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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from
_______________ to _______________.
Commission File Number 1-13578
DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
Delaware 95-1953342
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
3501 Jamboree Road 92660
Newport Beach, California (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (714) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
Common Stock, $0.01 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by a check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
The aggregate market value of the voting stock held by non-affiliates
of the registrant, based upon the closing sale price of its Common Stock on
February 27, 1998, on the New York Stock Exchange was $594,033,102.
At February 27, 1998, 26,755,938 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 22, 1998 are incorporated by reference in Part III
hereof.
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DOWNEY FINANCIAL CORP.
1997 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
ITEM 1. BUSINESS....................................................... 1
General....................................................... 1
Lending Activities............................................ 2
Loan and Mortgage-Backed Securities Portfolio................ 2
Residential Real Estate Lending.............................. 3
Secondary Marketing and Loan Servicing Activities............ 4
Commercial Real Estate and Multi-Family Lending.............. 5
Construction Lending......................................... 5
Commercial Lending........................................... 5
Consumer Lending............................................. 5
Investment Activities......................................... 6
Real Estate Investments....................................... 6
Sources of Funds.............................................. 6
Deposits..................................................... 6
Borrowings................................................... 7
Asset/Liability Management.................................... 7
Earnings Spread............................................... 7
Competition................................................... 8
Employees..................................................... 8
Regulation.................................................... 9
General...................................................... 9
Regulation of Downey......................................... 9
Regulation of the Bank....................................... 9
Taxation...................................................... 13
Factors That May Affect Future Results........................ 14
ITEM 2. PROPERTIES..................................................... 16
Branches...................................................... 16
Electronic Data Processing.................................... 16
ITEM 3. LEGAL PROCEEDINGS.............................................. 16
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS................ 16
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS........................................... 17
ITEM 6. SELECTED FINANCIAL DATA........................................ 18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS..................................... 19
Overview...................................................... 19
Results of Operations......................................... 20
Net Interest Income.......................................... 20
Provision for Loan Losses.................................... 21
Other Income................................................. 21
Loan and Deposit Related Fees............................... 21
Real Estate and Joint Venture Operations Held for Investment 22
Secondary Marketing Activities ............................. 22
Net Gains (Losses) on Sales of Investment Securities........ 22
Provision for Loss on Investment in Lease Residual.......... 22
Other Category.............................................. 22
Operating Expenses........................................... 23
Provision for Income Taxes................................... 23
Financial Condition........................................... 24
Loans and Mortgage-Backed Securities......................... 24
Investment Securities........................................ 27
Investments in Real Estate and Joint Ventures................ 28
Deposits..................................................... 30
Borrowings................................................... 31
Asset/Liability Management and Market Risk................... 31
Problem Loans and Real Estate................................ 36
Non-Performing Assets....................................... 36
Delinquent Loans............................................ 38
Allowance for Losses on Loans and Real Estate............... 40
Capital Resources and Liquidity.............................. 43
Regulatory Capital Compliance................................ 44
Current Accounting Issue..................................... 44
Year 2000.................................................... 45
ITEM 8. FINANCIAL STATEMENTS........................................... 46
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES..................................... 88
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............. 88
ITEM 11. EXECUTIVE COMPENSATION......................................... 88
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.................................................... 88
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................. 88
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K................................................... 88
SIGNATURES............................................................... 90
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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 (the "Reform Act") and, as such, may involve risks
and uncertainties. These forward-looking statements relate to, among other
things, expectations of the business environment in which Downey Financial Corp.
("Downey") 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 "Item 1. Business - Factors That May Affect Future Results" on
page 14.
ITEM 1. BUSINESS
GENERAL
Downey was incorporated in Delaware on October 21, 1994. On January 23,
1995, after obtaining necessary stockholder and regulatory approvals, Downey
acquired 100% of the issued and outstanding capital stock of Downey Savings and
Loan Association (the "Bank"), and the Bank's stockholders became the
stockholders of Downey. Downey was thereafter capitalized by the Bank and
presently operates as the Bank's holding company.
The Bank was formed in 1957 as a California-licensed savings and loan
association and conducts its business through 86 retail deposit branches (26 of
which are full-service in-store branches). Residential loans are originated by
retail loan officers who are located in 20 retail deposit branches providing
loan origination services to all the Bank's branches. Wholesale loans submitted
by mortgage brokers are originated from five loan origination centers in
California, three of which are located in or adjacent to a Bank office. The
executive offices of Downey are located at 3501 Jamboree Road, North Tower,
Newport Beach, California, 92660, and the telephone number is (714) 854-0300.
Downey's stock is traded on the New York Stock Exchange and Pacific Exchange
under trading symbol "DSL." Unless otherwise stated or indicated, references to
"Downey" or the "Bank" include their respective subsidiaries.
On March 9, 1995, the Bank completed its conversion from a
California-licensed to a federally chartered savings association and currently
operates under the name "Downey Savings and Loan Association, F.A." As a
federally chartered savings association, the Bank's activities and investments
are generally governed by the Home Owners' Loan Act, as amended ("HOLA"), and
implementing regulations and policies of the Office of Thrift Supervision (the
"OTS"). The Bank and Downey are subject to the primary regulatory and
supervisory jurisdiction of the OTS. As a federally insured depository
institution, the Bank is also subject to regulation and supervision by the
Federal Deposit Insurance Corporation ("FDIC") with respect to certain
activities and investments. The Bank is a member of the Federal Home Loan Bank
("FHLB") of San Francisco, which is one of the 12 regional banks for federally
insured depository institutions comprising the Federal Home Loan Bank System.
The Bank's savings deposits are insured through the Savings Association
Insurance Fund ("SAIF") of the FDIC, an instrumentality of the United States
government. The Bank is further subject to regulations of the Board of Governors
of the Federal Reserve System ("Federal Reserve Board") with respect to reserves
required to be maintained against deposits and certain other matters.
On January 25, 1995, Downey Affiliated Insurance Agency was incorporated as
a wholly owned subsidiary of Downey and was capitalized on February 24, 1995,
with $400,000. Operations commenced in the second quarter of 1995 at which time
representatives of Downey Affiliated Insurance Agency were available in Downey's
branches to offer annuity products. During 1996, Downey Affiliated Insurance
Agency began offering forced-placed casualty insurance policies on mortgage
loans and ceased offering annuity products.
Downey's principal business is attracting funds from the general public and
institutions, and originating and investing in loans, primarily residential real
estate mortgage loans, mortgage-backed securities ("MBSs"), and investment
securities. MBSs include securities issued or guaranteed by government-sponsored
enterprises ("Agency MBSs"), such as the Federal National Mortgage Association
("FNMA"), the Federal Home Loan Mortgage Corporation ("FHLMC") and the
Government National Mortgage Association ("GNMA"), and mortgage pass-through
securities issued by other entities. Downey's primary sources of revenue are
interest earned on mortgage loans and MBSs, income from investment securities,
gains on sales of loans and MBSs, fees earned in connection with loans and
deposits and income earned on its portfolio of loans and MBSs serviced for
investors. Downey's principal expenses are interest incurred on interest-bearing
liabilities,
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including deposits and borrowings, and general and administrative costs.
Downey's primary sources of funds are deposits, principal and interest payments
on loans and MBSs, proceeds from sales of loans and MBSs, and borrowings.
Scheduled payments on loans and MBSs are a relatively stable source of funds,
while prepayments of loans and MBSs and flows in deposits vary widely.
Prior to 1989, the Bank conducted substantial commercial and residential
real estate development and investment activities, primarily retail neighborhood
shopping centers located in California, principally through its subsidiary, DSL
Service Company, an active wholly owned real estate subsidiary of the Bank.
Since the passage in August 1989 of the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 ("FIRREA"), the Bank's ability to engage in new real
estate development activities and retain existing real estate investments has
been curtailed dramatically, and such activities may be economically unfeasible
for the Bank because of the capital requirements for such activities. Since
FIRREA, the Bank has been engaged in significant efforts to reduce its real
estate investments and is now within allowable limits for its investment in DSL
Service Company and other equity investments.
Downey's operations are significantly influenced by general economic
conditions, the monetary and fiscal policies of the federal government and the
regulatory policies of governmental authorities. Deposit flows and the cost of
interest-bearing liabilities ("cost of funds") to Downey are influenced by
interest rates on competing investments and general market interest rates.
Similarly, Downey's loan volume and yields on loans and MBSs, and the level of
prepayments on such loans and MBSs, are affected by market interest rates, as
well as additional factors affecting the supply of and demand for housing and
the availability of funds.
LENDING ACTIVITIES
Historically, Downey's lending activities have emphasized the origination
of first mortgage loans secured by residential property and retail neighborhood
shopping centers, and, to a lesser extent, real estate loans secured by
multi-family and commercial and industrial properties, including office
buildings, land and other properties with income producing capabilities. In
addition, Downey has provided construction loan financing for residential (both
single family and multi-family) and commercial retail neighborhood shopping
center projects, including loans to joint ventures where DSL Service Company or
the Bank was a participant. Downey also originates loans to businesses through
its commercial banking operations and loans on new and used automobiles through
the purchase of motor vehicle sales contracts from auto dealers in California
and other western states. The indirect auto lending program is in addition to
automobile loans originated directly through Downey's branch network.
During 1998, Downey's primary focus will continue to be the origination of
adjustable rate single family mortgage loans, particularly subprime loans which
carry higher interest rates, and consumer loans. In addition, Downey will
continue its secondary marketing activities of selling its production of certain
fixed rate single family loans as well as certain adjustable rate mortgage
("ARM") loan products. See "Lending Activities - Secondary Marketing and Loan
Servicing Activities" on page 4.
For additional information on the composition of Downey's loan and MBS
portfolio, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Financial Condition - Loans and Mortgage-Backed
Securities" on page 24.
Loan and Mortgage-Backed Securities Portfolio
Loans receivable held for investment are carried at cost, adjusted for
amortization of premiums and accretion of discounts which are recognized in
interest income using the interest method. MBSs represent participating
interests in pools of first mortgage loans originated and serviced by the
issuers of the securities. MBSs held to maturity are carried at unpaid principal
balances, adjusted for unamortized premiums and unearned discounts. Premiums and
discounts on MBSs are amortized using the interest method over the remaining
period to contractual maturity, adjusted for anticipated prepayments.
Downey identifies those loans which foreseeably may be sold prior to
maturity. These loans have been classified as held for sale in the Consolidated
Balance Sheets and are recorded at the lower of amortized cost or market value.
Net unrealized losses, if any, are recognized in a valuation allowance by
charges to income.
MBSs available for sale are carried at market value. Net unrealized
gains or losses are excluded from income and reported net of income taxes as a
component of stockholders' equity until realized.
2
Residential mortgage loans originated by Downey typically have contractual
maturities at origination of 15 to 40 years. To limit the interest rate risk
associated with such maturities, Downey, among other things, principally
originates ARMs for its own loan portfolio. Fixed rate loans are primarily
originated for sale in the secondary market on a non-recourse basis for cash.
However, Downey occasionally originates for its own portfolio fixed rate loans
to facilitate the sale of real estate acquired in settlement of loans and which
meet certain yield and other approved guidelines. See "Asset/Liability
Management" on page 7. In addition, the average term of such mortgage loans
historically has been significantly shorter than their contractual maturity due
to loan payoffs as a result of home sales or refinancings and prepayments.
Residential Real Estate Lending
Downey's primary lending activity is the origination of mortgage loans
secured by single family residential properties consisting of one-to-four units
located in California. Such loans are primarily for the purchase of residences
or for the refinancing of existing mortgages at lower rates or upon different
terms. At present, Downey is primarily originating ARMs for its portfolio of
loans held for investment. See "Asset/Liability Management" on page 7. Downey
also originates residential fixed interest rate mortgage loans to meet consumer
demand, but intends to sell the majority of all such loans in the secondary
market, rather than hold such loans in its portfolio. In addition, a small
volume of residential one-to-four unit fixed rate loans are originated for
investment to facilitate the sale of real estate acquired in settlement of loans
and which meet certain yield and other approved guidelines. See "Lending
Activities - Secondary Marketing and Loan Servicing Activities" on page 4.
Downey's ARMs generally begin with an interest rate below the current
market rate ("incentive rate") and adjust to the applicable index plus a defined
spread, subject to periodic and lifetime caps, after one, three or six months.
Downey's ARMs generally provide that the maximum rate that can be charged cannot
exceed the incentive rate by more than six to nine percentage points, depending
on the type of loan and the initial rate offered. The interest rate adjustment
on Downey's ARMs which adjust semi-annually generally is limited to 1% per
adjustment period. With respect to ARMs that adjust monthly, there is a lifetime
interest rate cap, but no specified periodic interest rate adjustment cap.
Instead, monthly adjustment ARMs have a periodic cap on changes in required
monthly payments, which adjust annually. Monthly adjustment ARMs allow for
negative amortization (the addition to loan principal of accrued interest that
exceeds the required monthly loan payments). In the event that a loan incurs
significant negative amortization, there is an increased risk that the market
value of the underlying collateral on the loan would be insufficient to satisfy
fully the outstanding principal and interest. There is a limit on the amount of
negative amortization, such that the principal plus the added amount cannot
exceed 125% of the original loan amount for loans originated prior to July 1994
and 110% of the original loan amount for loans originated thereafter. Downey
permits ARMs to be assumed by qualified borrowers.
During 1997, approximately 21% of Downey's one-to-four unit residential
real estate loans were originated by retail loan representatives of Downey.
Retail loan representatives typically receive loan referrals from real estate
agents, builders, depositors and customers obtained from retail advertising and
other sources. Prior to the fourth quarter of 1997, retail loan representatives
were compensated on a commission basis. Beginning in the 1997 fourth quarter,
the compensation program was changed to a salary plus a fixed amount per loan
originated. The remainder of Downey's one-to-four unit residential real estate
loans were obtained by Downey's wholesale loan representatives but originated
through outside mortgage brokers. Wholesale loan representatives are paid on a
commission basis. Compensation for the services performed by the mortgage broker
is considered in the overall pricing of mortgage loan products. These mortgage
brokers do not operate from Downey's offices and are not employees of Downey.
Downey requires that residential real estate loans be approved at various
levels of management, depending upon the amount of the loan. On a single family
residential loan originated for portfolio, the maximum amount Downey generally
will lend is $1 million. The average loan size, however, is much lower. In 1997,
the average loan size was $237,000. Downey generally makes loans with
loan-to-value ratios (the ratio of the principal amount of the loan to the
appraised value at origination of the property securing the loan) not exceeding
80% (up to 95% for certain loans made pursuant to Downey's low and moderate
income lending program under the Community Reinvestment Act ("CRA")). Downey
will make loans with loan-to-value ratios of over 80%, but not exceeding 97% of
the value of the property, if private mortgage insurance is obtained to reduce
the effective loan-to-value ratio to between 70% to 78%, consistent with
secondary marketing requirements. In addition, Downey requires hazard insurance
for all residential real estate loans covering the lower of the loan amount or
the replacement value of the structure.
In the approval process for the loans it originates or purchases, Downey
assesses both the value of the property securing the loan and the applicant's
ability to repay the loan. Loan underwriters analyze the loan application and
the
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property involved, and qualified staff appraisers or outside appraisers inspect
and appraise the property. All appraisers are approved by Downey's Chief
Appraiser or, with respect to Federal Housing Administration ("FHA") insured
loans, by the FHA. Appraisals performed by approved appraisers are selectively
reviewed by senior staff appraisers or approved fee review appraisers. Downey
also obtains information concerning the income, financial condition, employment
and credit history of the applicant. Typically, Downey will verify credit
information for loans originated by retail loan representatives or other Downey
employees. For loans from mortgage brokers, Downey requires the mortgage broker
to review and verify credit information and employment pursuant to Downey's
origination procedures. In addition, Downey obtains credit information and
performs certain other underwriting tests of such mortgage broker originated
loans. On its ARMs offered with incentive rates, Downey qualifies applicants for
loan programs with no negative amortization at the higher of the initial
incentive rate plus 2% or the fully indexed rate, with a minimum qualifying rate
of 7% for loans having a loan-to-value ratio of 80% or less; and qualifies
applicants at a minimum qualifying rate of 7% for loans having a loan-to-value
ratio of greater than 80%. For loan programs that include negative amortization,
Downey qualifies applicants at the lesser of the initial incentive rate plus 2%
or the fully indexed rate, with a minimum qualifying rate of 6% for loans having
a loan-to-value ratio of 80% or less; and qualifies applicants at a minimum
qualifying rate of 7% for loans having a loan-to-value ratio of greater than
80%.
Late in 1996, Downey began offering one-to-four unit residential loans to
borrowers who have or, in the case of purchases, will have equity in their homes
but whose credit rating contains certain exceptions which preclude them from
qualifying for the best market terms. These lower grade credits ("A-," "B" and
"C" loans), commonly referred to as subprime loans, are characterized by lower
loan-to-value ratios and higher average interest rates than higher credit grade
loans ("A" loans). Downey believes these lower credit grade borrowers represent
an opportunity to earn a higher net return for the risks assumed. Underwriting
guidelines have been developed for each classification of credit.
Secondary Marketing and Loan Servicing Activities
As part of its secondary marketing activities, Downey originates certain
residential real estate ARMs and loans with fixed rates with an intent of
selling such loans. Accordingly, such loans are classified as held for sale and
are carried at the lower of cost or market. These loans are secured by first
liens on one-to-four unit residential properties and have 15- to 30-year
maturities or 30-year amortization periods with balloon payments in five years,
seven years or other maturities. For additional information regarding loans held
for investment and for sale, see Notes 1 and 6 of Notes to the Consolidated
Financial Statements on pages 53 and 62, respectively. Downey utilizes various
hedging programs to manage the interest rate risk of its fixed rate mortgage
origination process. See "Asset/Liability Management" on page 7.
Management of Downey believes 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 inversely
to changes in net interest income. Because ARMs lag market interest rates, net
interest income associated with these loans is expected to decline in periods of
rising interest rates and increase in periods of falling rates. In contrast, the
value of the loan servicing portfolio normally increases as interest rates rise
(and loan prepayments decrease) and declines as interest rates fall (and loan
prepayments increase). In addition, increased levels of servicing activities can
provide additional income with minimal additional overhead costs.
Depending upon market pricing for servicing, loans are sold either
servicing retained or servicing released. When sold servicing retained, Downey
records gains or losses from the sale of loans at the time of sale, which are
determined by the difference between the net sales proceeds and the allocated
basis of the loans sold. Downey adopted, effective January 1, 1997, Statement of
Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities," ("SFAS 125"). In
accordance with SFAS 125, Downey capitalizes mortgage servicing rights ("MSRs")
acquired through either the purchase or origination of mortgage loans for sale
or securitization with servicing rights retained. The total cost of the mortgage
loans designated for sale is allocated to the MSRs and the mortgage loans
without the MSRs based on their relative fair values. MSRs are included in the
financial statements in the category of "other assets." Impairment losses are
recognized through a valuation allowance, with any associated provision recorded
as a component of loan servicing fees. At December 31, 1997, MSRs totaled $2.0
million.
Loans originated for sale may be exchanged with government agencies for
MBSs collateralized by such loans. Downey's cost for the exchange is the payment
of a monthly guaranty fee, which is expressed as a percentage of the unpaid
principal balance and which is deducted from interest income. The securities
received can be used by Downey to collateralize various types of borrowings at
rates which frequently are more favorable than rates on other types of
liabilities and also carry a lower risk-based capital requirement than whole
loans. Such MBSs available for sale are carried at fair
4
value. However, no gain or loss on the exchange is recorded in the statement of
income until the securities are sold to a third party. All changes in fair value
prior to the sale to third parties are shown as a separate component of
stockholders' equity, net of income taxes.
Commercial Real Estate and Multi-Family Lending
Downey has provided permanent loans secured by retail neighborhood shopping
centers and multi-family properties. Downey's commercial real estate lending and
multi-family activities are conducted by Downey's major loan account officers
who are compensated on a salary basis.
Commercial real estate and multi-family loans generally entail additional
risks as compared to single-family residential mortgage lending. Each loan,
including loans to facilitate the sale of real estate owned, is subject to
Downey's underwriting standards, which generally include an evaluation of the
creditworthiness and reputation of the borrower, 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 Downey's loan, Downey requires casualty insurance for the loan
amount or replacement cost. In addition, for non-residential loans in excess of
$500,000, Downey requires the borrower to obtain comprehensive general liability
insurance. All commercial real estate loans originated by Downey require the
approval of at least two officers, one of whom must be the originating loan
account officer and the other a designated officer with appropriate loan
approval authority.
Construction Lending
Downey has provided construction loan financing for residential (both
single family and multi-family) and commercial real estate projects (e.g.,
retail neighborhood shopping centers). Downey originates such loans principally
through its major loan officers. Construction loans generally are made at
floating rates based upon the prime or reference rate of a major commercial
bank. Generally, Downey requires a loan-to-value ratio of 75% or less on
construction lending and subjects each loan to Downey's underwriting standards.
Construction loans involve risks different from completed project lending
because loan funds are advanced upon the security of the project under
construction, and if the loan goes into default, additional funds may have to be
advanced to complete the project before it can be sold. Moreover, construction
projects are subject to uncertainties inherent in estimating construction costs,
potential delays in construction time, market demand and the accuracy of the
estimate of value upon completion. Downey requires the general contractor to,
among other things, carry contractor's liability insurance equal to certain
prescribed minimum amounts, carry builder's risk insurance and have a blanket
bond against employee misappropriation.
Commercial Lending
Downey originates commercial loans and revolving lines of credit, and
issues standby letters of credit for its middle market commercial customers. The
various credit products are offered on both a secured and unsecured basis with
interest rates being either fixed or variable. The portfolio emphasis is toward
secured, floating rate credit facilities. The activities are directed through
the Commercial Banking Group with the focus on long-term-relationship-based
customers. The retail branch network is also utilized as a source of commercial
customers, typically managed by the branch manager. The smaller branch
originated business borrowers are desirable due to their lower cost deposit
accounts which usually accompany the relationship.
Consumer Lending
Downey originates fixed rate automobile loans primarily through an indirect
lending program of Downey Auto Finance Corp. which utilizes preapproved
automobile dealers to finance consumer purchases of new and used automobiles.
This operation is centralized at Downey's headquarters and utilizes technology
to process and evaluate loan applications, including credit scoring and the
automated retrieval of consumer credit bureau files. In addition to indirect
automobile lending through Downey Auto Finance Corp., the Bank originates direct
automobile loans, home equity loans and lines of credit, and other consumer loan
products. Before making a consumer loan, Downey assesses the applicant's ability
to repay the loan and, if applicable, the value of the collateral securing the
loan. The risk involved with home equity loans and lines of credit is similar to
the risk involved with residential real estate loans. Downey offers customers a
credit card through a third party, which extends the credit and services the
loans made to Downey's customers.
5
INVESTMENT ACTIVITIES
Federal and state regulations require the Bank to maintain a specified
minimum amount of liquid assets invested in certain short-term obligations and
other securities. For additional information regarding liquidity requirements
and the Bank's compliance therewith, see "Regulation - Regulation of the Bank -
Liquidity Requirements" on page 13 and "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Capital
Resources and Liquidity" on page 43. As a federally chartered savings
association, the Bank is also permitted to make certain other securities
investments as prescribed under HOLA and OTS regulations. Investment decisions
are made by authorized officers of the Bank within guidelines established by the
Bank's Board of Directors. Such investments are managed in an effort to produce
the highest yield consistent with maintaining safety of principal, minimization
of interest rate risk and compliance with applicable regulations. Securities
held for investment are carried at cost, adjusted for amortization of premiums
and accretion of discounts which are recognized as interest income using the
interest method. For further information on the composition of Downey's
investment portfolio, see "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Financial Condition - Investment
Securities" on page 27.
REAL ESTATE INVESTMENTS
Historically, real estate development and joint venture operations have
been a significant part of Downey's business activities. These operations have
been conducted principally through the Bank's wholly owned service corporation
subsidiary, DSL Service Company. The Bank also engaged in these activities
directly, to a limited extent, but no longer has any such investments. Since the
passage in August 1989 of FIRREA, the ability to engage in new real estate
development and joint venture activities and to retain existing real estate
investments has been curtailed dramatically, and such activities may be
economically unfeasible for the Bank because of the capital requirements imposed
on such activities. FIRREA requires, with certain limited exceptions, a savings
institution such as the Bank to exclude from its regulatory capital its
investments in, and extensions of credit to, real estate subsidiaries such as
DSL Service Company, as well as its direct equity investments, and prohibits new
direct equity investments in real estate by the Bank. Since July 1, 1996, the
Bank has been 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, such as DSL Service Company, to the extent of
2% of 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 an association to such subsidiaries and their joint
venture investments are limited to 50% of 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. Downey is in compliance with each of these investment limitations.
To the extent real estate investments are made by Downey or a subsidiary of
Downey other than the Bank or its subsidiaries, the above-mentioned capital
deductions and limitations do not apply as they only pertain to such 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 28.
SOURCES OF FUNDS
Deposits
Downey prefers to use deposits as the principal source of funds for
supporting its lending activities, because the cost of these funds generally is
less than that of borrowings or other funding sources with comparable
maturities. Downey's savings deposits traditionally have been obtained primarily
from the areas in Southern and Northern California surrounding the Bank's branch
offices. However, Downey also occasionally raises certain retail deposits
through Wall Street activities.
Deposit flows are affected by general economic conditions. Funds may flow
from depository institutions such as savings associations into direct vehicles
such as government and corporate securities or other financial intermediaries.
The ability of Downey to attract and retain deposits will continue to be
affected by money market conditions and prevailing interest rates. Generally,
rates set by Downey are not restricted by state or federal regulation.
6
In 1996, Downey began establishing full-service branch facilities in
selected market locations throughout Southern California. Each in-store branch
offers a full range of financial services including checking and savings
accounts as well as residential and consumer loans.
When consistent with the maintenance of appropriate capital levels, Downey
may consider opportunities to augment its retail branch system and deposit base
through selected branch or deposit acquisitions.
For further information, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Deposits"
on page 30.
Borrowings
Downey's principal source of funds has been and continues to be deposits
raised through its retail branch system. At various times, however, Downey has
utilized other sources to fund its loan origination and other business
activities. Downey has from time to time relied upon borrowings from the FHLB of
San Francisco as an additional source of funds. Advances are made pursuant to
several different credit programs offered by the FHLB.
In 1994, Downey initiated a program to sell commercial paper supported by
an irrevocable letter of credit issued by the FHLB of San Francisco. At December
31, 1997, the irrevocable FHLB letter of credit was $300 million. The commercial
paper provides Downey with an alternative funding source to fund asset growth in
a cost effective manner.
From time to time, Downey utilizes securities and mortgage loans sold under
agreements to repurchase as additional sources of funds. These reverse
repurchase agreements are generally short term, and are collateralized by
mortgage-backed or investment securities and mortgage loans. Downey only deals
with investment banking firms which are recognized as primary dealers in U.S.
government securities or major commercial banks in connection with such reverse
repurchase agreements. In addition, Downey limits the amounts of 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 31.
ASSET/LIABILITY MANAGEMENT
Savings institutions are subject to interest rate risks to the degree that
their interest-bearing liabilities, consisting principally of customer deposits,
FHLB advances and other borrowings, mature or reprice more rapidly, or 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, such an asset/liability structure may result in
declining net earnings during periods of rising interest rates. A principal
objective of Downey is to manage the effects of adverse changes in interest
rates on Downey's interest income while maintaining asset quality and an
acceptable interest rate spread. To improve the rate sensitivity and maturity
balance of its interest-earning assets and liabilities, Downey has over the past
several years 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 Downey's assets to increase during
periods of rising interest rates, although such 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 31.
EARNINGS SPREAD
Downey's net interest income is determined by the difference (the "interest
rate spread") between the yields earned by Downey on its loans, MBSs and
investment securities ("interest-earning assets") and the interest rates paid by
Downey on its deposits and borrowings ("interest-bearing liabilities"), as well
as the relative dollar amounts of Downey's interest-earning assets and
interest-bearing liabilities.
The effective interest rate spread, which reflects the relative level of
interest-earning assets to interest-bearing liabilities, equals (i) the
difference between interest income on interest-earning assets and interest
expense on interest-bearing
7
liabilities, (ii) divided by average interest-earning assets for the period. For
information regarding net income and the components thereof and for management's
analysis of financial condition and results of operations, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
beginning on page 19. For returns on assets and other selected financial data
see "Selected Financial Data" on page 18.
COMPETITION
Downey faces competition both in attracting deposits and in making real
estate loans and other loans. Its most direct competition for deposits has
historically come from other savings institutions and from commercial banks
located in its principal market areas, including many large financial
institutions based in other parts of the country or their subsidiaries. In
addition, there is additional significant competition for investors' funds from
short-term money market securities and other corporate and government
securities. The ability of Downey to attract and retain savings deposits
depends, generally, on its 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.
Downey experiences competition for real estate loans principally from other
savings institutions, commercial banks, mortgage banking companies and insurance
companies. Downey competes for loans principally through the interest rates and
loan fees it charges and the efficiency and quality of services it provides
borrowers and real estate brokers.
EMPLOYEES
At December 31, 1997, Downey had approximately 908 full-time employees and
377 part-time employees. Downey provides its employees with certain health and
welfare benefits and a retirement and savings plan. Additionally, Downey offers
qualifying employees participation in a stock purchase plan. See Notes 19 and 21
of Notes to the Consolidated Financial Statements on pages 77 and 79, for a
further discussion of employee benefit plans. Employees are not represented by
any union or collective bargaining group, and Downey considers its employee
relations to be good.
REGULATION
General
Savings and loan holding companies and savings associations are extensively
regulated under both federal and state law. This regulation is intended
primarily for the protection of depositors and the SAIF and not for the benefit
of stockholders of Downey. The following information describes certain aspects
of that regulation applicable to Downey and the Bank, and does not purport to be
complete. The discussion is qualified in its entirety by reference to applicable
statutory or regulatory provisions.
Regulation of Downey
General. Downey is a unitary savings and loan holding company subject to
regulatory oversight by the OTS. As such, Downey is required to register and
file reports with the OTS and is subject to regulation and examination by the
OTS. In addition, the OTS has enforcement authority over Downey and its
subsidiaries, which also permits the OTS to restrict or prohibit activities that
are determined to be a serious risk to the subsidiary savings association.
Activities Restrictions. As a unitary savings and loan holding company,
Downey generally is not subject to activity restrictions, provided the Bank
satisfies the Qualified Thrift Lender ("QTL") test or meets the definition of
domestic building and loan association pursuant to section 7701 of the Internal
Revenue Code of 1986, as amended (the "Code"). If Downey acquires control of
another savings association as a separate subsidiary, it would become a multiple
savings and loan holding company, and the activities of Downey and any of its
subsidiaries (other than the Bank or any other SAIF-insured savings association)
would become subject to restrictions applicable to bank holding companies unless
such other associations each also qualify as a QTL or domestic building and loan
association and were acquired in a supervisory acquisition. See "Regulation of
the Bank - Qualified Thrift Lender Test" on page 11.
Restrictions on Acquisitions. Downey must obtain approval from the OTS
before acquiring control of any other SAIF-insured association. Such
acquisitions are generally prohibited if they result in a multiple savings and
loan holding company controlling savings associations in more than one state.
However, such interstate acquisitions are permitted based on specific state
authorization or in a supervisory acquisition of a failing savings association.
8
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," as that term is defined in OTS regulations, of a federally insured
savings association without giving at least 60 days written notice to the OTS
and providing the OTS an opportunity to disapprove the proposed acquisition. In
addition, no company may acquire control of such 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.
Regulation of the Bank
As a federally chartered, SAIF-insured savings association, the Bank is
subject to extensive regulation by the OTS and the FDIC. Lending activities and
other investments of the Bank must comply with various statutory and regulatory
requirements. The Bank is also subject to certain reserve requirements
promulgated by the Federal Reserve Board.
The OTS, in conjunction with the FDIC, regularly examines the Bank and
prepares reports for the consideration of the Bank's Board of Directors on any
deficiencies found in the operations of the Bank. The relationship between the
Bank and its depositors and borrowers is also regulated by federal and state
laws, especially in such matters as the ownership of savings accounts and the
form and content of mortgage documents utilized by the Bank.
The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition, in addition to obtaining regulatory
approvals prior to entering into certain transactions such as mergers with or
acquisitions of other financial institutions. This regulation and supervision
establishes a comprehensive framework of activities in which an institution may
engage and is intended primarily for the protection of the SAIF and depositors.
The regulatory structure also gives the regulatory authorities extensive
discretion in connection with their supervisory and enforcement activities and
examination policies, including policies with respect to the classification of
assets and the establishment of adequate loan loss reserves for regulatory
purposes. Any change in such regulations, whether by the OTS, the FDIC or the
Congress could have a material adverse impact on Downey, the Bank and their
respective operations.
Insurance of Deposit Accounts. The Bank's deposit accounts are insured by
the SAIF, as administered by the FDIC, up to the maximum amount permitted by
law. Insurance of deposits may be terminated by the FDIC upon a finding that the
institution has engaged in unsafe or unsound practices, is in an unsafe or
unsound condition to continue operations or 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, 1995, SAIF members paid within a range of 23
cents to 31 cents per $100 of domestic deposits, depending upon the
institution's risk classification. This risk classification is based on an
institution's capital group and supervisory subgroup assignment. Pursuant to the
Economic Growth and Paperwork Reduction Act of 1996 (the "Act"), the FDIC
imposed a special assessment on SAIF members to capitalize the SAIF at the
designated reserve level of 1.25% as of October 1, 1996. Based on the Bank's
deposits as of March 31, 1995, the date for measuring the amount of the special
assessment pursuant to the Act, the Bank paid a special assessment of $24.6
million in November 1996 to recapitalize the SAIF. This expense was recognized
during the fourth quarter of 1996.
Pursuant to the Act, the Bank pays its normal deposit insurance premium as
a member of the SAIF ranging from nothing to 27 cents per $100 of domestic
deposits. In addition, the Bank also pays an amount equal to approximately 6.4
cents per $100 of domestic deposits toward the retirement of the Financing
Corporation bonds ("Fico Bonds") issued in the 1980s to assist in the recovery
of the savings and loan industry. Members of the Bank Insurance Fund ("BIF"), by
contrast, pay, in addition to their normal deposit insurance premium,
approximately 1.3 cents per $100 of domestic deposits. Under the Act, the FDIC
also is not permitted to establish SAIF assessment rates that are lower than
comparable BIF assessment rates. Beginning no later than January 1, 2000, the
rate paid to retire the Fico Bonds will be equal for members of the BIF and the
SAIF. The Act also provides for the merging of the BIF and the SAIF by January
1, 1999 provided there are no financial institutions still chartered as savings
associations at that time. Should the insurance funds be merged before January
1, 2000, the rate paid by all members of this new fund to retire the Fico Bonds
would be equal.
9
Regulatory Capital Requirements. OTS capital regulations require savings
associations to meet three capital standards: (1) tangible capital equal to 1.5%
of total adjusted assets; (2) leverage capital (core capital) equal to 3% of
total adjusted assets; and (3) risk-based capital equal to 8.0% of total
risk-based assets. The Bank must meet each of these standards in order to be
deemed in compliance with OTS capital requirements. In addition, the OTS may
require a savings association to maintain capital above the minimum capital
levels.
The OTS has proposed to amend its leverage capital requirements. Under the
proposed regulation, a savings association which is assigned a composite rating
of 1 under the Uniform Financial Institutions Rating System, would be required
to maintain a minimum leverage capital ratio equal to 3% of total adjusted
assets. All other savings associations would be required to maintain a minimum
leverage capital ratio equal to 4% of total adjusted assets.
Under OTS regulations, a savings association with a greater than "normal"
level of interest rate exposure must deduct an interest rate risk ("IRR")
component in calculating its total capital for purposes of determining whether
it meets its risk-based capital requirement. Interest rate exposure is measured,
generally, as the decline in an institution's net portfolio value that would
result from a 200 basis point increase or decrease in market interest rates
(whichever would result in a lower net portfolio value), divided by the
estimated economic value of the savings association's assets. The interest rate
risk component to be deducted from total capital is equal to one-half of the
difference between an institution's measured exposure and "normal" IRR exposure
(which is defined as 2%), multiplied by the estimated economic value of the
institution's assets. In August 1995, the OTS indicated that it intends to delay
implementation of its automatic capital deduction for interest rate risk pending
the testing of an OTS appeals process and to provide an opportunity to assess
any further guidance from the other three federal banking agencies regarding
their planned implementation of a capital deduction. This delay is still in
effect and, based on the Bank's asset/liability structure, the Bank would not
have been subject to an IRR capital requirement at December 31, 1997.
These capital requirements are viewed as minimum standards by the OTS, and
most institutions are expected to maintain capital levels well above the
minimum. In addition, the OTS regulations provide that minimum capital levels
higher than those provided in the regulations may be established by the OTS 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: (1) a
savings association has a high degree of exposure to interest rate risk,
prepayment risk, credit risk, concentration of credit risk, certain risks
arising from nontraditional activities or similar risks or a high proportion of
off-balance sheet risk; (2) a savings association is growing, either internally
or through acquisitions, at such a rate that supervisory problems are presented
that are not dealt with adequately by OTS regulations; and (3) a savings
association may be adversely affected by activities or condition of its holding
company, affiliates, subsidiaries or other persons with which it has significant
business relationships. The Bank is not subject to any such individual minimum
regulatory capital requirement.
As shown in "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Financial Condition - Regulatory Capital Compliance"
on page 44 the Bank's regulatory capital exceeded all minimum regulatory capital
requirements as of December 31, 1997.
HOLA permits savings associations not in compliance with the OTS capital
standards to seek an exemption from certain penalties or sanctions for
noncompliance. Such an exemption will be granted only if certain strict
requirements are met, and must be denied under certain circumstances. If an
exemption is granted by the OTS, the savings association still may be subject to
enforcement actions for other violations of law or unsafe or unsound practices
or conditions.
Prompt Corrective Action. The prompt corrective action regulations adopted
by the OTS require certain mandatory actions and authorize certain other
discretionary actions to be taken by the OTS against a savings association that
falls within certain undercapitalized capital categories specified in the
regulation.
The regulations establish five categories of capital classification: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" and "critically undercapitalized." Under the regulations, an
institution's risk-based capital, leverage capital and tangible capital ratios
are used to determine the institution's capital classification. At December 31,
1997, the Bank exceeded the capital requirements of a well capitalized
institution under applicable OTS regulations.
10
In general, the prompt corrective action regulations prohibit an insured
depository institution from declaring any dividends, making any other capital
distribution or paying a management fee to a controlling person if, following
the distribution or payment, the institution would be within any of the three
undercapitalized categories. In addition, adequately capitalized institutions
may accept brokered deposits (as defined) only with a waiver from the FDIC and
are subject to restrictions on the interest rates that can be paid on such
deposits. Undercapitalized institutions may not accept, renew or rollover
brokered deposits.
If the OTS determines that an institution is in an unsafe or unsound
condition, or if the institution is deemed to be engaging in an unsafe and
unsound practice, the OTS may, if the institution is well capitalized,
reclassify it as adequately capitalized; if the institution is adequately
capitalized but not well capitalized, require it to comply with restrictions
applicable to undercapitalized institutions; and, if the institution is
undercapitalized, require it to comply with certain restrictions applicable to
significantly undercapitalized institutions.
Loans-to-One-Borrower. Savings associations generally are subject to the
lending limits applicable to national banks. With certain limited exceptions,
the maximum amount that a savings association or a national bank may lend to any
borrower (including certain related entities of the borrower) at one time may
not exceed 15% of the unimpaired capital and surplus of the institution, plus an
additional 10% of unimpaired capital and surplus for loans fully secured by
readily marketable collateral. Savings associations are additionally authorized
to make loans to one borrower, for any purpose, in an amount not to exceed
$500,000 or, 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: (i) the purchase price of each single-family
dwelling in the development does not exceed $500,000; (ii) the savings
association is in compliance with its fully phased-in capital requirements;
(iii) the loans comply with applicable loan-to-value requirements, and (iv) the
aggregate amount of loans made under this authority does not exceed 150% of
unimpaired capital and surplus. At December 31, 1997, the Bank's
loans-to-one-borrower limit was $67.3 million based upon the 15% of unimpaired
capital and surplus measurement.
Qualified Thrift Lender Test. Savings associations must meet a QTL test,
which test may be met either by maintaining a specified level of assets in
qualified thrift investments as specified in HOLA or by meeting the definition
of a "domestic building and loan association" in section 7701 of the Code. If
the Bank maintains an appropriate level of certain specified investments
(primarily residential mortgages and related investments, including certain
mortgage-related securities) and otherwise qualifies as a QTL or a domestic
building and loan association, it will continue to enjoy full borrowing
privileges from the FHLB. The required percentage of investments under HOLA is
65% of assets while the Code requires investments of 60% of assets. An
association must be in compliance with the QTL test or the definition of
domestic building and loan association on a monthly basis in nine out of every
12 months. Associations that fail to meet the QTL test will generally be
prohibited from engaging in any activity not permitted for both a national bank
and a savings association. As of December 31, 1997, the Bank was in compliance
with its QTL requirement and met the definition of a domestic building and loan
association.
Affiliate Transactions. Transactions between a savings association and its
"affiliates" are subject to quantitative and qualitative restrictions under
Sections 23A and 23B of the Federal Reserve Act. Affiliates of a savings
association include, among other entities, the savings association's holding
company and companies that are under common control with the savings
association.
In general, Sections 23A and 23B and OTS regulations issued in connection
therewith limit the extent to which a savings association or its subsidiaries
may engage in certain "covered transactions" with affiliates to an amount equal
to 10% of the association's capital and surplus, in the case of covered
transactions with any one affiliate, and to an amount equal to 20% of such
capital and surplus, in the case of covered transactions with all affiliates. In
addition, a savings association and its subsidiaries may engage in covered
transactions and certain other 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" is
defined to include a loan or extension of credit to an affiliate; a purchase of
investment securities issued by an affiliate; a purchase of assets from an
affiliate, with certain exceptions; the acceptance of securities issued by an
affiliate as collateral for a loan or extension of credit to any party; or the
issuance of a guarantee, acceptance, or letter of credit on behalf of an
affiliate.
In addition, under the OTS regulations, 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; a savings association
may not purchase or invest in securities of an affiliate other than shares of a
subsidiary; a savings association and its subsidiaries
11
may not purchase a low-quality asset from an affiliate; and covered transactions
and certain other 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. With certain exceptions, each loan or extension of
credit by a savings association to an affiliate must be secured by collateral
with a market value ranging from 100% to 130% (depending on the type of
collateral) of the amount of the loan or extension of credit.
The OTS regulation generally excludes all non-bank and non-savings
association subsidiaries of savings associations from treatment as affiliates,
except to the extent that the OTS or the Federal Reserve Board decides to treat
such subsidiaries as affiliates. The regulation also requires savings
associations to make and retain records that reflect affiliate transactions in
reasonable detail, and provides that certain classes of savings associations may
be required to give the OTS prior notice of affiliate transactions.
Capital Distribution Limitations. OTS regulations impose limitations upon
all capital distributions by savings associations, such as cash dividends,
payments to repurchase or otherwise acquire its shares, payments to shareholders
of another institution in a cash-out merger and other distributions charged
against capital. In general, the Bank may not declare or pay a cash dividend on
its capital stock if the effect thereof would cause the Bank to fail to meet one
of its regulatory capital requirements.
Under the regulation, an association that meets its capital requirements
both before and after a proposed distribution and has not been notified by the
OTS that it is in need of more than normal supervision (a "Tier 1 association")
may, after prior notice to but without the approval of the OTS, make capital
distributions during a calendar year up to the higher of: (i) 100% of its net
income to date during the calendar year plus the amount that would reduce by
one-half its surplus capital ratio at the beginning of the calendar year, or
(ii) 75% of its net income over the most recent four-quarter period. A Tier 1
association may make capital distributions in excess of the above amount if it
gives notice to the OTS and the OTS does not object to the distribution. A
savings association that meets its regulatory capital requirements both before
and after a proposed distribution but does not meet its capital requirement (a
"Tier 2 association") is authorized, after prior notice to the OTS but without
OTS approval, to make capital distributions in an amount up to 75% of its net
income over the most recent four-quarter period, taking into account all prior
distributions during the same period. Any distribution in excess of this amount
must be approved in advance by the OTS. A savings association that does not meet
its current regulatory capital requirements (a "Tier 3 association") cannot make
any capital distribution without prior approval from the OTS, unless the capital
distribution is consistent with the terms of a capital plan approved by the OTS.
At December 31, 1997, the Bank qualified as a Tier 1 association for
purposes of the capital distribution rule. The OTS may prohibit a proposed
capital distribution that would otherwise be permitted if the OTS determines
that the distribution would constitute an unsafe or unsound practice.
The OTS has proposed to amend its capital distribution regulation to
conform its requirements to the OTS prompt corrective action regulation. Under
the proposed regulation, an institution that would remain at least adequately
capitalized after making a capital distribution, and was not owned by a holding
company, would no longer be required to provide notice to the OTS prior to
making a capital distribution. "Troubled" associations and undercapitalized
associations would be allowed to make capital distributions only by filing an
application and receiving OTS approval, and such applications would be approved
under certain limited circumstances.
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 accordance with regulations and
orders of the OTS. The OTS has the power to require a savings association to
divest any subsidiary or terminate any activity conducted by a subsidiary that
the OTS determines to pose a serious threat to the financial safety, soundness
or stability of the savings association or to be otherwise inconsistent with
sound banking practices.
Community Reinvestment Act and the Fair Lending Laws. Savings associations
have a responsibility under CRA and related regulations of the OTS to help meet
the credit needs of their communities, including low- and moderate-income
neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair
Housing Act (together, the "Fair Lending Laws") 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 CRA could, at a minimum, result in regulatory restrictions on its
activities and the denial of certain applications, and failure to comply with
the Fair Lending Laws could result in enforcement actions by the OTS, as well as
other federal regulatory agencies and the Department of Justice.
12
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
to members loans (i.e., advances) in accordance with the policies and procedures
established by the Board of Directors of the individual FHLB.
As a member, the Bank is required to own capital stock in an FHLB in an
amount equal to the greater of: (i) 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, (ii) 0.3% of total assets,
or (iii) 5% of its FHLB advances (borrowings). At December 31, 1997, the Bank
had $44.1 million in FHLB stock. The Bank's required investment in FHLB stock,
based on December 31, 1997 financial data, was $47.4 million. The Bank received
a $0.7 million stock dividend and purchased additional stock amounting to $2.6
million in the first quarter of 1998, thereby increasing the Bank's investment
to the required amount. See Note 11 of Notes to the Consolidated Financial
Statements on page 69.
Liquidity Requirements. Under OTS regulations, a savings association is
required to maintain an average daily balance of liquid assets (including cash,
certain time deposits and savings accounts, bankers' acceptances, certain
government obligations, and certain other investments) in each calendar quarter
of not less than 4% of either: (i) its liquidity base (consisting of certain net
withdrawable accounts plus short-term borrowings) as of the end of the preceding
calendar quarter, or (ii) the average daily balance of its liquidity base during
the preceding quarter. This liquidity requirement may be changed from time to
time by the OTS to any amount between 4% and 10%, depending upon certain
factors, including economic conditions and savings flows of all savings
associations. The Bank maintains liquid assets in compliance with these
regulations. Monetary penalties may be imposed upon an institution for
violations of liquidity requirements.
Federal Reserve System. The Federal Reserve Board requires all depository
institutions to maintain non-interest bearing reserves at specified levels
against their transaction accounts (primarily checking, NOW, and Super NOW
checking accounts) and non-personal time deposits. The balances maintained to
meet the reserve requirements imposed by the Federal Reserve Board may be used
to satisfy the liquidity requirements that are imposed by the OTS. At December
31, 1997, the Bank was in compliance with these requirements.
Recent Proposed Legislation. Congress has been considering legislation in
various forms that would require federal thrifts, such as the Bank, to convert
their charters to national or state bank charters. The Treasury Department has
been studying the development of a common charter for federal savings
associations and commercial banks. In the event that the thrift charter is
eliminated by January 1, 1999, the Act would require the merger of the BIF and
the SAIF into a single Deposit Insurance Fund on that date. In the absence of
appropriate "grandfather" provisions, legislation eliminating the thrift charter
could have a material adverse effect on the Bank and Downey because, among other
things, the regulatory, capital and accounting treatment for national and state
banks and savings associations differs in certain significant respects. Downey
cannot determine whether, or in what form, such legislation may eventually be
enacted and there can be no assurance that any legislation that is enacted would
contain adequate grandfather rights for the Bank and Downey.
TAXATION
Federal. A savings institution generally is subject to tax in the same
manner as other corporations for federal income tax purposes, though savings
institutions have historically enjoyed favorable treatment under the Code in
determining the deduction allowed for bad debts. During 1996, however, Congress
enacted legislation which repealed the reserve method of determining bad debt
deductions for "large thrift institutions" (i.e., thrifts with assets greater
than $500 million), subjecting savings associations to rules similar to those
currently applicable to large commercial banks. The repeal was effective for tax
years beginning after 1995. Bad debt reserves accumulated since 1987 were
subject to recapture as taxable income over a six-year period beginning in 1996.
However, thrifts were allowed to defer recapture for up to two years if the
amount of mortgage loans originated in 1996 and 1997 equaled or exceeded the
average amount of mortgages originated in the six years prior to 1996. Based
upon originations in 1996 and 1997, the Bank qualifies for the two-year deferral
under this originations test, and thus will recapture its post-1987 bad debt
reserve over a six-year period beginning in 1998. The bad debt deductions for
1996 and 1997 were determined under the specific charge-off method, which allows
a tax deduction for loans determined to be wholly or partially worthless.
13
Prior to 1996, a savings institution which met certain definitional tests
relating to the composition of its assets and the sources of its income (a
"qualifying savings institution") was permitted to take deductions for additions
to reserves for bad debts, rather than recognizing deductions for specific loans
as they became worthless. A qualifying savings institution was allowed to make
annual additions to such reserves based upon the institution's actual loan loss
experience (the "experience method"). Alternatively, a qualifying savings
institution could elect to compute the allowable addition to its bad debt
reserve for qualifying real property loans (generally, loans secured by an
interest in improved real estate) as a percentage of the institution's taxable
income (the "percentage-of-taxable-income method").
Under applicable provisions of the Code, a savings institution organized in
stock form whose accumulated reserve for losses on qualifying real property
loans exceeds the reserve as calculated under the experience method may be
subject to recapture taxes on such reserve if it makes certain types of
distributions to its stockholders. Dividends may be paid out of retained
earnings without the imposition of any tax on the savings institution to the
extent that the amounts paid as dividends do not exceed the savings
institution's current or post-1951 accumulated earnings and profits as
calculated for federal income tax purposes. Stock redemptions, dividends paid in
excess of the savings institution's current or post-1951 accumulated earnings
and profits as calculated for tax purposes, and other distributions made with
respect to the savings institution's stock (and the taxes deemed to be
attributable thereto), however, are deemed under applicable sections of the Code
to be made from the savings institution's tax bad debt reserves to the extent
that such reserves exceed the amount that could have been accumulated under the
experience method. Thus, certain distributions to stockholders that are treated
as having been paid from the reserve for losses on qualifying real property
loans could result in a federal recapture tax. The Bank, however, has not in the
past made distributions that resulted in federal recapture tax under these rules
and does not expect to make any such distributions in the foreseeable future.
In addition to the regular corporate income tax, corporations, including
qualifying savings institutions, are subject to an alternative minimum tax. This
20% tax is computed with respect to the corporation's regular taxable income
(with certain adjustments), as increased by tax preference items ("alternative
minimum taxable income") and will apply to the extent that it exceeds the
corporation's regular tax liability. In addition, in computing a corporation's
alternative minimum taxable income, the corporation's regular taxable income is
required to be increased by 75% of the excess of the corporation's current
earnings and profits (subject to certain adjustments) over the corporation's
alternative minimum taxable income determined prior to this adjustment and
without regard to the alternative tax net operating loss deduction. A
corporation that incurs alternative minimum tax generally is entitled to take
such tax as a credit against its regular tax in subsequent years to the extent
that the corporation's regular tax liability in such subsequent years (reduced
by certain other tax credits) exceeds the corporation's so-called "tentative
minimum tax" (generally, an amount computed by multiplying the corporation's
alternative minimum taxable income for the year by the then-applicable rate for
the alternative minimum tax).
State. The California franchise tax applicable to the Bank is computed
under a formula which results in a rate higher than the rate applicable to
non-financial corporations because it reflects an amount "in lieu" of local
personal property and business license taxes paid by such corporations (but not
generally paid by banks or financial corporations such as the Bank). The
variable tax rate was 10.84% in 1997, and 11.3% for 1996. Downey and its wholly
owned subsidiaries file a California franchise tax return on a combined
reporting basis. Additional state income tax returns are filed on a
separate-entity basis in Arizona, Colorado, and Illinois for income-producing
property owned in those states.
Downey's federal income and state franchise tax returns have been audited
by the Internal Revenue Service and the California Franchise Tax Board,
respectively, for all years through 1989. Federal tax returns for years 1990
through 1995 are currently under examination. State franchise tax returns for
years subsequent to 1989 remain open to review.
FACTORS THAT MAY AFFECT FUTURE RESULTS
The following discusses certain factors which may affect Downey's financial
results and operations and should be considered in evaluating Downey.
Economic Conditions and Geographic Concentrations. Downey is headquartered
in Southern California, and its operations are concentrated in Southern and
Northern California. As a result of this geographic concentration, Downey's
results depend largely upon economic conditions in these areas. While the
California economy has exhibited positive economic and employment trends, there
is no assurance that such trends will continue. A deterioration in economic
conditions could have a material adverse impact on the quality of Downey's loan
portfolio and the demand for its products and services.
14
Interest Rates. Downey anticipates that interest rate levels will remain
generally constant in 1998, but if interest rates vary substantially from
present levels, Downey's results may differ materially from the results
currently anticipated. 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.
Government Regulation and Monetary Policy. The financial services industry
is subject to extensive federal and state supervision and regulation.
Significant new laws or changes in, or repeals of, existing laws may cause
Downey's results to differ materially. Further, federal monetary policy,
particularly as implemented through the Federal Reserve System, significantly
affects credit conditions for Downey, primarily through open market operations
in United States government securities, the discount rate for borrowings and
reserve requirements, and a material change in these conditions would be likely
to have a material impact on Downey's results.
Competition. The banking and financial services business in Downey's market
areas are highly competitive. The increasingly competitive environment is a
result primarily of changes in regulation, changes in technology and product
delivery systems, and the accelerating pace of consolidation among financial
services providers. Downey's results may differ if circumstances affecting the
nature or level of competition change.
Credit Quality. A significant source of risk arises from the possibility
that losses will be sustained because borrowers, guarantors and related parties
may fail to perform in accordance with the terms of their loans. Downey has
adopted underwriting and loan monitoring procedures and credit policies,
including the establishment and review of the allowance for loan losses, that
management believes are appropriate to minimize this risk by assessing the
likelihood of nonperformance, tracking loan performance and diversifying
Downey's loan portfolio. Such policies and procedures, however, may not prevent
unexpected losses that could materially adversely affect Downey's results.
Year 2000. Like most financial organizations, Downey has many computer
systems that identify dates using only the last two digits of the year. These
systems must be prepared to distinguish dates such as 1900 from 2000. Computer
system failures due to processing errors potentially arising from calculations
using Year 2000 dates are a known risk. Downey has established processes to
identify, prioritize, renovate or replace systems that may be affected by Year
2000 dates. To date, Downey has completed an inventory of all systems and
determined which processes are most critical to supporting customer transaction
processing and providing customer services. System renovation and replacement
plans have been started and are targeted for completion by the end of 1998, with
compliance testing and installation processes to be completed during 1999.
However, third party vendor dependency, including government entities, may
impact Downey's efforts to successfully complete Year 2000 compliance for all
systems in a timely fashion.
15
ITEM 2. PROPERTIES
BRANCHES
The executive offices of both Downey and the Bank are located at 3501
Jamboree Road, Newport Beach, California 92660, in a six-story building
containing approximately 320,000 square feet. Part of the first floor 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 Downey's administrative operations, however, are
located in the headquarters building.
At December 31, 1997, Downey owned the building and land occupied by 54 of
its branches and owned one building on leased land. Downey leases branches in 35
locations (including 26 in-store locations) with leases expiring at various
dates through November 2009, with options to extend the term. In 1997, Downey
purchased land and buildings for three new branch locations opening in 1998.
The net book value of the owned branches, including the one on leased land,
totaled $85.4 million at December 31, 1997, and the net book value of the leased
branch offices totaled $1.5 million at December 31, 1997. The net book value of
Downey's furniture and fixtures, including electronic data processing equipment,
was $14.9 million at December 31, 1997.
For additional information regarding Downey's offices and equipment, see
Notes 1 and 10 of Notes to the Consolidated Financial Statements on page 53 and
page 69, respectively.
ELECTRONIC DATA PROCESSING
Downey utilizes a mainframe computer system with use of various third-party
vendors' software for retail deposit operations, loan servicing, accounting and
loan origination functions. The net book value of Downey's electronic data
processing equipment, including personal computers and software, was $10.3
million at December 31, 1997.
ITEM 3. LEGAL PROCEEDINGS
Downey has been named as a defendant in legal actions arising in the
ordinary course of business, none of which, in the opinion of management, is
material.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
None.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Downey's Common Stock is traded on the New York Stock Exchange ("NYSE") and
the Pacific Exchange ("PCX") with the trading symbol "DSL." At February 27,
1998, Downey had approximately 1,078 stockholders of record (not including the
number of persons or entities holding stock in nominee or street name through
various brokerage firms) and 26,755,938 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 the common stock of Downey as reported on the NYSE
Composite Tape.
1997 1996
----------------------------------- ----------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
- -----------------------------------------------------------------------------------------
High ........ $ 29.00$ 24.50$ 23.63$ 22.50$ 18.69$ 16.03$ 15.23$ 15.23
Low ......... 24.19 21.50 18.09 18.09 15.88 12.86 12.86 13.09
End of period 28.44 24.38 23.63 19.28 18.69 16.03 13.89 14.92
During 1997 and 1996, Downey paid quarterly cash dividends totaling $0.315
and $0.304 per share, aggregating $8.5 and $8.1 million, respectively. On
February 27, 1998, Downey paid a $0.08 per share quarterly cash dividend,
aggregating $2.1 million.
Downey 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
12.
17
ITEM 6. SELECTED FINANCIAL DATA
(Dollars in Thousands, Except Per Share Data) 1997 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------------------
For the year:
Total interest income ..................................... $ 420,418 $ 346,360 $ 318,828 $ 228,970 $ 220,745
Total interest expense .................................... 266,260 211,765 214,238 122,601 109,973
- --------------------------------------------------------------------------------------------------------------------------------
Net interest income ................................... 154,158 134,595 104,590 106,369 110,772
Provision for loan losses ............................. 8,640 9,137 9,293 4,211 1,085
- --------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses ... 145,518 125,458 95,297 102,158 109,687
- --------------------------------------------------------------------------------------------------------------------------------
Other income, net:
Loan and deposit related fees ......................... 10,921 7,435 5,546 5,310 6,175
Real estate and joint ventures held for investment, net 14,222 8,241 11,192 9,530 4,769
Net gains (losses) on sales of:
Loans and mortgage-backed securities ................ 2,675 1,543 266 114 1,665
Investment securities ............................... -- 4,473 (15) -- --
(Provision for) reduction of loss on investment in
lease residual ...................................... -- -- 207 (920) (2,184)
Other ................................................. 7,370 3,507 3,403 3,703 4,609
- --------------------------------------------------------------------------------------------------------------------------------
Total other income, net ............................... 35,188 25,199 20,599 17,737 15,034
- --------------------------------------------------------------------------------------------------------------------------------
Operating expense:
General and administrative expense .................... 99,556 86,460 74,470 75,566 73,502
SAIF special assessment ............................... -- 24,644 -- -- --
Net operation of real estate acquired in settlement of
loans ............................................... 1,184 2,567 4,206 3,595 2,337
Amortization of excess of cost over fair value of net
assets acquired ..................................... 532 532 530 532 532
- --------------------------------------------------------------------------------------------------------------------------------
Total operating expense ............................... 101,272 114,203 79,206 79,693 76,371
- --------------------------------------------------------------------------------------------------------------------------------
Net income ................................................ 45,234 20,704 (1) 21,093 23,532 43,666 (2)
Loans originated .......................................... 2,329,266 1,583,784 637,490 1,810,096 1,104,252
Loans and mortgage-backed securities purchased ............ 35,828 30,296 44,194 196,255 19,625
Loans and mortgage-backed securities sold ................. 557,511 166,503 102,097 45,770 153,146
Effective interest rate spread ............................ 2.83% 2.96% 2.35% 3.02% 3.47%
At December 31:
Total assets .............................................. $5,835,825 $5,198,157 4,656,267 $4,650,651 $3,467,155
Total loans and mortgage-backed securities ................ 5,366,396 4,729,846 4,169,474 4,188,539 2,917,109
Investments and cash equivalents .......................... 221,201 222,255 237,904 215,960 313,989
Deposits .................................................. 4,869,978 4,173,102 3,790,221 3,557,398 3,068,929
Borrowings ................................................ 483,735 595,345 436,218 674,776 13,718
Stockholders' equity ...................................... 430,346 391,571 384,072 366,187 351,470
Loans serviced for others ................................. 612,529 576,044 527,234 468,123 503,711
Allowance for loan losses as a percentage of
non-performing loans .................................... 76.96% 66.84% 35.67% 49.29% 47.72%
Non-performing assets as a percentage of total assets ..... 0.89 1.19 2.09 1.41 2.01
Selected ratios:
Return on average assets .................................. 0.79% 0.43% (1) 0.45% 0.62% 1.25%(3)
Return on average equity .................................. 11.07 5.33 (1) 5.69 6.56 12.83 (3)
Dividend payout ratio ..................................... 18.69 39.35 36.78 33.97 12.96
Capital ratios:
Average stockholders' equity to average assets ........ 7.17 8.10 7.86 9.47 9.74
Core and tangible capital ............................. 6.61 6.56 7.28 7.22 9.45
Risk-based capital .................................... 12.64 12.66 14.25 14.21 16.93
Per Share Data: (4)
Earnings per share - Basic/Diluted ........................ $ 1.69 $ 0.77 (1) $ 0.79 $ 0.88 $ 1.64 (2)
Book value per share at end of period ..................... 16.08 14.65 14.37 13.70 13.15
Stock price at end of period .............................. 28.44 18.69 13.81 9.14 12.02
Cash dividends paid ....................................... 0.315 0.304 0.290 0.290 0.211
(1) Excluding the SAIF special assessment, net income would have been $34.7
million or $1.29 per share and the returns on average assets and average
equity would have been 0.73% and 8.95%, respectively.
(2) Includes $15.1 million, or $0.56 per share, cumulative benefit from the
adoption of SFAS 109, Accounting for Income Taxes.
(3) Excluding the SFAS 109 benefit, the returns on average assets and average
equity would have been 0.82% and 8.39%, respectively.
(4) Adjusted for a 5% stock dividend paid in May 1997.
18
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 Reform Act which involve risks and uncertainties. Downey's
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 Downey conducts its operations, fluctuations in interest
rates, credit quality and government regulation. For additional information
concerning these factors, see "Item 1. Business - Factors that May Affect Future
Results" on page 14.
OVERVIEW
Net income for 1997 totaled $45.2 million or $1.69 per share on a diluted
basis, more than double last year's $20.7 million or $0.77 per share. The 1996
results included a one-time assessment to recapitalize the Savings Association
Insurance Fund ("SAIF") which totaled $24.6 million ($14.0 million or $0.52 per
share on an after-tax basis). Excluding that assessment, net income in 1997
would have been $10.5 million or 30.2% above a year ago.
Excluding the one-time SAIF assessment, the increase in 1997 net income
primarily reflected higher net interest income. Net interest income increased
$19.6 million or 14.5% due to higher average earning assets. Also contributing
to the increase in net income between years was a $10.0 million increase in
other income and a $1.4 million decline in the net expense associated with the
operation of real estate acquired in settlement of loans. The increase in other
income reflected several factors. Favorably impacting other income were
increases of $6.0 million in income from real estate held for investment, $4.0
million in the all other category of other income representing a gain from the
sale of an asset obtained as part of the 1988 acquisition of Butterfield
Savings, $3.5 million in loan and deposit related fees and $1.1 million in net
gains from sales of loans and mortgage-backed securities. These favorable other
income items were partially offset by a decline of $4.5 million in net gains
from sales of investment securities. The favorable impact of higher net interest
and other income, and lower net expense associated with the operation of real
estate acquired in settlement of loans was partially offset by an increase of
$13.1 million in general and administrative expense. The increase in general and
administrative expense was primarily associated with branch expansion,
particularly into in-store banking, higher advertising expenditures and growth
in auto lending.
Assets increased $637.7 million or 12.3% during 1997 to $5.8 billion at
year end, following an 11.6% increase during 1996. Single family loan
originations increased from $1.25 billion in 1996 to $2.0 billion in 1997. Of
the 1997 amount, $221.2 million represented higher yielding subprime loans. In
addition to single family loans, $413.4 million of other loans were originated,
including $259.0 million of auto loans and $80.0 million of construction loans.
Asset growth was primarily funded with deposits as deposits increased
$696.9 million or 16.7% to $4.9 billion at December 31, 1997. Of the increase,
$102.6 million was generated by new branches opened in 1997.
Non-performing assets totaled $52.1 million or 0.89% of assets at December
31, 1997, down from $62.0 million or 1.19% of assets at December 31, 1996. The
decline in non-performing assets was spread throughout most categories. A
detailed review of all criticized, classified, watch and non-performing assets
is performed at least semi-annually. All assets greater than $1 million are
reviewed annually. The combined provisions for loan and real estate losses,
including real estate held for investment and acquired in settlement of loans,
totaled $6.6 million for 1997, compared to $7.5 million in 1996 and $8.9 million
in 1995.
At December 31, 1997, the Bank met and exceeded all three regulatory
capital tests, with capital-to-asset ratios of 6.61% in tangible and core
capital and 12.64% in risk-based capital. These capital levels are well 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 9, "Financial Condition - Investments in Real Estate
and Joint Ventures" on page 28 and "Regulatory Capital Compliance" on page 44.
19
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 and borrowings
("interest-bearing liabilities"). Net interest income is affected principally by
the spread between the yield on interest-earning assets and the cost of
interest-bearing liabilities and by the relative dollar amounts of such assets
and liabilities.
Net interest income was $154.2 million in 1997, up $19.6 million or 14.5%
from 1996 and $49.6 million or 47.4% greater than 1995. The 1997 improvement
over 1996 primarily reflected a 19.7% increase in average earning assets to $5.4
billion. In addition, 1997 benefited from approximately $1.3 million of higher
than usual distributions from agreements in which Downey shares in the net cash
flows of certain shopping centers which Downey currently, or in the past,
financed. These favorable items were partially offset by a decline in the
effective interest rate spread. The effective interest rate spread averaged
2.83% in 1997, down from 2.96% in 1996 but up from 2.35% in 1995. Between 1997
and 1996, the yield on earning assets increased 11 basis points, while the cost
of funding those earnings assets increased 22 basis points. The more rapid
increase in funding costs occurred as the growth in earning assets was primarily
funded with higher cost certificates of deposit and borrowings.
The following table presents for the periods indicated the total dollar
amount of interest income from average interest-earning assets and resultant
yields, the interest expense on average interest-bearing liabilities and the
resultant costs, expressed both in dollars and rates. The table also sets forth
the net earning balance (the difference between the average balance of
interest-earning assets and the average balance of interest-bearing liabilities)
for the periods indicated. Non-accrual loans are included in the average
interest-earning assets balance. Interest from non-accrual loans is included in
interest income only to the extent that payments were received and to the extent
that Downey believes it will recover the remaining principal balance of the
loan. Average balances are computed using a monthly average balance during the
period. The effective interest rate spread, which reflects a savings
association's relative level of interest-earning assets to interest-bearing
liabilities, equals (i) the difference between interest income on
interest-earning assets and interest expense on interest-bearing liabilities,
(ii) divided by average interest-earning assets for the period. The table also
sets forth the net interest income, the interest rate spread and the effective
interest rate spread.
1997 1996 1995
-------------------------------------------------------------------------------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ....................... $5,174,767 $ 404,081 7.81% $4,269,136 $ 329,746 7.72% $4,175,085 $ 300,734 7.20%
Mortgage-backed securities .. 55,045 3,633 6.60 64,957 4,317 6.65 63,772 4,311 6.76
Investment securities ....... 217,272 12,704 5.85 215,364 12,297 5.71 215,672 13,783 6.39
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning
assets ................... 5,447,084 420,418 7.72 4,549,457 346,360 7.61 4,454,529 318,828 7.16
Non-interest-earning assets ... 246,785 240,191 263,430
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets ............... $5,693,869 $4,789,648 $4,717,959
====================================================================================================================================
Interest-bearing liabilities:
Deposits .................... $4,588,320 $ 227,521 4.96% $3,892,981 $ 184,402 4.74% $3,758,948 $ 180,859 4.81%
Borrowings .................. 638,661 38,739 6.07 457,890 27,363 5.98 523,417 33,379 6.39
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing ..... 5,226,981 266,260 5.09 4,350,871 211,765 4.87 4,282,365 214,238 5.00
liabilities
Non-interest-bearing
liabilities ................. 58,415 50,590 64,880
Stockholders' equity .......... 408,473 388,187 370,714
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
stockholders' equity .... $5,693,869 $4,789,648 $4,717,959
====================================================================================================================================
Net interest income/interest
rate spread ................. $ 154,158 2.63% $ 134,595 2.74% $ 104,590 2.16%
Excess of interest-earning
assets over interest-bearing
liabilities $ 220,103 $ 198,586 $ 172,164
Effective interest rate spread 2.83 2.96 2.35
====================================================================================================================================
20
Changes in Downey's net interest income are a function of both changes in
rates and changes in volumes of interest-earning assets and interest-bearing
liabilities. The following table sets forth information regarding changes in
interest income and expense for Downey for the years indicated. For each
category of interest-earning asset and interest-bearing liability, information
is provided on changes attributable to: (i) change in rate (change in rate
multiplied by old volume), (ii) change in volume (change in volume multiplied by
old rate) and (iii) change in rate-volume (change in rate multiplied by change
in volume). Interest-earning asset and liability balances in the calculations
are computed using monthly average balances.
1997 versus 1996 1996 versus 1995
Change Due To Change Due To
------------------------------------------- ----------------------------------------------
Rate/ Rate/
(In Thousands) Volume Rate Volume Net Volume Rate Volume Net
- ------------------------------------------------------------------------------------------------------------------------------
Interest Income:
Loans ...................... $ 69,951 $ 3,617 $ 767 $ 74,335 $ 6,775 $ 21,747 $ 490 $ 29,012
Mortgage-backed securities . (659) (30) 5 (684) 80 (73) (1) 6
Investment securities ...... 109 295 3 407 (20) (1,468) 2 (1,486)
- ------------------------------------------------------------------------------------------------------------------------------
Change in interest income 69,401 3,882 775 74,058 6,835 20,206 491 27,532
- ------------------------------------------------------------------------------------------------------------------------------
Interest Expense:
Deposits ................... 32,937 8,639 1,543 43,119 6,449 (2,806) (100) 3,543
Borrowings ................. 10,801 412 163 11,376 (4,184) (2,094) 262 (6,016)
- ------------------------------------------------------------------------------------------------------------------------------
Change in interest expense 43,738 9,051 1,706 54,495 2,265 (4,900) 162 (2,473)
- ------------------------------------------------------------------------------------------------------------------------------
Change in net interest income . $ 25,663 $ (5,169) $ (931) $ 19,563 $ 4,570 $ 25,106 $ 329 $ 30,005
==============================================================================================================================
PROVISION FOR LOAN LOSSES
Provision for loan losses was $8.6 million in 1997, as compared to $9.1
million in 1996 and $9.3 million in 1995. The provision for loan losses in 1997
exceeded net loan charge-offs by $2.0 million primarily reflecting growth in
single family residential and automobile loans.
For further information, see "Financial Condition - Problem Loans and Real
Estate - Allowance for Losses on Loans and Real Estate" on page 40.
OTHER INCOME
Other income totaled $35.2 million in 1997, compared to $25.2 million in
1996 and $20.6 million in 1995. The increase in 1997 reflected several factors.
Favorably impacting other income were increases of $6.0 million in income from
real estate held for investment, $4.0 million in the all other category, $3.5
million in loan and deposit related fees, and $1.1 million in net gains from the
sales of loans. Partially offsetting those increases was a $4.5 million decline
in net gains from sales of investment securities. Below is a discussion of the
major other income categories.
Loan and Deposit Related Fees
Loan and deposit related fees totaled $10.9 million in 1997, compared to
$7.4 million in 1996 and $5.5 million in 1995. As depicted in the following
table, the current year reflected an increase in both loan and deposit related
fees, the latter primarily the result of higher fees from automated teller
machines.
(In Thousands) 1997 1996 1995
- --------------------------------------------------------------------
Loan related fees .................... $ 3,837 $ 2,496 $ 1,508
Deposit related fees ................. 7,084 4,939 4,038
- --------------------------------------------------------------------
Total loan and deposit related fees $10,921 $ 7,435 $ 5,546
====================================================================
21
Real Estate and Joint Venture Operations Held for Investment
Income from real estate and joint venture operations totaled $14.2 million
in 1997, compared to $8.2 million in 1996 and $11.2 million in 1995. The table
below sets forth the key components comprising income from real estate and joint
venture operations.
(In Thousands) 1997 1996 1995
- -------------------------------------------------------------------------------------------
Operations, net:
Rental operations net of expenses ..................... $ 2,317 $ 2,417 $ 3,711
Equity in net income (loss) from joint ventures ....... 3,931 55 (1,676)
Interest from joint venture advances .................. 1,880 2,071 1,702
- -------------------------------------------------------------------------------------------
Total operations, net .............................. 8,128 4,543 3,737
Net gains on sales of wholly owned real estate ........... 2,904 392 4,539
Reduction of losses on real estate and joint ventures .... 3,190 3,306 2,916
- ------------------------------------------------------------------------------------------