================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
For the quarterly period ended SEPTEMBER 30, 2002
OR
[ ] 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 33-0633413
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3501 JAMBOREE ROAD, NEWPORT BEACH, CA 92660
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
------------------- ---------------------------------
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
At September 30, 2002, 28,022,722 shares of the Registrant's Common Stock,
$0.01 par value were outstanding.
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DOWNEY FINANCIAL CORP.
SEPTEMBER 30, 2002 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
PART I
ITEM 1. FINANCIAL INFORMATION.............................................. 1
Consolidated Balance Sheets........................................ 1
Consolidated Statements of Income.................................. 2
Consolidated Statements of Comprehensive Income.................... 3
Consolidated Statements of Cash Flows.............................. 4
Notes To Consolidated Financial Statements......................... 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.............................. 13
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......... 42
ITEM 4. CONTROLS AND PROCEDURES............................................ 42
PART II
ITEM 1. LEGAL PROCEEDINGS.................................................. 43
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.......................... 43
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.................................... 43
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIY HOLDERS............... 43
ITEM 5. OTHER INFORMATION.................................................. 43
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................... 43
SIGNATURES ..................................................................45
i
PART I
ITEM 1. - FINANCIAL INFORMATION
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, December 31, September 30,
(Dollars in Thousands, Except Per Share Data) 2002 2001 2001
- -------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash .......................................................................... $ 135,493 $ 106,079 $ 103,000
Federal funds ................................................................. 16,702 37,001 2,401
- -------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents .................................................. 152,195 143,080 105,401
U.S. Treasury securities, agency obligations and other investment
securities available for sale, at fair value ............................... 267,243 402,355 296,204
Municipal securities held to maturity, at amortized cost (estimated
fair value of $6,372 at September 30, 2002, $6,373 at
December 31, 2001 and $6,533 at September 30, 2001) ........................ 6,387 6,388 6,549
Loans held for sale, at lower of cost or fair value ........................... 665,587 499,024 373,489
Mortgage-backed securities available for sale, at fair value .................. 1,019,030 118,981 4,562
Loans receivable held for investment .......................................... 10,000,420 9,514,408 9,534,438
Investments in real estate and joint ventures ................................. 40,371 38,185 38,043
Real estate acquired in settlement of loans ................................... 15,441 15,366 11,870
Premises and equipment ........................................................ 113,258 111,762 106,488
Federal Home Loan Bank stock, at cost ......................................... 116,041 113,139 111,649
Mortgage servicing rights, net ................................................ 46,912 56,895 37,507
Other assets .................................................................. 75,197 85,447 90,094
- -------------------------------------------------------------------------------------------------------------------------------
$ 12,518,082 $ 11,105,030 $ 10,716,294
===============================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ...................................................................... $ 9,056,932 $ 8,619,566 $ 8,868,782
Federal Home Loan Bank advances and other borrowings .......................... 1,869,789 1,522,712 927,427
Accounts payable and accrued liabilities ...................................... 618,068 67,431 67,392
Deferred income taxes ......................................................... 62,680 41,425 34,218
- -------------------------------------------------------------------------------------------------------------------------------
Total liabilities .......................................................... 11,607,469 10,251,134 9,897,819
- -------------------------------------------------------------------------------------------------------------------------------
Company obligated mandatorily redeemable capital securities of subsidiary trust
holding solely junior subordinated debentures
of the Company ("Capital Securities") ...................................... 120,000 120,000 120,000
STOCKHOLDERS' EQUITY:
Preferred stock, par value of $0.01 per share; authorized 5,000,000
shares; outstanding none ................................................... -- -- --
Common stock, par value of $0.01 per share; authorized 50,000,000
shares; issued 28,235,022 shares at September 30, 2002 and 28,213,048
shares at December 31, 2001 and September 30, 2001 ......................... 282 282 282
Additional paid-in capital .................................................... 93,792 93,400 93,400
Accumulated other comprehensive income (loss) ................................. 274 (239) 897
Retained earnings ............................................................. 704,978 640,453 603,896
Treasury stock, at cost, 212,300 shares at September 30, 2002 ................. (8,713) -- --
- -------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity ................................................. 790,613 733,896 698,475
- -------------------------------------------------------------------------------------------------------------------------------
$ 12,518,082 $ 11,105,030 $ 10,716,294
===============================================================================================================================
See accompanying notes to consolidated financial statements.
1
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------------------------------------------
(Dollars in Thousands, Except Per Share Data) 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans receivable ................................................. $ 150,987 $ 187,867 $ 459,712 $ 604,449
U.S. Treasury securities and agency obligations .................. 2,190 3,727 7,386 12,259
Mortgage-backed securities ....................................... 287 62 2,503 277
Other investments ................................................ 1,460 2,040 5,146 7,912
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest income .......................................... 154,924 193,696 474,747 624,897
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INTEREST EXPENSE
Deposits ......................................................... 59,598 107,033 188,354 336,220
Borrowings ....................................................... 15,314 10,176 45,226 53,700
Capital securities ............................................... 3,040 3,040 9,122 9,122
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest expense ......................................... 77,952 120,249 242,702 399,042
- ----------------------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME .............................................. 76,972 73,447 232,045 225,855
PROVISION FOR LOAN LOSSES ........................................ 471 791 812 1,274
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses ............ 76,501 72,656 231,233 224,581
- ----------------------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET
Loan and deposit related fees .................................... 11,848 13,274 34,762 37,640
Real estate and joint ventures held for investment, net .......... 2,407 746 6,420 2,438
Secondary marketing activities:
Loan servicing loss, net ....................................... (18,963) (11,771) (35,168) (22,854)
Net gains (losses) on sales of loans and mortgage-backed
securities ................................................... (971) 4,234 22,126 15,383
Net gains on sales of mortgage servicing rights ................ -- 87 306 758
Net gains on sales of investment securities ...................... -- 3 209 242
Other ............................................................ 913 497 2,034 1,759
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Total other income (loss), net ................................. (4,766) 7,070 30,689 35,366
- ----------------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE
Salaries and related costs ....................................... 29,067 24,943 86,819 72,860
Premises and equipment costs ..................................... 7,916 6,628 22,803 18,713
Advertising expense .............................................. 1,066 939 3,692 3,242
Professional fees ................................................ 91 2,432 888 4,613
SAIF insurance premiums and regulatory assessments ............... 765 786 2,313 2,259
Other general and administrative expense ......................... 7,474 5,981 20,035 17,293
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Total general and administrative expense ....................... 46,379 41,709 136,550 118,980
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Net operation of real estate acquired in settlement of loans ..... 110 110 79 2
Amortization of excess cost over fair value of branch acquisitions 111 116 336 344
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Total operating expense ........................................ 46,600 41,935 136,965 119,326
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INCOME BEFORE INCOME TAXES ....................................... 25,135 37,791 124,957 140,621
Income taxes ..................................................... 10,631 16,025 52,830 59,536
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NET INCOME ..................................................... $ 14,504 $ 21,766 $ 72,127 $ 81,085
==================================================================================================================================
PER SHARE INFORMATION
BASIC ............................................................ $ 0.52 $ 0.77 $ 2.56 $ 2.87
==================================================================================================================================
DILUTED .......................................................... $ 0.52 $ 0.77 $ 2.56 $ 2.86
==================================================================================================================================
CASH DIVIDENDS DECLARED AND PAID ................................. $ 0.09 $ 0.09 $ 0.27 $ 0.27
==================================================================================================================================
Weighted average diluted shares outstanding ...................... 28,132,199 28,278,485 28,229,288 28,274,894
==================================================================================================================================
See accompanying notes to consolidated financial statements.
2
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------------------
(In Thousands) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------
NET INCOME ............................................................ $ 14,504 $ 21,766 $ 72,127 $ 81,085
- ------------------------------------------------------------------------------------------------------------------------
OTHER COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES (BENEFITS)
Unrealized gains (losses) on securities available for sale:
U.S. Treasury securities, agency obligations and other investment
securities available for sale, at fair value ..................... 104 973 (441) 1,513
Mortgage-backed securities available for sale, at fair value ...... 774 9 1,698 64
Less reclassification of realized gains included in net income .... -- (2) (121) (139)
Unrealized gains (losses) on cash flow hedges:
Net derivative instruments ........................................ (3,383) (3,052) (7,008) (2,330)
Less reclassification of realized losses included in net income ... 2,543 575 6,385 1,102
- ------------------------------------------------------------------------------------------------------------------------
Total other comprehensive income (loss), net of income taxes (benefits) 38 (1,497) 513 210
- ------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME .................................................. $ 14,542 $ 20,269 $ 72,640 $ 81,295
========================================================================================================================
See accompanying notes to consolidated financial statements.
3
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
September 30,
-------------------------------
(In Thousands) 2002 2001
- -----------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income ................................................................................ $ 72,127 $ 81,085
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization .......................................................... 45,302 37,402
Provision for losses on loans, real estate acquired in settlement of loans, investments
in real estate and joint ventures, mortgage servicing rights and other assets ........ 34,912 21,376
Net gains on sales of loans and mortgage-backed securities, mortgage servicing rights,
investment securities, real estate and other assets .................................. (27,677) (18,255)
Interest capitalized on loans (negative amortization) .................................. (20,917) (36,633)
Federal Home Loan Bank stock dividends ................................................. (2,902) (5,293)
Loans originated for sale ................................................................. (4,131,463) (3,210,267)
Proceeds from sales of loans held for sale, including those sold
via mortgage-backed securities ......................................................... 4,036,188 3,071,593
(Increase) decrease in other, net ......................................................... 19,712 (2,979)
- -----------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities ...................................... 25,282 (61,971)
- -----------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of:
U.S. Treasury securities, agency obligations and other investment securities
available for sale ................................................................... 88,541 24,052
Wholly owned real estate and real estate acquired in settlement of loans ............... 26,036 8,426
Proceeds from maturities of U.S. Treasury securities, agency obligations
and other investment securities available for sale ..................................... 426,205 340,715
Purchase of:
U.S. Treasury securities, agency obligations and other investment securities
available for sale ................................................................... (381,730) (351,619)
Mortgage-backed securities available for sale .......................................... (503,874) --
Loans receivable held for investment ................................................... (31,204) (94,980)
Premises and equipment ................................................................. (15,878) (14,615)
Originations of loans receivable held for investment (net of refinances of $606,919 for the
nine months ended September 30, 2002 and $557,183 for the nine months ended ............
September 30, 2001) .................................................................... (2,697,856) (1,807,057)
Principal payments on loans receivable held for investment and mortgage-backed
securities available for sale .......................................................... 2,263,744 2,218,148
Net change in undisbursed loan funds ...................................................... 53,694 (8,946)
Investments in real estate held for investment ............................................ (15,965) (5,573)
Other, net ................................................................................ 3,600 3,526
- -----------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ...................................... (784,687) 312,077
- -----------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
4
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
Nine Months Ended
September 30,
-----------------------------
(In Thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits ..................................................... $ 437,366 $ 786,093
Proceeds from Federal Home Loan Bank advances and other borrowings ........... 4,325,258 2,040,850
Repayments of Federal Home Loan Bank advances and other borrowings ........... (3,978,181) (3,091,995)
Purchase of treasury stock ................................................... (8,713) --
Proceeds from exercise of stock options ...................................... 392 161
Cash dividends ............................................................... (7,602) (7,617)
- -------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities ......................... 768,520 (272,508)
- -------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents ......................... 9,115 (22,402)
Cash and cash equivalents at beginning of period ............................. 143,080 127,803
- -------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ................................... $ 152,195 $ 105,401
=============================================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest ................................................................ $ 243,440 $ 404,885
Income taxes ............................................................ 21,992 59,016
Supplemental disclosure of non-cash investing:
Loans transferred to held for investment from held for sale ............... 2,475 4,287
Loans transferred from held for investment to wholly owned real estate .... -- 15,688
Mortgage-backed securities available for sale, purchased and not settled .. 510,224 --
Loans exchanged for mortgage-backed securities ............................ 3,401,952 2,525,816
Real estate acquired in settlement of loans ............................... 20,245 17,588
Loans to facilitate the sale of real estate acquired in settlement of loans 10,778 8,156
=============================================================================================================
See accompanying notes to consolidated financial statements.
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE (1) - BASIS OF FINANCIAL STATEMENT PRESENTATION
In the opinion of Downey Financial Corp. and subsidiaries ("Downey," "we,"
"us" and "our"), the accompanying consolidated financial statements contain all
adjustments (consisting of only normal recurring accruals) necessary for a fair
presentation of Downey's financial condition as of September 30, 2002, December
31, 2001 and September 30, 2001, the results of operations and comprehensive
income for the three months and nine months ended September 30, 2002 and 2001,
and changes in cash flows for the nine months ended September 30, 2002 and 2001.
Certain prior period amounts have been reclassified to conform to the current
period presentation.
The accompanying consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America for interim financial statements and are in compliance with the
instructions for Form 10-Q and therefore do not include all information and
footnotes necessary for a fair presentation of financial condition, results of
operations, comprehensive income and cash flows. The following information under
the heading Management's Discussion and Analysis of Financial Condition and
Results of Operations is written with the presumption that the interim
consolidated financial statements will be read in conjunction with Downey's
Annual Report on Form 10-K for the year ended December 31, 2001, which contains
among other things, a description of the business, the latest audited
consolidated financial statements and notes thereto, together with Management's
Discussion and Analysis of Financial Condition and Results of Operations as of
December 31, 2001 and for the year then ended. Therefore, only material changes
in financial condition and results of operations are discussed in the remainder
of Part I.
NOTE (2) - EARNINGS PER SHARE
Earnings per share is calculated on both a basic and diluted basis. Basic
earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per share reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock or resulted from issuance of
common stock that then shared in earnings.
The following table presents a reconciliation of the components used to
derive basic and diluted earnings per share for the periods indicated.
Three Months Ended September 30,
--------------------------------------------------------------------------
2002 2001
--------------------------------------------------------------------------
Weighted Weighted
Average Average
Net Shares Per Share Net Shares Per Share
(Dollars in Thousands, Except Per Share Data) Income Outstanding Amount Income Outstanding Amount
- ----------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $14,504 28,092,920 $0.52 $21,766 28,212,575 $0.77
Effect of dilutive stock options -- 39,279 -- -- 65,910 --
- ----------------------------------------------------------------------------------------------------------------------------
Diluted earnings per share $14,504 28,132,199 $0.52 $21,766 28,278,485 $0.77
============================================================================================================================
Nine Months Ended September 30,
--------------------------------------------------------------------------
2002 2001
--------------------------------------------------------------------------
Weighted Weighted
Average Average
Net Shares Per Share Net Shares Per Share
(Dollars in Thousands, Except Per Share Data) Income Outstanding Amount Income Outstanding Amount
- ----------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $72,127 28,179,585 $2.56 $81,085 28,211,100 $2.87
Effect of dilutive stock options -- 49,703 -- -- 63,794 0.01
- ----------------------------------------------------------------------------------------------------------------------------
Diluted earnings per share $72,127 28,229,288 $2.56 $81,085 28,274,894 $2.86
============================================================================================================================
6
NOTE (3) - BUSINESS SEGMENT REPORTING
The following table presents the operating results and selected financial
data by major business segments for the periods indicated.
Real Estate
(In Thousands) Banking Investment Elimination Totals
- -------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30, 2002
Net interest income .............................. $ 76,960 $ 12 $ -- $ 76,972
Provision for loan losses ........................ 471 -- -- 471
Other income (loss) .............................. (7,507) 2,741 -- (4,766)
Operating expense ................................ 46,439 161 -- 46,600
Net intercompany income (expense) ................ 100 (100) -- --
- -------------------------------------------------------------------------------------------------------------------
Income before income taxes ....................... 22,643 2,492 -- 25,135
Income taxes ..................................... 9,607 1,024 -- 10,631
- -------------------------------------------------------------------------------------------------------------------
Net income .................................. $ 13,036 $ 1,468 $ -- $ 14,504
===================================================================================================================
AT SEPTEMBER 30, 2002
Assets:
Loans and mortgage-backed securities ........ $ 11,685,037 $ -- $ -- $ 11,685,037
Investments in real estate and joint ventures -- 40,371 -- 40,371
Other ....................................... 828,500 4,090 (39,916) 792,674
- -------------------------------------------------------------------------------------------------------------------
Total assets .............................. 12,513,537 44,461 (39,916) 12,518,082
- -------------------------------------------------------------------------------------------------------------------
Equity ........................................... $ 790,613 $ 39,916 $ (39,916) $ 790,613
===================================================================================================================
THREE MONTHS ENDED SEPTEMBER 30, 2001
Net interest income (loss) ....................... $ 73,473 $ (26) $ -- $ 73,447
Provision for loan losses ........................ 791 -- -- 791
Other income ..................................... 5,987 1,083 -- 7,070
Operating expense ................................ 40,071 1,864 -- 41,935
Net intercompany income (expense) ................ 92 (92) -- --
- -------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (benefit) ...... 38,690 (899) -- 37,791
Income taxes (benefit) ........................... 16,389 (364) -- 16,025
- -------------------------------------------------------------------------------------------------------------------
Net income (loss) ........................... $ 22,301 $ (535) $ -- $ 21,766
===================================================================================================================
AT SEPTEMBER 30, 2001
Assets:
Loans and mortgage-backed securities ........ $ 9,912,489 $ -- $ -- $ 9,912,489
Investments in real estate and joint ventures -- 38,043 -- 38,043
Other ....................................... 797,775 1,629 (33,642) 765,762
- -------------------------------------------------------------------------------------------------------------------
Total assets .............................. 10,710,264 39,672 (33,642) 10,716,294
- -------------------------------------------------------------------------------------------------------------------
Equity ........................................... $ 698,475 $ 33,642 $ (33,642) $ 698,475
===================================================================================================================
Real Estate
(In Thousands) Banking Investment Elimination Totals
- -------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED SEPTEMBER 30, 2002
Net interest income .............................. $ 232,015 $ 30 $ -- $ 232,045
Provision for loan losses ........................ 812 -- -- 812
Other income ..................................... 23,358 7,331 -- 30,689
Operating expense ................................ 136,338 627 -- 136,965
Net intercompany income (expense) ................ 279 (279) -- --
- -------------------------------------------------------------------------------------------------------------------
Income before income taxes ....................... 118,502 6,455 -- 124,957
Income taxes ..................................... 50,185 2,645 -- 52,830
- -------------------------------------------------------------------------------------------------------------------
Net income .................................. $ 68,317 $ 3,810 $ -- $ 72,127
===================================================================================================================
NINE MONTHS ENDED SEPTEMBER 30, 2001
Net interest income .............................. $ 225,843 $ 12 $ -- $ 225,855
Provision for loan losses ........................ 1,274 -- -- 1,274
Other income ..................................... 31,943 3,423 -- 35,366
Operating expense ................................ 115,924 3,402 -- 119,326
Net intercompany income (expense) ................ 273 (273) -- --
- -------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (benefit) ...... 140,861 (240) -- 140,621
Income taxes (benefit) ........................... 59,632 (96) -- 59,536
- -------------------------------------------------------------------------------------------------------------------
Net income (loss) ........................... $ 81,229 $ (144) $ -- $ 81,085
===================================================================================================================
7
NOTE (4) - MORTGAGE SERVICING RIGHTS
The following table summarizes the activity in our mortgage servicing
rights and related allowance for the periods indicated and other related
financial data.
Three Months Ended
-------------------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(Dollars in Thousands) 2002 2002 2002 2001 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Gross balance at beginning of period ............. $ 81,100 $ 74,914 $ 65,630 $ 61,651 $ 55,848
Additions ........................................ 9,304 10,156 14,997 15,300 10,294
Amortization ..................................... (4,120) (3,253) (2,916) (2,956) (2,495)
Sales of mortgage servicing rights ............... -- -- (35) (4,916) (582)
Impairment write-down ............................ (2,579) (717) (2,762) (3,449) (1,414)
- ------------------------------------------------------------------------------------------------------------------------------------
Gross balance at end of period ............... 83,705 81,100 74,914 65,630 61,651
- ------------------------------------------------------------------------------------------------------------------------------------
Allowance balance at beginning of period ......... 21,329 6,333 8,735 24,144 13,706
Provision for (reduction of) impairment .......... 18,043 15,713 360 (11,960) 11,852
Impairment write-down ............................ (2,579) (717) (2,762) (3,449) (1,414)
- ------------------------------------------------------------------------------------------------------------------------------------
Allowance balance at end of period ........... 36,793 21,329 6,333 8,735 24,144
- ------------------------------------------------------------------------------------------------------------------------------------
Total mortgage servicing rights, net ......... $ 46,912 $ 59,771 $ 68,581 $ 56,895 $ 37,507
====================================================================================================================================
Estimated fair value (1) ......................... $ 46,986 $ 59,771 $ 70,532 $ 58,047 $ 37,507
Weighted average expected life (in months) ....... 39 61 87 82 59
Custodial account earnings rate .................. 2.06% 3.82% 4.61% 4.36% 2.85%
Weighted average discount rate ................... 8.19 9.10 9.13 9.16 9.21
====================================================================================================================================
AT PERIOD END
Mortgage loans serviced for others:
Total ........................................ $ 7,502,157 $ 6,962,403 $ 6,408,812 $ 5,805,811 $ 5,458,970
With capitalized mortgage servicing rights:(1)
Amount ................................... 7,355,700 6,807,306 6,196,137 5,379,513 5,078,088
Weighted average interest rate ........... 6.71% 6.80% 6.85% 6.97% 7.19%
====================================================================================================================================
Custodial escrow balances ........................ $ 21,628 $ 13,044 $ 6,103 $ 10,596 $ 15,415
====================================================================================================================================
Nine Months Ended
September 30,
------------------------------
(In Thousands) 2002 2001
- -----------------------------------------------------------------------------------
Gross balance at beginning of period ............. $ 65,630 $ 46,214
Additions ........................................ 34,457 29,091
Amortization ..................................... (10,289) (6,857)
Sales of mortgage servicing rights ............... (35) (2,910)
Impairment write-down ............................ (6,058) (3,887)
- -----------------------------------------------------------------------------------
Gross balance at end of period ............... 83,705 61,651
- -----------------------------------------------------------------------------------
Allowance balance at beginning of period ......... 8,735 5,483
Provision for impairment ......................... 34,116 22,548
Impairment write-down ............................ (6,058) (3,887)
- -----------------------------------------------------------------------------------
Allowance balance at end of period ........... 36,793 24,144
- -----------------------------------------------------------------------------------
Total mortgage servicing rights, net ......... $ 46,912 $ 37,507
===================================================================================
(1) The estimated fair value may exceed book value for certain asset strata and
excluded loans sold or securitized prior to 1996 and loans temporarily
sub-serviced without capitalized mortgage servicing rights.
Key assumptions, which vary due to changes in market interest rates and are
used to determine the fair value of our mortgage servicing rights, include:
expected prepayment speeds, which impact the average life of the portfolio; the
earnings rate on custodial accounts, which impact the value of custodial
accounts; and the discount rate used in valuing future cash flows. The following
table summarizes the estimated changes in the fair value of our mortgage
servicing rights for changes in those assumptions individually and in
combination associated with an immediate 100 basis point increase or decrease in
market rates. Also summarized is the earnings impact associated with provisions
to or reductions in the valuation allowance for mortgage servicing rights.
Impairment is measured on a disaggregated basis based upon the predominant risk
8
characteristics of the underlying mortgage loans such as term and coupon.
Certain stratum may have impairment, while other stratum may not. Therefore,
changes in overall fair value may not equal provisions to or reductions in the
valuation allowance.
The sensitivity analysis in the table below is hypothetical and should be
used with caution. As the figures indicate, changes in fair value based on a 100
basis point variation in assumptions generally cannot be easily extrapolated
because the relationship of the change in the assumptions to the change in fair
value may not be linear. Also, in this table, the effect that a change in a
particular assumption may have on the fair value is calculated without changing
any other assumptions. In reality, changes in one factor may result in changes
in another, which might magnify or counteract the sensitivities.
Expected Value of
Prepayment Custodial Discount
(Dollars in Thousands) Speeds Accounts Rate Combination
- -----------------------------------------------------------------------------------------------------------
Increase rates 100 basis points:
Increase (decrease) in fair value (1) ........ $ 38,181 $ 2,435 $ (1,150) $ 36,990
Reduction of (increase in) valuation allowance 36,793 2,509 (1,076) 36,793
Decrease rates 100 basis points:
Increase (decrease) in fair value (2) ........ (19,849) (2,435) 1,209 (21,973)
Reduction of (increase in) valuation allowance (19,775) (2,361) 1,283 (21,899)
===========================================================================================================
(1) The weighted-average expected life is 81 months.
(2) The weighted-average expected life is 21 months.
The following table presents a breakdown of the components of our loan
servicing income (loss) during the periods indicated.
Three Months Ended
-------------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ---------------------------------------------------------------------------------------------------------------------
Income from servicing operations .......... $ 3,200 $ 3,349 $ 2,688 $ 2,477 $ 2,576
Amortization of MSRs ...................... (4,120) (3,253) (2,916) (2,956) (2,495)
(Provision for) reduction of impairment ... (18,043) (15,713) (360) 11,960 (11,852)
- ---------------------------------------------------------------------------------------------------------------------
Total loan servicing income (loss), net $(18,963) $(15,617) $ (588) $ 11,481 $(11,771)
=====================================================================================================================
Nine Months Ended
September 30,
--------------------------
(In Thousands) 2002 2001
- -----------------------------------------------------------------------
Income from servicing operations .......... $ 9,237 $ 6,551
Amortization of MSRs ...................... (10,289) (6,857)
Provision for impairment .................. (34,116) (22,548)
- -----------------------------------------------------------------------
Total loan servicing loss, net $(35,168) $(22,854)
=======================================================================
NOTE (5) - ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES
DERIVATIVES
We offer short-term interest rate lock commitments to help us attract
potential home loan borrowers. The commitments guarantee a specified interest
rate for a loan if our underwriting standards are met, but do not obligate the
potential borrower. Accordingly, a certain number of commitments never become
loans and merely expire. The residential one-to-four unit rate lock commitments
we ultimately expect to result in loans and sell in the secondary market are
treated as derivatives. Consequently, as derivatives, the hedging of the
expected rate lock commitments do not qualify for hedge accounting. Associated
fair value adjustments to the notional amount of the expected rate lock
commitments are recorded in current earnings under net gains (losses) on sales
of loans and mortgage-backed securities with an offset to the balance sheet in
either other assets, or accounts payable and accrued liabilities. Fair values
for the notional amount of expected rate lock
9
commitments are based on observable market prices acquired from third parties.
The carrying amount of loans held for sale includes a basis adjustment to the
loan balance at funding resulting from the change in fair value of the rate lock
derivative from the date of commitment to the date of funding. At September 30,
2002, we had a notional amount of expected rate lock commitments identified to
sell as part of our secondary marketing activities of $892 million, with an
estimated fair value gain of $12.1 million, of which $6.9 million was associated
with mortgage servicing rights.
HEDGING ACTIVITIES
As part of our secondary marketing activities, we typically utilize
short-term forward sale and purchase contracts--derivatives--that mature in less
than one year to offset the impact of changes in market interest rates on the
value of our residential one-to-four unit expected rate lock commitments and
loans held for sale. We do not generally enter into derivative transactions for
purely speculative purposes. Contracts designated to loans held for sale are
accounted for as cash flow hedges because these contracts have a high
correlation to the price movement of the loans being hedged (within a range of
80% - 125%). The measurement approach for determining the ineffective aspects of
the hedge is established at the inception of the hedge. Changes in fair value of
the notional amount of forward sale contracts not designated to loans held for
sale and the ineffectiveness of hedge transactions that are not perfectly
correlated are recorded in net gains (losses) on sales of loans and
mortgage-backed securities. Changes in fair value of the notional amount of
forward sale contracts designated as cash flow hedges for loans held for sale
are recorded in other comprehensive income, net of tax, provided cash flow hedge
requirements are met. The offset to these changes in fair value of the notional
amount of forward sale contracts are recorded in the balance sheet as either
other assets, or accounts payable and accrued liabilities. The amounts recorded
in accumulated other comprehensive income will be recognized in the income
statement when the hedged forecasted transactions settle. We estimate that all
of the related unrealized gains or losses in accumulated other comprehensive
income will be reclassified into earnings within the next three months. Fair
values for the notional amount of forward sale contracts are based on observable
market prices acquired from third parties. At September 30, 2002, the notional
amount of forward sale contracts amounted to $1.7 billion, with an estimated
fair value loss of $15.7 million, of which $659 million were designated as cash
flow hedges. The notional amount of forward purchase contracts amounted to $165
million, with an estimated fair value gain of $0.7 million that partially
offsets the loss on our forward sale contracts not designated to loans held for
sale.
We have not discontinued any designated derivative instruments associated
with loans held for sale due to a change in the probability of settling a
forecasted transaction.
The following table shows the impact from non-qualifying hedges and the
ineffectiveness of cash flow hedges on net gains (losses) on sales of loans and
mortgage-backed securities (i.e., SFAS 133 effect), as well as the impact to
other comprehensive income (loss) from qualifying cash flow transactions. Also
shown is the notional amount of expected rate lock commitment derivatives for
loans originated for sale, loans held for sale and the notional amounts for
their associated hedging derivatives (i.e., forward sale contracts).
Three Months Ended
-------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Net gains (losses) on non-qualifying hedge transactions ....... $ (2,663) $ (390) $ 4,864 $ (3,834) $ (1,149)
Net losses on qualifying cash flow hedge transactions:
Unrealized hedge ineffectiveness .......................... -- -- -- -- (27)
Less reclassification of realized hedge ineffectiveness ... -- -- -- -- 27
- ------------------------------------------------------------------------------------------------------------------------------------
Total net gains (losses) recognized in sales of loans and
mortgage-backed securities (SFAS 133 effect) .......... (2,663) (390) 4,864 (3,834) (1,149)
Other comprehensive income (loss) ............................. (840) (1,138) 1,355 501 (2,477)
====================================================================================================================================
NOTIONAL AMOUNT AT PERIOD END
Non-qualifying hedge transactions:
Expected rate lock commitments ............................ $ 892,429 $ 503,359 $ 235,099 $ 269,315 $ 422,606
Associated forward sale contracts ......................... 1,024,586 501,292 230,660 278,319 404,177
Associated forward purchase contracts ..................... 165,000 3 -- -- 53
Qualifying cash flow hedge transactions:
Loans held for sale, at lower of cost or fair value ....... 665,587 381,465 388,468 499,024 373,489
Associated forward sale contracts ......................... 659,305 378,238 392,099 508,706 369,335
====================================================================================================================================
10
Nine Months Ended
September 30,
---------------------------
(In Thousands) 2002 2001
- -------------------------------------------------------------------------------------------
Net gains (losses) on non-qualifying hedge transactions ....... $ 1,811 $ (2,130)
Net losses on qualifying cash flow hedge transactions:
Unrealized hedge ineffectiveness .......................... -- (467)
Less reclassification of realized hedge ineffectiveness ... -- 467
- -------------------------------------------------------------------------------------------
Total net gains (losses) recognized in sales of loans and
mortgage-backed securities (SFAS 133 effect) .......... 1,811 (2,130)
Other comprehensive loss ...................................... (623) (1,228)
===========================================================================================
NOTE (6) - INCOME TAXES
Downey and its wholly owned subsidiaries file a consolidated federal income
tax return and various state income and franchise tax returns on a calendar year
basis. The Internal Revenue Service and state taxing authorities have examined
Downey's tax returns for all tax years through 1997. Tax years subsequent to
1997 remain open to review. Downey's management believes it has adequately
provided for potential exposure to issues that may be raised in the years open
to review.
NOTE (7) - CURRENT ACCOUNTING ISSUES
Statement of Financial Accounting Standards No. 142. Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS
142"), applies to all acquired intangible assets whether acquired singularly, as
part of a group, or in a business combination. SFAS 142 supersedes APB Opinion
No. 17, "Intangible Assets," and carries forward provisions in Opinion 17
related to internally developed intangible assets. SFAS 142 changes the
accounting for goodwill from an amortization method to an impairment-only
approach. Goodwill should no longer be amortized, but instead tested for
impairment at least annually at the reporting unit level. The accounting
provisions are effective for fiscal years beginning after December 31, 2001. Our
intangible assets and goodwill are related to branch acquisitions and not within
the scope of SFAS 142. We recognized an unidentified intangible asset for branch
acquisitions because the fair value of the liabilities assumed exceeded the fair
value of the assets acquired. However, Statement of Financial Accounting
Standards No. 147, "Acquisitions of Certain Financial Institutions, an amendment
of FASB Statements No. 72 and 144 and FASB Interpretation No. 9," which was
issued on October 1, 2002, states that assets of this nature which meet the
definition of a business combination will be accounted for using the
impairment-only approach (see discussion below).
Statement of Financial Accounting Standards No. 143. Statement of Financial
Accounting Standards No. 143, "Accounting for Asset Retirement Obligations"
("SFAS 143"), addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. SFAS 143 is effective for financial statements issued
for fiscal years beginning after June 15, 2002. It is anticipated that the
financial impact of SFAS 143 will not have a material effect on Downey.
Statement of Financial Accounting Standards No. 144. Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" ("SFAS 144"), addresses financial accounting and reporting
for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," and the accounting and reporting provisions of APB
Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions," for the disposal of a business segment. SFAS
144 also eliminates the exception to consolidation for a subsidiary for which
control is likely to be temporary. The provisions of SFAS 144 are effective for
financial statements issued for fiscal years beginning after December 15, 2001,
and interim periods within those fiscal years. The provisions of SFAS 144
generally are to be applied prospectively.
Statement of Financial Accounting Standards No. 145. Statement of Financial
Accounting Standards No. 145, "Rescission of SFAS Statements No. 4, 44, and 64,
Amendment of SFAS Statement No. 13, and Technical Corrections" ("SFAS 145"),
updates, clarifies and simplifies existing accounting pronouncements. SFAS 145
rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt."
SFAS 145 amends SFAS No. 13, "Accounting for Leases," to eliminate an
inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. The provisions of SFAS
145 related to SFAS No. 4 and SFAS No. 13 are effective for fiscal years
beginning and transactions occurring after
11
May 15, 2002, respectively. It is anticipated that the financial impact of SFAS
145 will not have a material effect on Downey.
Statement of Financial Accounting Standards No. 146. Statement of Financial
Accounting Standards No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities" ("SFAS 146"), requires Downey to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of a commitment to an exit or disposal plan. SFAS 146 replaces Emerging Issues
Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The provisions of SFAS 146 are to be
applied prospectively to exit or disposal activities initiated after December
31, 2002.
Statement of Financial Accounting Standards No. 147. Statement of Financial
Accounting Standards No. 147, "Acquisitions of Certain Financial Institutions,
an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9"
("SFAS 147"), addresses the financial accounting and reporting for the
acquisition of all or part of a financial institution, except for a transaction
between two or more mutual enterprises. SFAS 147 removes acquisitions of
financial institutions, other than transactions between two or more mutual
enterprises, from the scope of Statement of Financial Accounting Standards No.
72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions,"
("SFAS 72"), and Financial Accounting Standards Board Interpretation No. 9,
"Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a
Similar Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method," and requires that those transactions be accounted for in
accordance with Statement of Financial Accounting Standards No. 141, "Business
Combinations," and SFAS 142. Thus, the requirement in SFAS 72 to recognize, and
subsequently amortize, any excess of the fair value of liabilities assumed over
the fair value of tangible and identifiable intangible assets acquired as an
unidentifiable intangible asset no longer applies to acquisitions within the
scope of SFAS 147. Consequently, Downey will cease amortizing the remaining
excess cost over fair value of branch acquisitions and subject this asset to
annual impairment testing. Downey will also restate previously issued financial
statements back to January 1, 2002, when SFAS 142 was applied. For the third
quarter of 2002, our amortization of excess cost over fair value of branch
acquisitions was $0.1 million and as of September 30, 2002, this asset totaled
$3 million. For the first nine months of 2002, our amortization was $0.3
million.
SFAS 147 also provides guidance on the accounting for the impairment or
disposal of acquired long-term customer-relationship intangible assets of
financial institutions such as depositor- and borrower-relationship intangible
assets and credit cardholder intangible assets. Those intangible assets are
subject to the same undiscounted cash flow recoverability test and impairment
loss recognition and measurement provisions that SFAS 144 requires for other
long-lived assets that are held and used. The provisions of SFAS 147 are
effective on October 1, 2002.
The following table shows the impact to net income on both an absolute and
per share basis for the restatement that will be made in fourth quarter 2002
pursuant to SFAS 147.
Three Months Ended Nine Months Ended
-------------------------------------------- -----------------
September 30, June 30, March 31, September 30,
(In Thousands, Except Per Share Data) 2002 2002 2002 2002
- -------------------------------------------------------------------------------------- -----------------
NET INCOME AS ORIGINALLY REPORTED
Amount ...................... $ 14,504 $ 20,309 $ 37,314 $ 72,127
Basic earnings per share .... 0.52 0.72 1.32 2.56
Diluted earnings per share .. 0.52 0.72 1.32 2.56
====================================================================================== =================
NET INCOME RESTATED FOR SFAS 147
Amount ...................... $ 14,568 $ 20,375 $ 37,378 $ 72,321
Basic earnings per share .... 0.52 0.72 1.32 2.56
Diluted earnings per share .. 0.52 0.72 1.32 2.56
====================================================================================== =================
12
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Certain statements under this caption may constitute "forward-looking
statements" under the Private Securities Litigation Reform Act of 1995 which
involve risks and uncertainties. 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.
OVERVIEW
Our net income for the third quarter of 2002 totaled $14.5 million or $0.52
per share on a diluted basis, compared to $21.8 million or $0.77 per share in
the third quarter of 2001. During the current quarter, 212,300 shares of common
stock were repurchased at an average price per share of $41.04, leaving $41
million of the $50 million authorization available for future share repurchases.
The decline in our net income between third quarters was primarily due to a
larger addition to the valuation allowance for mortgage servicing rights. The
addition was reflected within the category of loan servicing loss and was
necessary due to an approximate 120 basis point decline in long-term interest
rates, which resulted in an increase in the projected rate at which loans
serviced for others are expected to prepay, thereby shortening their expected
average life. In addition, the decline in long-term interest rates also reduced
the expected value of associated custodial accounts. The pre-tax addition during
the third quarter was $18.0 million, up from $11.9 million in the year-ago third
quarter. Excluding the valuation allowances, our net income in the current
quarter would have been $24.9 million, down $3.7 million or 12.9% from the
adjusted year-ago level. This decline reflected a decrease of $5.7 million in
adjusted net income from our banking operations, partially offset by a $2.0
million increase in net income from real estate investment activities which
benefited from higher gains from sales. The decline in our adjusted net income
from banking operations was primarily due to the following:
o a $7.3 million or 40.9% decline in other income primarily due to:
o a $5.3 million unfavorable change in net gains from the sales of
loans and mortgage servicing rights and
o a $1.4 million decline in loan and deposit related fees due
primarily to lower loan prepayment fees; and
o a $6.4 million or 15.9% increase in operating expense due to higher
costs associated with the increased number of branch locations and
higher loan origination activity.
These items were partially offset by a $3.5 million or 4.7% increase in net
interest income, due to higher interest-earning assets, and a $0.3 million
decline in provision for loan losses.
For the first nine months of 2002, our net income totaled $72.1 million or
$2.56 per share on a diluted basis, compared to $81.1 million or $2.86 per share
for the first nine months of 2001. The decline between nine-month periods
reflected lower net income from our banking operations and was primarily due to
higher valuation provisions associated with mortgage servicing rights.
For the third quarter of 2002, our return on average assets was 0.51% and
our return on average equity was 7.41%. For the first nine months of 2002, our
return on average assets was 0.87% and our return on average equity was 12.51%.
Our single family loan originations totaled a record $2.832 billion in the
third quarter of 2002, up 42.4% from the $1.988 billion we originated in the
third quarter of 2001 and 29.9% above the $2.179 billion we originated in the
previous quarter. Of the current quarter total, $1.032 billion represented
originations of loans for portfolio, of which $150 million represented subprime
credits. In addition to single family loans, we originated $43 million of other
loans in the quarter.
At quarter end, our assets totaled $12.5 billion, up 16.8% from a year ago.
Included in the total were $1.0 billion of 30-year fixed rate mortgage-backed
securities purchased in late September, of which about half were funded by
quarter end with short-term borrowings, while the other half settles in
mid-October. These securities were purchased due to a net interest spread of
over 3% given the steepness in the yield curve. However, these securities were
sold in early October due to interest rate volatility and the potential adverse
impact market interest rate changes could have on the carrying value of the
investment. Approximately $1.0 million was earned on these securities while
owned, virtually all of which will be recognized in the fourth quarter.
13
Our deposits totaled $9.1 billion, up 2.1% from a year ago. During the
quarter, we opened one new traditional and seven new in-store branches, bringing
our total branches at quarter end to 156, of which 85 were in-store. A year ago,
branches totaled 134, of which 67 were in-store.
Our non-performing assets increased $5 million during the quarter to $89
million or 0.71% of total assets (0.77% excluding the previously mentioned
mortgage-backed securities purchased in late September but sold in early
October). Residential non-performers increased $9 million during the quarter, of
which $6 million was associated with subprime loans. That increase was partially
offset by a $4 million decline in commercial real estate non-performers due to a
short-pay that was accepted in full consideration of the loan obligation.
At September 30, 2002, our primary subsidiary, Downey Savings and Loan
Association, F.A. (the "Bank") exceeded all regulatory capital tests, with
capital-to-asset ratios of 6.36% for both tangible and core capital and 13.65%
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.
CRITICAL ACCOUNTING POLICIES
We have established various accounting policies which govern the
application of accounting principles generally accepted in the United States of
America in the preparation of our financial statements. Our significant
accounting policies are described in Downey's Annual Report on Form 10-K for the
year ended December 31, 2001. 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 36.
o Valuation of mortgage servicing rights. For further information, see
Note 4 on page 8 of Notes to Consolidated Financial Statements.
14
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 $77.0 million in the third quarter of 2002,
up $3.5 million or 4.8% from the same period last year. The increase between
third quarters reflected higher interest-earning asset levels. Our
interest-earning assets averaged $10.9 billion during the quarter, up 5.6% from
the year-ago level. The effective interest rate spread averaged 2.83% in the
current quarter, slightly below 2.85% a year ago.
For the first nine months of 2002, net interest income totaled $232.0
million, up $6.2 million or 2.7% from a year ago. The increase reflected both a
higher effective interest rate spread and higher interest-earning asset levels.
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 quarter
using the average of each month's daily average balance during the periods
indicated.
15
Three Months Ended September 30,
----------------------------------------------------------------------------
2002 2001
----------------------------------------------------------------------------
Average Average
Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ........................................... $ 10,475,813 $ 150,987 5.77% $ 9,893,414 $ 187,867 7.60%
Mortgage-backed securities ...................... 32,601 287 3.52 4,951 62 5.01
Investment securities ........................... 387,325 3,650 3.74 420,635 5,767 5.44
- --------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ................. 10,895,739 154,924 5.69 10,319,000 193,696 7.51
Non-interest-earning assets ....................... 392,952 354,634
- --------------------------------------------------------------------------------------------------------------------------------
Total assets .................................... $ 11,288,691 $ 10,673,634
================================================================================================================================
Transaction accounts:
Non-interest-bearing checking ................... $ 301,169 $ -- -- % $ 313,665 $ -- -- %
Interest-bearing checking (a) ................... 414,909 323 0.31 406,779 501 0.49
Money market .................................... 114,544 487 1.69 93,388 648 2.75
Regular passbook ................................ 3,222,127 18,566 2.29 1,184,206 9,426 3.16
- --------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts .................... 4,052,749 19,376 1.90 1,998,038 10,575 2.10
Certificates of deposit ........................... 4,766,674 40,222 3.35 6,929,044 96,458 5.52
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits .................................. 8,819,423 59,598 2.68 8,927,082 107,033 4.76
Borrowings ........................................ 1,396,414 15,314 4.35 805,879 10,176 5.01
Capital securities ................................ 120,000 3,040 10.14 120,000 3,040 10.14
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits, borrowings and capital securities 10,335,837 77,952 2.99 9,852,961 120,249 4.84
Other liabilities ................................. 169,552 131,469
Stockholders' equity .............................. 783,302 689,204
- --------------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity ...... $ 11,288,691 $ 10,673,634
================================================================================================================================
Net interest income/interest rate spread .......... $ 76,972 2.70% $ 73,447 2.67%
Excess of interest-earning assets over deposits,
borrowings and capital securities ............... $ 559,902 $ 466,039
Effective interest rate spread .................... 2.83 2.85
================================================================================================================================
Nine Months Ended September 30,
----------------------------------------------------------------------------
2002 2001
----------------------------------------------------------------------------
Average Average
Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ........................................... $ 10,161,564 $ 459,712 6.03% $ 10,043,997 $ 604,449 8.02%
Mortgage-backed securities ...................... 73,283 2,503 4.55 6,121 277 6.03
Investment securities ........................... 412,504 12,532 4.06 450,942 20,171 5.98
- --------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ................. 10,647,351 474,747 5.95 10,501,060 624,897 7.93
Non-interest-earning assets ....................... 394,442 357,013
- --------------------------------------------------------------------------------------------------------------------------------
Total assets .................................... $ 11,041,793 $ 10,858,073
================================================================================================================================
Transaction accounts:
Non-interest-bearing checking ................... $ 293,964 $ -- -- % $ 285,427 $ -- -- %
Interest-bearing checking (a) ................... 421,894 1,065 0.34 404,065 1,633 0.54
Money market .................................... 112,830 1,497 1.77 90,869 1,903 2.80
Regular passbook ................................ 2,875,959 52,502 2.44 942,245 23,369 3.32
- --------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts .................... 3,704,647 55,064 1.99 1,722,606 26,905 2.09
Certificates of deposit ........................... 4,929,779 133,290 3.61 6,968,361 309,315 5.93
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits .................................. 8,634,426 188,354 2.92 8,690,967 336,220 5.17
Borrowings ........................................ 1,373,979 45,226 4.40 1,254,497 53,700 5.72
Capital securities ................................ 120,000 9,122 10.14 120,000 9,122 10.14
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits, borrowings and capital securities 10,128,405 242,702 3.20 10,065,464 399,042 5.30
Other liabilities ................................. 144,425 129,714
Stockholders' equity .............................. 768,963 662,895
- --------------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity ...... $ 11,041,793 $ 10,858,073
================================================================================================================================
Net interest income/interest rate spread .......... $ 232,045 2.75% $ 225,855 2.63%
Excess of interest-earning assets over deposits,
borrowings and capital securities ............... $ 518,946 $ 435,596
Effective interest rate spread .................... 2.91 2.87
================================================================================================================================
(a) Included amounts swept into money market deposit accounts.
16
Changes in our net interest income are a function of both changes in rates
and changes in volumes of interest-earning assets and interest-bearing
liabilities. The following table sets forth information regarding changes in our
interest income and expense for the periods indicated. For each category of
interest-earning assets and interest-bearing liabilities, we have provided
information on changes attributable to:
o changes in volume--changes in volume multiplied by comparative period
rate;
o changes in rate--changes in rate multiplied by comparative period
volume; and
o changes in rate/volume--changes in rate multiplied by changes in
volume.
Interest-earning asset and interest-bearing liability balances used in the
calculations represent quarterly average balances computed using the average of
each month's daily average balance during the period indicated.
Three Months Ended September 30, Nine Months Ended September 30,
2002 Versus 2001 2002 Versus 2001
Changes Due To Changes Due To
----------------------------------------------------------------------------------------------
Rate/ Rate/
(In Thousands) Volume Rate Volume Net Volume Rate Volume Net
- ------------------------------------------------------------------------------------------------------------------------------------
Interest income:
Loans ........................... $ 11,059 $(45,274) $ (2,665) $(36,880) $ 7,075 $(150,056) $ (1,756) $(144,737)
Mortgage-backed securities ...... 346 (18) (103) 225 3,039 (68) (745) 2,226
Investment securities ........... (457) (1,803) 143 (2,117) (1,719) (6,472) 552 (7,639)
- ------------------------------------------------------------------------------------------------------------------------------------
Change in interest income ..... 10,948 (47,095) (2,625) (38,772) 8,395 (156,596) (1,949) (150,150)
- ------------------------------------------------------------------------------------------------------------------------------------
Interest expense:
Transaction accounts:
Interest-bearing checking (1) . 10 (184) (4) (178) 72 (613) (27) (568)
Money market .................. 147 (251) (57) (161) 460 (697) (169) (406)
Regular passbook .............. 16,222 (2,603) (4,479) 9,140 47,959 (6,168) (12,658) 29,133
- ------------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts .. 16,379 (3,038) (4,540) 8,801 48,491 (7,478) (12,854) 28,159
Certificates of deposit ......... (30,102) (37,990) 11,856 (56,236) (90,490) (120,906) 35,371 (176,025)
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits (13,723) (41,028) 7,316 (47,435) (41,999) (128,384) 22,517 (147,866)
Borrowings ...................... 7,418 (1,348) (932) 5,138 5,052 (10,189) (3,337) (8,474)
Capital securities .............. -- -- -- -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Change in interest expense .... (6,305) (42,376) 6,384 (42,297) (36,947) (138,573) 19,180 (156,340)
- ------------------------------------------------------------------------------------------------------------------------------------
Change in net interest income ....... $ 17,253 $ (4,719) $ (9,009) $ 3,525 $ 45,342 $ (18,023) $(21,129) $ 6,190
====================================================================================================================================
(1) Included amounts swept into money market deposit accounts.
PROVISION FOR LOAN LOSSES
Provision for loan losses totaled $0.5 million in the current quarter, down
$0.3 million from the year-ago third quarter. The allowance for loan losses was
$35 million at September 30, 2002, compared to $36 million at year-end 2001. Net
charge-offs totaled $1.4 million in the third quarter of 2002, compared to less
than $0.1 million a year ago. The increase from a year ago primarily reflects a
$1.2 million charge-off in the current quarter of a commercial real estate loan
for which a short-pay was accepted in full consideration of the loan.
For the first nine months of 2002, provision for loan losses was $0.8
million and net charge-offs were $2.1 million. That compares to a provision for
loan losses of $1.3 million and net charge-offs of $0.7 million in the year-ago
period. For further information regarding our allowance for loan losses, see
Financial Condition--Problem Loans and Real Estate--Allowance for Losses on
Loans and Real Estate on page 36.
17
OTHER INCOME
A loss of $4.8 million was recognized in our total other income for the
third quarter of 2002, compared to income of $7.1 million in the year-ago third
quarter. The $11.8 million unfavorable change between third quarters primarily
reflected:
o a $7.2 million increase in the loss on our loan servicing activity due
primarily to a larger addition to the valuation allowance for mortgage
servicing rights, as the fair value of those rights dropped in the
current quarter due to an approximate 120 basis point decline in
long-term interest rates;
o a $5.3 million unfavorable change in net gains (losses) on sales of
loans and mortgage-backed securities and mortgage servicing rights;
and
o a $1.4 million decline in loan and deposit related fees, due primarily
to a $2.9 million decline in loan prepayment fees.
Partially offsetting those declines was a $1.7 million increase in income from
real estate held for investment due to higher gains from sales.
For the first nine months of 2002, total other income was $30.7 million,
down $4.7 million from a year ago, primarily reflecting a $12.3 million increase
in the loss from loan servicing and a $2.9 million decrease in loan and deposit
related fees. Those items were partially offset by a $6.3 million increase in
net gains (losses) on sales of loans and mortgage-backed securities and mortgage
servicing rights, and a $4.0 million increase in income from real estate and
joint ventures held for investment. Below is a further discussion of the major
other income categories.
LOAN AND DEPOSIT RELATED FEES
Loan and deposit related fees totaled $11.8 million in the third quarter of
2002, down $1.4 million from a year ago. Our loan related fees were down $2.8
million between third quarters, due primarily to a decline in loan prepayment
fees. This decline was partially offset by a $1.3 million or 28.6% increase in
our deposit related fees, primarily due to higher fees from our checking
accounts.
The following table presents a breakdown of loan and deposit related fees
during the quarterly periods indicated.
Three Months Ended
---------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ---------------------------------------------------------------------------------------------------------------
Loan related fees:
Prepayment fees ...................... $ 3,523 $ 4,140 $ 4,686 $ 5,475 $ 6,384
Other fees ........................... 2,366 1,992 2,167 2,477 2,257
Deposit related fees:
Automated teller machine fees ........ 2,051 1,668 1,543 1,670 1,671
Other fees ........................... 3,908 3,596 3,122 3,224 2,962
- ---------------------------------------------------------------------------------------------------------------
Total loan and deposit related fees $11,848 $11,396 $11,518 $12,846 $13,274
===============================================================================================================
18
For the nine months of 2002, loan and deposit related fees totaled $34.8
million, down $2.9 million from the same period of 2001. The decrease reflected
a $6.0 million decline in loan prepayment fees, as deposit related fees were up
$2.9 million.
The following table presents a breakdown of loan and deposit related fees
during the year-to-date periods indicated.
Nine Months Ended
September 30,
---------------------
(In Thousands) 2002 2001
- -----------------------------------------------------------------
Loan related fees:
Prepayment fees ...................... $12,349 $18,364
Other fees ........................... 6,525 6,287
Deposit related fees:
Automated teller machine fees ........ 5,262 4,854
Other fees ........................... 10,626 8,135
- -----------------------------------------------------------------
Total loan and deposit related fees $34,762 $37,640
=================================================================
REAL ESTATE AND JOINT VENTURES HELD FOR INVESTMENT
Income from our real estate and joint ventures held for investment totaled
$2.4 million in the third quarter of 2002, up $1.7 million from a year ago. The
favorable change reflected increases of $1.7 million in net gains from sales.
The gains primarily related to joint venture projects and were reported in the
category of equity in net income from joint ventures.
The following table sets forth the key components comprising our income
from real estate and joint venture operations during the quarterly periods
indicated.
Three Months Ended
------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ---------------------------------------------------------------------------------------------------------------------------
Rental operations, net of expenses ..................... $ 269 $ 521 $ 823 $ 1,026 $ 259
Equity in net income from joint ventures ............... 1,634 1,001 745 212 12
Interest from joint venture advances ................... 306 304 111 83 101
Net gains on sales of wholly owned real estate ......... 99 8 -- 127 --
(Provision for) reduction of losses on real estate and
joint ventures ...................................... 99 (818) 1,318 (1) 374
- ---------------------------------------------------------------------------------------------------------------------------
Total income from real estate and joint ventures held
for investment, net ............................... $ 2,407 $ 1,016 $ 2,997 $ 1,447 $ 746
===========================================================================================================================
For the first nine months of 2002, income from real estate and joint
ventures held for investment totaled $6.4 million, up $4.0 million from the same
period of 2001 due primarily to sales activity.
The following table sets forth the key components comprising our income
from real estate and joint venture operations during the year-to-date periods
indicated.
Nine Months Ended
September 30,
-------------------
(In Thousands) 2002 2001
- ------------------------------------------------------------------------------------------------
Rental operations, net of expenses ......................................... $1,613 $1,219
Equity in net income from joint ventures ................................... 3,380 524
Interest from joint venture advances ....................................... 721 385
Net gains on sales of wholly owned real estate ............................. 107 2
Reduction of losses on real estate and joint ventures ...................... 599 308
- ------------------------------------------------------------------------------------------------
Total income from real estate and joint ventures held for investment, net $6,420 $2,438
================================================================================================
19
SECONDARY MARKETING ACTIVITIES
A loss of $19.0 million was recorded in loan servicing from our portfolio
of loans serviced for others during the third quarter of 2002, $7.2 million
higher than the loss of $11.8 million in the year-ago period. The higher loss
primarily reflected a larger addition to the valuation allowance for mortgage
servicing rights, $18.0 million in the current quarter, compared to $11.9
million a year ago. The current quarter valuation addition was associated with
the deterioration in fair value of our mortgage servicing rights due to the
approximate 120 basis point decline in long-term interest rates, which resulted
in an increase in the projected rate at which loans serviced for others are
expected to prepay, thereby shortening their expected average life. In addition,
the decline in long-term interest rates also reduced the expected value of
custodial accounts. At September 30, 2002, we serviced loans for others of $7.5
billion, compared to $5.8 billion at December 31, 2001, and $5.5 billion at
September 30, 2001.
The following table presents a breakdown of the components of our loan
servicing income (loss) during the quarterly periods indicated.
Three Months Ended
----------------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ----------------------------------------------------------------------------------------------------------------------------
Income from servicing operations .......... $ 3,200 $ 3,349 $ 2,688 $ 2,477 $ 2,576
Amortization of MSRs ...................... (4,120) (3,253) (2,916) (2,956) (2,495)
(Provision for) reduction of impairment ... (18,043) (15,713) (360) 11,960 (11,852)
- ----------------------------------------------------------------------------------------------------------------------------
Total loan servicing income (loss), net $(18,963) $(15,617) $ (588) $11,481 $(11,771)
============================================================================================================================
For the first nine months of 2002, a loss of $35.2 million was recorded in
loan servicing, compared to a loss of $22.9 million from the same period of
2001, due to a larger addition to the valuation allowance for mortgage servicing
rights.
The following table presents a breakdown of the components of our loan
servicing loss during the year-to-date periods indicated.
Nine Months Ended
September 30,
---------------------------
(In Thousands) 2002 2001
- --------------------------------------------------------------
Income from servicing operations . $ 9,237 $ 6,551
Amortization of MSRs ............. (10,289) (6,857)
Provision for impairment ......... (34,116) (22,548)
- --------------------------------------------------------------
Total loan servicing loss, net $(35,168) $(22,854)
==============================================================
For further information regarding mortgage servicing rights, see Notes To
Consolidated Financial Statements--Note (4)--Mortgage Servicing Rights on page
8.
20
Sales of loans and mortgage-backed securities increased in the third
quarter of 2002 to a record $1.564 billion from $1.120 billion a year ago. A
loss of $1.0 million was recognized in the current quarter, compared to income
of $4.2 million a year ago. Included in the current quarter loss was a $2.7
million loss associated with the SFAS 133 impact of valuing derivatives
associated with the sale of loans. Excluding the SFAS 133 loss, a gain of $1.7
million or 0.11% of loans sold was realized. This result is below recent
quarters due, in part, to lower values of mortgage servicing rights being
recognized on loans sold servicing retained, given the decline that occurred in
long-term interest rates between the time the fixed rate was committed to the
borrower and when we sold the loan. Net losses in the current quarter included
the capitalization of mortgage servicing rights totaling $9.3 million, compared
to $10.3 million a year ago.
The following table presents a breakdown of the components of our net gains
(losses) on sales of loans and mortgage-backed securities during the quarterly
periods indicated.
Three Months Ended
----------------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- ----------------------------------------------------------------------------------------------------------------------------
Mortgage servicing rights .................... $ 9,304 $10,156 $14,997 $15,299 $10,294
All other components excluding SFAS 133 ...... (7,612) (2,870) (3,660) (4,416) (4,911)
SFAS 133 ..................................... (2,663) (390) 4,864 (3,834) (1,149)
- ----------------------------------------------------------------------------------------------------------------------------
Total net gains (losses) on sales of loans
and mortgage-backed securities ......... $ (971) $ 6,896 $16,201 $ 7,049 $ 4,234
============================================================================================================================
Total as percent of loans and
mortgage-backed securities sold .......... (0.06)% 0.63% 1.17% 0.48% 0.38%
============================================================================================================================
For the first nine months of 2002, net gains on sales of loans and
mortgage-backed securities totaled $22.1 million, up $6.7 million from the same
period of 2001.
The following table presents a breakdown of the components of our net gains
on sales of loans and mortgage-backed securities during the year-to-date periods
indicated.
Nine Months Ended
September 30,
---------------------------
(In Thousands) 2002 2001
- -------------------------------------------------------------------
Mortgage servicing rights ............. $ 34,457 $ 29,091
All other components excluding SFAS 133 (14,142) (11,578)
SFAS 133 .............................. 1,811 (2,130)
- -------------------------------------------------------------------
Total net gains on sales of loans
and mortgage-backed securities .. $ 22,126 $ 15,383
===================================================================
Total as percent of loans and
mortgage-backed securities sold ... 0.55% 0.50%
===================================================================
21
OPERATING EXPENSE
Our operating expense totaled $46.6 million in the current quarter, up $4.7
million or 11.1% from the third quarter of 2001. That increase was due primarily
to higher general and administrative costs associated with an increased number
of branch locations and higher loan origination activity.
The following table presents a breakdown of key components comprising
operating expense during the quarterly periods indicated.
Three Months Ended
--------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
(In Thousands) 2002 2002 2002 2001 2001
- -----------------------------------------------------------------------------------------------------------------
Salaries and related costs ................. $29,067 $28,315 $29,437 $27,075 $24,943
Premises and equipment costs ............... 7,916 7,754 7,133 7,303 6,628
Advertising expense ........................ 1,066 1,582 1,044 1,168 939
Professional fees .......................... 91 233 564 839 2,432
SAIF insurance premiums and regulatory
assessments ............................. 765 762 786 792 786
Other general and administrative expense ... 7,474 6,350 6,211 6,339 5,981
- -----------------------------------------------------------------------------------------------------------------
Total general and administrative expense 46,379 44,996 45,175 43,516 41,709
Net operation of real estate acquired in
settlement of loans ..................... 110 27 (58) 237 110
Amortization of excess cost over fair value
of branch acquisitions ................ 111 114 111 113 116
- -------------------------------------------------------------