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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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(Mark One)
|X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 for the fiscal year ended December 31, 2002.
| | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from ______________ to
______________.
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Commission File Number 1-13578
DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
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3501 Jamboree Road, Newport Beach, California 92660
(Address of principal executive offices) (Zip Code)
I.R.S. Employer Identification No.: 33-0633413
Registrant's telephone number, including area code: (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE
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Common Stock, $0.01 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the registrant's outstanding Common Stock
held by non-affiliates on June 28, 2002, based upon the closing sale price on
that date of $47.30, as quoted on the New York Stock Exchange, was
$1,016,518,482.
At February 28, 2003, 27,928,722 shares of the Registrant's Common Stock,
$0.01 par value, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's Proxy
Statement to be filed with the Securities and Exchange Commission in connection
with the Annual Meeting of Stockholders to be held April 23, 2003 are
incorporated by reference in Part III hereof.
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TABLE OF CONTENTS
ITEM
PAGE
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PART I
1. BUSINESS ........................................................... 1
General ......................................................... 1
Banking Activities .............................................. 2
Lending Activities ........................................... 2
Loan and Mortgage-Backed Securities Portfolio ....... 3
Residential Real Estate Lending ..................... 3
Secondary Marketing and Loan Servicing Activities ... 5
Multi Family and Commercial Real Estate Lending ..... 6
Construction Lending ................................ 6
Commercial Lending .................................. 6
Consumer Lending .................................... 6
Investment Activities ........................................ 7
Deposit Activities ........................................... 7
Borrowing Activities ......................................... 7
Capital Securities ........................................... 7
Earnings Spread .............................................. 8
Asset/Liability Management ................................... 8
Insurance Agency Activities .................................. 8
Real Estate Investment Activities ............................... 8
Competition ..................................................... 9
Employees ..................................................... 9
Regulation ..................................................... 9
General ..................................................... 9
Regulation of Downey ......................................... 9
Regulation of the Bank ....................................... 11
Regulation of DSL Service Company ............................ 17
Taxation ........................................................ 18
Factors That May Affect Future Results Of Operations ............ 18
2. PROPERTIES ......................................................... 20
Branches ........................................................ 20
Electronic Data Processing ...................................... 20
3. LEGAL PROCEEDINGS .................................................. 20
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ................ 20
PART II
5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS ............................................. 21
6. SELECTED FINANCIAL DATA ............................................ 22
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ....................................... 24
Overview ........................................................ 24
Critical Accounting Policies ................................. 25
Results of Operations ........................................... 26
Net Interest Income .......................................... 26
Provision for Loan Losses .................................... 28
Other Income ................................................. 28
Loan and Deposit Related Fees ....................... 29
Real Estate and Joint Ventures Held for Investment .. 29
Secondary Marketing Activities ...................... 30
Other Category ...................................... 31
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TABLE OF CONTENTS
ITEM
PAGE
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PART II----(CONTINUED)
Operating Expense ............................................ 31
Provision for Income Taxes ................................... 31
Business Segment Reporting ................................... 31
Banking ............................................... 32
Real Estate Investment ................................ 33
Financial Condition ............................................. 34
Loans and Mortgage-Backed Securities ......................... 34
Investment Securities ........................................ 38
Investments in Real Estate and Joint Ventures ................ 39
Deposits ..................................................... 41
Borrowings ................................................... 42
Capital Securities ........................................... 43
Off-Balance Sheet Arrangements ............................... 43
Transactions with Related Parties ..................... 44
Asset/Liability Management and Market Risk ................... 44
Problem Loans and Real Estate ................................ 49
Non-Performing Assets ................................. 49
Delinquent Loans ...................................... 51
Allowance for Losses on Loans and Real Estate ......... 53
Capital Resources and Liquidity .............................. 59
Contractual Obligations and Other Commitments ......... 60
Regulatory Capital Compliance ................................ 61
Newly Adopted Accounting Principles .......................... 61
Current Accounting Issues .................................... 62
Sale of Subsidiary ........................................... 63
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ......... 64
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ........................ 65
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES ............................ 112
PART III
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ................. 112
11. EXECUTIVE COMPENSATION ............................................. 112
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS ...................... 112
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ..................... 112
14. CONTROLS AND PROCEDURES ............................................ 112
PART IV
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K ...................................................... 112
AVAILABILITY OF REPORTS ............................................ 114
SIGNATURES ......................................................... 115
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY
ACT OF 2002 ..................................................... 116
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PART I
Certain matters discussed in this Annual Report may constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 and, as such, may involve risks and uncertainties.
These forward-looking statements relate to, among other things, expectations of
the business environment in which Downey Financial Corp. ("Downey," "we," "us"
and "our") operates, projections of future performance, perceived opportunities
in the market and statements regarding Downey's mission and vision. Downey's
actual results, performance or achievements may differ significantly from the
results, performance or achievements expressed or implied in such
forward-looking statements. For discussion of the factors that might cause such
a difference, see Business--Factors That May Affect Future Results on page 18.
ITEM 1. BUSINESS
GENERAL
We were incorporated in Delaware on October 21, 1994. On January 23, 1995,
after we obtained necessary stockholder and regulatory approvals, we acquired
100% of the issued and outstanding capital stock of Downey Savings and Loan
Association (the "Bank") and the Bank's stockholders became holders of our
stock. Downey was thereafter funded by the Bank and presently operates as the
Bank's holding company. Our stock is traded on the New York Stock Exchange and
Pacific Exchange under the trading symbol "DSL." Annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments
to those reports are available free of charge from our internet site,
www.downeysavings.com, by clicking on "Investor Relations" located on our home
page and proceeding to "Corporate Filings."
The Bank was formed in 1957 as a California-licensed savings and loan
association and converted to a federal charter in 1995. As of December 31, 2002,
it conducts its business through 165 retail deposit branches, including 93
full-service, in-store branches. Residential loans are originated or purchased:
o by branch managers and loan officers in our branches;
o by loan officers who solicit loans from realtors and other business
sources, including the internet;
o by wholesale loan representatives who obtain loans submitted by
mortgage brokers; and
o by purchases of loans from correspondent banking institutions and
mortgage bankers.
The Bank is regulated or affected by the following governmental entities
and laws:
o As a federally chartered savings association, the Bank's activities
and investments are generally governed by the Home Owners' Loan Act,
as amended, and regulations and policies of the Office of Thrift
Supervision (the "OTS").
o The Bank and Downey are subject to the primary regulatory and
supervisory jurisdiction of the OTS.
o As a federally insured depository institution, the Bank is regulated
and supervised by the Federal Deposit Insurance Corporation (the
"FDIC") with respect to some of its activities and investments.
o The Bank is a member of the Federal Home Loan Bank (the "FHLB") of San
Francisco, which is one of the 12 regional banks for federally insured
depository institutions comprising the Federal Home Loan Bank System.
o The Bank's savings deposits are insured through the Savings
Association Insurance Fund ("SAIF") of the FDIC, an instrumentality of
the United States government.
o The Bank is regulated by the Federal Reserve with respect to reserves
the Bank is required to maintain against deposits and other matters.
General economic conditions, the monetary and fiscal policies of the
federal government and the regulatory policies of governmental authorities
significantly influence our operations. Additionally, interest rates on
competing investments and general market interest rates influence our deposit
flows and the costs we incur on interest-bearing liabilities, which represents
our cost of funds. Similarly, market interest rates and other factors that
affect the supply of and demand for housing and the availability of funds affect
our loan volume and our yields on loans and mortgage-backed securities.
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Our primary business is banking and we are also involved in real estate
investments, each of which we discuss further below.
BANKING ACTIVITIES
Our primary business is banking. Our banking activities focus on:
o attracting funds from the general public and institutions; and
o originating and investing in loans, primarily residential real estate
mortgage loans, investment securities and mortgage-backed securities.
These mortgage-backed securities include mortgage pass-through securities issued
by other entities and securities issued or guaranteed by government-sponsored
enterprises like the Federal National Mortgage Association, the Federal Home
Loan Mortgage Corporation and the Government National Mortgage Association.
Our primary sources of revenue from our banking business are:
o interest we earn on loans, investment securities and mortgage-backed
securities;
o fees we earn in connection with loans and deposits;
o gains on sales of our loans, investment securities and mortgage-backed
securities; and
o income we earn on loans and mortgage-backed securities we service for
investors.
Our principal expenses in connection with our banking business are:
o interest we incur on our interest-bearing liabilities, including
deposits, borrowings and capital securities; and
o general and administrative costs.
Our primary sources of funds from our banking business are:
o deposits;
o principal and interest payments on our loans and mortgage-backed
securities;
o proceeds from sales of our loans and mortgage-backed securities; and
o borrowings and capital securities.
Scheduled payments we receive on our loans and mortgage-backed securities are a
relatively stable source of funds. However, the funds we receive from deposits
and the prepayment of loans and mortgage-backed securities vary widely. Below is
a detailed discussion of our banking activities.
LENDING ACTIVITIES
Historically, our lending activities have primarily emphasized our
origination of first mortgage loans secured by residential properties and retail
neighborhood shopping centers. To a lesser extent, our lending activities have
emphasized our origination of real estate loans secured by multi-family and
commercial properties, including land and other properties with income producing
capabilities. In addition, we have provided construction loan financing for
single family and multi-family residential properties and commercial retail
neighborhood shopping center projects. These construction loan financings have
included loans to joint ventures, which were being engaged in by DSL Service
Company, a wholly owned subsidiary of the Bank, with other participants. We also
originate loans to businesses through our commercial banking operations.
We originate automobile loans directly through our branch network. We also
conducted an indirect auto-lending program through our purchase of new or used
automobile sales contracts from auto dealers in California and other western
states. Downey Auto Finance Corp., a previous wholly owned subsidiary of the
Bank, operated this indirect auto-lending program, but was sold in February
2000. For more information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Sale of
Subsidiary on page 63.
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Our primary focus continues to be our origination of adjustable rate single
family mortgage loans for portfolio, including subprime loans which carry higher
interest rates. In addition, we will originate for portfolio other loans
including:
o multi-family loans;
o commercial real estate loans;
o construction loans to developers;
o loans to individuals for the construction and permanent financing of
single family homes; and
o consumer loans.
We will also continue our secondary marketing activities of originating and
selling single family mortgage loans to various investors.
For more information, see below under the caption entitled Secondary
Marketing and Loan Servicing Activities on page 5. For additional information on
the composition of our loan and mortgage-backed securities portfolio, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Loans and Mortgage-Backed Securities on page
34.
LOAN AND MORTGAGE-BACKED SECURITIES PORTFOLIO
We carry loans receivable held for investment at cost. Our net loans
receivable are adjusted for amortization of premiums and accretion of discounts
which are recognized in interest income using the interest method. Our
investments in mortgage-backed securities represent participating interests in
pools of first mortgage loans originated and serviced by the issuers of the
securities. We carry mortgage-backed securities held to maturity at unpaid
principal balances, which are adjusted for unamortized premiums and unearned
discounts. We amortize premiums and discounts on mortgage-backed securities by
using the interest method over the remaining period to contractual maturity,
adjusted for anticipated prepayments.
We identify loans that may be sold before their maturity. In our balance
sheets, we classify these as loans held for sale and record them at the lower of
amortized cost or fair value. Amortized cost includes a basis adjustment to the
loan at funding resulting from the change in the fair value of the associated
interest rate lock derivative from the date of commitment to the date of
funding. We recognize net unrealized losses on these loans, if any, in a
valuation allowance by making charges to our income.
We carry mortgage-backed securities available for sale at fair value. We
report net unrealized gains or losses on these securities net of income taxes in
stockholders' equity and as a separate component of our other comprehensive
income until realized.
RESIDENTIAL REAL ESTATE LENDING
Our primary lending activity is our origination of mortgage loans secured
by single family residential properties consisting of one-to-four units located
primarily in California. We provide these mortgage loans for borrowers to
purchase residences or to refinance their existing mortgages. The residential
mortgage loans we originate typically have contractual maturities at origination
of 15 to 40 years. To limit the interest rate risk associated with these 15- to
40-year maturities, we, among other things, principally originate adjustable
rate mortgages for our own loan portfolio. For more information, see
Asset/Liability Management on page 8. We also originate residential fixed rate
mortgage loans to meet consumer demand, but we intend to sell the majority of
these loans in the secondary market, rather than hold them in our portfolio. We
may, however, place residential fixed rate loans in our portfolio of loans held
for investment if these fixed rate loans are funded with long-term funds to
mitigate interest rate risk. In addition, we originate a small volume of fixed
rate loans for our own investment if they meet specific yield and other approved
guidelines, or to facilitate our sale of real estate acquired in settlement of
loans. The average term of these fixed rate mortgage loans we originate for our
own portfolio historically has been significantly shorter than their contractual
maturity due to loan payoffs as a result of home sales or refinancings and
prepayments. For more information, see Secondary Marketing and Loan Servicing
Activities on page 5.
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Our adjustable rate mortgages:
o generally either begin with an incentive interest rate, which is an
interest rate below the current market rate, that adjusts to the
applicable index plus a defined spread, subject to periodic and
lifetime caps, after one, three, six or twelve months, or are fixed
for a period of three to five years then adjust semi-annually or
annually thereafter;
o generally provide that the maximum interest rate we can charge
borrowers cannot exceed the incentive rate by more than six to nine
percentage points, depending on the type of loan and the initial rate
offered; and
o limit interest rate adjustments, for loans that adjust both the
interest rate and payment amount simultaneously, to 1% per adjustment
period for those that adjust semi-annually and 2% per adjustment
period for those that adjust annually.
Most of our adjustable rate mortgages adjust the interest rate monthly and
the payment amount annually. These monthly adjustable rate mortgages:
o have a lifetime interest rate cap, but no specified periodic interest
rate adjustment cap;
o have a periodic cap on changes in required monthly payments; and
o allow for negative amortization, which is the addition to loan
principal of accrued interest that exceeds the required monthly loan
payments.
If a loan incurs significant negative amortization, the loan-to-value ratio
could increase which creates an increased risk that the fair value of the
underlying collateral on the loan could be insufficient to satisfy fully the
outstanding principal and interest. A loan-to-value ratio is the ratio of the
principal amount of the loan to the lower of the sales price or appraised value
of the property securing the loan at origination. We currently impose a limit on
the amount of negative amortization. The principal plus the negative
amortization cannot exceed 125% of the original loan amount, except for subprime
loans and loans with loan-to-value ratios of greater than 80% where the borrower
has obtained private mortgage insurance to reduce the effective loan-to-value
ratio to between 67% and 80%. In those two instances, the principal plus
negative amortization cannot exceed 110% of the original loan amount. At
year-end 2002, loans with the higher 125% limit on negative amortization
represented 38% of our adjustable rate one-to-four unit residential portfolio.
We permit adjustable rate mortgages to be assumed by qualified borrowers.
During 2002, approximately 79% of our one-to-four unit residential real
estate loans were originated or purchased through outside mortgage brokers.
These mortgage brokers do not operate from our offices and are not our
employees. Our branch managers and residential loan officers originated
approximately 21% of our one-to-four unit residential loans during 2002.
We require that our residential real estate loans be approved at various
levels of management, depending upon the amount of the loan. On a single family
residential loan we originate for our portfolio, the maximum amount we generally
will lend is $1 million. Our average loan size, however, is much lower. In 2002,
our average loan size was $331,000. We generally make loans with loan-to-value
ratios not exceeding 80%. We will make loans with loan-to-value ratios of over
80%, if the borrower obtains private mortgage insurance to reduce the effective
loan-to-value ratio to between 67% and 80%, consistent with secondary marketing
requirements. In addition, we require that borrowers obtain hazard insurance for
all residential real estate loans covering the lower of the loan amount or the
replacement value of the residence.
In our approval process for the loans we originate or purchase, we assess
both the value of the property securing the loan and the applicant's ability to
repay the loan. Qualified appraisers on our staff or approved outside appraisers
establish the value of the collateral through appraisals or alternative
valuation formats that meet regulatory requirements. Appraisal reports prepared
by outside appraisers are selectively reviewed by our staff appraisers or by
approved fee appraisers. We generally obtain information about the applicant's
income, financial condition, employment and credit history. Typically, we will
verify an applicant's credit information for loans originated by our retail loan
representatives. For loans submitted from outside mortgage brokers, we require
the mortgage broker to obtain, review and verify the applicant's credit
information and employment.
We offer one-to-four unit residential loans to borrowers who have or, in
the case of purchases, will have equity in their homes but whose credit rating
contains exceptions which preclude them from qualifying for lower or better
market interest rates and terms. We refer to these lower rated credits, which we
characterize as "A-," "B"
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and "C" loans, as subprime loans in our loan portfolio. Our subprime loans are
characterized by lower loan-to-value ratios and higher average interest rates
than higher credit grade loans or "A" loans. We believe these lower credit rated
borrowers represent an opportunity for us to earn a higher net return for the
risks we assume. For further information, see Regulation--Regulation of the
Bank--Regulatory Capital Requirements on page 11.
We currently qualify applicants of our adjustable rate mortgages at the
higher of the fully-indexed rate or:
o for prime borrowers:
o 6.25% for owner occupied; or
o 6.50% for non-owner occupied.
o for subprime borrowers:
o 7.25% for owner occupied; or
o 7.50% for non-owner occupied.
SECONDARY MARKETING AND LOAN SERVICING ACTIVITIES
As part of our secondary marketing activities, we originate residential
real estate adjustable rate mortgages and fixed rate mortgages that we intend to
sell. Accordingly, we classify these loans as held for sale and carry them at
the lower of cost or fair value. Amortized cost includes a basis adjustment to
the loan at funding resulting from the change in the fair value of the
associated interest rate lock derivative from the date of commitment to the date
of funding. These loans are secured by first liens on one-to-four unit
residential properties and generally have maturities of 30 years or less.
We believe that servicing loans for others can be an important
asset/liability management tool because it produces operating results which, in
response to changes in market interest rates, tend to move opposite to changes
in net interest income. Because yields on adjustable rate mortgages take longer
to adjust to market interest rates than their funding sources, net interest
income associated with these loans is expected to decline in periods of rising
interest rates and increase in periods of falling rates. In contrast, the value
of a loan servicing portfolio normally:
o increases as interest rates rise and loan prepayments decrease;
and
o declines as interest rates fall and loan prepayments increase.
In addition, increased levels of servicing activities and the opportunity to
offer our other financial services in servicing loans for others can provide us
with additional income with minimal additional overhead costs.
Depending upon market pricing for servicing, we sell loans either servicing
retained or servicing released. When we sell loans servicing retained, we record
gains or losses from these loans at the time of sale. We calculate gains or
losses from our sale as the difference between the net sales proceeds and the
allocated basis of the loans sold. We capitalize mortgage servicing rights we
acquire through either our purchase or origination of mortgage loans we intend
to sell with servicing rights retained. We allocate the total cost of the
mortgage loans sold to both the mortgage servicing rights and to the mortgage
loans without mortgage servicing rights based on their relative fair values. We
disclose our mortgage servicing rights in our financial statements and include
them as a component of the gain on sale of loans. We recognize impairment losses
on the mortgage servicing rights through a valuation allowance and record any
associated provision as a component of loan servicing income (loss), net
category. For further information, see Note 1 on page 72 and Note 10 on page 89
of Notes to the Consolidated Financial Statements.
Generally, we use hedging programs to manage the interest rate risk of our
secondary marketing activities. However, to-date we have not hedged our mortgage
servicing rights. For further information, see Asset/Liability Management and
Market Risk on page 44.
We may exchange loans we originate for sale with government-sponsored
agencies for mortgage-backed securities collateralized by these loans. Our cost
for the exchange, a monthly guaranty fee, is expressed as a percentage of the
unpaid principal balance and is deducted from interest income. The securities we
receive can be used to collateralize various types of our borrowings at rates
that frequently are more favorable than rates on other types of liabilities and
also carry a lower risk-based capital requirement than whole loans. We carry
these mortgage-backed securities available for sale at fair value. However, we
record no gain or loss on the exchange
5
in our statement of income until the securities are sold to a third party.
Before we sell these securities to third parties, we show all changes in fair
value as a separate component of stockholders' equity as accumulated other
comprehensive income, net of income taxes.
MULTI-FAMILY AND COMMERCIAL REAL ESTATE LENDING
We have provided permanent loans secured by multi-family and retail
neighborhood shopping center properties. Our major loan officers conduct our
multi-family and commercial real estate lending activities.
Multi-family and commercial real estate loans generally entail additional
risks as compared to single family residential mortgage lending. We subject each
loan, including loans to facilitate the sale of real estate we own, to our
underwriting standards, which generally include:
o our evaluation of the creditworthiness and reputation of the borrower;
and
o the amount of the borrower's equity in the project as determined on
the basis of appraisal, sales and leasing information on the property
and cash flow projections.
To protect the value of the security for our loan, we require borrowers to
maintain casualty insurance for the loan amount or replacement cost. In
addition, for non-residential loans in excess of $500,000, we require the
borrower to obtain comprehensive general liability insurance. All commercial
real estate loans we originate must be approved by at least two of our officers,
one of whom must be the originating loan account officer and the other a
designated officer with appropriate loan approval authority.
CONSTRUCTION LENDING
We have provided construction loan financing for single family and
multi-family residential properties and commercial real estate projects, like
retail neighborhood shopping centers. Our major loan officers principally
originate these loans. We generally make construction loans at floating interest
rates based upon the prime or reference rate of a major commercial bank.
Generally, we require a loan-to-value ratio of 75% or less on construction
lending and we subject each loan to our underwriting standards.
Construction loans involve risks different from completed project lending
because we advance loan funds based upon the security of the completed project
under construction. If the borrower defaults on the loan, then we may have to
advance additional funds to finance the project's completion before the project
can be sold. Moreover, construction projects are affected by uncertainties
inherent in estimating:
o construction costs;
o potential delays in construction time;
o market demand; and
o the accuracy of the value on the completed project.
When providing construction loans, we require the general contractor to,
among other things, carry contractor's liability insurance equal to specific
prescribed minimum amounts, carry builder's risk insurance and have a blanket
bond against employee misappropriation.
COMMERCIAL LENDING
We originate commercial loans and revolving lines of credit and issue
standby letters of credit for our middle market commercial customers. We offer
the various credit products on both a secured and unsecured basis with interest
rates being either fixed or variable. Our portfolio emphasis is toward secured,
floating rate credit facilities. Our commercial banking group directs these
activities and focuses on our long-term, relationship-based customers. We also
utilize our retail branch network as a source of commercial customers, with the
lending to these customers being typically managed by the branch manager.
CONSUMER LENDING
The Bank originates direct automobile loans, home equity loans and home
equity lines of credit, and other consumer loan products. Before we make a
consumer loan, we assess the applicant's ability to repay the loan and, if
applicable, the value of the collateral securing the loan. The risk involved
with home equity loans and home
6
equity lines of credit is similar to the risk involved with residential real
estate loans. We offer customers a credit card through a third party, who
extends the credit and services the loans made to our customers.
INVESTMENT ACTIVITIES
As a federally chartered savings association, the Bank's ability to make
securities investments is prescribed under the OTS regulations and the Home
Owners' Loan Act. The Bank's authorized officers make investment decisions
within guidelines established by the Bank's Board of Directors. The Bank manages
these investments in an effort to produce the highest yield, while at the same
time maintaining safety of principal, minimizing interest rate risk and
complying with applicable regulations.
We carry securities held to maturity at amortized cost. We adjust these
costs for amortization of premiums and accretion of discounts, which we
recognize in interest income using the interest method. We carry securities
available for sale at fair value. We exclude unrealized holding gains and
losses, or valuation allowances established for net unrealized losses, from our
earnings and report them as a separate component of our stockholders' equity as
accumulated other comprehensive income, net of income taxes, unless the security
is deemed other than temporarily impaired. If the security is determined to be
other than temporarily impaired, we charge the amount of the impairment to
operations. For further information on the composition of our investment
portfolio, see Management's Discussion and Analysis of Financial Condition and
Results of Operations--Financial Condition--Investment Securities on page 38.
DEPOSIT ACTIVITIES
We prefer to use deposits raised through our retail branch system as our
principal source of funds for supporting our lending activities, because the
cost of these funds generally is less than that of borrowings or other funding
sources with comparable maturities. We traditionally have obtained our deposits
primarily from areas surrounding the Bank's branch offices. However, we
occasionally raise some retail deposits through Wall Street activities.
General economic conditions affect deposit flows. Funds may flow from
depository institutions such as savings associations into direct vehicles like
government and corporate securities or other financial intermediaries. Our
ability to attract and retain deposits will continue to be affected by money
market conditions, prevailing interest rates and available competing investment
vehicles. Generally, state or federal regulation does not restrict interest
rates we pay on deposits.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Deposits on
page 41.
BORROWING ACTIVITIES
Besides deposits, we have utilized other sources to fund our loan
origination and other business activities. We have at times relied upon our
borrowings from the FHLB of San Francisco as an additional source of funds. The
FHLB of San Francisco makes advances to us through several different credit
programs it offers.
From time to time, we obtain additional sources of funds by selling some of
our securities and mortgage loans under agreements to repurchase. These reverse
repurchase agreements are generally short-term and are collateralized by our
mortgage-backed or investment securities and our mortgage loans. We only deal
with investment banking firms that are recognized as primary dealers in U.S.
government securities or major commercial banks in connection with these reverse
repurchase agreements. In addition, we limit the amounts of our borrowings from
any single institution.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Borrowings
on page 42.
CAPITAL SECURITIES
On July 23, 1999, we issued $120 million in capital securities through
Downey Financial Capital Trust I. The capital securities pay quarterly
cumulative cash distributions at an annual rate of 10.00% of the liquidation
value of $25 per share. Of the $115 million of net proceeds, we invested $108
million as additional common stock of the Bank thereby increasing the Bank's
regulatory core/tangible capital by that same amount. The balance of the net
proceeds have been used for general corporate purposes. For further information
regarding our capital securities,
7
see Note 16 on page 96 of Notes to Consolidated Financial Statements.
EARNINGS SPREAD
Our primary source of earnings comes from our net interest income. We
determine our net interest income or the interest rate spread by calculating the
difference between:
o the yield we earn on our interest-earning assets like loans,
mortgage-backed securities and investment securities; and
o the cost we pay on our interest-bearing liabilities like deposits,
borrowings and capital securities.
Our net interest income is also determined by the relative dollar amounts of our
interest-earning assets and interest-bearing liabilities.
Our effective interest rate spread, which reflects the relative level of
our interest-earning assets to our interest-bearing liabilities, equals:
o the difference between interest income on our interest-earning assets
and interest expense on our interest-bearing liabilities, divided by
o our average interest-earning assets for the period.
For information regarding our net income and the components thereof and for
management's analysis of our financial condition and results of operations, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations beginning on page 24. For information regarding the return on our
assets and other selected financial data, see Selected Financial Data on page
22.
ASSET/LIABILITY MANAGEMENT
Savings institutions are affected by interest rate risks to the degree that
their interest-bearing liabilities, consisting principally of customer deposits,
FHLB advances, other borrowings and capital securities, mature or reprice on a
different basis than their interest-earning assets, which consist predominantly
of intermediate or long-term real estate loans. While having liabilities that on
average mature or reprice more frequently than assets may be beneficial in times
of declining interest rates, this asset/liability structure may result in
declining net earnings during periods of rising interest rates. Our principal
objectives are to actively monitor and manage the effects of adverse changes in
interest rates on our net interest income while maintaining our asset quality.
To improve the rate sensitivity and maturity balance of our interest-earning
assets and liabilities, we have emphasized the origination of loans with
adjustable interest rates or relatively short maturities. Loans with adjustable
interest rates have the beneficial effect of allowing the yield on our assets to
increase during periods of rising interest rates, although these loans have
contractual limitations on the frequency and extent of interest rate
adjustments.
For further information, see Lending Activities on page 2 and Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Asset/Liability Management and Market Risk on
page 44.
INSURANCE AGENCY ACTIVITIES
Downey Affiliated Insurance Agency was incorporated on January 25, 1995, as
Downey's wholly owned subsidiary. We capitalized Downey Affiliated Insurance
Agency on February 24, 1995 with $400,000. In the 1995 second quarter, Downey
Affiliated Insurance Agency commenced operations at which time representatives
of Downey Affiliated Insurance Agency were available in our branches to offer
annuity products. During 1996, Downey Affiliated Insurance Agency began offering
forced-placed casualty insurance policies on mortgage loans and stopped offering
annuity products. The offering of forced-placed casualty insurance policies
ceased in April 1999.
REAL ESTATE INVESTMENT ACTIVITIES
In addition to our primary business of banking, which has been described
above, we are also involved in real estate investment activities, which are
conducted primarily through DSL Service Company, a wholly owned subsidiary of
the Bank. DSL Service Company is a diversified real estate development company
which was
8
established in 1966 as a neighborhood shopping center and residential tract
developer. Today its capabilities include development, construction and property
management activities relating to its portfolio of projects primarily within
California, but also in Arizona. In addition to DSL Service Company developing
its own real estate projects, it associates with other qualified developers to
engage in joint ventures. The primary revenue sources of our real estate
investment activities include net rental income and gains from the sale of real
estate investments. The primary expenses of our real estate investment
activities are interest expense and general and administrative expense.
Due to federal law, the Bank is prohibited from making new investments in
real estate development and joint venture operations and is required to deduct
the full amount of its investment in DSL Service Company in calculating its
applicable ratios under the core, tangible and risk-based capital standards.
Savings associations generally may invest in service corporation subsidiaries,
like DSL Service Company, to the extent of 2% of the association's assets, plus
up to an additional 1% of assets for investments which serve primarily
community, inner-city or community development purposes. In addition,
"conforming loans" by the Bank to DSL's joint venture partnerships are limited
to 50% of the Bank's risk-based capital. "Conforming loans" are those generally
limited to 80% of appraised value, bear a market rate of interest and require
payments sufficient to amortize the principal balance of the loan. We are in
compliance with each of these investment limitations.
To the extent Downey or a subsidiary of Downey, other than the Bank or its
subsidiaries, makes real estate investments, the above-mentioned capital
deductions and limitations do not apply, as they only pertain to the specific
investments by savings associations or their subsidiaries.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Investments
in Real Estate and Joint Ventures on page 39.
COMPETITION
We face competition both in attracting deposits and in making loans. Our
most direct competition for deposits has historically come from other savings
institutions and from commercial banks located in our principal market areas,
including many large financial institutions based in other parts of the country
or their subsidiaries. In addition, we face additional significant competition
for investors' funds from short-term money market securities and other corporate
and government securities. Our ability to attract and retain savings deposits
depends, generally, on our ability to provide a rate of return, liquidity and
risk comparable to that offered by competing investment opportunities and the
appropriate level of customer service.
We experience competition for real estate loans principally from other
savings institutions, commercial banks, mortgage banking companies and insurance
companies. We compete for loans principally through our interest rates and loan
fees we charge and our efficiency and quality of services we provide borrowers
and real estate brokers.
EMPLOYEES
At December 31, 2002, we had 2,352 full-time employees and 640 part-time
employees. We provide our employees with health and welfare benefits and a
retirement and savings plan. Additionally, we offer qualifying employees
participation in our stock purchase plan. Our employees are not represented by
any union or collective bargaining group, and we consider our employee relations
to be good.
REGULATION
GENERAL
Federal and state law extensively regulate savings and loan holding
companies and savings associations. This regulation is intended primarily to
protect our depositors and the SAIF and is not for the benefit of our
stockholders. Below we describe some of the regulations applicable to us and the
Bank. We do not claim this discussion is complete and qualify our discussion by
reference to applicable statutory or regulatory provisions.
REGULATION OF DOWNEY
General. We are a savings and loan holding company and are subject to
regulatory oversight by the OTS. We are required to register and file reports
with the OTS and are regulated and examined by the OTS. The OTS has enforcement
authority over us, which also permits the OTS to restrict or prohibit our
activities that it determines to be a serious risk to the Bank.
9
Activities Restrictions. As a savings and loan holding company with only
one savings and loan association subsidiary, we generally are not limited by OTS
activity restrictions, provided the Bank satisfies the qualified thrift lender
test or meets the definition of a domestic building and loan association in the
Internal Revenue Code. If we acquire control of another savings association as a
separate subsidiary of Downey, we would become a multiple savings and loan
holding company. As a multiple savings and loan holding company, our activities,
other than the activities of the Bank or any other SAIF-insured savings
association, would become subject to restrictions applicable to bank holding
companies unless these other savings associations were acquired in a supervisory
acquisition and each also satisfies the qualified thrift lender test or meets
the definition of a domestic building and loan association. Furthermore, if in
the future we sold control of the Bank to any other company, such company would
not succeed to our grandfathered status as a unitary thrift holding company and
would be subject to the same business activity restrictions as a bank holding
company. For more information, see Restrictions on Acquisitions below and
Regulation of the Bank--Qualified Thrift Lender Test on page 13.
Restrictions on Acquisitions. We must obtain approval from the appropriate
bank regulatory agencies before acquiring control of any insured depository
institution. The OTS generally prohibits these types of acquisitions if they
result in a multiple savings and loan holding company controlling savings
associations in more than one state. However, the OTS permits interstate
acquisitions if the acquisition is authorized by specific state authorization or
a supervisory acquisition of a failing savings association.
Federal law generally provides that no "person," acting directly or
indirectly or through or in concert with one or more other persons, may acquire
"control" of a federally insured savings association unless the person gives at
least 60 days written notice to the OTS. The OTS then has the opportunity to
disapprove the proposed acquisition. In addition, no company may acquire control
of this type of an institution without prior OTS approval. These provisions also
prohibit, among other things, any director or officer of a savings and loan
holding company, or any individual who owns or controls more than 25% of the
voting shares of a savings and loan holding company, from acquiring control of
any savings association not a subsidiary of the savings and loan holding
company, unless the acquisition is approved by the OTS.
Financial Holding Company Legislation. On November 12, 1999, the
Gramm-Leach-Bliley Act of 1999 ("GLBA") was signed into law. This law
established a comprehensive framework to permit affiliations among commercial
banks, insurance companies, securities firms and other financial service
providers by revising and expanding the Bank Holding Company Act framework to
permit a holding company to engage in a full range of financial activities
through a new entity known as a "Financial Holding Company." "Financial
activities" is broadly defined to include not only banking, insurance and
securities activities, but also merchant banking and additional activities that
the Federal Reserve Board, in consultation with the Secretary of the Treasury,
determines to be financial in nature, related or incidental to such financial
activities, or complementary activities that do not pose a substantial risk to
the safety and soundness of depository institutions or the financial system
generally.
GLBA provides that no company may acquire control of an insured savings
association, unless that company engages, and continues to engage, only in the
financial activities permissible for a Financial Holding Company, unless
grandfathered as a unitary savings and loan holding company. Downey is a
grandfathered unitary savings and loan holding company and we may continue to
operate under present law as long as we continue to control only the Bank and
the Bank continues to meet the qualified thrift lender test.
We do not believe that this law will have a material adverse effect on our
operations in the near-term. However, to the extent that GLBA permits banks,
securities firms and insurance companies to affiliate, the financial services
industry may experience further consolidation. GLBA is intended to grant to
community banks certain powers as a matter of right that larger institutions
have accumulated on an ad hoc basis and which unitary savings and loan holding
companies, such as Downey, already possess. Nevertheless, GLBA may increase the
competition that we face from larger institutions and other types of companies
offering financial products, many of which may have greater financial resources
than we do. In addition, GLBA may have an anti-takeover effect because it may
tend to limit the range of potential acquirers of Downey to other savings and
loan holding companies and Financial Holding Companies.
The Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act
was signed into law. This new legislation addresses accounting oversight and
corporate governance matters, including:
o the creation of a five-member oversight board appointed by the
Securities and Exchange Commission ("SEC") that will set standards for
accountants and have investigative and disciplinary powers;
o the prohibition of accounting firms from providing various types of
consulting services to public clients and requiring accounting firms
to rotate partners among public client assignments every five years;
10
o increased penalties for financial crimes;
o expanded disclosure of corporate operations and internal controls and
certification of financial statements;
o enhanced controls on and reporting of insider trading; and
o statutory separations between investment bankers and analysts.
Various aspects of the new legislation are dependent upon subsequent rulemaking
by the SEC. We are currently evaluating what impact the new legislation and its
implementing regulations will have upon our operations, including a potential
increase in certain outside professional costs.
REGULATION OF THE BANK
General. The OTS and the FDIC extensively regulate the Bank because the
Bank is a federally chartered, SAIF-insured savings association. The Bank must
ensure that its lending activities and its other investments comply with various
statutory and regulatory requirements. The Bank is also regulated by the Federal
Reserve.
The OTS, in conjunction with the FDIC, regularly examines the Bank and
prepares reports for the Bank's Board of Directors to consider with respect to
any deficiencies the OTS or the FDIC finds in the Bank's operations. Federal and
state laws also regulate the relationship between the Bank and its depositors
and borrowers, especially in matters regarding the ownership of savings accounts
and the documents used by the Bank.
The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition. In addition, the Bank must obtain regulatory
approvals before entering into some transactions like mergers with or
acquisitions of other financial institutions. This regulation and supervision
establishes a comprehensive framework of activities in which an institution may
engage and is intended primarily to protect the SAIF and our depositors. The
regulatory structure also gives the regulatory authorities extensive discretion
in connection with their supervisory and enforcement activities and examination
policies, including policies regarding the classification of assets and adequate
loan loss reserves for regulatory purposes. Any change in regulations, whether
by the OTS, the FDIC or the Congress, could have a material adverse impact on
us, the Bank and our operations.
Insurance of Deposit Accounts. The SAIF, as administered by the FDIC,
insures the Bank's deposit accounts up to the maximum amount permitted by law.
The FDIC may terminate insurance of deposits upon a finding that the
institution:
o has engaged in unsafe or unsound practices;
o is in an unsafe or unsound condition to continue operations; or
o has violated any applicable law, regulation, rule, order or condition
imposed by the FDIC or the institution's primary regulator.
The FDIC charges an annual assessment for the insurance of deposits based
on the risk a particular institution poses to its deposit insurance fund. Under
this system as of December 31, 2002, SAIF members paid within a range of 0% to
0.27% of insured domestic deposits, depending upon the institution's risk
classification. This risk classification is based on an institution's capital
group and supervisory subgroup assignment.
The Bank also pays, in addition to its normal deposit insurance premium as
a member of the SAIF, assessments towards the retirement of the Financing
Corporation Bonds (known as FICO Bonds) issued in the 1980s to assist in the
recovery of the savings and loan industry. These assessments will continue until
the FICO Bonds mature in 2017. For the last quarter of fiscal 2002, this
assessment was equal to approximately 0.017% of insured deposits.
Regulatory Capital Requirements. The Bank must meet regulatory capital
standards to be deemed in compliance with OTS capital requirements. OTS capital
regulations require savings associations to meet the following three capital
standards:
o tangible capital equal to 1.5% of total adjusted assets;
o leverage capital, or "core capital," equal to 3% of total adjusted
assets for institutions such as the Bank; and
11
o risk-based capital equal to 8.0% of total risk-based assets.
The OTS views its capital regulation requirements as minimum standards, and
it expects most institutions to maintain capital levels well above the minimum.
In addition, the OTS regulations provide that the OTS may establish minimum
capital levels higher than those provided in the regulations for individual
savings associations, upon a determination that the savings association's
capital is or may become inadequate in view of its circumstances. The OTS
regulations provide that higher individual minimum regulatory capital
requirements may be appropriate in circumstances where, among others, a savings
association:
o has a high degree of exposure to interest rate risk, prepayment risk,
credit risk, concentration of credit risk, other risks arising from
nontraditional activities, or similar risks or a high proportion of
off-balance sheet risk;
o is growing, either internally or through acquisitions, at a rate that
presents supervisory issues; or
o may be adversely affected by activities or the condition of its
holding company, affiliates, subsidiaries or other persons, or savings
associations with which it has significant business relationships.
The Bank is not required to meet any individual minimum regulatory capital
requirement. At December 31, 2002, the Bank's regulatory capital exceeded all
minimum regulatory capital requirements.
As a result of a number of federally insured financial institutions
extending their lending risk selection standards to attract lower credit quality
borrowers due to their loans having higher interest rates and fees, the federal
banking regulatory agencies jointly issued Interagency Guidelines on Subprime
Lending. Subprime lending involves extending credit to individuals with less
than perfect credit histories.
The guidelines consider subprime lending a high-risk activity that is
unsafe and unsound if the risks associated with subprime lending are not
properly controlled. Specifically, the 2002 guidelines direct examiners to
expect regulatory capital one and one-half to three times higher than that
typically set aside for prime assets for institutions that:
o have subprime assets equal to 25% or higher of Tier 1 capital, or
o have subprime portfolios experiencing rapid growth or adverse
performance trends, are administered by inexperienced management, or
have inadequate or weak controls.
Our subprime portfolio, pursuant to our definition, represented 168% of
Tier 1 capital as of year-end 2002. Subsequent to year end, the OTS notified us
that beginning March 31, 2003, we will need to risk weight our subprime
residential loans at 75% versus their current 50% risk weighting. This change
will increase the required regulatory capital associated with our subprime loans
by one and one-half times that of prime residential loans. For further
information regarding the impact of this change to our capital ratios, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Regulatory Capital Compliance on page 61.
The Home Owners' Loan Act permits savings associations not in compliance
with the OTS capital standards to seek an exemption from penalties or sanctions
for noncompliance. The OTS will grant an exemption only if the savings
association meets strict requirements. In addition, the OTS must deny the
exemption in some circumstances. If the OTS does grant an exemption, the savings
association still may be exposed to enforcement actions for other violations of
law or unsafe or unsound practices or conditions.
Prompt Corrective Action. The OTS's prompt corrective action regulation
requires the OTS to take mandatory actions and authorizes the OTS to take
discretionary actions against a savings association that falls within
undercapitalized capital categories specified in the regulation.
The regulation establishes five categories of capital classification:
o "well capitalized;"
o "adequately capitalized;"
o "undercapitalized;"
o "significantly undercapitalized;" and
12
o "critically undercapitalized."
The regulation uses an institution's risk-based capital, leverage capital
and tangible capital ratios to determine the institution's capital
classification. At December 31, 2002, the Bank exceeded the capital requirements
of a well capitalized institution under applicable OTS regulations.
Loans-to-One-Borrower. Savings associations generally are subject to the
lending limits applicable to national banks. With limited exceptions, the
maximum amount that a savings association or a national bank may lend to any
borrower, including some related entities of the borrower, at one time may not
exceed:
o 15% of the unimpaired capital and surplus of the institution, plus
o an additional 10% of unimpaired capital and surplus if the loans are
fully secured by readily marketable collateral.
Savings associations are additionally authorized to make loans to one
borrower, for any purpose:
o in an amount not to exceed $500,000; or
o by order of the Director of OTS, in an amount not to exceed the lesser
of $30,000,000 or 30% of unimpaired capital and surplus to develop
residential housing, provided:
o the purchase price of each single-family dwelling in the
development does not exceed $500,000;
o the savings association is in compliance with its capital
requirements;
o the loans comply with applicable loan-to-value requirements; and
o the aggregate amount of loans made under this authority does not
exceed 15% of unimpaired capital and surplus.
At December 31, 2002, the Bank's loans-to-one-borrower limit was $135
million based upon the 15% of unimpaired capital and surplus measurement.
Qualified Thrift Lender Test. The OTS requires savings associations to meet
a qualified thrift lender test. The test may be met either by maintaining a
specified level of assets in qualified thrift investments as specified in the
Home Owners' Loan Act or by meeting the definition of a "domestic building and
loan association." Qualified thrift investments are primarily residential
mortgages and related investments, including some mortgage-related securities.
The required percentage of investments under the Home Owners' Loan Act is 65% of
assets while the Internal Revenue Code requires investments of 60% of assets. An
association must be in compliance with the qualified thrift lender test or the
definition of domestic building and loan association on a monthly basis in nine
out of every 12 months. Associations failing to meet the qualified thrift lender
test are generally allowed only to engage in activities permitted for both
national banks and savings associations.
The FHLB also relies on the qualified thrift lender test. A savings
association will only enjoy full borrowing privileges from an FHLB if the
savings association is a qualified thrift lender. As of December 31, 2002, the
Bank was in compliance with its qualified thrift lender test requirement and met
the definition of a domestic building and loan association.
Affiliate Transactions. Transactions between a savings association and its
"affiliates" are quantitatively and qualitatively restricted under the Federal
Reserve Act and regulations. Affiliates of a savings association include, among
other entities, the savings association's holding company and companies that are
under common control with the savings association.
In general, a savings association and its subsidiaries are limited in their
ability to engage in "covered transactions" with affiliates:
o to an amount equal to 10% of the association's capital and surplus, in
the case of covered transactions with any one affiliate; and
o to an amount equal to 20% of the association's capital and surplus, in
the case of covered transactions with all affiliates.
13
In addition, a savings association and its subsidiaries may engage in covered
transactions and other specified transactions only on terms and under
circumstances that are substantially the same, or at least as favorable to the
savings association or its subsidiary, as those prevailing at the time for
comparable transactions with nonaffiliated companies. A "covered transaction"
includes:
o a loan or extension of credit to an affiliate;
o a purchase of investment securities issued by an affiliate;
o a purchase of assets from an affiliate, with some exceptions;
o the acceptance of securities issued by an affiliate as collateral for
a loan or extension of credit to any party; or
o the issuance of a guarantee, acceptance or letter of credit on behalf
of an affiliate.
In addition, under the OTS regulations:
o a savings association may not make a loan or extension of credit to an
affiliate unless the affiliate is engaged only in activities
permissible for bank holding companies;
o a savings association may not purchase or invest in securities of an
affiliate other than shares of a subsidiary;
o a savings association and its subsidiaries may not purchase a
low-quality asset from an affiliate;
o covered transactions and other specified transactions between a
savings association or its subsidiaries and an affiliate must be on
terms and conditions that are consistent with safe and sound banking
practices; and
o with some exceptions, each loan or extension of credit by a savings
association to an affiliate must be secured by collateral with a fair
value ranging from 100% to 130%, depending on the type of collateral,
of the amount of the loan or extension of credit.
Regulations generally exclude all non-bank and non-savings association
subsidiaries of savings associations from treatment as affiliates, except for:
o a financial subsidiary;
o a subsidiary controlled by one or more affiliates;
o an Employee Stock Option Plan ("ESOP"); or
o a subsidiary which the OTS or the Federal Reserve determines to be an
affiliate.
The regulations also require savings associations to make and retain
records that reflect affiliate transactions in reasonable detail and provide
that specified classes of savings associations may be required to give the OTS
prior notice of affiliate transactions.
Capital Distribution Limitations. A savings association that is a
subsidiary of a savings and loan holding company, such as the Bank, must file an
application or a notice with the OTS at least 30 days before making a capital
distribution. Savings associations are not required to file an application for
permission to make a capital distribution and need only file a notice if the
following conditions are met:
o they are eligible for expedited treatment under OTS regulations;
o they would remain adequately capitalized after the distribution;
o the annual amount of capital distribution does not exceed net income
for that year to date added to retained net income for the two
preceding years; and
o the capital distribution would not violate any agreements between the
OTS and the savings association or any OTS regulations.
14
Any other situation would require an application to the OTS. The OTS may
disapprove an application or notice if the proposed capital distribution would:
o make the savings association undercapitalized, significantly
undercapitalized or critically undercapitalized;
o raise safety or soundness concerns; or
o violate a statute, regulation or agreement with the OTS (or with the
FDIC), or a condition imposed in an OTS approved application or
notice.
Privacy. Under the Financial Services Modernization Act, federal banking
regulators adopted rules that will limit the ability of banks and other
financial institutions to disclose non-public information about consumers to
nonaffiliated third parties. Pursuant to those rules, financial institutions
must provide:
o initial notices to customers about their privacy policies, describing
the conditions under which they may disclose nonpublic personal
information to nonaffiliated third parties and affiliates;
o annual notices of their privacy policies to current customers; and
o a reasonable method for customers to "opt out" of disclosures to
nonaffiliated third parties.
These privacy provisions affect how consumer information is transmitted through
diversified financial companies and conveyed to outside vendors.
USA Patriot Act of 2001. On October 26, 2001, the USA Patriot Act was
signed into law. The Patriot Act is intended to strengthen U.S law enforcement
and the intelligence communities' ability to combat terrorism on a variety of
fronts. The potential impact of the Patriot Act on financial institutions is
significant and wide ranging. The Patriot Act contains sweeping anti-money
laundering and financial transparency laws in addition to current requirements
and requires various regulations, including:
o due diligence requirements for financial institutions that administer,
maintain, or manage private banks accounts or correspondent accounts
for non-US persons;
o standards for verifying customer identification at account opening;
o rules to promote cooperation among financial institutions, regulators,
and law enforcement entities in identifying parties that may be
involved in terrorism or money laundering;
o reports by non-financial businesses filed with the Treasury
Department's Financial Crimes Enforcement Network for cash
transactions exceeding $10,000; and
o the filing of suspicious activities reports by securities brokers and
dealers if they believe a customer may be violating U.S. laws and
regulations.
On July 23, 2002, the U.S. Treasury proposed regulations requiring
institutions to incorporate into their written money laundering plans a Board of
Director approved customer identification program implementing reasonable
procedures to:
o verify the identity of any person seeking to open an account, to the
extent reasonable and practicable;
o maintain records of the information used to verify the person's
identity; and
o determine whether the person appears on any list of known or suspected
terrorists or terrorist organizations.
"Account" is defined as a formal banking or business relationship established to
provide ongoing services, dealings, or other financial transactions. We do not
expect the proposed regulations will have a material impact on our operations.
Activities of Subsidiaries. A savings association seeking to establish a
new subsidiary, acquire control of an existing company or conduct a new activity
through a subsidiary must provide 30 days prior notice to the FDIC and the OTS
and conduct any activities of the subsidiary in compliance with regulations and
orders of the OTS. The OTS may require a savings association to divest any
subsidiary or terminate any activity conducted by a subsidiary that the OTS
determines to pose a serious threat to the financial safety, soundness or
stability of the savings
15
association or to be otherwise inconsistent with sound banking practices.
Community Reinvestment Act and the Fair Lending Laws. Savings associations
have a responsibility under the Community Reinvestment Act and related OTS
regulations to help meet the credit needs of their communities, including low-
and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act
and the Fair Housing Act prohibit lenders from discriminating in their lending
practices on the basis of characteristics specified in those statutes. An
institution's failure to comply with the provisions of the Community
Reinvestment Act could, at a minimum, result in regulatory restrictions on its
activities and the denial of applications. In addition, an institution's failure
to comply with the Equal Credit Opportunity Act and the Fair Housing Act could
result in the OTS, other federal regulatory agencies as well as the Department
of Justice taking enforcement actions.
Federal Home Loan Bank System. The Bank is a member of the FHLB system.
Among other benefits, each FHLB serves as a reserve or central bank for its
members within its assigned region. Each FHLB is financed primarily from the
sale of consolidated obligations of the FHLB system. Each FHLB makes available
loans or advances to its members in compliance with the policies and procedures
established by the Board of Directors of the individual FHLB.
As an FHLB member, the Bank is required to own capital stock in an FHLB in
an amount equal to the greater of:
o 1% of its aggregate outstanding principal amount of its residential
mortgage loans, home purchase contracts and similar obligations at the
beginning of each calendar year;
o 5% of its FHLB advances or borrowings; or
o $500.
At December 31, 2002, the Bank had $118 million of FHLB stock, an amount in
excess of our required investment of $108 million.
The GLBA made significant reforms to the FHLB system, including:
o Expanded Membership - (i) expands the uses for, and types of,
collateral for advances; (ii) eliminates bias toward qualified thrift
lenders; and (iii) removes capital limits on advances using real
estate related collateral (e.g., commercial real estate and home
equity loans).
o New Capital Structure - each FHLB is allowed to establish two classes
of stock: Class A is redeemable within six months of notice; and Class
B is redeemable within five years notice. Class B is valued at 1.5
times the value of Class A stock. Each FHLB will be required to
maintain minimum capital equal to 5% of equity. Each FHLB, including
our FHLB of San Francisco, submitted capital plans for review and
approval by the Federal Housing Finance Board.
o Voluntary Membership - federally chartered savings associations, such
as the Bank, are no longer required to be members of the system.
o REFCorp Payments - changes the amount paid by the system on debt
incurred in connection with the thrift crisis in the late 1980s from a
fixed amount to 20% of net earnings after deducting certain expenses.
The new capital plan for the FHLB of San Francisco was approved by the
Federal Housing Finance Board on June 12, 2002. The FHLB of San Francisco has
not yet established an implementation date for the new capital plan, with
implementation required by June 2005. The Bank will receive at least 240 days
written notice of the implementation date. The new capital plan incorporates a
single class of stock and requires each member to own stock in an amount equal
to the greater of:
o a membership stock requirement, or
o an activity based stock requirement.
The new capital stock is redeemable on five years written notice, subject
to certain conditions.
We do not believe that the initial implementation of the new capital plan
for the FHLB of San Francisco as approved will have a material impact upon our
financial condition, cash flows, or results of operations. However, to maintain
membership, the Bank could be required to purchase as much as 50% additional
capital stock or sell
16
as much as 50% of its proposed capital stock requirement at the discretion of
the FHLB of San Francisco.
Federal Reserve System. The Federal Reserve requires all depository
institutions to maintain non-interest-bearing reserves at specified levels
against their transaction accounts and non-personal time deposits. These
transaction accounts include checking, NOW and Super NOW checking accounts. The
balances a savings association maintains to meet the reserve requirements
imposed by the Federal Reserve may be used to satisfy the OTS's liquidity
requirements that are imposed by the OTS. At December 31, 2002, the Bank was in
compliance with these requirements.
Proposed Legislation. From time to time, new laws are proposed that could
have an effect on the financial institutions industry. For example, legislation
is currently being considered in the U.S. House of Representatives Financial
Institutions Subcommittee which would:
o merge the Bank Insurance Fund ("BIF") and the SAIF;
o increase the current deposit insurance coverage limit for insured
deposits to $130,000 and index future coverage limits to inflation;
o increase deposit insurance coverage limits for municipal deposits;
o double deposit insurance coverage limits for individual retirement
accounts; and
o smooth out bank deposit insurance premiums to avoid sharp increases
during times of recession.
While we cannot predict whether such proposals will eventually become law, they
could have an effect on our operations and the way we conduct business.
REGULATION OF DSL SERVICE COMPANY
DSL Service Company is licensed as a real estate broker under the
California Real Estate Law and as a contractor with the Contractors State
License Board. Thus, the real estate investment activities of DSL Service
Company, including development, construction and property management activities
relating to its portfolio of projects, are governed by a variety of laws and
regulations. Changes occur frequently in the laws and regulations or their
interpretation by agencies and the courts. DSL Service Company must comply with
various federal, state and local laws, ordinances, rules and regulations
concerning zoning, building design, construction, hazardous waste and similar
matters. Environmental laws and regulations also affect the operations of DSL
Service Company, including regulations pertaining to availability of water,
municipal sewage treatment capacity, land use, protection of endangered species,
population density and preservation of the natural terrain and coastlines. These
and other requirements could become more restrictive in the future, resulting in
additional time and expense in connection with DSL Service Company's real estate
activities.
With regard to environmental matters, the construction products industry is
regulated by federal, state and local laws and regulations pertaining to several
areas including human health and safety and environmental compliance. The
Comprehensive Environmental Response, Compensation and Liability Act of 1980, as
amended by the Superfund Amendments and Reauthorization Act of 1986, as well as
analogous laws in some states, create joint and several liability for the cost
of cleaning up or correcting releases to the environment of designated hazardous
substances. Among those who may be held jointly and severally liable are:
o those who generated the waste;
o those who arranged for disposal;
o those who owned or operated the disposal site or facility at the time
of disposal; and
o current owners.
In general, this liability is imposed in a series of governmental
proceedings initiated by the government's identification of a site for initial
listing as a "Superfund site" on the National Priorities List or a similar state
list and the government's identification of potentially responsible parties who
may be liable for cleanup costs. None of the DSL Service Company's project sites
is listed as a "Superfund site."
In addition, California courts have imposed warranty-like responsibility
upon developers of new housing for defects in structure and the housing site,
including soil conditions. This responsibility is not necessarily dependent upon
a finding that the developer was negligent.
17
As a licensed entity, DSL Service Company is also examined and supervised
by the California Department of Real Estate and the Contractors State License
Board.
TAXATION
Federal. Savings institutions are taxed like other corporations for federal
income tax purposes, and are required to comply with income tax statutes and
regulations similar to those applicable to large commercial banks. The Bank's
bad debt deduction is determined under the specific charge-off method, which
allows the Bank to take an income tax deduction for loans determined to be
wholly or partially worthless.
In addition to the regular income tax, corporations are also subject to an
alternative minimum tax. This tax is computed at 20% of the corporation's
regular taxable income, after taking certain adjustments into account. The
alternative minimum tax applies to the extent that it exceeds the regular income
tax liability.
A corporation that incurs alternative minimum tax generally is entitled to
take this tax as a credit against its regular tax liability in later years to
the extent that the regular tax liability in these later years exceeds the
alternative minimum tax.
State. The Bank uses California's financial corporation income tax rate to
compute its California franchise tax liability. This rate is higher than the
California non-financial corporation income tax rate because the financial
corporation rate reflects an amount "in lieu" of local personal property and
business license taxes that are paid by non-financial corporations, but not by
banks or other financial corporations. The financial corporation income tax rate
was 10.84% for both 2002 and 2001.
The Bank files a California franchise tax return on a combined reporting
basis. Other income and franchise tax returns are filed on a separate-entity
basis in various other states. The Bank anticipates that additional state income
and franchise tax returns will be required in future years as its lending
business expands nationwide.
The Internal Revenue Service and various state taxing authorities have
examined the Bank's tax returns for all tax years through 1997. Management
believes it has adequately provided for potential exposure to issues that may be
raised by tax auditors in the years subsequent to 1997, which remain open to
review.
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
In addition to the other information contained in this report, the
following risks may affect us. If any of these risks occur, our business,
financial condition or operating results could be adversely affected.
OUR CALIFORNIA BUSINESS FOCUS AND ECONOMIC CONDITIONS IN CALIFORNIA COULD
ADVERSELY AFFECT OUR OPERATIONS.
Downey is headquartered in and its operations are concentrated in
California. As a result of this geographic concentration, our results depend
largely upon economic and business conditions in this state. The economy in our
market areas has exhibited weakness. Deterioration of economic conditions in
California could have a material adverse impact on the quality of our loan and
real estate portfolios and the demand for our products and services.
SIGNIFICANT CHANGES IN INTEREST RATES COULD ADVERSELY AFFECT OUR
PERFORMANCE AND RESULTS OF OPERATIONS.
If interest rates vary substantially from present levels, our results may
differ materially from recent levels. Changes in interest rates will influence
the growth of loans, investments and deposits and affect the rates received on
loans and investment securities and paid on deposits. Changes in interest rates
also affect the value of our recorded mortgage servicing rights on loans we
service for others, generally increasing in value as interest rates rise and
declining as interest rates fall. If interest rates were to increase
significantly, the economic feasibility of real estate investment activities
also could be adversely affected.
WE ARE SUBJECT TO GOVERNMENT REGULATION AND FEDERAL MONETARY POLICY THAT
COULD LIMIT OR RESTRICT OUR ACTIVITIES, WHICH COULD ADVERSELY AFFECT OUR
OPERATIONS.
The financial services industry is subject to extensive federal and state
supervision and regulation. Significant new laws or changes in, or repeals of,
existing laws may cause our results to differ materially. Further,
18
federal monetary policy, particularly as implemented through the Federal Reserve
System, significantly affects credit conditions for Downey, primarily through
open market operations in United States government securities, the discount rate
for borrowings and reserve requirements. A material change in these conditions
would be likely to have a material impact on our results.
COMPETITION MAY ADVERSELY AFFECT OUR PERFORMANCE.
The banking and financial services business in our market areas is highly
competitive. The increasingly competitive environment is a result primarily of
changes in regulation, changes in technology and product delivery systems, and
the expectation of continued consolidation among financial services providers.
Increasing levels of competition in the banking and financial services
businesses may reduce our market share or cause the prices we charge for our
products to decline. Our results may differ in future periods depending on the
nature or level of competition.
IF A SIGNIFICANT NUMBER OF BORROWERS, GUARANTORS AND RELATED PARTIES FAIL
TO PERFORM AS REQUIRED BY THE TERMS OF THEIR LOANS, WE WILL SUSTAIN LOSSES.
A significant source of risk arises from the possibility that losses will
be sustained because borrowers, guarantors and related parties may fail to
perform in accordance with the terms of their loans. While we have adopted
underwriting and loan quality monitoring systems, procedures and credit
policies, including the establishment and review of the allowance for loan
losses, such policies and procedures, may not prevent unexpected losses that
could materially affect our results.
BECAUSE DOWNEY OPERATES AS A HOLDING COMPANY, CHANGES IN THE ABILITY OF THE
BANK TO PAY DIVIDENDS MAY ADVERSELY AFFECT DOWNEY'S ABILITY TO PAY DIVIDENDS.
Although we have been paying regular quarterly dividends, our ability to
pay dividends to our stockholders depends to a large extent upon the dividends
we receive from the Bank. Dividends paid by the Bank are subject to restrictions
under various federal and state banking laws. In addition, the Bank must
maintain certain capital levels, which may restrict the ability of the Bank to
pay dividends to us. The Bank's regulators have the authority to prohibit the
Bank or us from engaging in unsafe or unsound practices in conducting our
business. As a consequence, the Bank regulators could deem the payment of
dividends by the Bank to be an unsafe or unsound practice, depending on the
Bank's financial condition or otherwise, and prohibit such payments. If the Bank
were unable to pay dividends to us, we might cease paying or reduce the rate or
frequency at which we pay dividends to stockholders until such time that the
Bank could again pay us dividends.
TERRORIST ACTIVITIES COULD CAUSE REDUCTIONS IN INVESTOR CONFIDENCE AND
SUBSTANTIAL VOLATILITY IN REAL ESTATE AND SECURITIES MARKETS.
It is impossible to predict the extent to which terrorist activities may
occur in the United States or, if they occur, the extent of the effect on a
particular security issue. Moreover, it is uncertain what effects any past or
future terrorist activities and/or any consequent actions on the part of the
United States Government and others will have on the United States and world
financial markets; local, regional and national economies; real estate markets
across the United States; and/or particular business segments. Among other
things, reduced investor confidence could result in substantial volatility in
securities markets, a decline in real estate related investments and in increase
in defaults on loans. Such unexpected losses could materially affect our results
of operations.
19
ITEM 2. PROPERTIES
BRANCHES
The corporate offices of Downey, the Bank and DSL Service Company are
located at 3501 Jamboree Road, Newport Beach, California 92660. Part of that
corporate facility houses a branch office of the Bank. Certain departments
(warehousing, record retention, etc.) are located in other owned and leased
facilities in Orange County, California. The majority of our administrative
operations, however, are located in our corporate headquarters.
At December 31, 2002, we had 165 branches. We owned the building and land
occupied by 61 of our branches and we owned one branch building on leased land.
We operate branches in 103 locations (including 93 in-store locations) with
leases or licenses expiring at various dates through August 2011, with options
to extend the term.
The net book value of our owned branches, including the one on leased land,
totaled $84 million at December 31, 2002, and the net book value of our leased
branch offices totaled $4 million at December 31, 2002. The net book value of
our furniture and fixtures, including electronic data processing equipment, was
$26 million at December 31, 2002.
For additional information regarding our offices and equipment, see Note 1
on page 72 and Note 8 on page 88 of Notes to Consolidated Financial Statements.
ELECTRONIC DATA PROCESSING
We utilize a mainframe computer system and use various internally developed
and third-party vendors' software for retail deposit operations, loan servicing,
accounting and loan origination functions, including our operations conducted
over the Internet. The net book value of our electronic data processing
equipment, including personal computers and software, was $12 million at
December 31, 2002.
ITEM 3. LEGAL PROCEEDINGS
We have been named as a defendant in legal actions arising in the ordinary
course of business, none of which, in the opinion of management, is material.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to shareholders during the fourth quarter of
2002.
20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange ("NYSE") and the
Pacific Exchange ("PCX") under the trading symbol "DSL." At February 28, 2003,
we had approximately 725 stockholders of record (not including the number of
persons or entities holding stock in nominee or street name through various
brokerage firms) and 27,928,722 outstanding shares of common stock.
The following table sets forth for the quarters indicated the range of high
and low sale prices per share of our common stock as reported on the NYSE
Composite Tape.
2002 2001
-----------------------------------------------------------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
- -------------------------------------------------------------------------------------------------------
High ........ $ 41.55 $ 49.25 $ 55.56 $ 48.83 $ 44.46 $ 58.81 $ 48.85 $ 54.31
Low ......... 31.32 33.34 46.70 41.84 32.98 40.61 41.44 39.45
End of period 39.00 34.25 47.30 45.60 41.25 44.13 47.26 45.30
=======================================================================================================
During 2002 and 2001, we paid quarterly cash dividends of $0.09 per share,
or $0.36 per share annually. Total cash dividends were $10.1 million in 2002 and
$10.2 million in 2001. On February 21, 2003, we paid a $0.09 per share quarterly
cash dividend, aggregating $2.5 million.
We may pay additional dividends out of funds legally available therefor at
such times as the Board of Directors determines that dividend payments are
appropriate. The Board of Directors' policy is to consider the declaration of
dividends on a quarterly basis.
The payment of dividends by the Bank to Downey is subject to OTS
regulations. For further information regarding these regulations, see
Business--Regulation--Regulation of the Bank--Capital Distribution Limitations
on page 14.
21
ITEM 6. SELECTED FINANCIAL DATA
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT DATA
Total interest income .......................................... $ 633,038 $ 808,381 $ 784,360 $ 533,751 $ 440,404
Total interest expense ......................................... 317,640 502,811 521,885 326,273 266,057
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income ........................................ 315,398 305,570 262,475 207,478 174,347
Provision for loan losses ...................................... 939 2,564 3,251 11,270 3,899
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses ........ 314,459 303,006 259,224 196,208 170,448
- ------------------------------------------------------------------------------------------------------------------------------------
Other income, net:
Loan and deposit related fees .............................. 47,220 50,486 30,089 20,097 15,645
Real estate and joint ventures held for investment, net .... 10,250 3,885 8,798 19,302 22,363
Secondary marketing activities:
Loan servicing income (loss), net ........................ (39,629) (11,373) (3,628) 1,672 259
Net gains on sales of loans and mortgage-backed securities 45,860 22,432 3,297 14,806 6,462
Net gains on sales of mortgage servicing rights .......... 331 934 -- -- --
Net gains (losses) on sales of investment securities ....... 219 329 (106) 288 68
Gain on sale of subsidiary (1) ............................. -- -- 9,762 -- --
Other ...................................................... 2,431 1,843 2,342 3,113 2,556
- ------------------------------------------------------------------------------------------------------------------------------------
Total other income, net .................................. 66,682 68,536 50,554 59,278 47,353
- ------------------------------------------------------------------------------------------------------------------------------------
Operating expense:
General and administrative expense ......................... 186,644 162,496 136,189 144,382 115,890
Net operation of real estate acquired in settlement of loans 11 239 818 19 260
Amortization of excess cost over fair value of branch
acquisitions (2) ......................................... -- 457 462 474 510
- ------------------------------------------------------------------------------------------------------------------------------------
Total operating expense .................................. 186,655 163,192 137,469 144,875 116,660
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (1) ................................................. $ 112,293 $ 120,181 $ 99,251 $ 63,804 $ 57,973
PER SHARE DATA
Earnings per share--Basic (1) .................................. $ 3.99 $ 4.26 $ 3.52 $ 2.27 $ 2.06
Earnings per share--Diluted (1) ................................ 3.99 4.25 3.51 2.26 2.05
Book value per share at end of period .......................... 29.47 26.01 22.15 18.91 17.08
Stock price at end of period ................................... 39.00 41.25 55.00 20.19 25.44
Cash dividends paid ............................................ 0.36 0.36 0.36 0.35 0.32
SELECTED FINANCIAL RATIOS
Effective interest rate spread ................................. 2.91% 2.91% 2.66% 2.88% 3.08%
Efficiency ratio (3) ........................................... 50.23 43.93 46.23 58.41 58.16
Return on average assets (1) ................................... 1.00 1.11 0.97 0.85 0.98
Return on average equity (1) ................................... 14.42 17.81 17.17 12.70 12.71
Dividend payout ratio .......................................... 9.02 8.45 10.22 15.44 15.33
LOAN ACTIVITY
Loans originated ............................................... $10,445,978 $ 8,128,285 $ 5,218,368 $ 7,132,486 $4,071,262
Loans and mortgage-backed securities purchased ................. 1,497,645 216,214 18,828 49,669 7,463
Loans and mortgage-backed securities sold ...................... 7,103,861 4,553,944 1,662,600 2,386,958 1,740,416
BALANCE SHEET SUMMARY (END OF PERIOD)
Total assets ................................................... $11,978,151 $11,105,030 $10,893,863 $ 9,407,540 $6,270,419
Loans and mortgage-backed securities ........................... 10,976,942 10,132,413 10,084,353 8,746,063 5,788,365
Investments, cash and cash equivalents ......................... 590,092 551,823 439,968 299,698 215,086
Deposits ....................................................... 9,238,350 8,619,566 8,082,689 6,562,761 5,039,733
Borrowings ..................................................... 1,624,084 1,522,712 1,978,572 2,122,780 703,720
Capital securities ............................................. 120,000 120,000 120,000 120,000 --
Stockholders' equity ........................................... 823,104 733,896 624,636 532,418 480,566
Loans serviced for others ...................................... 8,316,236 5,805,811 3,964,462 2,923,778 1,040,264
AVERAGE BALANCE SHEET DATA
Assets ......................................................... $11,230,354 $10,850,683 $10,217,371 $ 7,501,228 $5,918,507
Loans .......................................................... 10,336,951 10,033,155 9,514,978 6,937,342 5,345,380
Deposits ....................................................... 8,768,204 8,701,424 7,290,850 5,697,292 5,102,045
Stockholders' equity ........................................... 778,463 674,972 577,979 502,412 456,237
22
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------------------------------------------------------
CAPITAL RATIOS
Average stockholders' equity to average assets ................. 6.93% 6.22% 5.66% 6.70% 7.71%
Bank only--end of period (4):
Core and tangible capital .................................. 6.92 7.10 6.42 6.27 6.83
Risk-based capital ......................................... 14.08 14.53 12.94 12.14 12.88
SELECTED ASSET QUALITY DATA (END OF PERIOD)
Total non-performing assets .................................... $79,814 $ 92,632 $ 54,974 $ 39,194 $ 27,419
Non-performing assets as a percentage of total assets .......... 0.67% 0.83% 0.50% 0.42% 0.44%
Allowance for loan losses:
Amount ..................................................... $34,999 $ 36,120 $ 34,452 $ 38,342 $ 31,517
As a percentage of non-performing loans .................... 51.89% 46.76% 76.63% 116.25% 140.86%
====================================================================================================================================
(1) In 2000, a $5.6 million after-tax gain was recognized from the sale of
Downey Auto Finance Corp. Excluding the gain, 2000 net income would have
been $93.6 million or $3.33 per share on a basic basis and $3.32 per share
on a diluted basis, the return on average assets would have been 0.92% and
the return on average equity would have been 16.20%.
(2) During the fourth quarter of 2002, we adopted SFAS 147, which required us
to cease the amortization of goodwill as of January 1, 2002.
(3) The amount of general and administrative expense incurred for each $1 of
net interest income plus other income, except for income associated with
real estate held for investment and securities gains or losses.
(4) For more information regarding these ratios, see Management's Discussion
and Analysis of Financial Condition and Results of Operations--Financial
Condition--Regulatory Capital Compliance on page 61.
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements under this caption constitute "forward-looking
statements" under the Private Securities Litigation Reform Act of 1995 which
involve risks and uncertainties. Our actual results may differ significantly
from the results discussed in such forward-looking statements. Factors that
might cause such a difference include, but are not limited to, economic
conditions, competition in the geographic and business areas in which we conduct
our operations, fluctuations in interest rates, credit quality and government
regulation. For additional information concerning these factors, see
Business--Factors That May Affect Future Results Of Operations on page 18.
OVERVIEW
Our net income for 2002 totaled $112.3 million or $3.99 per share on a
diluted basis, down from last year's record of $120.2 million or $4.25 per
share, but second highest in Downey's history. During the year, we repurchased
306,300 shares of common stock at an average price per share of $39.73, leaving
$38 million of the $50 million authorization available for future share
repurchases.
The decline in our net income between years reflected lower net income from
our banking operations, as net income from our real estate operations increased
$5.5 million to $6.2 million due primarily to higher gains from sales and lower
operating expense. Net income from our banking operations totaled $106.1
million, down $13.4 million due to the following:
o a $28.3 million higher loss from loan servicing due primarily to
higher provisions to the valuation allowance for mortgage servicing
rights reflecting the continued decline in market interest rates that
increased the actual and expected rate of prepayments on loans we
service for others;
o a $26.3 million increase in operating expense due to higher costs
associated with the increased number of branch locations and higher
loan origination activity; and
o a $7.3 million decline in loan related fees due to lower prepayment
fees.
Those unfavorable items were partially offset by the following:
o a $23.4 million increase in net gains on sales of loans and
mortgage-backed securities due to a record volume of sales and the
favorable impact from the SFAS 133 valuation of derivatives associated
with the sale of loans;
o a $9.8 million increase in net interest income due to higher
interest-earning assets;
o a $4.1 million increase in deposit related fees; and
o a $1.6 million decline in provision for loan losses.
For 2002, our return on average assets was 1.00% and our return on average
equity was 14.42%. These compare to our 2001 returns of 1.11% on average assets
and 17.81% on average equity.
Our single family loan originations increased from $8.0 billion in 2001 to
a record $10.7 billion in 2002, of which $6.2 billion were originated for sale
in the secondary market. Of the 2002 total, $4.5 billion represented
originations of loans for portfolio, of which $520 million were subprime
credits. In addition to single family loans, we originated $269 million of other
loans during the year, including $181 million of construction and land loans.
Our assets increased $873 million or 7.9% during 2002 to $12.0 billion at
year end, following a 1.9% increase during 2001. We primarily funded our asset
growth with deposits that increased $619 million or 7.2% to a record year-end
level of $9.2 billion at December 31, 2002.
Non-performing assets totaled $80 million at December 31, 2002, down from
$93 million a year ago. The decrease was due primarily to a decline in our
residential non-performers. When measured as a percentage of total assets, our
non-performing assets dropped from 0.83% at year-end 2001 to 0.67% at year-end
2002.
24
At December 31, 2002, the Bank exceeded all regulatory capital tests, with
capital-to-asset ratios of 6.92% for both tangible and core capital and 14.08%
for risk-based capital. These capital levels are significantly above the "well
capitalized" standards defined by the federal banking regulators of 5% for core
and tangible capital and 10% for risk-based capital. For further information,
see Business--Regulation--Regulation of the Bank--Insurance of Deposit Accounts
on page 11, Financial Condition--Investments in Real Estate and Joint Ventures
on page 39 and Financial Condition--Regulatory Capital Compliance on page 61.
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 the Notes to the Consolidated Financial
Statements beginning on page 72. 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 53 and
Note 1 of Notes to the Consolidated Financial Statements on page 72.
o Valuation of mortgage servicing rights. For further information, see
Note 1 on page 72 and Note 10 on page 89 of Notes to the Consolidated
Financial Statements.
o Valuation of expected rate lock commitments. For further information,
see Note 1 on page 72 and Note 20 on page 101 of Notes to the
Consolidated Financial Statements.
25
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 $315.4 million in 2002, up $9.8 million or
3.2% from 2001 and $52.9 million or 20.2% greater than 2000. The improvement
during 2002 reflected higher interest-earning assets, as our effective interest
rate spread was unchanged. Our average interest-earning assets increased by $343
million or 3.3% to $10.8 billion. Our effective interest rate spread averaged
2.91% in both 2002 and 2001, up from 2.66% in 2000.
The following table presents for the years 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