any deficiencies the OTS or the FDIC finds in the Bank's operations. Federal and
state laws also regulate the relationship between the Bank and its depositors
and borrowers, especially in matters regarding the ownership of savings accounts
and the form and content of mortgage documents used by the Bank.
The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition. In addition, the Bank must obtain regulatory
approvals before entering into some transactions like mergers with or
acquisitions of other financial institutions. This regulation and supervision
establishes a comprehensive framework of activities in which an institution may
engage and is intended primarily for the protection of the SAIF and our
depositors. The regulatory structure also gives the regulatory authorities
extensive discretion in connection with their supervisory and enforcement
activities and examination policies, including policies with respect to the
classification of assets and the establishment of adequate loan loss reserves
for regulatory purposes. Any change in regulations, whether by the OTS, the FDIC
or the Congress, could have a material adverse impact on us, the Bank and our
operations.
Insurance of Deposit Accounts. The SAIF, as administered by the FDIC,
insures the Bank's deposit accounts up to the maximum amount permitted by law.
The FDIC may terminate insurance of deposits upon a finding that the
institution:
o has engaged in unsafe or unsound practices;
o is in an unsafe or unsound condition to continue operations; or
o has violated any applicable law, regulation, rule, order or condition
imposed by the FDIC or the institution's primary regulator.
The FDIC charges an annual assessment for the insurance of deposits based
on the risk a particular institution poses to its deposit insurance fund. Under
this system as of December 31, 2001, SAIF members paid within a range of 0% to
0.27% of insured domestic deposits, depending upon the institution's risk
classification. This risk classification is based on an institution's capital
group and supervisory subgroup assignment.
The Bank also pays, in addition to its normal deposit insurance premium as
a member of the SAIF, an amount equal to approximately 0.0212% of insured
deposits toward the retirement of the Financing Corporation bonds (known as FICO
Bonds) issued in the 1980s to assist in the recovery of the savings and loan
industry. These assessments will continue until the FICO Bonds mature in 2017.
Regulatory Capital Requirements. The Bank must meet regulatory capital
standards to be deemed in compliance with OTS capital requirements. OTS capital
regulations require savings associations to meet the following three capital
standards:
o tangible capital equal to 1.5% of total adjusted assets;
o leverage capital, or "core capital," equal to 3% of total adjusted
assets for institutions such as the Bank; and
o risk-based capital equal to 8.0% of total risk-based assets.
A savings association with a greater than "normal" level of interest rate
exposure must deduct an interest rate risk component in calculating its total
capital for purposes of determining whether it meets its risk-based capital
requirement. Interest rate exposure is measured, generally, as equal to:
o the decline in an institution's net portfolio value that would result
from a 200 basis point increase or decrease in market interest rates,
whichever would result in a lower net portfolio value, divided by
o the estimated economic value of the savings association's assets.
The interest rate risk component a savings association must deduct from its
total capital is equal to:
o one-half of the difference between an institution's measured exposure
and "normal" interest rate risk exposure, which the OTS defines as 2%,
multiplied by
o the estimated economic value of the institution's assets.
In August 1995, the OTS indefinitely delayed implementation of its interest
rate risk regulation. However, based on the asset / liability structure of the
Bank at December 31, 2001, the Bank would not have been required
11
to deduct an interest rate component in calculating its total risk-based capital
had the OTS's interest rate risk regulation been in effect.
The OTS views its capital regulation requirements as minimum standards, and
it expects most institutions to maintain capital levels well above the minimum.
In addition, the OTS regulations provide that the OTS may establish minimum
capital levels higher than those provided in the regulations for individual
savings associations, upon a determination that the savings association's
capital is or may become inadequate in view of its circumstances. The OTS
regulations provide that higher individual minimum regulatory capital
requirements may be appropriate in circumstances where, among others:
o a savings association has a high degree of exposure to interest rate
risk, prepayment risk, credit risk, concentration of credit risk,
other risks arising from nontraditional activities, or similar risks
or a high proportion of off-balance sheet risk;
o a savings association is growing, either internally or through
acquisitions, at a rate that presents supervisory issues; or
o a savings association may be adversely affected by activities or
condition of its holding company, affiliates, subsidiaries or other
persons, or savings associations with which it has significant
business relationships.
The Bank is not required to meet any individual minimum regulatory capital
requirement. At December 31, 2001, the Bank's regulatory capital exceeded all
minimum regulatory capital requirements.
As a result of a number of federally insured financial institutions
extending their risk selection standards to attract lower credit quality
accounts due to their having higher interest rates and fees, the federal banking
regulatory agencies jointly issued Interagency Guidelines on Subprime Lending.
Subprime lending involves extending credit to individuals with less than perfect
credit histories.
The agencies guidelines consider subprime lending a high-risk activity that
is unsafe and unsound if the risks associated with subprime lending are not
properly controlled. Specifically, the 2001 guidelines direct examiners to
expect regulatory capital one and one-half to three times higher than that
typically set aside for prime assets for institutions that:
o have subprime assets equal to 25% or higher of Tier 1 capital, or
o have subprime portfolios experiencing rapid growth or adverse
performance trends, are administered by inexperienced management, or
have inadequate or weak controls.
Our subprime portfolio, pursuant to our definition, represented 192% of
Tier 1 capital as of year-end 2001. Any requirement for us to maintain
additional regulatory capital as a result of our activities in subprime lending
could have an adverse affect on our future prospects and operations and may
restrict our ability to grow. If we are unable to comply with any new capital
requirements imposed upon regulatory examination, we may be subject to the
prompt corrective action regulations of the OTS. Although we believe we maintain
appropriate controls and regulatory capital for our subprime activities, we
cannot determine whether, or to what extent, additional capital requirements
will be imposed on us after periodic examinations by the OTS.
The Home Owners' Loan Act permits savings associations not in compliance
with the OTS capital standards to seek an exemption from penalties or sanctions
for noncompliance. The OTS will grant an exemption only if the savings
association meets strict requirements. In addition, the OTS must deny the
exemption in some circumstances. If the OTS does grant an exemption, the savings
association still may be exposed to enforcement actions for other violations of
law or unsafe or unsound practices or conditions.
Prompt Corrective Action. The OTS's prompt corrective action regulation
requires the OTS to take mandatory actions and authorizes the OTS to take
discretionary actions against a savings association that falls within
undercapitalized capital categories specified in the regulation.
The regulation establishes five categories of capital classification:
o "well capitalized;"
o "adequately capitalized;"
o "undercapitalized;"
12
o "significantly undercapitalized;" and
o "critically undercapitalized."
The regulation uses an institution's risk-based capital, leverage capital and
tangible capital ratios to determine the institution's capital classification.
At December 31, 2001, the Bank exceeded the capital requirements of a well
capitalized institution under applicable OTS regulations.
Loans-to-One-Borrower. Savings associations generally are subject to the
lending limits applicable to national banks. With limited exceptions, the
maximum amount that a savings association or a national bank may lend to any
borrower, including some related entities of the borrower, at one time may not
exceed:
o 15% of the unimpaired capital and surplus of the institution, plus
o an additional 10% of unimpaired capital and surplus if the loans are
fully secured by readily marketable collateral.
Savings associations are additionally authorized to make loans to one
borrower, for any purpose:
o in an amount not to exceed $500,000; or
o by order of the Director of OTS, in an amount not to exceed the lesser
of $30,000,000 or 30% of unimpaired capital and surplus to develop
residential housing, provided:
o the purchase price of each single-family dwelling in the
development does not exceed $500,000;
o the savings association is in compliance with its capital
requirements;
o the loans comply with applicable loan-to-value requirements; and
o the aggregate amount of loans made under this authority does not
exceed 15% of unimpaired capital and surplus.
At December 31, 2001, the Bank's loans-to-one-borrower limit was $128
million based upon the 15% of unimpaired capital and surplus measurement.
Qualified Thrift Lender Test. The OTS requires savings associations to meet
a qualified thrift lender test. The qualified thrift lender test may be met
either by maintaining a specified level of assets in qualified thrift
investments as specified in the Home Owners' Loan Act or by meeting the
definition of a "domestic building and loan association." Qualified thrift
investments are primarily residential mortgages and related investments,
including some mortgage-related securities. The required percentage of
investments under the Home Owners' Loan Act is 65% of assets while the Internal
Revenue Code requires investments of 60% of assets. An association must be in
compliance with the qualified thrift lender test or the definition of domestic
building and loan association on a monthly basis in nine out of every 12 months.
Associations failing to meet the qualified thrift lender test are generally
allowed only to engage in activities permitted for both national banks and
savings associations.
The FHLB also relies on the qualified thrift lender test. A savings
association will only enjoy full borrowing privileges from an FHLB if the
savings association is a qualified thrift lender. As of December 31, 2001, the
Bank was in compliance with its qualified thrift lender test requirement and met
the definition of a domestic building and loan association.
Affiliate Transactions. Transactions between a savings association and its
"affiliates" are quantitatively and qualitatively restricted under the Federal
Reserve Act. Affiliates of a savings association include, among other entities,
the savings association's holding company and companies that are under common
control with the savings association.
In general, a savings association or its subsidiaries are limited in their
ability to engage in "covered transactions" with affiliates:
o to an amount equal to 10% of the association's capital and surplus, in
the case of covered transactions with any one affiliate; and
o to an amount equal to 20% of the association's capital and surplus, in
the case of covered transactions with all affiliates.
13
In addition, a savings association and its subsidiaries may engage in covered
transactions and other specified transactions only on terms and under
circumstances that are substantially the same, or at least as favorable to the
savings association or its subsidiary, as those prevailing at the time for
comparable transactions with nonaffiliated companies. A "covered transaction"
includes:
o a loan or extension of credit to an affiliate;
o a purchase of investment securities issued by an affiliate;
o a purchase of assets from an affiliate, with some exceptions;
o the acceptance of securities issued by an affiliate as collateral for
a loan or extension of credit to any party; or
o the issuance of a guarantee, acceptance or letter of credit on behalf
of an affiliate.
In addition, under the OTS regulations:
o a savings association may not make a loan or extension of credit to an
affiliate unless the affiliate is engaged only in activities
permissible for bank holding companies;
o a savings association may not purchase or invest in securities of an
affiliate other than shares of a subsidiary;
o a savings association and its subsidiaries may not purchase a
low-quality asset from an affiliate;
o covered transactions and other specified transactions between a
savings association or its subsidiaries and an affiliate must be on
terms and conditions that are consistent with safe and sound banking
practices; and
o with some exceptions, each loan or extension of credit by a savings
association to an affiliate must be secured by collateral with a fair
value ranging from 100% to 130%, depending on the type of collateral,
of the amount of the loan or extension of credit.
The OTS regulations generally exclude all non-bank and non-savings
association subsidiaries of savings associations from treatment as affiliates,
except to the extent that the OTS or the Federal Reserve decides to treat these
subsidiaries as affiliates. The regulations also require savings associations to
make and retain records that reflect affiliate transactions in reasonable detail
and provides that specified classes of savings associations may be required to
give the OTS prior notice of affiliate transactions.
Capital Distribution Limitations. A savings association that is a
subsidiary of a savings and loan holding company, such as the Bank, must file an
application or a notice with the OTS at least 30 days before making a capital
distribution. Savings associations are not required to file an application for
permission to make a capital distribution and need only file a notice if the
following conditions are met:
o they are eligible for expedited treatment under OTS regulations;
o they would remain adequately capitalized after the distribution;
o the annual amount of capital distribution does not exceed net income
for that year to date added to retained net income for the two
preceding years; and
o the capital distribution would not violate any agreements between the
OTS and the savings association or any OTS regulations.
Any other situation would require an application to the OTS. The OTS may
disapprove an application or notice if the proposed capital distribution would:
o make the savings association undercapitalized, significantly
undercapitalized or critically undercapitalized,
o raise safety or soundness concerns or
o violate a statute, regulation or agreement with the OTS (or with the
FDIC), or a condition imposed in an OTS approved application or
notice.
14
Privacy. Under the Financial Services Modernization Act, federal banking
regulators adopted rules that will limit the ability of banks and other
financial institutions to disclose non-public information about consumers to
nonaffiliated third parties. Pursuant to those rules, financial institutions
must provide:
o initial notices to customers about their privacy policies, describing
the conditions under which they may disclose nonpublic personal
information to nonaffiliated third parties and affiliates;
o annual notices of their privacy policies to current customers; and
o a reasonable method for customers to "opt out" of disclosures to
nonaffiliated third parties.
These privacy provisions affect how consumer information is transmitted through
diversified financial companies and conveyed to outside vendors.
Activities of Subsidiaries. A savings association seeking to establish a
new subsidiary, acquire control of an existing company or conduct a new activity
through a subsidiary must provide 30 days prior notice to the FDIC and the OTS
and conduct any activities of the subsidiary in compliance with regulations and
orders of the OTS. The OTS has the power to require a savings association to
divest any subsidiary or terminate any activity conducted by a subsidiary that
the OTS determines to pose a serious threat to the financial safety, soundness
or stability of the savings association or to be otherwise inconsistent with
sound banking practices.
Community Reinvestment Act and the Fair Lending Laws. Savings associations
have a responsibility under the Community Reinvestment Act and related
regulations of the OTS to help meet the credit needs of their communities,
including low- and moderate-income neighborhoods. In addition, the Equal Credit
Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in
their lending practices on the basis of characteristics specified in those
statutes. An institution's failure to comply with the provisions of the
Community Reinvestment Act could, at a minimum, result in regulatory
restrictions on its activities and the denial of applications. In addition, an
institution's failure to comply with the Equal Credit Opportunity Act and the
Fair Housing Act could result in the OTS, other federal regulatory agencies as
well as the Department of Justice taking enforcement actions.
Federal Home Loan Bank System. The Bank is a member of the FHLB system.
Among other benefits, each FHLB serves as a reserve or central bank for its
members within its assigned region. Each FHLB is financed primarily from the
sale of consolidated obligations of the FHLB system. Each FHLB makes available
loans or advances to its members in compliance with the policies and procedures
established by the Board of Directors of the individual FHLB.
As an FHLB member, the Bank is required to own capital stock in an FHLB in
an amount equal to the greater of:
o 1% of its aggregate outstanding principal amount of its residential
mortgage loans, home purchase contracts and similar obligations at the
beginning of each calendar year;
o 5% of its FHLB advances or borrowings; or
o $500.
The Bank's required investment in FHLB stock, based on December 31, 2001
financial data, was $98 million. At December 31, 2001, the Bank had $113 million
of FHLB stock.
The Gramm-Leach-Bliley Act made significant reforms to the FHLB system,
including:
o Expanded Membership - (i) expands the uses for, and types of,
collateral for advances; (ii) eliminates bias toward qualified thrift
lenders; and (iii) removes capital limits on advances using real
estate related collateral (e.g., commercial real estate and home
equity loans).
o New Capital Structure - each FHLB is allowed to establish two classes
of stock: Class A is redeemable within six months of notice; and Class
B is redeemable within five years notice. Class B is valued at 1.5
times the value of Class A stock. Each FHLB will be required to
maintain minimum capital equal to 5% of equity. Each FHLB, including
our FHLB of San Francisco, submitted capital plans for review and
approval by the Federal Housing Finance Board.
o Voluntary Membership - federally chartered savings associations, such
as the Bank, are no longer required to be members of the system.
15
o REFCorp Payments - changes the amount paid by the system on debt
incurred in connection with the thrift crisis in the late 1980s from a
fixed amount to 20% of net earnings after deducting certain expenses.
At this time it is not possible to predict the impact, if any, such changes or
capital plans will have on our financial condition or results of operation.
Federal Reserve System. The Federal Reserve requires all depository
institutions to maintain non-interest-bearing reserves at specified levels
against their transaction accounts and non-personal time deposits. These
transaction accounts include checking, NOW and Super NOW checking accounts. The
balances a savings association maintains to meet the reserve requirements
imposed by the Federal Reserve may be used to satisfy the liquidity requirements
that are imposed by the OTS. At December 31, 2001, the Bank was in compliance
with these requirements.
Proposed Legislation. From time to time, new laws are proposed that could
have an effect on the financial institutions industry. For example, legislation
is currently being considered in the U.S. House of Representatives Financial
Institutions Subcommittee which would:
o Merge the Bank Insurance Fund ("BIF") and the SAIF.
o Increase the current deposit insurance coverage limit for insured
deposits to $130,000 and index future coverage limits to inflation.
o Increase deposit insurance coverage limits for municipal deposits.
o Double deposit insurance coverage limits for individual retirement
accounts.
o Even out bank deposit insurance premiums to avoid sharp increases
during times of recession.
While we cannot predict whether such proposals will eventually become law, they
could have an effect on our operations and the way we conduct business.
REGULATION OF DSL SERVICE COMPANY
DSL Service Company is licensed as a real estate broker under the
California Real Estate Law and as a contractor with the Contractors State
License Board. Thus, the real estate investment activities of DSL Service
Company, including development, construction and property management activities
relating to its portfolio of projects, are governed by a variety of laws and
regulations. Changes in the laws and regulations or their interpretation by
agencies and the courts occur frequently. DSL Service Company must comply with
various federal, state and local laws, ordinances, rules and regulations
concerning zoning, building design, construction, hazardous waste and similar
matters. Environmental laws and regulations also affect the operations of DSL
Service Company, including regulations pertaining to availability of water,
municipal sewage treatment capacity, land use, protection of endangered species,
population density and preservation of the natural terrain and coastlines. These
and other requirements could become more restrictive in the future, resulting in
additional time and expense in connection with DSL Service Company's real estate
activities.
With regard to environmental matters, the construction products industry is
regulated by federal, state and local laws and regulations pertaining to several
areas including human health and safety and environmental compliance. The
Comprehensive Environmental Response, Compensation and Liability Act of 1980, as
amended by the Superfund Amendments and Reauthorization Act of 1986, as well as
analogous laws in some states, create joint and several liability for the cost
of cleaning up or correcting releases to the environment of designated hazardous
substances. Among those who may be held jointly and severally liable are:
o those who generated the waste;
o those who arranged for disposal;
o those who owned or operated the disposal site or facility at the time
of disposal; and
o current owners.
In general, this liability is imposed in a series of governmental
proceedings initiated by the government's identification of a site for initial
listing as a "Superfund site" on the National Priorities List or a similar state
list and the government's identification of potentially responsible parties who
may be liable for cleanup costs. None of the DSL Service Company's project sites
are listed as a "Superfund site."
16
In addition, California courts have imposed warranty-like responsibility
upon developers of new housing for defects in structure and the housing site,
including soil conditions. This responsibility is not necessarily dependent upon
a finding that the developer was negligent.
As a licensed entity, DSL Service Company is also examined and supervised
by the California Department of Real Estate and the Contractors State License
Board.
TAXATION
Federal. A savings institution is taxed like other corporations for federal
income tax purposes, and are required to comply with income tax statutes and
regulations similar to those applicable to large commercial banks. The Bank's
bad debt deduction is determined under the specific charge-off method, which
allows the Bank to take an income tax deduction for these loans only when they
have been determined to be wholly or partially worthless.
In addition to the regular income tax, corporations are also subject to an
alternative minimum tax. This tax is computed at 20% of the corporation's
regular taxable income, after taking certain adjustments into account. The
alternative minimum tax applies to the extent that it exceeds the regular income
tax liability.
A corporation that incurs alternative minimum tax generally is entitled to
take this tax as a credit against its regular tax liability in later years to
the extent that the regular tax liability in these later years exceeds the
alternative minimum tax.
State. The Bank uses California's financial corporation income tax rate to
compute its California franchise tax liability. This rate is higher than the
California non-financial corporation income tax rate because the financial
corporation income tax rate reflects an amount "in lieu" of local personal
property and business license taxes that are paid by non-financial corporations,
but not by banks or other financial corporations. The financial corporation
income tax rate was 10.84% for both 2001 and 2000.
The Bank files a California franchise tax return on a combined reporting
basis. Other income and franchise tax returns are filed on a separate-entity
basis in various other states. The Bank anticipates that additional state income
and franchise tax returns will be required in future years as its lending
business is expanded nationwide.
The Internal Revenue Service and various state taxing authorities have
examined our tax returns for all tax years through 1995, and are currently
reviewing returns filed for the 1996 and 1997 tax years. The Bank's management
believes it has adequately provided for potential exposure with regard to issues
that may be raised in the years currently under examination. Our tax years
subsequent to 1997 remain open to review by federal and state tax authorities.
FACTORS THAT MAY AFFECT FUTURE RESULTS
The following discusses certain factors which may affect our financial
results and operations and should be considered in evaluating Downey.
Economic Conditions and Geographic Concentrations. Downey is headquartered
in and its operations are concentrated in California. As a result of this
geographic concentration, our results depend largely upon economic conditions in
the state. Leading business forecasters and economists predict that economic
growth will likely be modest in 2002 and unemployment rates will likely rise. A
significant contributor to the projected 2002 forecast is the impact from the
terrorist attack occurring on September 11, 2001 resulting in job losses in the
travel and entertainment sector and other businesses. A deterioration in
economic conditions could have a material adverse impact on the quality of our
loan and real estate portfolios and the demand for our products and services.
Interest Rates. We anticipate that short-term interest rate levels will
likely remain relatively stable throughout most of 2002, with the possibility
rates might increase modestly in the latter part of the year. If interest rates
vary substantially from present levels, our results may differ materially from
current levels. Changes in interest rates will influence the growth of loans,
investments and deposits and affect the rates received on loans and investment
securities and paid on deposits. Changes in interest rates also affect the value
of our recorded mortgage servicing rights on loans we service for others,
generally increasing in value as interest rates rise and declining as interest
rates fall. If interest rates were to increase significantly, the economic
feasibility of real estate investment activities also could be adversely
affected.
17
Government Regulation and Monetary Policy. The financial services industry
is subject to extensive federal and state supervision and regulation.
Significant new laws or changes in, or repeals of, existing laws may cause our
results to differ materially. Further, federal monetary policy, particularly as
implemented through the Federal Reserve System, significantly affects credit
conditions for Downey, primarily through open market operations in United States
government securities, the discount rate for borrowings and reserve
requirements, and a material change in these conditions would be likely to have
a material impact on our results.
Competition. The banking and financial services business in our market
areas is highly competitive. The increasingly competitive environment is a
result primarily of changes in regulation, changes in technology and product
delivery systems, and the accelerating pace of consolidation among financial
services providers. Our results may differ if circumstances affecting the nature
or level of competition change.
Credit Quality. A significant source of risk arises from the possibility
that losses will be sustained because borrowers, guarantors and related parties
may fail to perform in accordance with the terms of their loans. We have adopted
prudent underwriting and loan quality monitoring systems, procedures and credit
policies, including the establishment and review of the allowance for loan
losses, that management believes are appropriate to minimize this risk by
tracking loan performance, assessing the likelihood of nonperformance and
diversifying our loan portfolio. Such policies and procedures, however, may not
prevent unexpected losses that could materially adversely affect our results.
18
ITEM 2. PROPERTIES
BRANCHES
The corporate offices of Downey, the Bank and DSL Service Company are
located at 3501 Jamboree Road, Newport Beach, California 92660. Part of that
corporate facility houses a branch office of the Bank. Certain departments
(warehousing, record retention, etc.) are located in other owned and leased
facilities in Orange County, California. The majority of our administrative
operations, however, are located in our corporate headquarters.
At December 31, 2001, we had 137 branches. We owned the building and land
occupied by 59 of our branches and we owned one branch building on leased land.
We operate branches in 77 locations (including 68 in-store locations) with
leases or licenses expiring at various dates through August 2011, with options
to extend the term.
The net book value of our owned branches, including the one on leased land,
totaled $84 million at December 31, 2001, and the net book value of our leased
branch offices totaled $3 million at December 31, 2001. The net book value of
our furniture and fixtures, including electronic data processing equipment, was
$25 million at December 31, 2001.
For additional information regarding our offices and equipment, see Note 1
on page 68 and Note 9 on page 84 of Notes to Consolidated Financial Statements.
ELECTRONIC DATA PROCESSING
We utilize a mainframe computer system with use of various third-party
vendors' software for retail deposit operations, loan servicing, accounting and
loan origination functions, including our operations conducted over the
Internet. The net book value of our electronic data processing equipment,
including personal computers and software, was $13 million at December 31, 2001.
ITEM 3. LEGAL PROCEEDINGS
We have been named as a defendant in legal actions arising in the ordinary
course of business, none of which, in the opinion of management, is material.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
No matters were submitted to shareholders during the fourth quarter of
2001.
19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange ("NYSE") and the
Pacific Exchange ("PCX") with the trading symbol "DSL." At February 28, 2002, we
had approximately 757 stockholders of record (not including the number of
persons or entities holding stock in nominee or street name through various
brokerage firms) and 28,213,048 outstanding shares of common stock.
The following table sets forth for the quarters indicated the range of high
and low sale prices per share of our common stock as reported on the NYSE
Composite Tape.
2001 2000
------------------------------------------------------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------
High ........ $44.46 $58.81 $48.85 $54.31 $60.88 $40.94 $33.00 $21.44
Low ......... 32.98 40.61 41.44 39.45 33.13 29.94 20.44 18.75
End of period 41.25 44.13 47.26 45.30 55.00 39.50 28.98 21.25
==============================================================================================
During 2001, we paid quarterly cash dividends totaling $0.36 per share,
aggregating $10.2 million compared to $0.36 per share, aggregating $10.1 million
during 2000. On February 22, 2002, we paid a $0.09 per share quarterly cash
dividend, aggregating $2.5 million.
We may pay additional dividends out of funds legally available therefor at
such times as the Board of Directors determines that dividend payments are
appropriate. The Board of Directors' policy is to consider the declaration of
dividends on a quarterly basis.
The payment of dividends by the Bank to Downey is subject to OTS
regulations. For further information regarding these regulations, see
Business--Regulation--Regulation of the Bank--Capital Distribution Limitations
on page 14.
20
ITEM 6. SELECTED FINANCIAL DATA
(Dollars in Thousands, Except Per Share Data) 2001 2000 1999 1998 1997
- ----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT DATA:
Total interest income .......................................... $ 808,381 $ 784,360 $ 533,751 $ 440,404 $ 420,418
Total interest expense ......................................... 502,811 521,885 326,273 266,057 266,260
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income ........................................ 305,570 262,475 207,478 174,347 154,158
Provision for loan losses ...................................... 2,564 3,251 11,270 3,899 8,640
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses ........ 303,006 259,224 196,208 170,448 145,518
- ----------------------------------------------------------------------------------------------------------------------------------
Other income, net:
Loan and deposit related fees .............................. 50,486 30,089 20,097 15,645 10,921
Real estate and joint ventures held for investment, net .... 3,885 8,798 19,302 22,363 14,222
Secondary marketing activities:
Loan servicing income (loss), net ........................ (11,373) (3,628) 1,672 259 1,276
Net gains on sales of loans and mortgage-backed securities 22,432 3,297 14,806 6,462 2,675
Net gains on sales of mortgage servicing rights .......... 934 -- -- -- --
Net gains (losses) on sales of investment securities ....... 329 (106) 288 68 --
Gain on sale of subsidiary (1) ............................. -- 9,762 -- -- --
Other ...................................................... 1,843 2,342 3,113 2,556 6,094
- ----------------------------------------------------------------------------------------------------------------------------------
Total other income, net .................................. 68,536 50,554 59,278 47,353 35,188
- ----------------------------------------------------------------------------------------------------------------------------------
Operating expense:
General and administrative expense ......................... 162,496 136,189 144,382 115,890 99,556
Net operation of real estate acquired in settlement of loans 239 818 19 260 1,184
Amortization of excess of cost over fair value of net assets
acquired ................................................. 457 462 474 510 532
- ----------------------------------------------------------------------------------------------------------------------------------
Total operating expense .................................. 163,192 137,469 144,875 116,660 101,272
- ----------------------------------------------------------------------------------------------------------------------------------
Net income (1) ................................................. $ 120,181 $ 99,251 $ 63,804 $ 57,973 $ 45,234
PER SHARE DATA
Earnings per share--Basic (1) .................................. $ 4.26 $ 3.52 $ 2.27 $ 2.06 $ 1.61
Earnings per share--Diluted (1) ................................ 4.25 3.51 2.26 2.05 1.61
Book value per share at end of period .......................... 26.01 22.15 18.91 17.08 15.32
Stock price at end of period ................................... 41.25 55.00 20.19 25.44 27.08
Cash dividends paid ............................................ 0.36 0.36 0.35 0.32 0.30
SELECTED FINANCIAL RATIOS
Effective interest rate spread ................................. 2.91% 2.66% 2.88% 3.08% 2.83%
Efficiency ratio (2) ........................................... 43.93 46.23 58.41 58.16 56.85
Return on average assets (1) ................................... 1.11 0.97 0.85 0.98 0.79
Return on average equity (1) ................................... 17.81 17.17 12.70 12.71 11.07
Dividend payout ratio .......................................... 8.45 10.22 15.44 15.33 18.69
LOAN ACTIVITY
Loans originated ............................................... $ 8,128,285 $ 5,218,368 $ 7,132,486 $4,071,262 $2,329,266
Loans and mortgage-backed securities purchased ................. 216,214 18,828 49,669 7,463 35,828
Loans and mortgage-backed securities sold ...................... 4,553,944 1,662,600 2,386,958 1,740,416 557,511
BALANCE SHEET SUMMARY (END OF PERIOD)
Total assets ................................................... $11,105,030 $10,893,863 $ 9,407,540 $6,270,419 $5,835,825
Loans and mortgage-backed securities ........................... 10,132,413 10,084,353 8,746,063 5,788,365 5,366,396
Investments and cash equivalents ............................... 551,823 439,968 299,698 215,086 221,201
Deposits ....................................................... 8,619,566 8,082,689 6,562,761 5,039,733 4,869,978
Borrowings ..................................................... 1,522,712 1,978,572 2,122,780 703,720 483,735
Capital securities ............................................. 120,000 120,000 120,000 -- --
Stockholders' equity ........................................... 733,896 624,636 532,418 480,566 430,346
Loans serviced for others ...................................... 5,805,811 3,964,462 2,923,778 1,040,264 612,529
AVERAGE BALANCE SHEET DATA
Assets ......................................................... $10,850,683 $10,217,371 $ 7,501,228 $5,918,507 $5,693,869
Loans .......................................................... 10,033,155 9,514,978 6,937,342 5,345,380 5,174,767
Deposits ....................................................... 8,701,424 7,290,850 5,697,292 5,102,045 4,588,320
Stockholders' equity ........................................... 674,972 577,979 502,412 456,237 408,473
21
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
(Dollars in Thousands, Except Per Share Data) 2001 2000 1999 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
CAPITAL RATIOS
Average stockholders' equity to average assets ................. 6.22% 5.66% 6.70% 7.71% 7.17%
Bank only--end of period (3):
Core and tangible capital .................................. 7.10 6.42 6.27 6.83 6.61
Risk-based capital ......................................... 14.53 12.94 12.14 12.88 12.64
SELECTED ASSET QUALITY DATA (END OF PERIOD)
Total non-performing assets .................................... $ 92,632 $ 54,974 $ 39,194 $ 27,419 $ 52,120
Non-performing assets as a percentage of total assets .......... 0.83% 0.50% 0.42% 0.44% 0.89%
Allowance for loan losses:
Amount ..................................................... $ 36,120 $ 34,452 $ 38,342 $ 31,517 $ 32,092
As a percentage of non-performing loans .................... 46.76% 76.63% 116.25% 140.86% 76.96%
====================================================================================================================================
(1) In 2000, a $5.6 million after-tax gain was recognized from the sale of
Downey Auto Finance Corp. Excluding the gain, 2000 net income would have
been $93.6 million or $3.33 per share on a basic basis and $3.32 per share
on a diluted basis, the return on average assets would have been 0.92% and
the return on average equity would have been 16.20%.
(2) The amount of general and administrative expense incurred for each $1 of
net interest income plus other income, except for income associated with
real estate held for investment and securities gains or losses.
(3) For more information regarding these ratios, see Management's Discussion
and Analysis of Financial Condition and Results of Operations--Financial
Condition--Regulatory Capital Compliance on page 58.
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements under this caption constitute "forward-looking
statements" under the Private Securities Litigation Reform Act of 1995 which
involve risks and uncertainties. Our actual results may differ significantly
from the results discussed in such forward-looking statements. Factors that
might cause such a difference include, but are not limited to, economic
conditions, competition in the geographic and business areas in which we conduct
our operations, fluctuations in interest rates, credit quality and government
regulation. For additional information concerning these factors, see
Business--Factors that May Affect Future Results on page 17.
OVERVIEW
Our net income for 2001 totaled a record $120.2 million or $4.25 per share
on a diluted basis. This represented the fourth consecutive year of record net
income, which increased by $26.6 million or 28.3% from $93.6 million or $3.31
per share for 2000, excluding the $5.6 million or $0.20 per share after-tax gain
from the sale of our indirect automobile finance subsidiary from the year-ago
results. Including the gain, net income in 2000 totaled $99.2 million or $3.51
per share. On January 1, 2001, we adopted Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended, ("SFAS 133") and, as a result, recorded an immaterial
cumulative effect of change in accounting principle. For further information,
see Financial Condition--Newly Adopted Accounting Principles on page 59.
The increase in our adjusted net income between years was due to higher net
income from our banking operations, which increased on an adjusted basis by
$30.3 million or 33.9% to $119.5 million. That increase more than offset a $3.7
million decline to $0.7 million in net income from our real estate investment
activities due primarily to lower net gains from sales of properties. Adjusted
net income from our banking operations increased due to the following:
o net interest income increased $43.3 million or 16.5% due to increases
in both average earning assets and our effective interest rate spread;
o net gains from sales of loans, mortgage-backed securities and mortgage
servicing rights increased $20.1 million due primarily to a record
volume of sales;
o loan and deposit related fees increased $19.7 million; and
o provision for loan losses declined $0.7 million.
Those favorable items were partially offset by the following:
o loan servicing losses increased $7.7 million primarily due to higher
provisions to the valuation allowance for mortgage servicing rights
reflecting the continued decline in market interest rates that
increased the expected rate of prepayments on loans we service for
others; and
o operating expenses increased $23.6 million reflecting an increased
number of branch locations, which expanded our market presence, and
higher loan origination activity. Despite the increase in operating
expense, our efficiency ratio (the percentage of our net interest
income and other income, excluding income from real estate investment
activities and investment securities gains or losses used to cover our
general and administrative expense) improved from 46.2% in 2000 to
43.9% in 2001.
For 2001, our return on average assets was 1.11% and our return on average
equity was 17.81%. Both these performance ratios compare favorably to our
adjusted 2000 returns of 0.92% for average assets and 16.20% for average equity.
Our assets increased $211 million or 1.9% during 2001 to $11.1 billion at
year-end, following a 15.8% increase during 2000. The slower growth in 2001
reflected a significant increase in loan repayments as borrowers took advantage
of record low mortgage interest rates. Our single family loan originations
increased from $5.0 billion in 2000 to a record $8.0 billion in 2001, of which
$4.8 billion were originated for sale in the secondary market. Of the 2001
total, $3.2 billion represented originations of loans for portfolio, of which
$428 million represented subprime credits. In addition to single family loans,
we originated $180 million of other loans during the year, including $118
million of construction and land loans.
We funded our asset growth with deposits that increased 6.6% to a record
year-end level of $8.6 billion at December 31, 2001.
23
Non-performing assets totaled $93 million at December 31, 2001, up from $55
million a year ago. This increase was due primarily to a rise in residential
non-performers, of which $12 million was in the subprime category. When measured
as a percentage of total assets, our non-performing assets rose from 0.50% at
year-end 2000 to 0.83% at year-end 2001.
At December 31, 2001, the Bank exceeded all regulatory capital tests, with
capital-to-asset ratios of 7.10% for tangible and core capital and 14.53% for
risk-based capital. These capital levels are significantly above the "well
capitalized" standards defined by the federal banking regulators of 5% for core
and tangible capital and 10% for risk-based capital. For further information,
see Business--Regulation--Regulation of the Bank--Insurance of Deposit Accounts
on page 11, Financial Condition--Investments in Real Estate and Joint Ventures
on page 38 and Financial Condition--Regulatory Capital Compliance on page 58.
We have established various accounting policies which govern the
application of accounting principles generally accepted in the United States of
America in the preparation of our financial statements. Our significant
accounting policies are described in the Notes to the Consolidated Financial
Statements beginning on page 68. Certain accounting policies require us to make
significant estimates and assumptions which 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 we use 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 carrying
value of assets and liabilities at the balance sheet dates and our results of
operations for the reporting periods.
We believe the following are critical accounting policies that require the
most significant estimates and assumptions that are particularly susceptible to
significant change in the preparation of our financial statements:
o Allowance for losses on loans and real estate. For further
information, see Financial Condition--Problem Loans and Real
Estate--Allowance for Losses on Loans and Real Estate on page 52 and
Note 1 of Notes to the Consolidated Financial Statements on page 68.
o Allowance for mortgage servicing rights. For further information, see
Note 1 on page 68 and Note 11 on page 85 of Notes to the Consolidated
Financial Statements.
24
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, borrowings and
capital securities ("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 $305.6 million in 2001, up $43.1 million or
16.4% from 2000 and $98.1 million or 47.3% greater than 1999. The 2001
improvement over 2000 primarily reflected increases in both average earning
assets and our effective interest rate spread. Our average earning assets
increased by $613 million or 6.2% to $10.5 billion. Our effective interest rate
spread averaged 2.91% in 2001, up from 2.66% in 2000 and 2.88% in 1999. This
improvement was due to our cost of funds declining more rapidly than our yield
on earning assets. This is indicative of what typically happens when interest
rates decline, as there is an administrative lag in the repricing of our loans
which are primarily priced to the Federal Home Loan Bank ("FHLB") Eleventh
District Cost of Funds Index ("COFI").
The following table presents for the periods indicated the total dollar
amount of:
o interest income from average interest-earning assets and the resultant
yields; and
o interest expense on average interest-bearing liabilities and the
resultant costs, expressed as rates.
The table also sets forth our net interest income, interest rate spread and
effective interest rate spread. The effective interest rate spread reflects the
relative level of interest-earning assets to interest-bearing liabilities and
equals:
o the difference between interest income on interest-earning assets and
interest expense on interest-bearing liabilities, divided by
o average interest-earning assets for the period.
The table also sets forth our net interest-earning balance--the difference
between the average balance of interest-earning assets and the average balance
of total deposits, borrowings and capital securities--for the periods indicated.
We included non-accrual loans in the average interest-earning assets balance. We
included interest from non-accrual loans in interest income only to the extent
we received payments and to the extent we believe we will recover the remaining
principal balance of the loans. We computed average balances for the year using
the average of each month's daily average balance during the periods indicated.
25
2001 2000 1999
-------------------------------------------------------------------------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ............................. $10,033,155 $782,784 7.80% $ 9,514,978 $760,538 7.99% $6,937,342 $519,006 7.48%
Mortgage-backed securities ........ 13,747 726 5.28 15,959 1,060 6.64 26,361 1,638 6.21
Investment securities ............. 443,386 24,871 5.61 346,192 22,762 6.57 232,746 13,107 5.63
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ... 10,490,288 808,381 7.71 9,877,129 784,360 7.94 7,196,449 533,751 7.42
Non-interest-earning assets .......... 360,395 340,242 304,779
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets ...................... $10,850,683 $10,217,371 $7,501,228
====================================================================================================================================
Transaction accounts:
Non-interest-bearing checking ..... $ 302,628 $ -- -- % $ 209,221 $ -- -- % $ 165,271 $ -- -- %
Interest-bearing checking (1) ..... 406,666 2,057 0.51 381,269 3,520 0.92 336,604 3,517 1.04
Money market ...................... 93,964 2,436 2.59 89,495 2,544 2.84 95,282 2,641 2.77
Regular passbook .................. 1,118,287 34,553 3.09 796,212 27,841 3.50 767,238 26,224 3.42
- --