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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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(Mark One)
|X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 1998
|_| Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ______________ to
______________.
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Commission File Number 1-13578
DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation or organization)
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3501 Jamboree Road Newport Beach, California 92660
(Address of principal executive offices) (Zip Code)
I.R.S. Employer Identification No.: 95-1953342
Registrant's telephone number, including area code: (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE
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Common Stock, $0.01 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by 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
26, 1999, on the New York Stock Exchange was $433,528,529.
At February 26, 1999, 28,131,776 shares of the Registrant's Common Stock, $0.01
par value were outstanding.
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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 28, 1999 are
incorporated by reference in Part III hereof.
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TABLE OF CONTENTS
ITEM PAGE
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PART I
1. BUSINESS ........................................................ 1
General....................................................... 1
Banking Activities............................................ 2
Lending Activities......................................... 2
Loan and Mortgage-Backed Securities Portfolio........... 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........................................ 6
Investment Activities...................................... 6
Sources of Funds........................................... 6
Deposits................................................ 6
Borrowings.............................................. 7
Asset/Liability Management................................. 7
Earnings Spread............................................ 7
Real Estate Investment Activities............................. 8
Competition .................................................. 8
Employees..................................................... 9
Regulation.................................................... 9
General.................................................... 9
Regulation of Downey....................................... 9
Regulation of the Bank..................................... 9
Regulation of DSL Service Company.......................... 14
Taxation...................................................... 15
Factors That May Affect Future Results........................ 16
2. PROPERTIES....................................................... 17
Branches...................................................... 17
Electronic Data Processing.................................... 17
3. LEGAL PROCEEDINGS................................................ 17
4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS.................. 17
PART II
5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS............................................. 18
6. SELECTED FINANCIAL DATA................. ........................ 19
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS....................................... 20
Overview...................................................... 20
Results of Operations......................................... 22
Net Interest Income........................................ 22
Provision for Loan Losses.................................. 23
Other Income............................................... 23
Loan and Deposit Related Fees........................... 23
Real Estate and Joint Venture
Operations Held for Investment.......................... 24
Secondary Marketing Activities ......................... 24
Other Category.......................................... 24
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TABLE OF CONTENTS
ITEM PAGE
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PART II----(CONTINUED)
Operating Expenses......................................... 25
Provision for Income Taxes................................. 25
Business Segment Reporting................................. 25
Banking................................................. 26
Real Estate Investment.................................. 27
Financial Condition........................................... 28
Loans and Mortgage-Backed Securities....................... 28
Investment Securities...................................... 32
Investments in Real Estate and Joint Ventures.............. 33
Deposits................................................... 35
Borrowings................................................. 36
Asset/Liability Management and Market Risk................. 37
Problem Loans and Real Estate.............................. 42
Non-Performing Assets................................... 42
Delinquent Loans........................................ 44
Allowance for Losses on Loans and Real Estate........... 46
Capital Resources and Liquidity............................ 50
Regulatory Capital Compliance.............................. 51
Current Accounting Issue................................... 51
Year 2000.................................................. 52
Risks of the Year 2000 Issue............................ 52
State of Readiness...................................... 52
Costs to Address the Year 2000 Issue.................... 53
Contingency Plans....................................... 53
8. FINANCIAL STATEMENTS............................................. 54
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES............................ 97
PART III
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............... 97
11. EXECUTIVE COMPENSATION........................................... 97
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT...................................................... 97
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................... 97
PART IV
14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K..................................................... 97
SIGNATURES ........................................................... 99
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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 16.
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. Unless otherwise stated or indicated, references to
"Downey" or the "Bank" include their respective subsidiaries.
The Bank was formed in 1957 as a California-licensed savings and loan
association and conducts its business through 91 retail deposit branches (28 of
which are full-service in-store branches). Residential loans are originated by
retail loan officers who are located in 42 retail deposit branches in California
providing loan origination services to all the Bank's branches, and two centers
outside California, one each in Arizona and Washington. Retail loan officers
also originated residential loans via the internet from a call center located in
California. Wholesale loans submitted by mortgage brokers are originated from
seven loan origination centers in California, five of which are located in or
adjacent to a Bank office, and two loan origination centers located outside of
California, one each in Arizona and Washington. The executive offices of Downey
are located at 3501 Jamboree Road, North Tower, Newport Beach, California,
92660, and the telephone number is (949) 854-0300. Downey's stock is traded on
the New York Stock Exchange and Pacific Exchange under trading symbol "DSL."
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 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
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and general market interest rates. Similarly, Downey's loan volume and yields on
loans and mortgage-backed securities ("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.
Downey views its business as consisting of two business segments--banking and
real estate investment--each of which is discussed further below.
Banking Activities
Downey's principal business segment is banking, which consists of attracting
funds from the general public and institutions, and originating and investing in
loans, primarily residential real estate mortgage loans, 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, 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.
Below is a detailed discussion of Downey's banking activities.
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 conducted through
Downey Auto Finance Corp., a wholly-owned subsidiary of the Bank, in addition to
automobile loans originated directly through Downey's branch network.
During 1999, 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. Given the current low interest rate environment and
customer preference for fixed rate loans, it is likely Downey may originate more
single family loans for sale in the secondary market than for portfolio during
1999 as was the case in 1998. See "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 28.
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.
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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 fair value. Net unrealized gains or
losses are reported net of income taxes as a separate component of other
comprehensive income until realized.
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
primarily in California. Such loans are for the purchase of residences or for
the refinancing of existing mortgages at lower rates or upon different terms.
Downey's primary strategy is to originate 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. Residential fixed rate
loans may be placed in loans held for investment when funded with long-term
funds to mitigate interest rate risk, and small volumes 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 "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, six or twelve
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 on loans having a loan-to-value ratio of
80% or less and 110% on loans having a loan-to-value ratio over 80%. Downey
permits ARMs to be assumed by qualified borrowers.
During 1998, approximately 87% 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. Retail loan representatives generated approximately 13% of
Downey's one-to-four unit residential loans during 1998 and are compensated on a
salary basis plus a fixed amount per loan originated. Retail loan
representatives typically receive loan referrals from real estate agents,
builders, depositors and customers obtained from retail advertising and other
sources, including over the internet.
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 1998,
the average loan size
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was $247,397. 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%. 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 property involved, and qualified staff appraisers or outside appraisers
establish the value of the collateral through the use of full appraisals or
alternative valuation formats in accordance with regulatory requirements.
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 61 and 70, 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
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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, 1998, MSRs totaled $8 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 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 other comprehensive income, 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,
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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.
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 14 and "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition - Capital
Resources and Liquidity" on page 50. 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. Securities available for sale are carried at market value.
Unrealized holding gains and losses, or valuation allowances established for net
unrealized losses, are excluded from earnings and reported as a separate
component of stockholders' equity as accumulated other comprehensive income, net
of income taxes, unless the security is deemed other than temporarily impaired.
If the security is determined to be other than temporarily impaired, the amount
of the impairment is charged to operations. 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 32.
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.
In 1996, Downey began establishing full-service branch facilities in selected
supermarket 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.
6
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
35.
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. However, this
program was no longer cost effective relative to other sources and was
terminated in 1998.
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
36.
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 37.
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 liabilities, (ii) divided by average
interest-earning assets for the period. For information regarding
7
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 20. For
returns on assets and other selected financial data see "Selected Financial
Data" on page 19.
Real Estate Investment Activities
Downey's second business segment is real estate investment, which is primarily
performed through DSL Service Company, a wholly-owned subsidiary of the Bank.
DSL Service Company is a diversified real estate development company which was
established in 1966 as a neighborhood shopping center and residential tract
developer, as well as the contractor for the Bank's branch locations. Today its
capabilities include development, construction and property management
activities relating to a diverse portfolio of projects primarily within
California, but also in Arizona. In addition to DSL Service Company developing
its own real estate projects, it associates with other qualified developers to
engage in joint ventures. The primary revenue sources of real estate investment
activities include net rental income and gains from the sale of real estate
investments. The primary expenses of real estate investment activities are
interest expense and general and administrative expense.
Prior to the passage in August 1989 of the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 ("FIRREA"), the Bank conducted real estate
development and joint venture operations directly, in addition to operations
conducted through DSL Service Company. Since FIRREA, however, the Bank's 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' 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 33.
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.
8
Employees
At December 31, 1998, Downey had approximately 1,270 full-time employees and 393
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 84 and 87, 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 12.
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.
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
9
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 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 "Paperwork Reduction 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 last quarter of fiscal 1996.
Pursuant to the Paperwork Reduction Act, the Bank pays, in addition to its
normal deposit insurance premium as a member of the SAIF ranging from nothing to
27 cents per $100 of domestic deposits as of October 1, 1996, 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
Paperwork Reduction 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 Paperwork Reduction Act also
provides for the merging of the BIF and the SAIF by January 1, 1999 provided
there were no financial institutions still chartered as savings associations at
that time. Although legislation to eliminate the savings association charter had
been proposed, at January 1, 1999, financial institutions such as the Bank were
still chartered as savings associations. 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.
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.
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
10
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
indefinitely delayed implementation of its IRR regulation. However, based on the
asset/liability structure of the Bank, at December 31, 1998, the Bank would not
have been required to deduct an IRR component in calculating total risk-based
capital had the IRR component of the capital regulations been in effect.
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, or savings associations
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 51 the Bank's regulatory capital exceeded all minimum regulatory capital
requirements as of December 31, 1998.
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 regulation of the OTS,
requires certain mandatory actions and authorizes 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 regulation establishes five categories of capital classification: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" and "critically undercapitalized." Under the regulation, the
risk-based capital, leverage capital and tangible capital ratios are used to
determine an institution's capital classification. At December 31, 1998, the
Bank exceeded the capital requirements of a well capitalized institution under
applicable OTS regulations.
In general, the prompt corrective action regulation prohibits 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 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 roll-over 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.
11
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, 1998, the Bank's
loans-to-one-borrower limit was $75 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, 1998, 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 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.
12
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. The OTS recently adopted an amendment to these capital distribution
limitations. Under the new rule, a savings association in certain circumstances
may be required to file an application and await approval from the OTS prior to
making a capital distribution, may be required to file a notice 30 days prior to
the capital distribution, or may be permitted to make the capital distribution
without notice or application to the OTS.
An application is required (1) if the savings association is not eligible for
expedited treatment of its other applications under OTS regulations; (2) the
total amount of all of capital distributions (including the proposed capital
distribution) for the applicable calendar year exceeds net income for that year
to date plus retained net income for the preceding two years; (3) the savings
association would not be at least adequately capitalized, under the prompt
corrective action regulations of the OTS following the distribution; or (4) the
savings association's proposed capital distribution would violate a prohibition
contained in any applicable statute, regulation, or agreement between the
savings association and the OTS (or the FDIC), or violate a condition imposed on
the savings association in an OTS-approved application or notice.
A notice of a capital distribution is required if a savings association is not
required to file an application, but: (1) would not be well capitalized under
the prompt corrective action regulations of the OTS following the distribution;
(2) the proposed capital distribution would reduce the amount of or retire any
part of your common or preferred stock or retire any part of debt instruments
such as notes or debentures included in capital (other than regular payments
required under a debt instrument approved by the OTS); or (3) the savings
association is a subsidiary of a savings and loan holding company.
If neither the savings association nor the proposed capital distribution meet
any of the above listed criteria, no application or notice is required for the
savings association to make the proposed capital distribution. 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.
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.
Year 2000 Compliance. The Federal Financial Institutions Examination Council
issued an interagency statement to the chief executive officers of all federally
supervised financial institutions regarding year 2000 project management
awareness. It is expected that unless financial institutions address the
technology issues relating to the coming of the year 2000, there will be major
disruptions in the operations of financial institutions. The statement provides
guidance to financial institutions, providers of data services, and all
examining personnel of the federal banking agencies regarding the year 2000
problem. The federal banking agencies intend to conduct year 2000 compliance
examinations, and the failure to implement a year 2000 program may be seen by
the federal banking agencies as an unsafe and unsound banking practice. If a
federal banking agency determines that the Bank is operating in an unsafe and
unsound manner, the Bank may be required to submit a compliance plan. Failure to
submit a compliance plan or to implement an accepted plan may result in
enforcement action being taken, which may include a cease and desist order and
fines.
Community Reinvestment Act and the Fair Lending Laws. Savings associations have
a responsibility under the Community Reinvestment Act ("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.
13
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, 1998, the Bank had $49
million of FHLB stock. The Bank's required investment in FHLB stock, based on
December 31, 1998 financial data, was $52 million. The Bank received a $1
million stock dividend and will purchase additional stock amounting to $2
million in the first quarter of 1999, thereby increasing the Bank's investment
to the required amount. See Note 11 of Notes to the Consolidated Financial
Statements on page 77.
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, 1998, 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. Pursuant to the Paperwork Reduction Act, if
the thrift charter is eliminated after January 1, 1999, the Paperwork Reduction
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. The Bank 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 provisions for the Bank and Downey.
REGULATION OF DSL SERVICE COMPANY
DSL Service company is licensed as a real estate broker under the California
Real Estate Law and as a contractor with the Contractors State License Board. As
such, the real estate investment activities of DSL Service Company, including
development, construction and property management activities relating to a
diverse portfolio of projects are subject to a variety of laws and regulations.
Changes in the laws and regulation, or their interpretation by agencies and the
courts, occur frequently. DSL Service Company must comply with various federal,
state and local laws, ordinances, rules and regulations concerning zoning,
building design, construction, hazardous waste, and similar matters. The
operations of DSL Service Company are also affected by environmental laws and
regulations, including regulations pertaining to availability of water,
municipal sewage treatment capacity, land use, protection of endangered species,
population density and preservation of the natural terrain and coastlines. These
and other requirements could become more restrictive in the future, resulting in
additional time and expense in connection with DSL Service Company's real estate
activities.
14
With regard to environmental matters, the construction products industry is
regulated by federal, state and local laws and regulations pertaining to several
areas including human health and safety and environmental compliance. The
Comprehensive Environmental Response, Compensation, and Liability Act of 1980
("CERCLA"), as amended by the Superfund Amendments and Reauthorization Act of
1986, as well as analogous laws in certain states, create joint and several
liability for the cost of cleaning up or correcting releases to the environment
of designated hazardous substances. Among those who may be held jointly and
several liable are those who generated the waste, those who arranged for
disposal, those who owned or operate the disposal site or facility at the time
of disposal, and current owners. In general, this liability is imposed in a
series of governmental proceedings initiated by the identification of a site for
initial listing as a "Superfund site" on the National Priorities List or a
similar state list and the identification of potentially responsible parties who
may be liable for cleanup costs. None of the DSL Services Company's project
sites are listed as a "Superfund site."
In addition, California courts have imposed warranty-like responsibility upon
developers of new housing for defects in structure and the housing site,
including soil conditions. This responsibility is not necessarily dependent upon
a finding that the developer was negligent.
As a licensed entity, DSL Service Company is also subject to examination and
supervision by the California Department of Real Estate and the Contractors
State License Board.
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 began to recapture its post-1987 bad debt
reserve over a six-year period beginning in 1998. The bad debt deductions for
1997 and 1998 were determined under the specific charge-off method, which allows
a tax deduction for loans determined to be wholly or partially worthless.
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 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 1998 and 1997. 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 Oregon. Additional state tax returns will be required in future years as the
Bank expands its lending business nationwide.
15
The Internal Revenue Service and state taxing authorities have examined Downey's
tax returns for all tax years through 1995. Proposed adjustments for the years
examined by the Internal Revenue Service have been protested by Downey, and are
currently moving through the appeals process. Downey believes that substantial
legal authority exists for the positions taken on the tax returns and intends to
vigorously defend those positions, and that adequate provisions have been
provided for the potential exposure. Tax years subsequent to 1995 remain open to
review by federal and state tax authorities. For further information regarding
income taxes, see Note 18 of Notes to the Consolidated Financial Statements on
page 81.
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
and real estate portfolios and the demand for its products and services.
Interest Rates. Downey anticipates that interest rate levels will remain
generally constant in 1999, 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. If interest rates were to increase
significantly, the economic feasibility of real estate investment activities
also could be adversely affected.
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 tracking loan performance,
assessing the likelihood of nonperformance 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. Downey, like most financial organizations, 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.
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. For further information regarding Downey's Year
2000 compliance program and its status, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Financial Condition
- - Year 2000" on page 52.
16
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, 1998, Downey owned the building and land occupied by 54 of its
branches and owned one branch building on leased land. Downey operates branches
in 36 locations (including 28 in-store locations) with leases or licenses
expiring at various dates through November 2009, with options to extend the
term. In 1998, Downey purchased land and buildings for two new branch locations
opening in 1999.
The net book value of the owned branches, including the one on leased land,
totaled $84 million at December 31, 1998, and the net book value of the leased
branch offices totaled $1 million at December 31, 1998. The net book value of
Downey's furniture and fixtures, including electronic data processing equipment,
was $18 million at December 31, 1998.
For additional information regarding Downey's offices and equipment, see Notes 1
and 10 of Notes to the Consolidated Financial Statements on page 61 and page 77,
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 $11 million
at December 31, 1998.
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.
17
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 26 1999,
Downey had approximately 1,102 stockholders of record (not including the number
of persons or entities holding stock in nominee or street name through various
brokerage firms) and 28,131,776 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.
1998 1997
-----------------------------------------------------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
- --------------------------------------------------------------------------------------------
High ........ $26.38 $35.00 $34.50 $30.95 $27.63 $23.33 $22.50 $21.42
Low ......... 17.75 23.06 30.83 23.58 23.03 20.47 17.23 17.23
End of period 25.44 23.81 32.69 30.83 27.08 23.22 22.50 18.38
============================================================================================
During 1998 and 1997, Downey paid quarterly cash dividends totaling $0.316 and
$0.301 per share, aggregating $8.9 million and $8.5 million, respectively. On
February 26, 1999, Downey paid a $0.08 per share quarterly cash dividend,
aggregating $2.3 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 13.
18
ITEM 6. SELECTED FINANCIAL DATA
(Dollars in Thousands, Except Per Share Data) 1998 1997 1996 1995 1994
- ---------------------------------------------------------------------------------------------------------------------------------
FOR THE YEAR:
Total interest income ...................................... $ 440,404 $ 420,418 $ 346,360 $ 318,828 $ 228,970
Total interest expense ..................................... 266,057 266,260 211,765 214,238 122,601
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income .................................... 174,347 154,158 134,595 104,590 106,369
Provision for loan losses .............................. 3,899 8,640 9,137 9,293 4,211
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses .. 170,448 145,518 125,458 95,297 102,158
- ---------------------------------------------------------------------------------------------------------------------------------
Other income, net:
Loan and deposit related fees .......................... 15,645 10,921 7,435 5,546 5,310
Real estate and joint ventures held for investment, net 22,363 14,222 8,241 11,192 9,530
Net gains (losses) on sales of:
Loans and mortgage-backed securities ................. 6,462 2,675 1,543 266 114
Investment securities ................................ 68 -- 4,473 (15) --
(Provision for) reduction of loss on investment in lease
residual ............................................. -- -- -- 207 (920)
Other .................................................. 2,815 7,370 3,507 3,403 3,703
- ---------------------------------------------------------------------------------------------------------------------------------
Total other income, net .............................. 47,353 35,188 25,199 20,599 17,737
- ---------------------------------------------------------------------------------------------------------------------------------
Operating expense:
General and administrative expense ..................... 115,890 99,556 86,460 74,470 75,566
SAIF special assessment ................................ -- -- 24,644 -- --
Net operation of real estate acquired in settlement of
loans ................................................ 260 1,184 2,567 4,206 3,595
Amortization of excess of cost over fair value of net
assets acquired ...................................... 510 532 532 530 532
- ---------------------------------------------------------------------------------------------------------------------------------
Total operating expense .............................. 116,660 101,272 114,203 79,206 79,693
- ---------------------------------------------------------------------------------------------------------------------------------
Net income (1) ............................................. 57,973 45,234 20,704 21,093 23,532
Loans originated ........................................... 4,071,262 2,329,266 1,583,784 637,490 1,810,096
Loans and mortgage-backed securities purchased ............. 7,463 35,828 30,296 44,194 196,255
Loans and mortgage-backed securities sold .................. 1,740,416 557,511 166,503 102,097 45,770
Effective interest rate spread ............................. 3.08% 2.83% 2.96% 2.35% 3.02%
AT DECEMBER 31:
Total assets ............................................... $6,270,419 $5,835,825 $5,198,157 $4,656,267 $4,650,651
Total loans and mortgage-backed securities ................. 5,788,365 5,366,396 4,729,846 4,169,474 4,188,539
Investments and cash equivalents ........................... 215,086 221,201 222,255 237,904 215,960
Deposits ................................................... 5,039,733 4,869,978 4,173,102 3,790,221 3,557,398
Borrowings ................................................. 703,720 483,735 595,345 436,218 674,776
Stockholders' equity ....................................... 480,566 430,346 391,571 384,072 366,187
Loans serviced for others .................................. 1,040,264 612,529 576,044 527,234 468,123
Allowance for loan losses as a percentage of non-performing
loans .................................................... 140.86% 76.96% 66.84% 35.67% 49.29%
Non-performing assets as a percentage of total assets ...... 0.44 0.89 1.19 2.09 1.41
SELECTED RATIOS:
Return on average assets (1) ............................... 0.98% 0.79% 0.43% 0.45% 0.62%
Return on average equity (1) ............................... 12.71 11.07 5.33 5.69 6.56
Dividend payout ratio ...................................... 15.33 18.69 39.35 36.78 33.97
Capital ratios:
Average stockholders' equity to average assets ......... 7.71 7.17 8.10 7.86 9.47
Core and tangible capital (Bank only) .................. 6.83 6.61 6.56 7.28 7.22
Risk-based capital (Bank only) ......................... 12.88 12.64 12.66 14.25 14.21
PER SHARE DATA: (2)
Earnings per share - Basic (1) ............................. $ 2.06 $ 1.61 $ 0.74 $ 0.75 $ 0.84
Earnings per share - Diluted (1) ........................... 2.05 1.61 0.74 0.75 0.84
Book value per share at end of period ...................... 17.08 15.32 13.95 13.68 13.05
Stock price at end of period ............................... 25.44 27.08 17.80 13.16 8.70
Cash dividends paid ........................................ 0.316 0.301 0.290 0.276 0.276
=================================================================================================================================
(1) Excluding the SAIF special assessment in 1996, net income would have been
$34.7 million or $1.23 per share on both a basic and diluted basis and the
returns on average assets and average equity would have been 0.73% and
8.95%, respectively.
(2) Adjusted for a 5% stock dividend paid in May 1998.
19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements under this caption constitute "forward-looking statements"
under the Private Securities Litigation Reform Act of 1995 which involve risks
and uncertainties. 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 16.
Overview
Net income for 1998 totaled a record $58.0 million or $2.05 per share on a
diluted basis, up 28.2% from last year's $45.2 million or $1.61 per share.
Net income in 1998 benefited by $4.8 million from the settlement of litigation
regarding obligations of a prior joint venture partner ("settlement"). The
pre-tax amount totaled $8.4 million of which $1.4 million represented the
recovery of a prior loan charge-off thereby reducing provision for loan losses;
$4.4 million was recorded in income from real estate and joint venture
operations of which $4.3 million was a reduction of loss; $1.0 million was
recorded in miscellaneous other income; and $1.6 million was recorded as a
reduction to professional fees within general and administrative expense.
Excluding that amount, 1998 net income would have been $53.2 million or $1.89
per share on a diluted basis, up 17.7% from a year ago.
Excluding the settlement, the increase in 1998 net income primarily reflected
higher net interest income. Net interest income increased $20.2 million or 13.1%
due to increases in both average earning assets and the effective interest
spread. Also contributing to the increase in net income between years was an
adjusted $6.8 million increase in other income and declines of $3.3 million and
$1.0 million in adjusted provision for loan losses and net operation of real
estate acquired in satisfaction of loans, respectively. The increase in other
income reflected several factors. Favorably impacting other income were
increases of $4.7 million in loan and deposit related fees, $3.8 million in net
gains on sales of loans, and $3.7 million in adjusted income from real estate
held for investment. These favorable other income items were partially offset by
declines of $3.8 million in the all other category, as 1997 included a gain from
the sale of an asset obtained as part of the 1988 acquisition of Butterfield
Savings, and a $1.0 million decline in loan servicing fees primarily due to
additions made to the valuation allowance for mortgage servicing rights. The
favorable impact of higher net interest and other income, and lower provision
for loan losses and cost of net operation of real estate acquired in settlement
of loans was partially offset by higher general and administrative expense. The
$17.9 million adjusted increase in general and administrative expense reflected
significantly higher lending volumes, branch expansion and expense related to
resolving Year 2000 compliance issues.
Assets increased $435 million or 7.4% during 1998 to $6.3 billion at year end,
following a 12.3% increase during 1997. Asset growth slowed in 1998 even though
loan originations reached a record level, as the low interest rate environment
prevalent during the year resulted in a high level of loan prepayments as
borrowers refinanced into low, fixed rate loans. Single family loan originations
increased from $2.0 billion in 1997 to $3.7 billion in 1998, of which $2.2
billion were originated for sale in the secondary market. In addition to single
family loans, $396 million of other loans were originated, including $175
million of auto loans and $160 million of construction and land loans.
An increase of $220 million in borrowings, primarily long-term FHLB advances,
and an increase of $170 million in deposits funded asset growth. Deposits
totaled $5.0 billion at December 31, 1998, up 3.5% from year-end 1997.
Non-performing assets totaled $27 million or 0.44% of assets at December 31,
1998, down from $52 million or 0.89% of assets at December 31, 1997. The decline
in non-performing assets was primarily in the commercial real estate loan
category, as several loans were returned to accrual status following an extended
period of satisfactory payment performance. 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
20
provisions for loan and real estate losses, including real estate held for
investment and acquired in settlement of loans, resulted in a $0.9 million
reduction of expense for 1998, primarily due to the aforementioned settlement,
which included $4.3 million of settlement proceeds as a reduction to the
provision for losses. Excluding this item, the combined provisions would have
been $3.4 million in 1998, $6.6 million in 1997 and $7.5 million in 1996.
At December 31, 1998, the Bank met and exceeded all three regulatory capital
tests, with capital-to-asset ratios of 6.83% in tangible and core capital and
12.88% 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 10, "Financial Condition - Investments in Real Estate and
Joint Ventures" on page 33 and "Regulatory Capital Compliance" on page 51.
21
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 $174.3 million in 1998, up $20.2 million or 13.1% from
1997 and $39.8 million or 29.5% greater than 1996. The 1998 improvement over
1997 primarily reflected increases in both average earning assets and the
effective interest rate spread. Average earning assets increased by $217 million
or 4.0% to $5.7 billion. The effective interest rate spread averaged 3.08% in
1998, up from 2.83% in 1997 and 2.96% in 1996. The 1998 effective interest rate
spread improved over 1997 as the yield on earning assets increased 6 basis
points, while the cost of funding those earnings assets declined by 16 basis
points.
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
interest income, the interest rate spread and the effective interest rate
spread. 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 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 the average of each
month's daily average balance during the period indicated.
1998 1997 1996
---------------------------------------------------------------------------------------------
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 ............................. $5,345,380 $421,942 7.89% $5,174,767 $404,081 7.81% $4,269,136 $329,746 7.72%
Mortgage-backed securities ........ 42,075 2,780 6.61 55,045 3,633 6.60 64,957 4,317 6.65
Investment securities ............. 276,139 15,682 5.68 217,272 12,704 5.85 215,364 12,297 5.71
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ... 5,663,594 440,404 7.78 5,447,084 420,418 7.72 4,549,457 346,360 7.61
Non-interest-earning assets .......... 254,913 246,785 240,191
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets .................... $5,918,507 $5,693,869 $4,789,648
====================================================================================================================================
Interest-bearing liabilities:
Deposits .......................... $5,102,045 $248,337 4.87% $4,588,320 $227,521 4.96% $3,892,981 $184,402 4.74%
Borrowings ........................ 292,044 17,720 6.07 638,661 38,739 6.07 457,890 27,363 5.98
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing
liabilities .................. 5,394,089 266,057 4.93 5,226,981 266,260 5.09 4,350,871 211,765 4.87
Non-interest-bearing liabilities ..... 68,181 58,415 50,590
Stockholders' equity ................. 456,237 408,473 388,187
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
stockholders' equity ......... $5,918,507 $5,693,869 $4,789,648
====================================================================================================================================
Net interest income/interest rate
spread ............................ $174,347 2.85% $154,158 2.63% $134,595 2.74%
Excess of interest-earning assets over
interest-bearing liabilities ...... $ 269,505 $ 220,103 $ 198,586
Effective interest rate spread ....... 3.08 2.83 2.96
====================================================================================================================================
22
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) changes in volume (changes in volume
multiplied by comparative period rate); (ii) changes in rate (changes in rate
multiplied by comparative period volume); and (iii) changes in rate-volume
(changes in rate multiplied by changes in volume). Interest-earning asset and
interest-bearing liability balances used in the calculations represent average
balances computed using the average of each month's daily average balance during
the period indicated.
1998 versus 1997 1997 versus 1996
Changes Due To Changes Due To
-----------------------------------------------------------------------------
Rate/ Rate/
(In Thousands) Volume Rate Volume Net Volume Rate Volume Net
- ----------------------------------------------------------------------------------------------------------------
Interest Income:
Loans ...................... $ 13,322 $ 4,394 $ 145 $ 17,861 $69,951 $ 3,617 $ 767 $74,335
Mortgage-backed securities . (856) 4 (1) (853) (659) (30) 5 (684)
Investment securities ...... 3,442 (365) (99) 2,978 109 295 3 407
- ----------------------------------------------------------------------------------------------------------------
Change in interest income 15,908 4,033 45 19,986 69,401 3,882 775 74,058
- ----------------------------------------------------------------------------------------------------------------
Interest Expense:
Deposits ................... 25,474 (4,189) (469) 20,816 32,937 8,639 1,543 43,119
Borrowings ................. (21,019) -- -- (21,019) 10,801 412 163 11,376
- ----------------------------------------------------------------------------------------------------------------
Change in interest expense 4,455 (4,189) (469) (203) 43,738 9,051 1,706 54,495
- ----------------------------------------------------------------------------------------------------------------
Change in net interest income . $ 11,453 $ 8,222 $ 514 $ 20,189 $25,663 $(5,169) $ (931) $19,563
================================================================================================================
PROVISION FOR LOAN LOSSES
Provision for loan losses was $3.9 million in 1998, down from $8.6 million in
1997 and $9.1 million in 1996. The decline in provision for loan losses in 1998
reflects a $1.4 million recovery of a prior loan charge-off as a result of the
previously mentioned settlement, as well as less growth in the loan portfolio
than in 1997.
For further information, see "Financial Condition - Problem Loans and Real
Estate - Allowance for Losses on Loans and Real Estate" on page 46.
OTHER INCOME
Other income totaled $47.4 million in 1998, up from $35.2 million in 1997 and
$25.2 million in 1996. The increase in 1998 reflected several factors. Favorably
impacting other income were increases of $8.1 million in income from real estate
held for investment, $4.7 in loan and deposit related fees, and $3.8 million in
net gains from the sale of loans and MBSs. These favorable items were partially
offset by declines of $3.5 million in the other category and $1.0 million in
loan servicing fees. Below is a further discussion of the major other income
categories.
Loan and Deposit Related Fees
Loan and deposit related fees totaled $15.6 million in 1998, up from $10.9
million in 1997 and $7.4 million in 1996. As depicted in the following table,
loan related fees increased by $3.4 million in 1998 due primarily to higher
prepayment and wire transfer fees from funding a higher volume of loans, while
deposit related fees increased by $1.3 million.
(In Thousands) 1998 1997 1996
- -----------------------------------------------------------------
Loan related fees ..................... $ 7,225 $ 3,837 $2,496
Deposit related fees .................. 8,420 7,084 4,939
- -----------------------------------------------------------------
Total loan and deposit related fees $15,645 $10,921 $7,435
=================================================================
23
Real Estate and Joint Venture Operations Held for Investment
Income from real estate and joint venture operations totaled $22.4 million in
1998, up from $14.2 million in 1997 and $8.2 million in 1996. The table below
sets forth the key components comprising income from real estate and joint
venture operations.
(In Thousands) 1998 1997 1996
- ------------------------------------------------------------------------------------
Operations, net:
Rental operations, net of expenses ................... $ 3,723 $ 2,317 $2,417
Equity in net income from joint ventures ............. 9,203 3,931 55
Interest from joint venture advances ................. 1,584 1,880 2,071
- ------------------------------------------------------------------------------------
Total operations, net .............................. 14,510 8,128 4,543
Net gains on sales of wholly owned real estate ........... 2,557 2,904 392
Reduction of losses on real estate and joint ventures .... 5,296 3,190 3,306
- ------------------------------------------------------------------------------------
Income from real estate and joint venture operations $22,363 $14,222 $8,241
====================================================================================
Favorably impacting 1998 was $4.4 million of proceeds from the previously
mentioned settlement, of which $4.3 million was recorded as a recovery of losses
on real estate and joint ventures. The balance of the 1998 increase primarily
reflected higher gains on sale associated with residential and shopping center
joint venture projects, which appears within the category of equity in net
income from joint ventures.
For additional information, see "Financial Condition - Investments in Real
Estate and Joint Ventures" on page 33, "Financial Condition - Problem Loans and
Real Estate - Allowance for Losses on Loans and Real Estate" on page 46 and Note
8 of Notes to the Consolidated Financial Statements on page 73.
Secondary Marketing Activities
Sales of loans and MBSs originated by Downey increased in 1998 to $1.7 billion
from $558 million in 1997 and $167 million in 1996. Net gains associated with
loan and MBS sales totaled $6.5 million in 1998, up from $2.7 million in 1997
and $1.5 million in 1996. The net gains include $7.3 million in 1998, $1.2
million in 1997 and $1.0 million in 1996 related to the capitalization of
mortgage servicing rights.
Loan servicing fees from Downey's portfolio of loans serviced for others totaled
$0.3 million for 1998, down from $1.3 million in 1997 and $1.4 million in 1996.
The decline in 1998 reflects an addition to the valuation allowance for mortgage
servicing rights due to higher than expected prepayments from the low interest
rate environment that existed during the year. At December 31, 1998, Downey
serviced $1.0 billion of loans for others, compared to $613 million at December
31, 1997, and $576 million at December 31, 1996.
Other Category
The all other category of other income totaled $2.6 million in 1998, down from
$6.1 million in 1997 but up from $2.1 million in 1996. Included in the 1998
total were $1.0 million of proceeds from the previously mentioned settlement.
Excluding that amount, the adjusted decline from 1997 would have been $4.5
million. That decrease primarily reflects that 1997 included a gain from the
sale of an asset obtained as part of the 1988 acquisition of Butterfield
Savings.
24
OPERATING EXPENSES
Operating expenses totaled $116.7 million in 1998, up from $101.3 million in
1997 and $114.2 million in 1996 which included a one-time SAIF assessment of
$24.6 million. The current year increase was due to higher general and
administrative expense, as the net operation of real estate acquired in
settlement of loans declined by $0.9 million to $0.3 million. General and
administrative expense increased $16.3 million or 16.4% in 1998 due to
significantly higher lending volumes, branch expansion and expense related to
Year 2000 costs. Year 2000 related costs totaled $1.8 million for the current
year, up from $0.1 million in 1997. Included within general and administrative
expense in the current year was a $1.6 million reduction to professional fees
due to proceeds from the previously mentioned settlement, while the prior year
included $1.4 million of expense associated with the departure of a former chief
executive.
(In Thousands) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------
Salaries and related costs .......................................... $ 66,152 $ 54,366 $ 45,811
Premises and equipment costs ........................................ 16,834 15,272 12,640
Advertising expense ................................................. 5,954 6,847 4,071
Professional fees ................................................... 2,867 5,113 2,985
SAIF insurance premiums and regulatory assessments .................. 3,832 3,439 8,949
Other general and administrative expense ............................ 20,251 14,519 12,004
- ---------------------------------------------------------------------------------------------------
Total general and administrative expense ........................ 115,890 99,556 86,460
SAIF special assessment ............................................. -- -- 24,644
Net operation of real estate acquired in settlement of loans ........ 260 1,184 2,567
Amortization of excess of cost over fair value of net assets acquired 510 532 532
- ---------------------------------------------------------------------------------------------------
Total operating expense ......................................... $116,660 $101,272 $114,203
===================================================================================================
For further information regarding the potential expense impact of the Year 2000
compliance issue, see "Financial Condition - Year 2000" on page 52.
PROVISION FOR INCOME TAXES
Downey's effective tax rate for 1998 was 42.7%, similar to 43.1% in 1997 and
43.2% in 1996. See Notes 1 and 18 of Notes to the Consolidated Financial
Statements on pages 61 and 81, respectively, for a further discussion of income
taxes and an explanation of the factors which impact Downey's effective tax
rate.
BUSINESS SEGMENT REPORTING
The previous sections of the Results of Operations discussed the consolidated
results of Downey. The purpose of this section is to present data on the results
of operations of Downey's two business segments - banking and real estate
investment. For a description of these business segments and the accounting
policies used, see "Business" on page 1, and Notes 1 and 25 of Notes to the
Consolidated Financial Statements on pages 61 and 91, respectively.
The following table presents by business segment net income for 1998, 1997 and
1996, followed by a discussion of the results of operations of each segment.
(In Thousands) 1998 1997 1996
- -----------------------------------------------------
Banking .............. $46,736 $38,662 $17,191 (1)
Real estate investment 11,237 6,572 3,513
- -----------------------------------------------------
Total net income .. $57,973 $45,234 $20,704 (1)
=====================================================
(1) Excluding the SAIF special assessment, net income for Banking and the total
would have been $31.2 million and $34.7 million, respectively.
25
Banking
Net income from banking operations totaled $46.7 million in 1998, up from $38.7
million in 1997 and $17.2 million in 1996. Net income in 1998 benefited by $1.9
million from the previously mentioned settlement. Excluding that amount, 1998
net income would have been $44.8 million, up $6.1 million or 15.8% from a year
ago. Adjusting for the settlement, the increase in 1998 net income primarily
reflected higher net interest income. Net interest income increased $20.2
million or 13.0% due to increases in both average earning assets and the
effective interest rate spread. Also contributing to the increase in net income
between years was an adjusted $3.2 million decline in provision for loan losses
and an adjusted $3.0 million increase in other income. The increase in adjusted
other income reflected increases in loan and deposit related fees and net gains
on sales of loans, partially offset by a decline in loan servicing fees and that
1997 results included a gain from the sale of an asset obtained as part of the
1988 acquisition of Butterfield Savings. The favorable impact of these items
were partially offset by higher operating expense. The $16.0 million adjusted
operating expense increase reflected significantly higher lending volumes,
branch expansion and expense related towards resolving Year 2000 compliance
issues. The table below sets forth banking operational results for the periods
indicated.
(In Thousands) 1998 1997 1996
- --------------------------------------------------------------------------
Net interest income ............ $ 174,967 $ 154,799 $ 134,808
Provision for loan losses ...... 3,918 8,522 9,026
Other income ................... 24,617 20,783 16,956
Operating expense .............. 113,954 98,803 87,275
SAIF special assessment ........ -- -- 24,644
Net intercompany expense ....... (107) (357) (574)
- --------------------------------------------------------------------------
Income before income tax expense 81,605 67,900 30,245
Income tax expense ............. 34,869 29,238 13,054
- --------------------------------------------------------------------------
Net income .................. $ 46,736 $ 38,662 $ 17,191 (1)
==========================================================================
AT DECEMBER 31:
Assets:
Loans ....................... $5,788,365 $5,366,396 $4,729,846
Other ....................... 463,960 449,174 446,975
- --------------------------------------------------------------------------
Total assets .............. 6,252,325 5,815,570 5,176,821
- --------------------------------------------------------------------------
Equity ......................... 480,566 430,346 391,571
==========================================================================
(1) Excluding the SAIF special assessment, net income would have been
$31.2 million.
26
Real Estate Investment
Net income from real estate investment operations totaled $11.2 million in 1998,
up from $6.6 million in 1997 and $3.5 million in 1996. Net income in 1998
benefited by $2.9 million from the previously mentioned settlement. Adjusting
for the settlement, adjusted 1998 net income would have been $8.3 million, up
$1.7 million or 25.8% from a year ago. The adjusted increase primarily reflected
higher gains on sale associated with residential and shopping center joint
venture projects which appears in the other income category. The table below
sets forth real estate investment operational results for the periods indicated.
(In Thousands) 1998 1997 1996
- -------------------------------------------------------------------
Net interest expense ................ $ (620) $ (641) $ (213)
Provision (reduction) for loan losses (19) 118 111
Other income ........................ 22,736 14,405 8,243
Operating expense ................... 2,706 2,469 2,284
Net intercompany income ............. 107 357 574
- -------------------------------------------------------------------
Income before income tax expense .... 19,536 11,534 6,209
Income tax expense .................. 8,299 4,962 2,696
- -------------------------------------------------------------------
Net income ....................... $11,237 $ 6,572 $ 3,513
===================================================================
AT DECEMBER 31:
Assets:
Real estate held for investment .. $49,447 $41,356 $46,498
Other ............................ 11,224 14,455 14,514
- -------------------------------------------------------------------
Total assets ................... 60,671 55,811 61,012
- -------------------------------------------------------------------
Equity .............................. 42,577 35,556 39,676
===================================================================
For a further discussion regarding income from real estate investment, see
"Results of Operations - Other Income - Real Estate and Joint Venture Operations
Held For Investment" on page 24, and for information regarding related assets
see "Financial Condition - Investments in Real Estate and Joint Ventures" on
page 33.
27
Financial Condition
LOANS AND MORTGAGE-BACKED SECURITIES
Loans and mortgage-backed securities, including those held for sale, totaled
$5.8 billion, or 92.3% of assets at December 31, 1998. This represents an
increase of $422 million or 7.9% from the $5.4 billion at December 31, 1997. The
increase primarily represents a higher level of loans held for sale.
Loan originations (including loans purchased) totaled a record $4.1 billion in
1998, up from $2.4 billion in 1997 and $1.6 billion in 1996. This increase
primarily reflected an increase in originations of one-to-four unit residential
loans. Due to the low interest rate environment prevalent during 1998, borrower
preference for such loans was primarily fixed rate. Therefore, of the $3.7
billion of one-to-four unit residential loans originated, approximately
two-thirds or $2.3 billion were fixed rate, all but $198 million of which were
originated for sale in the secondary market. In addition, $380 million of
subprime loans were originated in 1998, up from $221 million in 1997.
The table below presents information regarding interest rates and fees collected
on loans originated during the periods indicated.
(Dollars in Thousands) 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Average interest rate on new loans ................. 6.45% 6.04% 6.06% 6.99% 4.94%
Average total loan origination fees on new loans ... 0.75 0.80 0.79 1.08 0.85
Total loan fees (net of costs) and discounts (net of
premiums) deferred during the year ............. $(30,621) $(11,505) $(4,525) $ 880 $(7,861)
================================================================================================================
Downey originates one-to-four unit residential adjustable rate mortgages
("ARMs") both with and without loan origination fees. In ARM transactions for
which no origination fees are charged, Downey receives a larger margin over the
index to which the loan pricing is tied than in those in which fees are charged.
In addition, such loans are generally subject to a prepayment fee if prepaid
within the first three years. This trend towards loans with no origination fees
has generally resulted in deferrable loan origination costs exceeding loan
origination fees except in 1995, which included increases in interest buydowns,
or discounts, on new real estate loans.
Residential one-to-four unit ARM originations (including loans purchased through
correspondent lending relationships) were $1.4 billion during 1998, compared to
$1.7 billion and $1.1 billion in 1997 and 1996, respectively. Refinancing
activities related to residential one-to-four unit loans (including new loans to
refinance loans originated by Downey and other lenders) increased during 1998,
constituting 71% of originations during the year compared to 45% and 43% during
1997 and 1996, respectively. As market interest rates began to rise in 1994 and
1995, one-to-four unit residential borrower preference changed from being
predominantly interested in ARMs tied to the one-year constant maturity Treasury
("CMT") index, a market rate index, to ARMs tied to the Federal Home Loan Bank
("FHLB") Eleventh District Cost of Funds Index ("COFI"), an index which lags the
movement in market interest rates. For the year, 74% of one-to-four unit
originations for investment represented monthly adjusting COFI ARMs which
provide for negative amortization, 11% represented COFI ARMs which reprice every
six months but do not provide for negative amortization, with the balance
represented by a variety of other pricing terms. At December 31, 1998, $3.0
billion of one-to-four unit ARMs were subject to negative amortization of which
$47 million represented the amount of negative amortization added to the unpaid
loan balance. For further information, see "Business - Banking Activities -
Lending Activities - Residential Real Estate Lending" on page 3.
Originations of commercial real estate loans (including loans purchased) totaled
$11 million in 1998, compared to $8 million in 1997 and $2 million in 1996. Most
of the commercial real estate lending in these years was to facilitate the sale
of real estate investments by the Bank and DSL Service Company. Originations of
loans secured by multi-family properties (including loans purchased) totaled $15
million in 1998, compared to $6 million in 1997 and $20 million in 1996.
28
During 1998, Downey originated $112 million of construction loans, principally
for entry level and first time move-up residential tracts. This compares to $80
million in 1997 and $72 million in 1996. Originations of land development loans
totaled $48 million in 1998, compared to $20 million in 1997 and $10 million in
1996.
Originations of non-mortgage commercial loans decreased to $6 million in 1998
from $14 million in 1997. Virtually all of such originations represented secured
loans.
In 1995, Downey augmented its direct automobile lending program with the
commencement of an indirect lending program through preapproved automobile
dealers to finance consumer purchases of new and used automobiles. These loans
are fixed rate with maturities generally up to five years. Originations of
automobile loans totaled $175 million in 1998, compared to $259 million in 1997
and $201 million in 1996.
29
The following table sets forth the origination, purchase and sale activity
relating to loans and MBSs during the periods indicated.
(In Thousands) 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO:
Loans originated:
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable ............................................ $ 943,736 $ 1,384,442 $ 1,026,812 $ 396,111 $ 1,673,822
Adjustable - subprime ................................. 372,286 218,399 33,030 -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Total adjustable .................................... 1,316,022 1,602,841 1,059,842 396,111 1,673,822
Fixed ................................................. 192,436 22,265 33,073 13,888 7,411
Fixed - subprime ...................................... 6,020 2,786 545 -- --
Five or more units:
Adjustable ............................................ 875 4,600 17,409 128 18,385
Fixed ................................................. 13,229 -- 2,253 419 953
- ------------------------------------------------------------------------------------------------------------------------------------
Total residential ................................... 1,528,582 1,632,492 1,113,122 410,546 1,700,571
Commercial real estate ................................... 10,363 7,830 1,548 10,629 18,900
Construction ............................................. 111,534 80,014 71,678 28,931 14,785
Land ..................................................... 48,357 20,295 10,468 12,906 --
Non-mortgage:
Commercial ............................................... 6,376 14,336 11,835 1,115 1,605
Automobile ............................................... 175,193 259,040 200,966 62,234 1,869
Other consumer ........................................... 28,274 25,988 14,226 17,633 39,945
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans originated ................................ 1,908,679 2,039,995 1,423,843 543,994 1,777,675
Real estate loans purchased (1) ............................... 7,463 35,828 223 44,194 145,117
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans originated and purchased ....................... 1,916,142 2,075,823 1,424,066 588,188 1,922,792
Loan repayments ............................................... (1,855,157) (1,130,357) (832,713) (538,217) (631,836)
Other net changes (2), (3) .................................... (34,145) (319,183) (39,978) (50,544) (38,330)
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for investment ....... 26,840 626,283 551,375 (573) 1,252,626
- ------------------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities held to maturity, net:
Repayments ................................................. -- -- -- (5,588) (11,917)
Transferred to mortgage-backed securities available for sale -- -- -- (33,555) --
- ------------------------------------------------------------------------------------------------------------------------------------
Net decrease in mortgage-backed securities, net .......... -- -- -- (39,143) (11,917)
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans and mortgage-backed
securities held for investment ....................... 26,840 626,283 551,375 (39,716) 1,240,709
- ------------------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO:
Residential, one-to-four units:
Originated whole loans ..................................... 2,162,583 289,271 159,941 93,496 32,421
Loans transferred from (to) the investment portfolio (3) ... (3,056) 290,558 1,791 (100) --
Originated whole loans sold (3) ............................ (1,130,303) (467,989) (135,426) (80,725) (45,770)
Loans exchanged for mortgage-backed securities ............. (608,831) (89,522) (26,452) -- --
Other net changes .......................................... (8,111) (83) (48) (10) (16)
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for sale ........... 412,282 22,235 (194) 12,661 (13,365)
- ------------------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities, net:
Received in exchange for loans ............................. 608,831 89,522 26,452 -- --
Purchased .................................................. -- -- 30,073 -- 51,138
Transferred from mortgage-backed securities held to maturity -- -- -- 33,555 --
Sold ....................................................... (610,113) (89,522) (31,077) (21,372) --
Repayments ................................................. (15,129) (12,560) (15,661) (6,862) (5,263)
Other net changes .......................................... (742) 592 (596) 2,669 (1,789)
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in mortgage-backed securities
available for sale .................................... (17,153) (11,968) 9,191 7,990 44,086
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase in loans and mortgage-backed securities held
for sale and available for sale ....................... 395,129 10,267 8,997 20,651 30,721
- ------------------------------------------------------------------------------------------------------------------------------------
Total net increase (decrease) in loans and mortgage-backed
securities ............................................ $ 421,969 $ 636,550 $ 560,372 $ (19,065) $ 1,271,430
====================================================================================================================================
(1) Primarily one-to-four unit residential loans. Included in 1998 were $0.7
million of five or more unit residential loans and $0.6 million of
commercial loans. Included in 1997 were $1.3 million of five or more unit
residential loans.
(2) Primarily includes borrowings against and repayments of lines of credit and
construction loans, changes in loss allowances, loans transferred to real
estate acquired in settlement of loans or to the held for sale portfolio,
and interest capitalized on loans (negative amortization).
(3) Includes $290.5 million of one-to-four unit residential ARMs transferred
from the held for investment portfolio during 1997 and sold servicing
released.
30
The following table sets forth the composition of Downey's loan and
mortgage-backed securities portfolio at the dates indicated. At December 31,
1998, approximately 99% of Downey's real estate loans were secured by real
estate located in California (principally in Los Angeles, Orange, Santa Clara,
San Diego and San Mateo counties).
December 31,
-------------------------------------------------------------------
(In Thousands) 1998 1997 1996 1995 1994
- ---------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO:
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable .............................. $3,721,728 $4,190,160 $3,840,862 $3,486,774 $3,493,435
Adjustable - subprime ................... 580,232 245,749 32,715 -- --
Fixed ................................... 325,454 168,315 172,328 169,738 194,845
Fixed - subprime ........................ 8,719 3,321 543 -- --
- ---------------------------------------------------------------------------------------------------------------------------
Total one-to-four units ............... 4,636,133 4,607,545 4,046,448 3,656,512 3,688,280
Five or more units:
Adjustable .............................. 18,617 29,246 43,050 44,438 48,782
Fixed ................................... 21,412 9,032 13,857 12,883 15,000
Commercial real estate:
Adjustable ................................. 39,360 87,604 158,656 170,498 178,377
Fixed ...................................... 101,430 114,821 101,953 100,085 116,041
Construction ................................. 127,761 70,865 66,651 28,593 11,367
Land ......................................... 44,859 25,687 21,177 21,867 9,822
Non-mortgage:
Commercial ................................... 28,293 26,024 22,136 12,864 12,975
Automobile ................................... 357,988 342,326 202,186 56,127 3,028
Other consumer ............................... 41,894 47,735 47,281 50,945 53,241
- ---------------------------------------------------------------------------------------------------------------------------
Total loans held for investment ......... 5,417,747 5,360,885 4,723,395 4,154,812 4,136,913
Increase (decrease) for:
Undisbursed loan funds ....................... (108,414) (64,884) (49,250) (29,942) (13,872)
Net deferred costs and premiums .............. 31,021 18,088 11,663 7,412 7,468
Allowance for estimated loss ................. (31,517) (32,092) (30,094) (27,943) (25,597)
- ---------------------------------------------------------------------------------------------------------------------------
Total loans held for investment, net .... 5,308,837 5,281,997 4,655,714 4,104,339 4,104,912
- ---------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities held to maturity, net:
Adjustable ................................... -- -- -- -- 19,897
Fixed ........................................ -- -- -- -- 19,246
- ---------------------------------------------------------------------------------------------------------------------------
Total mortgage-backed securities held to
maturity, net ........................... -- -- -- -- 39,143
- ---------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities
held for investment ..................... 5,308,837 5,281,997 4,655,714 4,104,339 4,144,055
- ---------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO, NET:
Loans held for sale (all one-to-four units):
Adjustable ................................... 7,975 1,617 1,145 238 --
Fixed ........................................ 439,407 33,483 11,720 12,821 398
- ---------------------------------------------------------------------------------------------------------------------------
Total loans held for sale .................. 447,382 35,100 12,865 13,059 398
Mortgage-backed securities available for sale:
Adjustable ................................... 10,996 17,751 23,620 34,355 44,086
Fixed ........................................ 21,150 31,548 37,647 17,721 --
- ---------------------------------------------------------------------------------------------------------------------------
Total mortgage-backed securities available
for sale ................................ 32,146 49,299 61,267 52,076 44,086
- ---------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities
held for sale and available for sale .... 479,528 84,399 74,132 65,135 44,484
- ---------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities . $5,788,365 $5,366,396 $4,729,846 $4,169,474 $4,188,539
===========================================================================================================================
31
The table below sets forth the scheduled contractual maturities of Downey's
total loan and mortgage-backed securities portfolio as of December 31, 1998.
Within 1-2 2-3 3-5 5-10 10-15 Beyond
(In Thousands) 1 year years years years years years 15 years Total
- ---------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable (1) ........ $ 37,087 $ 39,965 $ 43,067 $ 96,418 $314,646 $457,205 $3,321,547 $4,309,935
Fixed (1) ............. 9,520 10,251 11,039 24,687 80,353 116,342 521,388 773,580
Five or more units:
Adjustable ............ 310 335 361 809 2,645 3,855 10,302 18,617
Fixed ................. 2,908 3,165 3,446 7,834 4,059 -- -- 21,412
Commercial real estate:
Adjustable ............ 1,294 1,395 1,505 3,371 11,025 16,067 4,703 39,360
Fixed ................. 6,051 6,596 7,191 16,386 55,780 9,426 -- 101,430
Construction - adjustable 127,761 -- -- -- -- -- -- 127,761
Land:
Adjustable ............ 32,213 11,399 -- -- -- -- -- 43,612
Fixed ................. 60 66 73 170 602 276 -- 1,247
Non-mortgage:
Commercial ................ 23,272 1,573 1,727 1,721 -- -- -- 28,293
Automobile ................ 85,246 94,025 103,709 75,008 -- -- -- 357,988
Other consumer (2) ........ 1,904 2,032 2,168 755 35,035 -- -- 41,894
- ---------------------------------------------------------------------------------------------------------------------------
Total loans ........... 327,626 170,802 174,286 227,159 504,145 603,171 3,857,940 5,865,129
Mortgage-backed securities, net 693 14,237 594 1,333 4,382 4,553 6,354 32,146
- ---------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-
backed securities ..... $328,319 $185,039 $174,880 $228,492 $508,527 $607,724 $3,864,294 $5,897,275
===========================================================================================================================
(1) Includes loans held for sale.
(2) Includes home equity line of credit loans which are interest only, with
balances due at the end of the term. All or part of the outstanding
balances may be paid off at any time during the term without penalty.
At December 31, 1998, the maximum amount the Bank could have loaned to any one
borrower (and related entities) under regulatory limits was $75 million, or $124
million for loans secured by readily marketable collateral, compared to $67
million and $112 million, respectively, at December 31, 1997. The Bank does not
expect that these regulatory limitations will adversely impact its proposed
lending activities during 1999.
INVESTMENT SECURITIES
The following table sets forth the composition of Downey's investment securities
portfolio at the dates indicated. In the 1995 fourth quarter, the held to
maturity U.S. Treasury and agency portfolio was transferred to available for
sale consistent with the "Guide to Statement 115 on Accounting for Certain
Investments in Debt and Equity Securities" issued by the Financial Accounting
Standards Board.
December 31,
----------------------------------------------------
(In Thousands) 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------
Federal funds ...................... $ 33,751 $ 6,095 $ 6,038 $ 7,249 $ 6,112
U.S. Treasury and agency securities:
Held to maturity ............... -- -- -- -- 155,109
Available for sale ............. 116,061 159,398 141,999 164,880 --
Municipal bonds - held to maturity . 6,764 6,885 6,997 7,194 --
- -------------------------------------------------------------------------------------------
Total .......................... $156,576 $172,378 $155,034 $179,323 $161,221
===========================================================================================
32
As of December 31, 1998, the maturities of Downey's investment securities and
the weighted average yield of those securities were as follows.
After 1 Year
1 Year or Less Through 5 Years After 5 Years Total
-----------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
(Dollars in Thousands) Amount Yield Amount Yield Amount Yield Amount Yield
- ---------------------------------------------------------------------------------------------------------------------
Federal funds ....................... $33,751 4.13% $ -- -% $ -- -% $ 33,751 4.13%
U.S. Treasury and agency securities -- - 116,061 5.77 -- - 116,061 5.77
Municipal bonds (1) ............... -- - -- - 6,764 5.28 6,764 5.28
- ---------------------------------------------------------------------------------------------------------------------
Total .......................... $33,751 4.13% $116,061 5.77% $6,764 5.28% $156,576 5.40%
=====================================================================================================================
(1) Yield on a fully tax-equivalent basis is 9.26%.
INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
DSL Service Company participates as an owner of, or a partner in, a variety of
real estate development projects, principally retail neighborhood shopping
center developments, most of which are located in California. In addition,
Downey Financial Corp. owns one investment in land which it purchased from DSL
Service Company at fair value in 1995. For additional information regarding the
location of these real estate investments see Note 8 of Notes to the
Consolidated Financial Statements on page 73. Most of the real estate
development projects have been completed and are substantially leased (with a
weighted average occupancy of 83% for retail neighborhood shopping centers at
December 31, 1998). At December 31, 1998, the Bank had outstanding loans of $47
million to such joint ventures.
In its joint ventures, DSL Service Company is entitled to interest on its equity
invested in the project on a priority basis after third-party debt, and shares
profits and losses with the developer partner, generally on an equal basis. DSL
Service Company has obtained personal guarantees from the principals of the
developer partners in a number of the joint ventures and generally requires the
developer partner to secure any outstanding obligations to the joint venture,
such as its portion of operating losses, when the partner is unable to satisfy
such obligations on a current basis. Partnership equity (deficit) accounts are
affected by current period results of operations, additional partner advances,
partnership distributions and partnership liquidations.
As of December 31, 1998, DSL Service Company was involved with five joint
venture partners. Three of these partners were operators of four retail
neighborhood shopping centers, a commercial building, two residential housing
developments and vacant land held for sale. The other two joint venture partners
are separately involved in the development of a new industrial building and in
the rehabilitation of a large apartment complex. DSL Service Company has ten
wholly owned retail neighborhood shopping centers located in California and
Arizona.
33
The following table sets forth the condensed balance sheets of DSL Service
Company's joint ventures by property type at December 31, 1998, on a historical
cost basis. Included in the following condensed balance sheet are allowances for
losses recorded by DSL Service Company. These allowances are determined
quarterly by means of Downey's internal asset review process. See "Problem Loans
and Real Estate - Allowance for Losses on Loans and Real Estate" on page 46. To
the extent the fair market value of the real estate assets is less than the
carrying value, then a provision is made to create a valuation allowance for the
difference. If such a valuation allowance is needed, it is reflected in the
investment accounts for the joint ventures on DSL Service Company's books. Not
all of the joint venture investments have valuation allowances as the fair
market value of the associated property exceeds its carrying value.
Retail
Neighborhood
Shopping
(Dollars In Thousands) Centers Commercial Residential Total
- -------------------------------------------------------------------------------------------------------
Cash ................................................... $ 445 $ 351 $ 1,980 $ 2,776
Projects under development ............................. -- 707 17,819 18,526
Completed projects ..................................... 20,913 4,796 5,663 31,372
Other assets ........................................... 2,674 316 519 3,509
- -------------------------------------------------------------------------------------------------------
Total assets .................................... $24,032 $ 6,170 $25,981 $ 56,183
=======================================================================================================
Secured notes payable to the Bank ...................... $25,195 $ 903 $20,446 $ 46,544
Secured notes payable to others ........................ -- 3,633 -- 3,633
Other liabilities ...................................... 4,418 1,936 642 6,996
Equity (deficit):
DSL Service Company (1) ............................ 2,057 464 5,362 7,883
Allowance for losses recorded by DSL Service Company 19 1,393 -- 1,412
Other partners' (2) ................................ (7,657) (2,159) (469) (10,285)
- -------------------------------------------------------------------------------------------------------
Total liabilities and equity .................... $24,032 $ 6,170 $25,981 $ 56,183
=======================================================================================================
Number of joint venture projects ....................... 4 3 3 10
=======================================================================================================
(1) Included in these amounts are interest-bearing joint venture advances with
priority interest payments from joint ventures to DSL Service Company.
(2) The aggregate other partners' deficit of $10 million represents their
equity interest in the accumulated retained earnings (deficit) of the
respective joint ventures. Those results include not only the net profit on
sales and the operating results of the real estate assets, but depreciation
expense and funding costs as well. Except for any secured financing which
has been obtained, DSL Service Company has provided all other financing. As
part of Downey's internal asset review process, the fair value of the joint
venture real estate assets is compared to the secured notes payable to the
Bank and others and DSL Service Company's equity investment. To the extent
the fair value of the real estate assets is less than the aggregate of
those amounts, a provision is made to create a valuation allowance. Those
allowances totaled $1 million at December 31, 1998. At December 31, 1998,
the fair value of the real estate assets of certain joint venture
partnerships in which the other partners' equity was a deficit exceeded the
amount of third party notes and DSL Service Company's investment thereby
eliminating the need for a valuation allowance since the sale of the real
estate would allow DSL Service Company to realize its investment. Thus, the
other partners' deficit of $10 million exceeds the amount of valuation
allowances established of $1 million.
34
The following table sets forth by property type Downey's wholly owned
investments in real estate and related allowances for losses at December 31,
1998.
Retail
Single Family Neighborhood
(Dollars in Thousands) Developments Shopping Centers Land Total
- ------------------------------------------------------------------------------------------------
Wholly Owned Properties:
Investment in wholly owned projects ... $ -- $27,434 (1) $20,435 (2) $47,869
Allowance for losses .................. -- (1,594) (4,711) (6,305)
- ------------------------------------------------------------------------------------------------
Net investment in wholly owned projects $ -- $25,840 $15,724 $41,564
================================================================================================
Number of projects .................... -- 10 11 21
================================================================================================
(1) Includes eight free-standing stores that are part of neighborhood shopping
centers totaling $1 million and are counted as one project.
(2) Includes five properties totaling $20 million.
Real estate investments entail risks similar to those presented by Downey's
construction and commercial lending activities. In addition, California courts
have imposed warranty-like responsibility upon developers of new housing for
defects in structure and the housing site, including soil conditions. This
responsibility is not necessarily dependent upon a finding that the developer
was negligent. Owners of real property also may incur liabilities with respect
to environmental matters, including financial responsibility for clean-up of
hazardous waste or other conditions, under various federal and state laws.
DEPOSITS
Deposits increased $170 million or 3.5% in 1998, and totaled $5.0 billion at
December 31, 1998. Transaction accounts (i.e., checking, regular passbook and
money market) increased $302 million or 32.3%, while higher-rate certificates of
deposits decreased $132 million or 3.4%. Of the total increase in deposits, $49
million was associated with 5 new branches opened during 1998. The following
table sets forth the amount of deposits by classification.
December 31,
------------------------------------------------------------
1998 1997 1996
------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
(Dollars in Thousands) Rate Amount Rate Amount Rate Amount
- ------------------------------------------------------------------------------------------------
Transaction accounts ............. 2.30% $1,238,062 2.15% $ 935,869 2.04% $ 831,598
Certificates of deposit:
Less than 3.00% ............... 2.62 25,126 2.64 30,623 2.65 39,061
3.00-3.49 ..................... 3.01 593 3.02 766 3.03 723
3.50-3.99 ..................... 3.88 51,474 -- -- 3.99 79
4.00-4.49 ..................... 4.39 428,316 4.31 60,095 4.39 63,577
4.50-4.99 ..................... 4.80 668,204 4.87 40,356 4.87 186,576
5.00-5.99 ..................... 5.53 2,421,333 5.63 2,896,291 5.54 2,489,852
6.00-6.99 ..................... 6.06 204,065 6.06 901,920 6.17 536,307
7.00 and greater .............. 7.24 2,560 7.22 4,058 7.15 25,329
- ------------------------------------------------------------------------------------------------
Total certificates of deposit 5.26 3,801,671 5.68 3,934,109 5.56 3,341,504
- ------------------------------------------------------------------------------------------------
Total deposits .............. 4.53% $5,039,733 5.00% $4,869,978 4.86% $4,173,102
================================================================================================
35
The following table shows as of December 31, 1998, certificates of deposit
maturities by interest rate category.
Less
Than 4.00%- 4.50%- 5.00%- 6.00%- 7.00% Percent
(Dollars in Thousands) 4.00% 4.49% 4.99% 5.99% 6.99% and greater Total (1) of Total
- --------------------------------------------------------------------------------------------------------------------
Within 3 months ......... $72,983 $ 12,948 $131,873 $ 986,573 $ 21,349 $ 215 $1,225,941 32.25%
3 to 6 months ........... 3,025 138,912 169,456 528,986 117,951 206 958,536 25.21
6 to 12 months .......... 769 245,387 279,597 673,641 35,247 601 1,235,242 32.50
12 to 24 months ......... 403 30,618 80,316 184,869 12,165 1,538 309,909 8.15
24 to 36 months ......... 3 240 1,388 22,163 5,206 -- 29,000 0.76
36 to 60 months ......... 10 31 4,394 24,966 12,002 -- 41,403 1.09
Over 60 months ......... -- 180 1,180 135 145 -- 1,640 0.04
- --------------------------------------------------------------------------------------------------------------------
$77,193 $428,316 $668,204 $2,421,333 $204,065 $2,560 $3,801,671 100.00%
====================================================================================================================
(1) Includes jumbo (over $100,000) certificates of deposit of $443 million with
maturities of 3 months or less, $316 million and $413 million of 3 to 6
month and 6 to 12 month maturities, respectively, and $105 million with a
remaining term of over 12 months.
BORROWINGS
At December 31, 1998, borrowings totaled $704 million, compared to $484 million
at December 31, 1997 and $595 million at December 31, 1996. The increase in 1998
occurred as Downey took advantage of obtaining long-term advances from the FHLB
at attractive borrowing rates. The following table sets forth information
concerning Downey's FHLB advances and other borrowings at the dates indicated.
December 31,
---------------------------------------------------------
(Dollars in Thousands) 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------
FHLB advances ....................................... $695,012 $352,458 $386,883 $220,715 $411,800
Other borrowings:
Reverse repurchase agreements ................... -- 34,803 -- 16,099 53,946
Commercial paper ................................ -- 83,811 198,113 196,602 197,839
Industrial revenue bonds ........................ -- -- -- -- 6,421
Real estate notes ............................... 8,708 12,663 10,349 2,802 4,770
- -----------------------------------------------------------------------------------------------------------------
Total borrowings .............................. $703,720 $483,735 $595,345 $436,218 $674,776
=================================================================================================================
Weighted average rate on borrowings during the period 6.07% 6.07% 5.98% 6.39% 5.57%
Total borrowings as a percentage of total assets .... 11.22 8.29 11.45 9.37 14.51
=================================================================================================================
36
The following table sets forth certain information with respect to Downey's
short-term borrowings.
(Dollars in Thousands) 1998 1997 1996
- -------------------------------------------------------------------------------------------------------
FHLB advances with original maturities less than one year:
Balance at end of year ........................................ $120,000 $214,300 $279,000
Average balance outstanding during the year ................... 38,393 328,886 174,380
Maximum amount outstanding at any month-end during the year ... 120,000 427,100 279,000
Weighted average interest rate during the year ................ 5.96% 5.83% 5.78%
Weighted average interest rate at the end of year ............. 5.36 5.81 5.70
Securities sold under agreement to repurchase:
Balance at end of year ........................................ $ -- $ 34,803 $ --
Average balance outstanding during the year ................... 1,877 4,029 11,761
Maximum amount outstanding at any month-end during the year ... 50,088 34,803 70,015
Weighted average interest rate during the year ................ 5.90% 5.61% 5.19%
Weighted average interest rate at the end of year ............. - 6.65 -
Commercial paper sold:
Balance at end of year ........................................ $ -- $ 83,811 $198,113
Average balance outstanding during the year ................... 30,589 182,296 174,739
Maximum amount outstanding at any month-end during the year ... 103,749 272,818 198,113
Weighted average interest rate during the year ................ 6.32% 5.75% 5.74%
Weighted average interest rate at the end of year ............. - 5.61 5.45
Total short-term borrowings:
Total average short-term borrowings outstanding during the year $ 70,859 $515,211 $360,880
Total weighted average rate on borrowings during the year ..... 6.11% 5.80% 5.74%
=======================================================================================================
As previously mentioned, Downey increased its intermediate and long-term
advances from the FHLB during 1998. At year-end, total intermediate and
long-term advances were $575 million, up from $138 million at December 31, 1997.
The weighted average rate at year-end 1998 was 5.49%. The following table sets
forth the associated maturities at December 31, 1998.
(In Thousands)
- --------------------------------------------------------------
1999 ............................................. $ 43,105
2000 ............................................. 28,796
2001 ............................................. 16,056
2002 ............................................. 55,921
2003 ............................................. 134
Thereafter ....................................... 431,000
- --------------------------------------------------------------
Total intermediate and long-term FHLB advances $575,012
==============================================================
ASSET/LIABILITY MANAGEMENT AND MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. Downey's market risk arises primarily from interest rate risk in
its lending and deposit taking activities. This interest rate risk occurs to the
degree that interest-bearing liabilities reprice or mature more rapidly or on a
different basis than interest-earning assets. Since Downey's earnings depend
primarily on its net interest income, which is the difference between the
interest and dividends earned on interest-earning assets and the interest paid
on interest-bearing liabilities, a principal objective of Downey is to actively
monitor and manage the effects of adverse changes in interest rates on net
interest income while maintaining asset quality.
Downey's Asset/Liability Management Committee ("ALCO") is responsible for
implementing the interest rate risk management policy which sets forth limits
established by the Board of Directors on acceptable changes in net
37
interest income and net portfolio value ("NPV") from specified changes in
interest rates. NPV is defined by the OTS as the present value of expected net
cash flows from existing assets minus the present value of expected net cash
flows from existing liabilities plus the present value of expected cash flows
from existing off-balance sheet contracts. ALCO reviews, among other items,
economic conditions, the interest rate outlook, the demand for loans, the
availability of deposits and borrowings, and Downey's current operating results,
liquidity, capital and interest rate exposure. In addition, ALCO monitors asset
and liability maturities and repricing characteristics on a regular basis and
performs various simulations and other analyzes to determine the potential
impact of various business strategies in controlling interest rate risk and the
potential impact of those strategies upon future earnings under various interest
rate scenarios. Based on such reviews, ALCO formulates a strategy that is
intended to implement the objectives set forth in Downey's business plan without
exceeding the net interest income and NPV limits set forth in the interest rate
risk policy.
One measure of Downey's exposure to differential changes in interest rates
between assets and liabilities is shown in the following table which sets forth
the repricing frequency of Downey's major asset and liability categories as of
December 31, 1998, as well as certain information regarding the repricing and
maturity difference between interest-earning assets and interest-bearing
liabilities ("GAP") in future periods. The repricing frequencies have been
determined by reference to projected maturities, based upon contractual
maturities as adjusted for scheduled repayments and "repricing mechanisms"
(provisions for changes in the interest and dividend rates of assets and
liabilities). Prepayment rates are assumed on substantially all of Downey's loan
portfolio based upon its historical loan prepayment experience and anticipated
future prepayments. Repricing mechanisms on certain of Downey's assets are
subject to limitations, such as caps on the amount that interest rates and
payments on Downey's loans may adjust, and accordingly, such assets do not
normally respond as completely or rapidly as Downey's liabilities to changes in
market interest rates. The interest rate sensitivity of Downey's assets and
liabilities illustrated in the following table would vary substantially if
different assumptions were used or if actual experience differed from the
assumptions set forth.
38
December 31, 1998
-----------------------------------------------------------------------------
Within 7 - 12 2 - 5 6 - 10 Over Total
(Dollars in Thousands) 6 Months Months Years Years 10 Years Balance
- --------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Investment securities and FHLB stock .....(1) $ 89,945 $ -- $116,061 $ -- $ -- $ 206,006
Loans and mortgage-backed securities:
Mortgage-backed securities ..............(2) 16,261 4,725 10,361 745 54 32,146
Loans secured by real estate:
Residential:
Adjustable ..........................(2) 4,227,780 106,498 6,720 -- -- 4,340,998
Fixed ...............................(2) 483,212 36,636 171,606 68,474 35,688 795,616
Commercial real estate ................(2) 36,528 9,454 80,983 9,087 1,919 137,971
Construction ..........................(2) 46,122 -- -- -- -- 46,122
Land ..................................(2) 22,430 42 370 568 225 23,635
Non-mortgage:
Commercial ............................(2) 19,154 -- -- -- -- 19,154
Consumer ..............................(2) 119,718 74,288 198,717 -- -- 392,723
- --------------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities 4,971,205 231,643 468,757 78,874 37,886 5,788,365
- --------------------------------------------------------------------------------------------------------------------------------
Total ................................... $5,061,150 $ 231,643 $584,818 $ 78,874 $ 37,886 $5,994,371
================================================================================================================================
Deposits and borrowings:
Interest-bearing deposits:
Fixed maturity deposits .................(1) $2,184,477 $ 1,235,242 $380,312 $ 1,640 $ -- $3,801,671
Transaction accounts ....................(3) 1,082,795 -- -- -- -- 1,082,795
Non-interest-bearing transaction accounts 155,267 -- -- -- -- 155,267
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits .......................... 3,422,539 1,235,242 380,312 1,640 -- 5,039,733
- --------------------------------------------------------------------------------------------------------------------------------
Borrowings ............................... 143,575 22,305 105,142 432,698 -- 703,720
- --------------------------------------------------------------------------------------------------------------------------------
Total deposits and borrowings ........... $3,566,114 $ 1,257,547 $485,454 $ 434,338 $ -- $5,743,453
================================================================================================================================
Excess (shortfall) of interest-earning assets
over interest-bearing liabilities ........ $1,495,036 $(1,025,904) $ 99,364 $(355,464) $ 37,886 $ 250,918
Cumulative gap ............................... 1,495,036 469,132 568,496 213,032 250,918
Cumulative gap - as a % of total assets:
December 31, 1998 ........................ 23.84% 7.48% 9.07% 3.40% 4.00%
December 31, 1997 ........................ 24.82 1.35 2.71 3.54 3.93
December 31, 1996 ........................ 16.71 2.68 0.50 1.47 3.04
================================================================================================================================
(1) Based upon contractual maturity and repricing date.
(2) Based upon contractual maturity, repricing date and projected repayment and
prepayments of principal.
(3) Subject to immediate repricing.
Downey's six-month gap at December 31, 1998, was a positive 23.84% (i.e., more
interest earning assets reprice within six months than interest-bearing
liabilities). This compares to a positive six-month gap of 24.82% and 16.71% at
December 31, 1997 and 1996, respectively. Downey's primary strategy to manage
interest rate risk is to emphasize the origination of ARMs or loans with
relatively short maturities. Interest rates on ARMs are primarily tied to the
CMT or COFI. During 1998, 1997 and 1996, Downey originated and purchased
approximately $1.5 billion, $2.0 billion and $1.4 billion, respectively, of
loans and mortgage-backed securities with adjustable interest rates or
maturities of five years or less, representing approximately 80%, 96% and 95%,
respectively, of all loans and mortgage-backed securities originated and
purchased for investment during such periods. ARM originations during those
three years were primarily tied to COFI rather than the CMT index.
At December 31, 1998, 98% of Downey's interest-earning assets mature, reprice or
are estimated to prepay within five years, compared to 99% and 97% at December
31, 1997 and 1996, respectively. At December 31, 1998, loans held for investment
with adjustable interest rates represented 85% of Downey's loan and
mortgage-backed securities portfolio. During 1999, Downey will continue to offer
residential fixed rate loan products to its customers
39
to meet customer demand. Fixed rate loans are primarily originated for sale in
the secondary market and are priced accordingly in order to create loan
servicing income and to increase opportunities for originating ARMs. However,
Downey may originate fixed rate loans for investment when funded with long-term
funds to mitigate interest rate risk, and small volumes to facilitate the sale
of real estate acquired through foreclosure or that meet certain yield and other
approved guidelines. See "Business - Banking Activities - Lending Activities-
Secondary Marketing and Loan Servicing Activities" on page 4.
Downey is better protected against rising interest rates with a positive
six-month GAP. However, Downey remains subject to possible interest rate spread
compression, which would adversely impact Downey's net interest income if
interest rates rise. This is primarily due to the lag in the repricing of the
indices to which Downey's adjustable-rate loans and mortgage-backed securities
are tied, as well as the repricing frequencies and periodic interest rate caps
on such adjustable-rate loans and mortgage-backed securities. The amount of such
interest rate spread compression would depend upon the frequency and severity of
such interest rate fluctuations. The positive six-month GAP could decrease in
future periods due to, among other things, the continued expansion of the auto
and consumer loan portfolios.
In addition to measuring interest rate risk via a GAP analysis, Downey
establishes limits on, and measures the sensitivity of, its net interest income
and NPV to changes in interest rates. Changes in interest rates are defined as
instantaneous and sustained movements in interest rates in 100 basis point
increments. Downey utilizes an internally maintained asset/liability management
simulation model to make the calculations which, for NPV, is calculated on a
discounted cash flow basis. First, Downey estimates its net interest income for
the next twelve months and the current NPV assuming no change in interest rates
from those at period end. Once the base case has been estimated, calculations
are made for each of the defined changes in interest rates, to include any
associated differences in the anticipated prepayment speed of loans. Those
results are then compared against the base case to determine the estimated
change to net interest income and NPV due to the changes in interest rates. The
following are the estimated impacts to net interest income and NPV from various
instantaneous, parallel shifts in interest rates based upon Downey's asset and
liability structure as of year-ends 1998 and 1997. Since these estimates are
based upon numerous assumptions, such as the expected maturities of Downey's
interest-bearing assets and liabilities and the shape of the period-end interest
rate yield curve, Downey's actual sensitivity to interest rate changes could
vary significantly if actual experience differs from those assumptions used in
making the calculations.
1998 1997
Percentage Change In Percentage Change In
Change in Interest Rates Net Interest Net Portfolio Net Interest Net Portfolio
(In Basis Points) Income(1) Value (2) Income (1) Value (2)
- ---------------------------------------------------------------------------------------------------------
+200 ......................... (10.0)% 1.2% (13.6)% (9.3)%
+100 ......................... (4.4) 2.0 (5.7) (3.4)
(100) ........................ 2.9 (1.0) 5.5 3.2
(200) ........................ 3.9 (0.6) 12.0 9.1
=========================================================================================================
(1) The percentage change in this column represents net interest income for 12
months in a stable interest rate environment versus the net interest income
in the various rate scenarios.
(2) The percentage change in this column represents the NPV of the Bank in a
stable interest rate environment versus the NPV in the various rate
scenarios.
40
The following table shows Downey's financial instruments that are sensitive to
changes in interest rates, categorized by expected maturity, and the
instruments' fair values at December 31, 1998. This data differs from that in
the GAP table as it does not incorporate the repricing characteristics of assets
and liabilities. Rather, it only reflects contractual maturities adjusted for
anticipated prepayments. Market risk sensitive instruments are generally defined
as on and off balance sheet derivatives and other financial instruments.
Expected Maturity Date at December 31, 1998 (1)
-----------------------------------------------------------------------------------------------
Total Fair
(Dollars in Thousands) 1999 2000 2001 2002 2003 Thereafter Balance Value
- ------------------------------------------------------------------------------------------------------------------------------
INTEREST-SENSITIVE ASSETS:
Investment securities ....... $ 83,181 $ 40,375 $ 50,448 $ 25,238 $ -- $ 6,764 $ 206,006 $ 205,987
Average interest rate .. 5.48% 5.74% 5.37% 6.45% -% 5.25% 5.62%
Loans held for sale ......... 447,382 -- -- -- -- -- 447,382 447,468
Average interest rate .. 6.91% -% -% -% -% -% 6.91%
Mortgage-backed securities
available for sale ....... 12,772 9,980 2,452 1,716 1,227 3,999 32,146 32,146
Average interest rate .. 6.71% 6.59% 7.58% 7.51% 7.44% 7.16% 6.86%
Loans held for investment:
Loans secured by real
estate:
Residential:
Adjustable ............ 1,062,467 844,589 625,298 461,153 339,734 999,782 4,333,023 4,474,114
Average interest rate 7.42% 7.43% 7.41% 7.41% 7.51% 7.38% 7.42%
Fixed ................. 79,388 59,790 46,148 36,398 29,270 105,215 356,209 368,737
Average interest rate 8.37% 8.35% 8.27% 8.20% 8.14% 7.68% 8.11%
Other .................. 73,969 20,833 15,368 15,974 16,631 64,953 207,728 210,172
Average interest rate 8.87% 8.81% 8.71% 8.72% 8.72% 7.96% 8.54%
Non-mortgage:
Commercial ............. 16,299 1,188 1,322 345 -- -- 19,154 19,154
Average interest rate 8.59% 8.59% 8.59% 8.59% -% -% 8.59%
Consumer ............... 149,029 121,324 122,370 -- -- -- 392,723 396,421
Average interest rate 9.93% 9.92% 9.29% -% -% -% 9.73%
Interest bearing advances to
joint ventures ........... 25,540 -- -- -- -- -- 25,540 25,540
Average interest rate .. 3.61% -% -% -% -% -% 3.61%
Mortgage servicing assets ... 1,630 1,471 1,282 1,095 927 1,388 7,793 11,976
- ------------------------------------------------------------------------------------------------------------------------------
Total interest-sensitive
assets ................... $1,951,657 $1,099,550 $864,688 $541,919 $387,789 $1,182,101 $6,027,704 $6,191,715
==============================================================================================================================
INTEREST-SENSITIVE
LIABILITIES:
Deposits:
Transaction accounts ..... $ 226,130 $ 184,827 $151,069 $123,477 $100,924 $ 451,635 $1,238,062 $1,238,062
Average interest rate .. 2.30% 2.30% 2.30% 2.30% 2.30% 2.30% 2.30%
Certificates of deposit .. 3,419,719 309,909 29,000 19,863 21,540 1,640 3,801,671 3,804,269
Average interest rate .. 5.26% 5.23% 5.69% 5.88% 5.37% 4.96% 5.26%
Borrowings .................. 165,880 31,199 16,743 56,467 733 432,698 703,720 709,223
Average interest rate .. 5.62% 6.34% 6.28% 4.97% 8.58% 5.44% 5.51%
- ------------------------------------------------------------------------------------------------------------------------------
Total interest-sensitive
liabilities .............. $3,811,729 $ 525,935 $196,812 $199,807 $123,197 $ 885,973 $5,743,453 $5,751,554
==============================================================================================================================
(1) Expected maturities are contractual maturities adjusted for prepayments of
principal. Downey uses certain assumptions to estimate fair values and
expected maturities. For assets, expected maturities are based upon
contractual maturity, projected repayments and prepayments of principal.
The prepayment experience reflected herein is based on Downey's historical
experience. Downey's average constant prepayment rate ("CPR") is 21.1% and
27.6% on its fixed-rate and ARM portfolios, respectively, for
interest-earning assets (excluding investment securities, which do not have
prepayment features). For deposit liabilities, in accordance with standard
industry practice and Downey's own historical experience, "decay factors",
used to estimate deposit runoff, of 20% per year have been applied. The
actual maturities of these instruments could vary substantially if future
prepayments differ from the Downey's historical experience.
41
The following table sets forth the interest rate spread between Downey's
interest-earning assets and interest-bearing liabilities as of the dates
indicated.
December 31,
-------------------------------------
1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------
Weighted average yield:
Loan and mortgage-backed securities 7.72% 7.95% 7.77% 7.67% 6.24%
FHLB stock ........................ 5.44 5.88 6.45 5.16 5.69
Investment securities ............. 5.40 5.63 6.02 6.46 6.17
- ----------------------------------------------------------------------------------
Earning assets yield .............. 7.65 7.87 7.71 7.60 6.24
- ----------------------------------------------------------------------------------
Weighted average cost:
Deposits .......................... 4.53 5.00 4.86 4.81 4.23
Borrowings:
FHLB advances ................... 5.47 6.11 5.80 6.07 6.41
Other borrowings ................ 8.69 6.15 5.60 5.62 5.88
- ----------------------------------------------------------------------------------
Combined borrowings ............... 5.51 6.12 5.73 5.84 6.20
- ----------------------------------------------------------------------------------
Combined funds .................... 4.66 5.11 4.97 4.92 4.55
- ----------------------------------------------------------------------------------
Interest rate spread .................. 2.99% 2.76% 2.74% 2.68% 1.69%
==================================================================================
The year-end weighted average yield on the loan portfolio decreased to 7.72%,
from 7.95% as of December 31, 1997. The weighted average rate on new loans
originated during 1998, 1997 and 1996 was 6.45%, 6.04% and 6.06%, respectively.
At December 31, 1998, the ARM portfolio of single family residential loans,
including mortgage-backed securities, totaled $4.3 billion with a weighted
average rate of 7.53%, compared to $4.5 billion and $3.9 billion with weighted
average rates of 7.58% and 7.38% at December 31, 1997 and 1996, respectively.
PROBLEM LOANS AND REAL ESTATE
Non-performing Assets
Non-performing assets consist of loans on which Downey has ceased the accrual of
interest ("non-accrual loans") and real estate acquired in settlement of loans.
Non-performing assets totaled $27 million at December 31, 1998, compared to $52
million at December 31, 1997, and $62 million at December 31, 1996. The decrease
in non-performing assets was primarily attributed to several loans in the
commercial real estate loan category that were returned to accrual status
following an extended period of satisfactory payment performance. The effective
yield on these loans bear a market rate of interest and are, therefore, not
considered troubled debt restructurings. Of the total, real estate acquired in
settlement of loans, net of allowances, represented $4 million at December 31,
1998, down from $10 million at December 31, 1997, and $16 million at December
31, 1996.
42
The following table summarizes the non-performing assets of Downey at the dates
indicated.
December 31,
----------------------------------------------------
(Dollars in Thousands) 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------
Non-accrual loans:
One-to-four unit residential .................... $15,571 $20,816 $22,885 $25,587 $24,012
One-to-four unit residential - subprime ......... 1,975 -- -- -- --
Other ........................................... 4,829 20,883 22,136 52,754 28,025
- ------------------------------------------------------------------------------------------------------------
Total non-accrual loans ....................... 22,375 41,699 45,021 78,341 52,037
Real estate acquired in settlement of loans, net (1) 4,475 9,626 16,078 18,854 13,558
Repossessed automobiles ............................. 569 795 928 -- --
- ------------------------------------------------------------------------------------------------------------
Gross non-performing assets ...................... $27,419 $52,120 $62,027 $97,195 $65,595
- ------------------------------------------------------------------------------------------------------------
Allowance for loan losses (2):
Amount .......................................... $31,517 $32,092 $30,094 $27,943 $25,650
As a percentage of non-performing loans ......... 140.86% 76.96% 66.84% 35.67% 49.29%
Non-performing assets as a percentage of total assets 0.44 0.89 1.19 2.09 1.41
============================================================================================================
(1) Excludes real estate acquired in settlement of loans covered under the
Butterfield Assistance Agreement. All such assets were sold to the FDIC's
Division of Resolution in December 1995.
(2) Allowance for loan losses does not include the allowance for real estate
and real estate acquired in settlement of loans.
It is Downey's policy to take appropriate, timely and aggressive action when
necessary to resolve non-performing assets. When resolving problem loans, it is
Downey's policy to determine collectibility under various circumstances which
will result in maximum financial benefit to Downey. This is accomplished by
either working with the borrower to bring the loan current or by foreclosing and
selling the asset. Downey performs ongoing reviews of loans that display
weaknesses and maintains adequate loss allowances on the loans. For a discussion
on Downey's internal asset review policy, refer to "Allowance for Losses on
Loans and Real Estate" on page 46.
All of Downey's non-performing assets at December 31, 1998, were located in
California.
Downey evaluates the need for appraisals for non-performing assets on a periodic
basis. A new appraisal will generally be obtained when Downey believes that
there may have been an adverse change in the property operations or in the
economic conditions of the geographic market of the property securing its loans.
Downey's policy is to obtain new appraisals at least annually for major real
estate acquired in settlement of loans. Throughout 1998, Downey obtained new
appraisals for non-performing loans and real estate acquired in settlement of
loans.
Non-Accrual Loans. It is Downey's general policy to account for a loan as
non-accrual when the loan becomes 90 days delinquent or when collection of
interest appears doubtful. In certain cases, loans may remain on accrual status
past 90 days when it is determined that continued accrual is warranted because
the loan is well-secured and in process of collection. As of December 31, 1998,
Downey had no loans 90 days or more delinquent which remained on accrual status.
Any interest previously accrued with respect to non-accrual loans is reversed
and charged against interest income. Interest income is recognized on
non-accrual loans to the extent that payments are received and to the extent
that Downey believes it will recover the remaining principal balance of the
loan. Such loans are restored to an accrual status only if all past due payments
are made by the borrower and the borrower has demonstrated the ability to make
future payments of principal and interest. At December 31, 1998, non-accrual
loans aggregating $4 million were less than 90 days delinquent relative to their
contractual terms. Additional loans aggregating $1 million were not
contractually past due, but were deemed non-accrual due to management's
assessment of the borrower's ability to pay.
Impaired Loans. Downey considers a loan to be impaired when, based upon current
information and events, it believes it is probable that Downey will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. Impaired loans are carried at either the present value of expected
future cash flows
43
discounted at the loan's effective interest rate, or at the loan's observable
market price or the net fair value of the collateral securing the loan. Impaired
loans exclude large groups of smaller balance homogeneous loans that are
collectively evaluated for impairment. For Downey, loans collectively reviewed
for impairment include all single family loans and performing multi-family and
non-residential loans having principal balances of less than $1 million.
In determining impairment, Downey considers large non-homogeneous loans with the
following characteristics: non-accrual loans, debt restructurings, and
performing loans which exhibit, among other characteristics, high loan-to-value
ratios or delinquent taxes. Downey bases the measurement of collateral dependent
impaired loans on the fair value of the loan's collateral. Non-collateral
dependent loans are valued based on a present value calculation of expected
future cash flows, discounted at the loan's effective rate. Cash receipts on
impaired loans not performing according to contractual terms are generally used
to reduce the carrying value of the loan, unless Downey believes it will recover
the remaining principal balance of the loan. Impairment losses are included in
the allowance for loan losses through a charge to provision for loan losses.
Adjustments to impairment losses due to changes in the fair value of the
collateral of impaired loans are included in provision for loan losses. Upon
disposition of an impaired loan, loss of principal is recorded through a
charge-off to the allowance for loan losses. At December 31, 1998, the recorded
investment in loans for which impairment has been recognized totaled $13
million, compared to $14 million at December 31, 1997. The total allowance for
losses related to such loans was $1 million at December 31, 1998, and 1997. For
further information regarding impaired loans, see Note 6 of the Notes to the
Consolidated Financial Statements on page 70.
Troubled Debt Restructurings. A restructuring of a debt is considered a troubled
debt restructuring when Downey, for economic or legal reasons related to the
borrower's financial difficulties, grants a concession to the borrower that it
would not otherwise grant. Troubled debt restructurings may include changing
repayment terms, reducing the stated interest rate and reducing the amounts of
principal and/or interest due or extending the maturity date. The restructuring
of a loan is intended to recover as much of Downey's investment as possible and
to achieve the highest yield possible. There were no troubled debt
restructurings on accrual status at December 31, 1998 and 1997.
Real Estate Acquired in Settlement of Loans. Real estate acquired in settlement
of loans consists of real estate acquired through foreclosure or deeds in lieu
of foreclosure.
Delinquent Loans
When a borrower fails to make required payments on a loan and does not cure the
delinquency within 60 days, Downey normally records a notice of default, subject
to any required prior notice to the borrower, and commences foreclosure
proceedings. If the loan is not reinstated within the time permitted by law for
reinstatement, which is normally five business days prior to the date set for
the non-judicial trustee's sale, the property may then be sold at a foreclosure
sale. If Downey has elected to pursue a non-judicial foreclosure, Downey is not
permitted under applicable California law to obtain a deficiency judgment
against the borrower, even if the security property is insufficient to cover the
balance owed. In foreclosure sales, Downey generally acquires title to the
property. At December 31, 1998, loans delinquent 30 days or more as a percentage
of total loans was 0.65%, down from 0.79% and 0.89% at December 31, 1997 and
1996, respectively.
44
The following table indicates the amounts of Downey's past due loans at the
dates indicated.
December 31,
-----------------------------------------------------------------------------------
1998 1997
-----------------------------------------------------------------------------------
30-59 60-89 90+ 30-59 60-89 90+
(Dollars in Thousands) Days Days Days (1) Total Days Days Days (1) Total
- ----------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $ 9,841 $6,014 $12,832 $28,687 $12,099 $4,101 $18,579 $34,779
One-to-four units - subprime (2) ..... 244 784 947 1,975 185 -- -- 185
Five or more units ................... -- -- 155 155 -- 222 -- 222
Commercial real estate ................. -- -- -- -- -- -- 279 279
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- -- -- -- -- -- --
- ----------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 10,085 6,798 13,934 30,817 12,284 4,323 18,858 35,465
Non-mortgage:
Commercial ............................. -- -- -- -- -- -- -- --
Automobile ............................. 4,650 888 1,048 6,586 4,167 981 961 6,109
Other consumer ......................... 334 45 344 723 218 54 533 805
- ----------------------------------------------------------------------------------------------------------------------------------
Total loans ........................ $15,069 $7,731 $15,326 $38,126 $16,669 $5,358 $20,352 $42,379
- ----------------------------------------------------------------------------------------------------------------------------------
Delinquencies as a percentage of total loans 0.26% 0.13% 0.26% 0.65% 0.31% 0.10% 0.38% 0.79%
==================================================================================================================================
1996 1995
-----------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $14,519 $5,502 $18,549 $38,570 $14,047 $6,645 $22,303 $42,995
One-to-four units - subprime (2) ..... 198 -- -- 198 -- -- -- --
Five or more units ................... -- -- -- -- 89 -- 447 536
Commercial real estate ................. -- -- -- -- -- -- 30,675 30,675
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- 566 566 -- -- 6,516 6,516
- ----------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 14,717 5,502 19,115 39,334 14,136 6,645 59,941 80,722
Non-mortgage:
Commercial ............................. -- -- -- -- -- -- 115 115
Automobile ............................. 2,080 328 274 2,682 667 249 540 1,456
Other consumer ......................... 158 15 181 354 257 410 170 837
- ----------------------------------------------------------------------------------------------------------------------------------
Total loans ........................ $16,955 $5,845 $19,570 $42,370 $15,060 $7,304 $60,766 $83,130
- ----------------------------------------------------------------------------------------------------------------------------------
Delinquencies as a percentage of total loans 0.36% 0.12% 0.41% 0.89% 0.36% 0.17% 1.46% 1.99%
==================================================================================================================================
1994
----------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $15,306 $9,273 $20,584 $45,163
Five or more units ................... -- -- 149 149
Commercial real estate ................. -- -- 1,139 1,139
Construction ........................... -- -- -- --
Land ................................... -- -- 836 836
- ---------------------------------------------------------------------------------------
Total real estate loans .............. 15,306 9,273 22,708 47,287
Non-mortgage:
Commercial ............................. -- -- -- --
Automobile ............................. 22 12 24 58
Other consumer ......................... 291 171 334 796
- ---------------------------------------------------------------------------------------
Total loans ........................ $15,619 $9,456 $23,066 $48,141
- ---------------------------------------------------------------------------------------
Delinquencies as a percentage of total loans 0.38% 0.23% 0.55% 1.16%
=======================================================================================
(1) All 90 day or greater delinquencies are on non-accrual status and reported
as part of non-performing assets.
(2) Downey commenced one-to-four units subprime lending in the first quarter of
1996.
45
Allowance for Losses On Loans and Real Estate
Valuation allowances for losses on loans and real estate are established on a
specific and general basis. Specific allowances are determined based on the
difference between the carrying value of the asset and its net fair value.
General valuation allowances are determined based on historical loss experience,
current and anticipated levels and trends of delinquent and non-performing loans
and the economic environment in Downey's market areas. See Note 1 of Notes to
the Consolidated Financial Statements on page 61.
Downey's Internal Asset Review Department conducts independent reviews to
evaluate the risk and quality of all Downey assets. Downey's Internal Asset
Review Committee ("IARC") is responsible for the review and classification of
assets. The IARC members include the Chief Internal Asset Review Officer, Chief
Executive Officer, Chief Financial Officer, Chief Lending Officer, General
Counsel, Director of Compliance/Risk Management, Credit Administrator and Chief
Appraiser. The IARC meets quarterly to review and to determine asset
classifications and to recommend any changes to asset valuation allowances. With
the exception of payoffs or asset sales, the classification of an asset, once
established, can be removed or upgraded only upon approval of the IARC. The
Chief Internal Asset Review Officer reports quarterly to the Audit Committee of
the Board of Directors regarding overall asset quality, the adequacy of
valuation allowances on classified assets and Downey's adherence to policies and
procedures regarding asset classification and valuation.
Downey adheres to an internal asset review system and loss allowance methodology
designed to provide for timely recognition of problem assets and adequate
general valuation allowances to cover asset losses. Downey's current asset
monitoring process includes the use of asset classifications to segregate the
assets, largely loans and real estate, into various risk categories. Downey uses
the various asset classifications as a means of measuring risk for determining
the general valuation allowances at a point in time. Downey currently uses a six
grade system to classify its assets. The current grades are Pass, Watch, Special
Mention, Substandard, Doubtful and Loss. Substandard, Doubtful and Loss assets
are considered "classified assets" for regulatory purposes. A brief description
of these classifications follows:
o The Pass classification represents a level of credit quality which contains
no well-defined deficiency or weakness.
o The Watch classification is used to identify an asset that currently
contains no well-defined deficiency or weakness, but it is determined to be
desirable to closely monitor the asset (e.g., loans to facilitate the sale
of real estate acquired in settlement of loans). This category may also be
used for assets upgraded from lower classifications where continuing
monitoring is deemed appropriate.
o A Special Mention asset does not currently expose Downey to a sufficient
degree of risk to warrant an adverse classification, but does possess a
correctable deficiency or potential weakness deserving management's close
attention.
o Substandard assets have a well-defined weakness or weaknesses. They are
characterized by the distinct possibility that Downey will sustain some
loss if the deficiencies are not corrected.
o An asset classified Doubtful has all the weaknesses inherent in those
classified Substandard with the added characteristic that the weaknesses
make collection or liquidation in full, on the basis of currently existing
facts, conditions and values, highly questionable and improbable. Downey
considers Doubtful to be a temporary classification until resolution of
pending weakness issues enables Downey to more clearly define the potential
for loss.
o That portion of an asset classified Loss is considered uncollectible and of
such little value that its continuance as an asset, without establishment
of a specific valuation allowance, is not warranted. A Loss classification
does not mean that an asset has absolutely no recovery or salvage value,
but rather it is not reasonable to defer writing off or providing for all
or a portion of an impaired asset even though partial recovery may be
effected in the future. Downey will generally classify as Loss the balance
of the asset that is greater than the net fair value of the asset unless
payment from another source can be expected. Therefore, the amount of an
asset classified as Loss reflects the total of specific valuation
allowances established for the particular asset. Specific valuation
allowances are not includable in determining the Bank's total regulatory
capital.
46
The OTS has the authority to require Downey to change its asset classifications.
If such a change results in an asset being classified in whole or in part as
Loss, a specific allowance must be established against the amount so classified
or that amount must be charged off. OTS guidelines set forth quantitative
benchmarks as a starting point for the determination of appropriate levels of
general valuation allowances. The OTS directs its examiners to rely on
management's estimates of adequate general valuation allowances if the
association's process for determining adequate allowances is deemed to be sound.
It is Downey's policy to provide an allowance for losses on loans and real
estate when it is probable that the value of the asset has been impaired and the
loss can be reasonably estimated. To comply with this policy, Downey has
established a monitoring system that requires at least an annual review of all
assets in excess of $1 million and a semiannual review of all assets considered
adversely classified or criticized. The monitoring system requires a review of
current operating statements, an evaluation of the property's current and past
performance, an evaluation of the borrower's ability to repay and the
preparation of a discounted cash flow analysis. Based on the results of the
review, a new appraisal may be required.
Downey's provision for loan losses totaled $3.9 million in 1998, down $4.7
million from 1997. Net loan charge-offs exceeded the provision for loan losses
by $0.6 million resulting in a decrease in the allowance for loan losses to
$31.5 million at December 31, 1998. This decrease reflects an improvement in
overall loan quality. Included in the current year-end allowance was $31.3
million of general valuation allowances of which $2.8 million was unallocated to
any specific loan category.
A summary of activity in the allowances for loan losses is set forth below for
the years indicated.
(In Thousands) 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------
Balance at beginning of period $32,092 $30,094 $27,943 $25,650 $26,835
Provision .................... 3,899 8,640 9,137 9,293 4,211
Charge-offs .................. (7,372) (7,773) (7,660) (8,017) (5,511)
Recoveries ................... 2,898 1,131 674 1,017 115
- ------------------------------------------------------------------------------------------
Balance at end of period ..... $31,517 $32,092 $30,094 $27,943 $25,650
==========================================================================================
47
Net loan charge-offs were $4.5 million in 1998, down from $6.6 million and $7.0
million in 1997 and 1996, respectively. The decline primarily reflected a $1.3
million decline in net charge-offs of one-to-four unit residential loans and a
$1.4 million recovery of a prior commercial real estate loan charge-off due to
proceeds from the previously mentioned settlement. The growth in automobile loan
net charge-offs reflects the growth in that portfolio as the ratio of automobile
net charge-offs to the average of such loans was 1.40% in 1998 compared to 1.58%
in 1997 and 1.37% in 1996. Charge-offs, net of recoveries, by category of loan
are as follows for the years indicated.
(Dollars in Thousands) 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four unit (1) ......................... $ 910 $2,165 $4,982 $5,165 $4,051
Five or more unit ............................ 68 -- 102 469 264
Commercial real estate .......................... (1,610) (261) (250) 807 959
Land ............................................ -- -- -- 4 --
Non-mortgage:
Commercial ...................................... -- -- 115 (152) (52)
Automobile ...................................... 4,959 4,468 1,791 398 9
Other consumer .................................. 147 270 246 309 165
- ----------------------------------------------------------------------------------------------------------------
Total net loan charge-offs ................... $ 4,474 $6,642 $6,986 $7,000 $5,396
- ----------------------------------------------------------------------------------------------------------------
Net loan charge-offs as a percentage of average loans
and mortgage-backed securities held to maturity . 0.09% 0.13% 0.16% 0.17% 0.16%
================================================================================================================
(1) Includes net charge-offs associated with the January 1994 Northridge
earthquake of $1.0 million, $1.1 million and $0.8 million in 1996, 1995 and
1994, respectively.
48
The allocation of the allowance for loan losses at the dates indicated is as set
forth in the following table.
December 31,
-----------------------------------------------------------------------------------------------
1998 1997 1996
-----------------------------------------------------------------------------------------------
Gross Allowance Gross Allowance Gross Allowance
Loan Percentage Loan Percentage Loan Percentage
Portfolio to Loan Portfolio to Loan Portfolio to Loan
(Dollars in Thousands) Allowance Balance Balance Allowance Balance Balance Allowance Balance Balance
- ---------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units ... $14,299 $4,636,133 0.31% $14,652 $4,607,545 0.32% $13,241 $4,046,448 0.33%
Five or more units .. 401 40,029 1.00 314 38,278 0.82 517 56,907 0.91
Commercial real estate 2,632 140,790 1.87 4,112 202,425 2.03 6,956 260,609 2.67
Construction .......... 1,508 127,761 1.18 847 70,865 1.20 773 66,651 1.16
Land .................. 568 44,859 1.27 331 25,687 1.29 466 21,177 2.20
Non-mortgage:
Commercial ............ 218 28,293 0.77 196 26,024 0.75 236 22,136 1.07
Automobile ............ 8,344 357,988 2.33 8,016 342,326 2.34 4,303 202,186 2.13
Other consumer ........ 747 41,894 1.78 824 47,735 1.73 802 47,281 1.70
Other .................... -- -- - -- -- - -- -- -
Not specifically allocated 2,800 -- - 2,800 -- - 2,800 -- -
- ---------------------------------------------------------------------------------------------------------------------------
Total loans held for
investment .......... $31,517 $5,417,747 0.58% $32,092 $5,360,885 0.60% $30,094 $4,723,395 0.64%
===========================================================================================================================
1995 1994
------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units ... $12,254 $3,656,512 0.34% $12,404 $3,688,280 0.34%
Five or more units .. 895 57,321 1.56 978 63,782 1.53
Commercial real estate 8,456 270,583 3.13 6,814 294,418 2.31
Construction .......... 335 28,593 1.17 131 11,367 1.15
Land .................. 973 21,867 4.45 862 9,822 8.78
Non-mortgage:
Commercial ............ 259 12,864 2.01 472 12,975 3.64
Automobile ............ 849 56,127 1.51 42 3,028 1.39
Other consumer ........ 1,122 50,945 2.20 1,094 53,241 2.05
Other .................... -- -- - 53 39,143 0.14
Not specifically allocated 2,800 -- - 2,800 --
- -----------------------------------------------------------------------------------------
Total loans held for
investment .......... $27,943 $4,154,812 0.67% $25,650 $4,176,056 0.61%
=========================================================================================
The following table is a summary of the activity in Downey's allowance for real
estate held for investment and non-conforming loans to joint ventures for the
years indicated. In 1998, $4.3 million of the provision reduction and $7.1
million of charge-offs relate to the previously mentioned settlement. Also
included in 1998 were $1.1 million of charge-offs due to sales of undeveloped
land. The provision reductions in all years presented were due to a continuing
improvement in the real estate market which favorably impacted the valuation of
certain neighborhood retail shopping center investments and to a reduction in
the investment in certain joint venture investments.
(In Thousands) 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------
Balance at beginning of period $21,244 $30,071 $34,338 $37,198 $38,674
Provision (reduction) ........ (5,296) (3,190) (3,306) (2,916) (1,400)
Charge-offs .................. (8,231) (5,637) (1,035) -- (76)
Recoveries ................... -- -- 74 56 --
- ------------------------------------------------------------------------------------------
Balance at end of period ..... $ 7,717 $21,244 $30,071 $34,338 $37,198
==========================================================================================
49
In addition to losses charged against the allowance for loan losses, Downey has
recorded losses on real estate acquired in settlement of loans by direct
write-off to net operations of real estate acquired in settlement of loans and
against an allowance for losses specifically established for such assets. The
following table is a summary of the activity of Downey's allowance for real
estate acquired in settlement of loans for the years indicated.
(In Thousands) 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------
Balance at beginning of period $ 839 $ 1,078 $ 1,217 $ 743 $ 747
Provision .................... 455 1,107 1,658 2,498 2,035
Charge-offs .................. (761) (1,346) (1,797) (2,024) (2,039)
Recoveries ................... -- -- -- -- --
- -----------------------------------------------------------------------------------
Balance at end of period ..... $ 533 $ 839 $ 1,078 $ 1,217 $ 743
===================================================================================
CAPITAL RESOURCES AND LIQUIDITY
Downey's sources of funds include deposits, advances from the FHLB and other
borrowings, proceeds from the sale of real estate, sales of loans and
mortgaged-backed securities, payments of loans and mortgaged-backed securities,
payments for and sales of loan servicing and income from other investments.
Repayments on loans and mortgage-backed securities and deposit inflows and
outflows are affected significantly by interest rates, real estate sales
activity and general economic conditions. Loan repayments increased $0.7 billion
in 1998 to $1.9 billion and were virtually equal to new loan originations and
purchases for portfolio. In 1997, new loan originations and purchases for
portfolio exceeded repayments by $0.9 billion.
During 1998, aggregate borrowings increased $220 million as Downey took
advantage of obtaining long-term advances from the FHLB at attractive borrowing
rates to fund fixed-rate loans for investment. Downey also experienced a net
deposit inflow of $170 million, of which $302 million represented transaction
accounts partially offset by a $132 million decrease in certificates of deposit.
To the extent 1999 deposit growth falls short of satisfying ongoing commitments
to fund maturing and withdrawable deposits, repay borrowings, fund existing and
future loan and other investment commitments, continue branch improvement
programs and maintenance of regulatory liquidity requirements, Downey will
utilize borrowing arrangements with the FHLB and other sources. At December 31,
1998, Downey had commitments to fund loans amounting to $941 million, loans in
process of $100 million, undrawn lines of credit of $70 million, and letters of
credit and other contingent liabilities of $4 million. Downey believes its
current sources of funds will enable it to meet these obligations while
maintaining its liquidity at appropriate levels.
The principal measure of liquidity in the savings and loan industry is the
regulatory ratio of cash and eligible investments to the sum of withdrawable
savings and borrowings due within one year. The minimum liquidity ratio set by
federal regulators was reduced in 1997 from 5% to 4%. At December 31, 1998, the
Bank's ratio was 4.04% compared to 4.80% and 5.26% at December 31, 1997 and
1996, respectively.
Downey Financial Corp. currently has liquid assets, including due from Bank -
interest bearing balances, of $9 million and can obtain further funds by means
of dividends from subsidiaries, subject to certain limitations, or issuance of
further debt or equity.
50
REGULATORY CAPITAL COMPLIANCE
The following table is a reconciliation of the Bank's stockholder's equity to
federal regulatory capital as of December 31, 1998. The core and tangible
capital ratios were 6.83% and the risk-based capital ratio was 12.88%. These
levels are up slightly from comparable ratios of 6.61% and 12.64%, respectively,
at December 31, 1997, and continue to exceed the "well capitalized" standards of
5% for core and 10% for risk-based, as defined by regulation. During 1998, the
amount of the Bank's non-includable investment in real estate required to be
deducted from regulatory capital increased by $7 million due to DSL Service
Company's growth in retained earnings.
Tangible Capital Core Capital Risk-Based Capital
(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio
- -------------------------------------------------------------------------------------------------------------------------
Stockholder's Equity ............................... $470,504 $470,504 $470,504
Adjustments:
Deductions:
Investment in subsidiary, primarily real estate (42,119) (42,119) (42,119)
Goodwill ....................................... (4,543) (4,543) (4,543)
Non-permitted mortgage servicing rights ........ (779) (779) (779)
Additions-:
Unrealized gain on securities available for sale (753) (753) (753)
General loss allowance - Investment in DSL ..... 1,383 1,383 1,383
Loan general valuation allowances (1) .......... -- -- 31,267
- -------------------------------------------------------------------------------------------------------------------------
Regulatory capital ................................. 423,693 6.83% 423,693 6.83% 454,960 12.88%
Well capitalized requirement ....................... 93,053 1.50 (2) 310,178 5.00 353,195 10.00 (3)
- -------------------------------------------------------------------------------------------------------------------------
Excess ............................................. $330,640 5.33% $113,515 1.83% $101,765 2.88%
=========================================================================================================================
(1) Limited to 1.25% of risk-weighted assets.
(2) Represents the minimum requirement for tangible capital, as no "well
capitalized" requirement has been established for this category.
(3) A third requirement is Tier 1 capital to risk-weighted assets of 6%, which
the Bank meets and exceeds with a ratio of 12.00%.
CURRENT ACCOUNTING ISSUE
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133").
SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, (collectively referred to as derivatives) and for hedging activities.
It requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, an available for sale security, or a
foreign-currency-denominated forecasted transaction.
Under SFAS 133, an entity that elects to apply hedge accounting is required to
establish at the inception of the hedge the method it will use for assessing the
effectiveness of the hedging derivative and the measurement approach for
determining the ineffective aspect of the hedge. Those methods must be
consistent with the entity's approach to managing risk.
As part of its secondary marketing activities, Downey utilizes forward sale and
purchase contracts to hedge the value of loans originated for sale against
adverse changes in interest rates. At December 31, 1998, such sales and purchase
contracts amounted to approximately $622 million and $34 million, respectively.
These contracts have a high correlation to the price movement of the loans being
hedged. There is no recognition of unrealized gains and losses on these
contracts in the balance sheet or statement of income. When the related loans
are
51
sold, the deferred gains or losses from these contracts are recognized in the
statement of income as a component of net gains or losses on sales of loans and
mortgage-backed securities.
This statement is effective for all fiscal quarters of fiscal years beginning
after June 15, 1999. It is not anticipated that the financial impact of this
statement will have a material impact on Downey.
YEAR 2000
Risks of the Year 2000 Issue
The Year 2000 issue is the result of computer programs being written using two
digits rather than four digits to represent the calendar year (e.g., "99" for
"1999"). Software so developed, and not corrected, could produce inaccurate or
unpredictable results or system failures commencing January 1, 2000, when dates
present a lower two digit year number than dates in the prior century. Such
occurrences may have a material adverse effect on Downey's financial condition,
results of operation, business or business prospects, as Downey, like most
financial organizations, is significantly subject to the potential impact of the
Year 2000 issue due to the nature of financial information. Potential impacts to
Downey may arise from software, computer hardware, and other equipment both
within Downey's direct control and outside Downey's ownership, yet with which
Downey electronically or operationally interfaces. Financial institution
regulators have intensively focused upon Year 2000 exposures, issuing guidance
concerning the responsibilities of management and the board of directors. Year
2000 testing and certification is being addressed as a key safety and soundness
issue in conjunction with regulatory exams and the OTS has authority to bring
enforcement actions against any institution under its supervision which it
believes is not properly addressing Year 2000 compliance issues.
State of Readiness
Downey has established a four-phase process to address the Year 2000 issue. In
addition, Downey's Board of Directors oversees the Year 2000 compliance
project's progress through monthly status reports and quarterly reviews with the
Year 2000 project manager.
As part of the first phase, which is now completed, Downey inventoried of all
data systems to determine which are most critical to support customer
transaction processing and provide customer services. This inventory not only
included in-house systems, but those provided by third party vendors as well.
Systems were prioritized as being mission critical, high risk, moderate risk or
low risk, from which modification plans were developed which place priority
emphasis on those systems requiring change and classified mission critical or
high risk. Third party vendors were contacted during this phase to determine
their process and timeline in correcting any Year 2000 compliance issues. In
addition, commercial loan borrowers of Downey were also contacted to determine
the extent of their preparations for Year 2000 and any potential impact Year
2000 may have on their businesses and ability to repay loan obligations to
Downey. Commercial lending does not represent a significant portion of Downey's
loan portfolio (i.e., approximately 0.3%); therefore, Downey believes the Year
2000 preparedness of its commercial loan borrowers does not pose a significant
risk.
Phase two of the process consists of making appropriate Year 2000 programming
changes to Downey's in-house systems, while phase three consists of acceptance
testing and sign-off of both Downey's in-house and vendor provided systems. The
fourth and final phase of the Year 2000 compliance project includes installation
of the system modifications into Downey's daily operation. The fourth phase is
scheduled to occur once a system has been successfully tested and determined to
be Year 2000 compliant.
In addition to phase one, phase two has been completed and phase three has begun
with respect to Downey's in-house mainframe system, which performs all
significant loan, deposit and general ledger accounting processes. It is
expected that acceptance testing of the in-house mainframe system will be
finalized and installation completed by the end of first quarter 1999.
For Downey developed PC-based systems classified mission critical, all
programming changes and acceptance testing have been completed. Completion of
programming and acceptance testing of all other Downey developed
52
PC-based systems is expected to be completed by the end of second quarter 1999,
as is the installation of Year 2000 modifications.
The timing of Year 2000 acceptance testing and installation of all third party
vendor changes is dependent upon when such systems become available to Downey.
Downey has in place a process to monitor third party vendor progress in making
required Year 2000 corrections and, when completed, requires third party vendors
to represent that their systems are Year 2000 compliant. Although such vendor
representations are requested, Downey does not intend to rely solely upon them.
Rather, Downey intends to test such vendor programs or review testing conducted
by others for Year 2000 compliance.
In addition to the computer systems utilized by Downey, Downey has also
inventoried other essential services that may be impacted by Year 2000 issues
such as telecommunications and utilities. Downey is monitoring such essential
service providers to determine their progress and how they are addressing Year
2000 issues. To date, no information exists to suggest such essential services
will not be Year 2000 compliant.
Costs to Address the Year 2000 Issue
Currently Downey estimates that Year 2000 project costs will approximate $6.5
million. This cost is in addition to existing personnel who are working on the
Year 2000 compliance project and includes estimates for hardware and software
renovation or replacement, as well as additions to existing staff who will be
specifically devoted to the project. Approximately 50% of the Year 2000
compliance project cost represents costs to migrate to a new personal computer
environment and to replace certain older automated teller machines, both of
which Downey might otherwise have implemented or replaced during the period
notwithstanding the Year 2000 issue. As such, that portion of Year 2000 costs
will be amortized over the useful life of the equipment. Of the estimated total
expense, approximately $1.9 million has been incurred to-date, $0.1 million in
1997 and $1.8 million in 1998. The table below summarizes by year the estimated
amount and anticipated timing of the planned Year 2000 expense.
(In Millions) 1997 1998 1999 2000 Thereafter Total
- -----------------------------------------------------------------------------
Estimated Year 2000 expense $0.1 $1.8 $2.8 $1.0 $0.8 $6.5
=============================================================================
As Downey progresses in addressing the Year 2000 compliance project and
additional information becomes available, estimates of costs could change. At
this time, no significant data system projects have been delayed as a result of
Downey's Year 2000 compliance effort.
Contingency Plans
Downey believes its Year 2000 compliance project should enable it to be
successful in modifying its computer systems to be Year 2000 compliant. As
previously stated, acceptance testing and installation with respect to Downey's
in-house mainframe system which performs all significant loan, deposit and
general ledger accounting processes is expected to be completed by the end of
first quarter 1999. In addition to Year 2000 compliance system modification
plans, Downey has also developed contingency plans for all other systems
classified as mission critical and high risk. These contingency plans provide
timetables to pursue various alternatives based upon the failure of a system to
be adequately modified or sufficiently tested and validated to ensure Year 2000
compliance. However, there can be no assurance that either the compliance
process or contingency plans will avoid partial or total system interruptions or
the costs necessary to update hardware and software would not have a material
adverse effect upon Downey's financial condition, results of operation, business
or business prospects.
53
ITEM 8. FINANCIAL STATEMENTS
Index to Consolidated Financial Statements
Independent Auditors' Report.......................... 55
Consolidated Balance Sheets........................... 56
Consolidated Statements of Income..................... 57
Consolidated Statements of Comprehensive Income....... 58
Consolidated Statements of Stockholders' Equity....... 58
Consolidated Statements of Cash Flows................. 59
Notes to Consolidated Financial Statements............ 61
54
725 South Figueroa Street
Los Angeles, CA 90017
Independent Auditors' Report
The Board of Directors and Stockholders
Downey Financial Corp.:
We have audited the accompanying consolidated balance sheets of Downey Financial
Corp. and subsidiaries ("Downey") as of December 31, 1998 and 1997, and the
related consolidated statements of income, comprehensive income, stockholders'
equity and cash flows for each of the years in the three-year period ended
December 31, 1998. These consolidated financial statements are the
responsibility of Downey's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Downey Financial
Corp. and subsidiaries as of December 31, 1998 and 1997, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ KPMG LLP
Los Angeles, California
January 20, 1999
55
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31,
-----------------------
(Dollars in Thousands, Except Per Share Data) 1998 1997
- ------------------------------------------------------------------------------------------------------------
ASSETS
Cash ............................................................................ $ 58,510 $ 48,823
Federal funds ................................................................... 33,751 6,095
- ------------------------------------------------------------------------------------------------------------
Cash and cash equivalents ................................................... 92,261 54,918
U.S. Treasury securities and agency obligations available for sale, at fair value 116,061 159,398
Municipal securities being held to maturity, at amortized cost (estimated market
value of $6,745 at December 31, 1998, and $6,865 at December 31, 1997) ...... 6,764 6,885
Loans held for sale, at the lower of cost or market ............................. 447,382 35,100
Mortgage-backed securities available for sale, at fair value .................... 32,146 49,299
Loans receivable held for investment ............................................ 5,308,837 5,281,997
Investments in real estate and joint ventures ................................... 49,447 41,356
Real estate acquired in settlement of loans ..................................... 4,475 9,626
Premises and equipment .......................................................... 103,979 101,901
Federal Home Loan Bank stock, at cost ........................................... 49,430 44,085
Other assets .................................................................... 59,637 51,260
- ------------------------------------------------------------------------------------------------------------
$6,270,419 $5,835,825
============================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ........................................................................ $5,039,733 $4,869,978
Securities sold under agreements to repurchase .................................. -- 34,803
Federal Home Loan Bank advances ................................................. 695,012 352,458
Commercial paper ................................................................ -- 83,811
Other borrowings ................................................................ 8,708 12,663
Accounts payable and accrued liabilities ........................................ 40,989 40,579
Deferred income taxes ........................................................... 5,411 11,187
- ------------------------------------------------------------------------------------------------------------
Total liabilities ........................................................... 5,789,853 5,405,479
- ------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY:
Common stock, par value of $0.01 per share; authorized 50,000,000 shares;
outstanding 28,131,776 shares at December 31, 1998, and 26,755,938
shares at December 31, 1997 ................................................. 281 268
Additional paid-in capital ...................................................... 92,166 45,954
Accumulated other comprehensive income - unrealized gains
on securities available for sale ............................................ 753 110
Retained earnings ............................................................... 387,366 384,014
- ------------------------------------------------------------------------------------------------------------
Total stockholders' equity .................................................. 480,566 430,346
- ------------------------------------------------------------------------------------------------------------
$6,270,419 $5,835,825
============================================================================================================
See accompanying notes to consolidated financial statements.
56
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Income
Years Ended December 31,
--------------------------------------
(Dollars in Thousands, Except Per Share Data) 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------
INTEREST INCOME:
Loans receivable .................................................... $421,942 $404,081 $329,746
U.S. Treasury and agency securities ................................. 7,078 8,300 7,765
Mortgage-backed securities .......................................... 2,780 3,633 4,317
Other investments ................................................... 8,604 4,404 4,532
- -------------------------------------------------------------------------------------------------------------------
Total interest income ............................................ 440,404 420,418 346,360
- -------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE:
Deposits ............................................................ 248,337 227,521 184,402
Borrowings .......................................................... 17,720 38,739 27,363
- -------------------------------------------------------------------------------------------------------------------
Total interest expense ........................................... 266,057 266,260 211,765
- -------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME ................................................. 174,347 154,158 134,595
PROVISION FOR LOAN LOSSES ........................................... 3,899 8,640 9,137
- -------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses .............. 170,448 145,518 125,458
- -------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET:
Loan and deposit related fees ....................................... 15,645 10,921 7,435
Real estate and joint ventures held for investment, net:
Net gains on sales of wholly owned real estate ................... 2,557 2,904 392
Reduction of losses on real estate and joint ventures ............ 5,296 3,190 3,306
Operations, net .................................................. 14,510 8,128 4,543
Secondary marketing activities:
Loan servicing fees .............................................. 259 1,276 1,415
Net gains on sales of loans and mortgage-backed securities ....... 6,462 2,675 1,543
Net gains on sales of investment securities ......................... 68 -- 4,473
Other ............................................................... 2,556 6,094 2,092
- -------------------------------------------------------------------------------------------------------------------
Total other income, net .......................................... 47,353 35,188 25,199
- -------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE:
Salaries and related costs .......................................... 66,152 54,366 45,811
Premises and equipment costs ........................................ 16,834 15,272 12,640
Advertising expense ................................................. 5,954 6,847 4,071
Professional fees ................................................... 2,867 5,113 2,985
SAIF insurance premiums and regulatory assessments .................. 3,832 3,439 8,949
Other general and administrative expense ............................ 20,251 14,519 12,004
- -------------------------------------------------------------------------------------------------------------------
Total general and administrative expense ......................... 115,890 99,556 86,460
- -------------------------------------------------------------------------------------------------------------------
SAIF special assessment ............................................. -- -- 24,644
Net operation of real estate acquired in settlement of loans ........ 260 1,184 2,567
Amortization of excess of cost over fair value of net assets acquired 510 532 532
- -------------------------------------------------------------------------------------------------------------------
Total operating expense .......................................... 116,660 101,272 114,203
- -------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES .............................................. 101,141 79,434 36,454
Income taxes ............................................................ 43,168 34,200 15,750
- -------------------------------------------------------------------------------------------------------------------
NET INCOME .......................................................... $ 57,973 $ 45,234 $ 20,704
===================================================================================================================
PER SHARE INFORMATION:
BASIC ................................................................... $ 2.06 $ 1.61 $ 0.74
===================================================================================================================
DILUTED ................................................................. $ 2.05 $ 1.61 $ 0.74
===================================================================================================================
CASH DIVIDENDS PAID ..................................................... $ 0.316 $ 0.301 $ 0.290
===================================================================================================================
Weighted average diluted shares outstanding ............................. 28,176,243 28,140,200 28,103,291
===================================================================================================================
See accompanying notes to consolidated financial statements.
57
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
Years Ended December 31,
------------------------------
(In Thousands) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
NET INCOME .................................................................. $57,973 $45,234 $20,704
- ---------------------------------------------------------------------------------------------------------------
OTHER COMPREHENSIVE INCOME, NET OF INCOME TAXES:
Unrealized gains (losses) on securities available for sale:
U.S. Treasury securities and agency obligations
available for sale, at fair value .................................... 1,104 1,331 (2,160)
Less reclassification of realized gains net of losses included in income (39) -- (2,550)
Mortgage-backed securities available for sale, at fair value ........... (422) 338 (344)
- ---------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss) ........................................ 643 1,669 (5,054)
- ---------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME ........................................................ $58,616 $46,903 $15,650
===============================================================================================================
Consolidated Statements of Stockholders' Equity
Accumulated
Additional Other
Common Paid-in Comprehensive Retained
(Dollars in Thousands, Except Per Share Data) Stock Capital Income Earnings Total
- -----------------------------------------------------------------------------------------------------------
Balances at December 31, 1995 ..................... $170 $22,696 $ 3,495 $357,711 $384,072
Cash dividends, $0.290 per share .................. -- -- -- (8,147) (8,147)
Three-for-two stock split effected in the form of a
stock dividend ................................ 85 (89) -- -- (4)
Unrealized loss on securities available for sale .. -- -- (5,054) -- (5,054)
Net income ........................................ -- -- -- 20,704 20,704
- -----------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 ..................... 255 22,607 (1,559) 370,268 391,571
Cash dividends, $0.301 per share .................. -- -- -- (8,454) (8,454)
Stock dividend .................................... 13 23,012 -- (23,034) (9)
Exercise of stock options ......................... -- 335 -- -- 335
Unrealized gain on securities available for sale .. -- -- 1,669 -- 1,669
Net income ........................................ -- -- -- 45,234 45,234
- -----------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 ..................... 268 45,954 110 384,014 430,346
Cash dividends, $0.316 per share .................. -- -- -- (8,889) (8,889)
Stock dividend .................................... 13 45,702 -- (45,732) (17)
Exercise of stock options ......................... -- 510 -- -- 510
Unrealized gain on securities available for sale .. -- -- 643 -- 643
Net income ........................................ -- -- -- 57,973 57,973
- -----------------------------------------------------------------------------------------------------------
Balances at December 31, 1998 ..................... $281 $92,166 $ 753 $387,366 $480,566
===========================================================================================================
See accompanying notes to consolidated financial statements.
58
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years Ended December 31,
------------------------------------------
(In Thousands) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ....................................................................... $ 57,973 $ 45,234 $ 20,704
Adjustments activities:
Depreciation and amortization .................................................. 7,052 9,389 8,279
Provision (recovery) for losses on loans, real estate acquired in settlement
of loans, investments in real estate and joint ventures and other assets ..... (1,017) 6,780 7,533
Net gains on sales of loans and mortgage-backed securities, investment
securities, real estate and other assets ..................................... (20,365) (9,210) (6,827)
Interest capitalized on loans (negative amortization) .......................... (18,953) (12,885) (9,388)
Federal Home Loan Bank stock dividends ......................................... (2,728) (2,638) (2,301)
Loans originated for sale ........................................................ (2,162,583) (289,271) (159,941)
Proceeds from sales of loans originated for sale ................................. 1,130,164 179,046 135,074
Other, net ....................................................................... 4,314 1,559 4,112
- ----------------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities .............................................. (1,006,143) (71,996) (2,755)
- ----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from:
Maturities of U.S. Treasury and agency obligations ............................. 10,001 9,875 --
Sales of investment securities available for sale .............................. 60,319 -- 189,541
Sales of mortgage-backed securities available for sale ......................... 608,158 88,723 31,314
Sales of loans held for investment ............................................. -- 294,469 --
Sales of wholly owned real estate and real estate acquired in settlement
of loans ..................................................................... 14,035 15,043 10,337
Purchase of:
U.S. Treasury securities and agency obligations ................................ (27,617) (25,000) (170,455)
Mortgage-backed securities available for sale .................................. -- -- (30,073)
Loans receivable held for investment ........................................... (7,463) (35,828) (223)
Loans receivable originated held for investment (net of refinances of
$39,794, $56,366, and $90,824 at December 31, 1998, 1997 and 1996, respectively) (1,854,801) (1,961,710) (1,309,663)
Principal payments on loans receivable held for investment and
mortgage-backed securities available for sale .................................. 1,830,492 1,086,551 757,550
Net change in undisbursed loan funds ............................................. 43,222 13,356 12,147
Proceeds from (Investments in) real estate held for investment ................... (4,074) 5,115 (6,454)
Other, net ....................................................................... (10,147) (14,086) (7,698)
- ----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ................................ 662,125 (523,492) (523,677)
- ----------------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
59
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Continued)
Years Ended December 31,
--------------------------------------
(In Thousands) 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits .................................................. $ 169,755 $ 696,876 $ 382,881
Net increase (decrease) in securities sold under agreements to repurchase . (34,803) 34,803 (16,099)
Proceeds from Federal Home Loan Bank advances ............................. 857,200 872,900 1,018,700
Repayments of Federal Home Loan Bank advances ............................. (514,646) (907,325) (852,532)
Net increase (decrease) in other borrowings ............................... (87,766) (111,988) 9,058
Proceeds from exercise of stock options ................................... 510 335 --
Cash dividends ............................................................ (8,889) (8,454) (8,147)
- -----------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities .................................... 381,361 577,147 533,861
- -----------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents ......................... 37,343 (18,341) 7,429
Cash and cash equivalents at beginning of year ............................... 54,918 73,259 65,830
- -----------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ................................... $ 92,261 $ 54,918 $ 73,259
=======================================================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest ................................................................ $ 266,407 $ 267,589 $ 212,482
Income taxes ............................................................ 52,784 23,572 19,753
Supplemental disclosure of non-cash investing:
Loans transferred from held for investment to held for sale ............... -- 290,558 1,791
Loans transferred to held for investment from held for sale ............... 3,056 -- --
Loans exchanged for mortgage-backed securities ............................ 608,831 89,522 26,452
Real estate acquired in settlement of loans ............................... 14,958 23,686 27,367
Loans to facilitate the sale of real estate acquired in settlement of loans 14,084 21,919 23,356
=======================================================================================================================
See accompanying notes to consolidated financial statements.
60
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
For the Years Ended December 31, 1998, 1997, and 1996
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements of Downey Financial Corp. and
subsidiaries ("Downey") include all accounts of Downey Financial Corp. and
the consolidated accounts of all subsidiaries, including Downey Savings and
Loan Association, F.A. (the "Bank"). All significant intercompany balances
and transactions have been eliminated.
Business
Downey provides a full range of financial services to individual and
corporate customers through subsidiaries and branches located in
California. Downey is subject to competition from other financial
institutions. Downey is subject to the regulations of certain governmental
agencies and undergoes periodic examinations by those regulatory
authorities.
Basis of Financial Statement Presentation
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles. In preparing the consolidated
financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities as
of the dates of the balance sheets and the results of operations for the
periods. Actual results could differ significantly from those estimates.
Material estimates that are particularly susceptible to significant change
in the near-term relate to the determination of the allowance for loan
losses and the valuation of real estate. Management believes that the
allowances established for losses on loans and real estate are adequate.
While management uses available information to recognize losses on loans
and real estate, future additions to the allowances may be necessary based
on changes in economic conditions. In addition, various regulatory
agencies, as an integral part of their examination process, periodically
review Downey's allowances for losses on loans and real estate. Such
agencies may require Downey to recognize additions to the allowances based
on their judgments about information available to them at the time of their
examination.
Downey is required to carry its loans held for sale portfolio,
mortgage-backed securities available for sale portfolio, real estate
acquired in settlement of loans, and real estate held for investment or
under development at the lower of cost or fair value or in certain cases,
at fair value. Fair value estimates are made at a specific point in time
based upon relevant market information and other information about the
asset. Such estimates related to the mortgage-backed and investment
securities portfolios include published bid prices or bid quotations
received from securities dealers. Fair value estimates for real estate
acquired in settlement of loans and real estate held for investment or
under development is determined by current appraisals and, where no active
market exists for a particular property, discounting a forecast of expected
cash flows at a rate commensurate with the risk involved.
Cash and Cash Equivalents
For purposes of the statements of cash flows, cash and cash equivalents
include cash on hand, amounts due from banks and Federal funds sold.
Generally, Federal funds are purchased and sold for one-day periods.
61
Mortgage-backed Securities Purchased Under Resale Agreements, U.S. Treasury
Securities and Agency Obligations, Other Investment Securities, Municipal
Securities and Mortgage-backed Securities
Downey has established written guidelines and objectives for its investing
activities. At the time of purchase of a mortgage-backed security purchased
under resale agreement, U.S. Treasury security and agency obligation, other
investment security or a mortgage-backed security, management of Downey
designates the security as either held to maturity, available for sale or
held for trading based on Downey's investment objectives, operational needs
and intent. Downey then monitors its investment activities to ensure that
those activities are consistent with the established guidelines and
objectives.
Held to Maturity. Securities held to maturity are carried at cost, adjusted
for amortization of premiums and accretion of discounts which are
recognized in interest income using the interest method. Mortgage-backed
securities represent participating interests in pools of long-term first
mortgage loans originated and serviced by the issuers of the securities.
Mortgage-backed securities held to maturity are carried at unpaid principal
balances, adjusted for unamortized premiums and unearned discounts.
Premiums and discounts on mortgage-backed securities are amortized using
the interest method over the remaining period to contractual maturity,
adjusted for anticipated prepayments. It is the positive intent of Downey,
and Downey has the ability, to hold these securities until maturity as part
of its portfolio of long-term interest-earning assets. If the cost basis of
these securities is determined to be other than temporarily impaired, the
amount of the impairment is charged to operations.
Available for Sale. Securities available for sale are carried at market
value. Premiums and discounts are amortized using the interest method over
the remaining period to contractual maturity and, in the case of
mortgage-backed securities, adjusted for anticipated prepayments.
Unrealized holding gains and losses, or valuation allowances established
for net unrealized losses, are excluded from earnings and reported as a
separate component of stockholders' equity as accumulated other
comprehensive income, net of income taxes, unless the security is deemed
other than temporarily impaired. If the security is determined to be other
than temporarily impaired, the amount of the impairment is charged to
operations.
Realized gains and losses on the sale of securities available for sale,
determined using the specific identification method and recorded on a trade
date basis, are reflected in earnings.
Held for Trading. Securities held for trading are carried at market value.
Realized and unrealized gains and losses are reflected in earnings.
Loans Held for Sale
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. In response to unforeseen events such as changes in
regulatory capital requirements, liquidity shortfalls, changes in the
availability of sources of funds, and excess loan demand by borrowers that
could not be controlled immediately by loan price changes, Downey may sell
loans which had been held for investment. In such occurrences, the loans
are transferred at amortized cost and the lower of cost or market method is
then applied.
Gains or Losses On Sales of Loans and Mortgage Servicing Assets
Gains or losses on sales of loans are recognized at the time of sale and
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
62
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. The
MSRs are included in other assets and as a component of gain on sale of
loans. The MSRs are amortized in proportion to and over the estimated
period of net servicing income. Such amortization is reflected as a
component of loan servicing fees.
The MSRs are periodically reviewed for impairment based on their fair
value. The fair value of the MSRs, for the purposes of impairment, is
measured using a discounted cash flow analysis based on Downey's estimated
net servicing income, market prepayment rates and market-adjusted discount
rates. Impairment is measured on a disaggregated basis based on predominant
risk characteristics of the underlying mortgage loans. The risk
characteristics used by Downey for the purposes of capitalization and
impairment evaluation include loan type, interest rate tranches, loan term
and collateral type. Impairment losses are recognized through a valuation
allowance, with any associated provision recorded as a component of loan
servicing fees.
Derivative Financial Instruments
As part of its secondary marketing activities, Downey utilizes forward sale
contracts to hedge the value of loans originated for sale against adverse
changes in interest rates. These contracts have a high correlation to the
price movement of the loans being hedged. There is no recognition of
unrealized gains and losses on these contracts in the balance sheet or
statement of income. When the related loans are sold, the deferred gains or
losses from these contracts are recognized in the statement of income as a
component of net gains or losses on sales of loans and mortgage-backed
securities.
Loans Receivable Held for Investment
Loans receivable are recorded at cost, net of discounts and premiums,
undisbursed loan proceeds, net deferred fees and costs and the allowance
for loan losses.
Interest income on loans is accrued based on the outstanding principal
amount of loans using the interest method. Discounts and premiums on loans
are amortized to income using the interest method over the remaining period
to contractual maturity. The amortization of discounts into income is
discontinued on loans that are contractually ninety days past due.
Loan origination fees and related incremental direct loan origination costs
are deferred and amortized to income using the interest method over the
contractual life of the loans, adjusted for actual prepayments. Fees
received for a commitment to originate or purchase a loan or group of loans
are deferred and, if the commitment is exercised, recognized over the life
of the loan as an adjustment of yield or, if the commitment expires
unexercised, recognized as income upon expiration of the commitment. The
amortization of deferred fees and costs is discontinued on loans that are
contractually ninety days past due.
Accrued interest on loans that are contractually ninety days or more past
due or when collection of interest appears doubtful is generally reversed
and charged against interest income. Income is subsequently recognized only
to the extent cash payments are received and the principal balance is
expected to be recovered. Such loans are restored to an accrual status only
if the loan is brought contractually current and the borrower has
demonstrated the ability to make future payments of principal and interest.
63
Allowance for Loan Losses
The allowance for loan losses is maintained at an amount management deems
adequate to cover estimated losses. Downey has implemented and adheres to
an internal asset review system and loan loss allowance methodology
designed to provide for the detection of problem assets and adequate
general valuation allowances to cover loan losses. In determining the
allowance for loan losses related to specific major loans, management
evaluates its allowance on an individual loan basis, including an analysis
of the creditworthiness, cash flows and financial status of the borrower,
and the condition and the estimated value of the collateral. Downey reviews
all loans under $1 million by analyzing their performance and composition
of their collateral as a whole, because of the relatively homogeneous
nature of the portfolios. Specific valuation allowances for secured loans
are determined by the excess of the recorded investment in the loan over
the fair value, where appropriate, of the collateral. In determining
overall general valuation allowances to be maintained and the loan loss
allowance ratios, management evaluates many factors including prevailing
and forecasted economic conditions, regular reviews of the quality of loans
by Downey's Internal Asset Review Committee, industry experience,
historical loss experience, year of origination, composition and geographic
concentrations of the loan portfolio, the borrowers' ability to repay and
repayment performance and estimated collateral values.
Downey considers a loan to be impaired when, based upon current information
and events, it believes it is probable that Downey will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. In determining impairment, Downey considers large
non-homogeneous loans with the following characteristics: non-accrual
loans, debt restructurings, and performing loans which exhibit, among other
characteristics, high loan-to-value ratios or delinquent taxes. Downey
bases the measurement of collateral dependent impaired loans on the fair
value of the loan's collateral. Non-collateral dependent loans are valued
based on a present value calculation of expected future cash flows,
discounted at the loan's effective rate. Cash receipts on impaired loans
not performing according to contractual terms are generally used to reduce
the carrying value of the loan, unless Downey believes it will recover the
remaining principal balance of the loan. Impairment losses are included in
the allowance for loan losses through a charge to provision for loan
losses. Adjustments to impairment losses due to changes in the fair value
of collateral of impaired loans are included in provision for loan losses.
Upon disposition of an impaired loan, loss of principal, if any, is
recorded through a charge-off to the allowance for loan losses.
In the opinion of management, and in accordance with the loan loss
allowance methodology, the present allowance is considered adequate to
absorb estimable and probable loan losses. Additions to the allowances are
reflected in current operations. Charge-offs to the allowance are made when
the loan is considered uncollectible or is transferred to real estate
owned. Recoveries are credited to the allowance.
For regulatory capital purposes, the Bank's general allowance for loan
losses is included to a limit of 1.25% of regulatory risk-weighted assets.
Loan Servicing
Downey services mortgage loans for investors. Fees earned for servicing
loans owned by investors are reported as income when the related mortgage
loan payments are collected. Loan servicing costs are charged to expense as
incurred.
Investment in Real Estate and Joint Ventures
Real estate held for investment or under development is held at the lower
of cost (less accumulated depreciation) or fair value. Costs, including
interest, of holding real estate in the process of development or
improvement are capitalized, whereas costs relating to holding completed
property are expensed. An
64
allowance for losses is established by a charge to operations if the
carrying value of a property exceeds its fair value, including the
consideration of disposition costs.
Downey utilizes the equity method of accounting for investments in
non-controlled joint ventures, and the consolidation method for investments
in controlled joint ventures. All intercompany profits are eliminated.
Income from the sale of real estate is recognized principally when title to
the property has passed to the buyer, minimum down payment requirements are
met, and the terms of any notes received by Downey satisfy continuing
investment requirements. At the time of sale, costs are relieved from real
estate projects on a relative sales value basis and charged to operations.
Real Estate Acquired in Settlement of Loans
Real estate acquired through foreclosure is initially recorded at fair
value (net of an allowance for estimated selling costs and delinquent
property taxes) at the date of foreclosure, and a valuation allowance is
established for any subsequent declines in fair value. All legal fees and
direct costs, including foreclosure and other related costs, are expensed
as incurred.
Premises and Equipment
Buildings, leasehold improvements and furniture, fixtures, and equipment
are carried at cost, less accumulated depreciation and amortization.
Buildings and furniture, fixtures, and equipment are depreciated using the
straight-line method over the estimated useful lives of the assets. The
cost of leasehold improvements is being amortized using the straight-line
method over the shorter of the estimated useful life of the asset or the
terms of the related leases.
Impairment of Long-lived Assets
Downey reviews long-lived assets and certain identifiable intangibles for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying
amount of an asset to future net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the
assets exceed the fair value of the assets. Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs to
sell.
Securities Sold Under Agreements to Repurchase
Downey enters into sales of securities under agreements to repurchase
("reverse repurchase agreements"). Reverse repurchase agreements are
treated as financing arrangements and, accordingly, the obligations to
repurchase the securities sold are reflected as liabilities in Downey's
consolidated financial statements. The securities collateralizing reverse
repurchase agreements are delivered to several major national brokerage
firms who arranged the transactions. These securities are reflected as
assets in Downey's consolidated financial statements. The brokerage firms
may loan such securities to other parties in the normal course of their
operations and agree to return the identical securities to Downey at the
maturity of the agreements.
Income Taxes
Downey applies the asset and liability method of accounting for income
taxes. The asset and liability method recognizes deferred income taxes for
the tax consequences of "temporary differences" by applying enacted
statutory tax rates applicable to future years to differences between the
financial statement
65
carrying amounts and the tax bases of existing assets and liabilities. The
effect on deferred taxes of a change in tax rates is recognized in income
in the period that includes the enactment date.
Deferred tax assets are to be recognized for temporary differences that
will result in deductible amounts in future years and for tax carryforwards
if, in the opinion of management, it is more likely than not that the
deferred tax assets will be realized.
Stock Option Plan
Prior to January 1, 1996, Downey accounted for its stock option plan in
accordance with the provisions of Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25"), and related
interpretations. As such, compensation expense would be recorded on the
date of grant only if the current market price of the underlying stock
exceeded the exercise price. On January 1, 1996, Downey adopted Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), which permits entities to recognize as expense
over the vesting period the fair value of all stock-based awards on the
date of grant. Alternatively, SFAS 123 also allows entities to continue to
apply the provisions of APB 25 and provide pro forma net income and pro
forma net income per share disclosures for employee stock option grants
made in 1995 and future years as if the fair-value-based method defined in
SFAS 123 had been applied. Downey has elected to continue to apply the
provisions of APB 25 and provide the pro forma disclosure provisions of
SFAS 123.
Per Share Information
Downey adopted, effective December 31, 1997, Statement of Financial
Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128
simplifies the standards for computing and presenting earnings per share
("EPS") as previously prescribed by Accounting Principles Board Opinion No.
15, "Earnings per Share." SFAS 128 replaces primary EPS with basic EPS and
fully diluted EPS with diluted EPS. Basic EPS excludes dilution and is
computed by dividing income available to common stockholders by the
weighted average number of common shares outstanding for the period.
Diluted EPS reflects the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into
common stock or resulted from issuance of common stock that then shared in
earnings.
Current Accounting Pronouncement
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("SFAS 133").
SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, (collectively referred to as derivatives) and for hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure
those instruments at fair value. If certain conditions are met, a
derivative may be specifically designated as (a) a hedge of the exposure to
changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to variable cash
flows of a forecasted transaction, or (c) a hedge of the foreign currency
exposure of a net investment in a foreign operation, an unrecognized firm
commitment, an available for sale security, or a
foreign-currency-denominated forecasted transaction.
Under SFAS 133, an entity that elects to apply hedge accounting is required
to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods
must be consistent with the entity's approach to managing risk.
66
As part of its secondary marketing activities, Downey utilizes forward sale
and purchase contracts to hedge the value of loans originated for sale
against adverse changes in interest rates. At December 31, 1998, such sales
and purchase contracts amounted to approximately $622 million and $34
million, respectively. These contracts have a high correlation to the price
movement of the loans being hedged. There is no recognition of unrealized
gains and losses on these contracts in the balance sheet or statement of
income. When the related loans are sold, the deferred gains or losses from
these contracts are recognized in the statement of income as a component of
net gains or losses on sales of loans and mortgage-backed securities.
This statement is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999. It is not anticipated that the financial
impact of this statement will have a material impact on Downey.
(2) BUSINESS COMBINATION
During 1988, the Bank acquired Butterfield Savings and Loan Association,
FSA ("Butterfield") from the Federal Savings and Loan Insurance Corporation
("FSLIC") in a FSLIC assisted acquisition.
Concurrent with the acquisition, the Bank and the FSLIC entered into an
assistance agreement ("Butterfield Assistance Agreement") that provides for
the indemnification of the Bank against losses incurred on the disposal of
certain defined covered assets and the settlement of certain unreserved
preacquisition liabilities or contingencies reduced by tax benefits
associated with those expenses as defined. Additionally, the FSLIC agreed
to provide yield maintenance assistance on certain covered assets at the
Federal Home Loan Bank ("FHLB") Eleventh District Cost of Funds Index
("COFI"). All such amounts received are nontaxable under the Internal
Revenue Code.
All assets subject to the Butterfield Assistance Agreement were sold or
repurchased by the Federal Deposit Insurance Corporation ("FDIC") on
December 29, 1995. By its terms the Butterfield Assistance Agreement
terminated on March 31, 1997.
The Butterfield Assistance Agreement provides broad authority to the FDIC
to conduct audits. A compliance audit was competed by the FDIC for the
period July 1, 1993 to June 30, 1996. A final post termination audit of the
Butterfield Assistance Agreement by the FDIC remains to be completed.
(3) U.S. TREASURY SECURITIES AND AGENCY OBLIGATIONS AVAILABLE FOR SALE
The amortized cost and estimated market value of U.S. Treasury securities
and agency obligations available for sale are summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Market
(In Thousands) Cost Gains Losses Value
---------------------------------------------------------------------------
December 31, 1998 .......... $114,882 $1,193 $ 14 $116,061
===========================================================================
December 31, 1997 .......... $160,089 $ 441 $1,132 $159,398
===========================================================================
67
The amortized cost and estimated market value of U.S. Treasury securities
and agency obligations available for sale at December 31, 1998, by
contractual maturity, are shown below.
Amortized Market
(In Thousands) Cost Value
---------------------------------------------------------------
Due in one year or less ................. $ -- $ --
Due after one year through five years (1) 114,882 116,061
---------------------------------------------------------------
Total ................................ $114,882 $116,061
===============================================================
(1) No investment matures beyond five years.
Proceeds, gross realized gains and losses on the sales of U.S. Treasury
securities and agency obligations available for sale are summarized as
follows:
(In Thousands) 1998 1997 1996
-------------------------------------------------------
Proceeds ............ $60,319 $ -- $189,541
=======================================================
Gross realized gains $ 68 $ -- $ 4,578
=======================================================
Gross realized losses $ -- $ -- $ 105
=======================================================
Net unrealized gains on investment securities available for sale were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $1.2 million, or $0.7 million net of income taxes,
at December 31, 1998, compared to net unrealized losses of $0.7 million, or
$0.4 million net of income taxes, at December 31, 1997.
(4) LOANS AND MORTGAGE-BACKED SECURITIES PURCHASED UNDER RESALE AGREEMENTS AND
OTHER INVESTMENT SECURITIES HELD TO MATURITY
Loans and Mortgage-backed Securities Purchased Under Resale Agreements
There were no loans or mortgage-backed securities purchased under resale
agreements at December 31, 1998 or 1997. The average interest rate and
balance was 5.67% and $73 million, respectively, during 1998, and 5.72% and
$8 million, respectively, during 1997. The maximum amount outstanding at
any month-end during 1998 and 1997 was $110 million and $20 million,
respectively.
Municipal Securities Held to Maturity
The amortized cost and estimated market value of municipal securities held
to maturity are summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Market
(In Thousands) Cost Gains Losses Value
-----------------------------------------------------------------
December 31, 1998 .... $6,764 $ -- $19 $6,745
=================================================================
December 31, 1997 .... $6,885 $ -- $20 $6,865
=================================================================
The investment at December 31, 1998 and 1997 represents an industrial
revenue bond on which the interest income is not subject to federal income
taxes and matures in 2015.
68
(5) MORTGAGE-BACKED SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated market value of the mortgage-backed
securities available for sale are summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Market
(In Thousands) Cost Gains Losses Value
------------------------------------------------------------------------
December 31, 1998:
GNMA certificates ..... $ 7,027 $ 309 $ -- $ 7,336
FNMA certificates ..... 145 6 -- 151
FHLMC certificates .... 13,668 -- 6 13,662
Non-agency certificates 11,164 1 168 10,997
------------------------------------------------------------------------
Total .............. $32,004 $ 316 $ 174 $32,146
========================================================================
December 31, 1997:
GNMA certificates ..... $ 9,623 $ 459 $ -- $10,082
FNMA certificates ..... 201 9 -- 210
FHLMC certificates .... 19,659 -- 163 19,496
Non-agency certificates 18,933 583 5 19,511
------------------------------------------------------------------------
Total .............. $48,416 $1,051 $ 168 $49,299
========================================================================
Net unrealized gains on mortgage-backed securities available for sale were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $0.1 million, or $81,400 net of income taxes, at
December 31, 1998. At December 31, 1997, net unrealized gains were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $0.9 million, or $0.5 million net of income taxes.
Proceeds, gross realized gains and losses on the sales of mortgage-backed
securities available for sale are summarized as follows:
(In Thousands) 1998 1997 1996
----------------------------------------------------
Proceeds ............ $608,158 $88,723 $31,314
====================================================
Gross realized gains $ 3,490 $ 728 $ 809
====================================================
Gross realized losses $ 3,814 $ 928 $ 221
====================================================
69
(6) LOANS RECEIVABLE
Loans receivable are summarized as follows:
December 31,
--------------------------
(In Thousands) 1998 1997
-------------------------------------------------------------------------------------
Held for investment:
Loans secured by real estate:
Residential:
One-to-four units ............................. $4,047,182 $4,358,475
One-to-four units - subprime .................. 588,951 249,070
Five or more units ............................ 40,029 38,278
Commercial real estate .......................... 140,790 202,425
Construction .................................... 127,761 70,865
Land ............................................ 44,859 25,687
Non-mortgage:
Commercial ...................................... 28,293 26,024
Automobile ...................................... 357,988 342,326
Other consumer .................................. 41,894 47,735
-------------------------------------------------------------------------------------
Total loans receivable held for investment .... 5,417,747 5,360,885
Less:
Undisbursed loan funds .......................... (108,414) (64,884)
Net deferred costs and premiums ................. 31,021 18,088
Allowance for estimated losses .................. (31,517) (32,092)
-------------------------------------------------------------------------------------
Total loans receivable held for investment, net $5,308,837 $5,281,997
=====================================================================================
Held for sale:
Loans secured by residential one-to-four units ..... $ 447,382 $ 35,100
=====================================================================================
Over 99% of the real estate securing Downey's loans is located in
California.
70
A summary of activity in the allowance for loan losses for loans receivable
held for investment during 1998, 1997 and 1996 follows:
Not
Real Other Specifically
(In Thousands) Estate Commercial Automobile Consumer Allocated Total
-----------------------------------------------------------------------------------------------------------
Balance at December 31, 1995 ........... $22,913 $ 259 $ 849 $1,122 $2,800 $27,943
Provision for (reduction of) loan losses 3,874 92 5,245 (74) -- 9,137
Charge-offs ............................ (5,200) (115) (2,096) (249) -- (7,660)
Recoveries ............................. 366 -- 305 3 -- 674
-----------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 ........... 21,953 236 4,303 802 2,800 30,094
Provision for (reduction of) loan losses 207 (40) 8,181 292 -- 8,640
Charge-offs ............................ (2,389) -- (5,109) (275) -- (7,773)
Recoveries ............................. 485 -- 641 5 -- 1,131
-----------------------------------------------------------------------------------------------------------
Balance at December 31, 1997 ........... 20,256 196 8,016 824 2,800 32,092
Provision for (reduction of) loan losses (1,480) 22 5,287 70 -- 3,899
Charge-offs ............................ (1,103) -- (6,118) (151) -- (7,372)
Recoveries ............................. 1,735 -- 1,159 4 -- 2,898
-----------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 ........... $19,408 $ 218 $ 8,344 $ 747 $2,800 $31,517
===========================================================================================================
Net charge-offs represented 0.09%, 0.13% and 0.16% of average loans for
1998, 1997 and 1996, respectively.
All impaired loans at December 31, 1998 and 1997 were secured by commercial
real estate. The following table presents impaired loans with specific
allowances and the amount of such allowances, and impaired loans without
specific allowances.
Net Specific Net
(In Thousands) Carrying Value Allowance Balance
-------------------------------------------------------------------------
December 31, 1998:
Loans with specific allowances .. $ -- $ -- $ --
Loans without specific allowances 13,302 -- 13,302
-------------------------------------------------------------------------
Total impaired loans ............ $13,302 $ -- $13,302
=========================================================================
December 31, 1997:
Loans with specific allowances .. $ -- $ -- $ --
Loans without specific allowances 13,798 -- 13,798
-------------------------------------------------------------------------
Total impaired loans ............ $13,798 $ -- $13,798
=========================================================================
The average recorded investment in impaired loans during 1998 totaled $14
million and $15 million in 1997. During 1998, total interest recognized on
the impaired loan portfolio, on a cash basis, was $2.0 million, unchanged
from 1997.
The combined weighted average interest yield on loans receivable held for
investment and sale was 7.73% and 7.96% as of December 31, 1998 and 1997,
respectively, and averaged 7.89%, 7.81% and 7.72% during 1998, 1997 and
1996, respectively.
71
The aggregate amount of non-accrual loans receivable that are contractually
past due 90 days or more as to principal or interest, in the foreclosure
process, restructured, or upon which interest collection is doubtful were
$22 million and $42 million as of December 31, 1998 and 1997, respectively.
There were no troubled debt restructurings on accrual status as of December
31, 1998 and 1997.
Interest due on non-accrual loans but excluded from interest income was
approximately $0.5 million for 1998, $1.8 million for 1997 and $4.1 million
for 1996.
Downey has had, and expects in the future to have, transactions in the
ordinary course of business with executive officers, directors and their
associates ("related parties") on substantially the same terms, including
interest rates and collateral, as those prevailing at the time for
comparable transactions with other non-related parties. Those transactions
neither involve more than the normal risk of collectibility nor present any
unfavorable features. At December 31, 1998 and 1997, the Bank had extended
loans to certain directors, executive officers and their associates
totaling $26 million and $27 million, respectively. All such loans are
performing in accordance with their loan terms. Presented below is a
summary of activity with respect to such loans for the years ending
December 31, 1998 and 1997:
(In Thousands) 1998 1997
------------------------------------------------------
Balance at beginning of period $27,094 $28,835
Additions .................... -- 3,857
Repayments ................... (1,331) (5,598)
------------------------------------------------------
Balance at end of period ..... $25,763 $27,094
======================================================
(7) LOAN SERVICING
Mortgage loans serviced for others are not included in the accompanying
consolidated balance sheets. The unpaid principal balances of mortgage
loans serviced for others was $1.0 billion and $613 million at December 31,
1998 and 1997, respectively.
Custodial escrow balances maintained in connection with the foregoing loan
servicing, and included in demand deposits, were $3 million and $2 million
at December 31, 1998 and 1997, respectively.
Mortgage servicing rights of $7.3 million, $1.2 million and $1.0 million
related to loans sold with servicing rights retained were capitalized in
1998, 1997 and 1996, respectively. Mortgage servicing rights have been
written down to their fair value of $7.8 million, $2.0 million and $1.2
million at December 31, 1998, 1997 and 1996, respectively. Amortization of
mortgage servicing rights was $0.7 million in 1998, $0.3 million in 1997
and $0.2 million in 1996.
A summary of activity in the allowance for mortgage servicing rights during
1998, 1997 and 1996 is as follows:
(In Thousands) 1998 1997 1996
-----------------------------------------------------------
Balance at beginning of period $ 206 $ 101 $--
Additions .................... 1,350 249 129
Reductions ................... (581) (144) (28)
Impairment write-down ........ (511) -- --
-----------------------------------------------------------
Balance at end of period ..... $ 464 $ 206 $ 101
===========================================================
72
(8) INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
Investments in real estate and joint ventures are summarized as follows:
December 31,
--------------------
(In Thousands) 1998 1997
--------------------------------------------------------------------------------------
Gross investments in real estate ............................. $57,084 $ 63,321
Accumulated depreciation ..................................... (9,215) (9,432)
Allowance for estimated losses ............................... (6,305) (19,617)
--------------------------------------------------------------------------------------
Investments in real estate (1) ............................ 41,564 34,272
--------------------------------------------------------------------------------------
Investments in and interest bearing advances to joint ventures 9,295 8,711
Joint venture valuation allowance ............................ (1,412) (1,627)
--------------------------------------------------------------------------------------
Investments in joint ventures ............................. 7,883 7,084
--------------------------------------------------------------------------------------
Total investments in real estate and joint ventures ....... $49,447 $ 41,356
======================================================================================
(1) Includes $0.4 million at December 31, 1997, associated with three
single family housing developments which are joint ventures for legal
purposes. They are reported as wholly owned for financial reporting
purposes because DSL Service Company assumed operating control
effective in the fourth quarter of 1993.
The table set forth below describes the type, location, and amount invested
in real estate and joint ventures, net of specific valuation allowances of
$6 million and general valuation allowances of $1 million, at December 31,
1998:
(In Thousands) California Arizona Other Total
-----------------------------------------------------------------------------------------------
Shopping centers ...................................... $14,675 $14,532 $-- $29,207
Office buildings ...................................... 695 281 -- 976
Residential ........................................... 5,362 -- -- 5,362
Land .................................................. 14,761 176 459 15,396
-----------------------------------------------------------------------------------------------
Total real estate before general valuation allowance $35,493 $14,989 $459 $50,941
-----------------------------------------------------------------------------------------------
General valuation allowance ........................... (1,494)
-----------------------------------------------------------------------------------------------
Net investment in real estate and joint ventures ...... $49,447
===============================================================================================
73
A summary of real estate and joint venture operations included in Downey's
results of operations follows:
(In Thousands) 1998 1997 1996
-----------------------------------------------------------------------------------------
Wholly owned operations:
Rental operations:
Rental income .................................. $ 5,189 $ 4,689 $ 4,649
Costs and expenses ............................. (1,466) (2,372) (2,232)
-----------------------------------------------------------------------------------------
Net rental operations ........................ 3,723 2,317 2,417
Net gains on sales of real estate ................. 2,557 2,904 392
Reduction of losses on real estate ................ 5,081 985 1,263
-----------------------------------------------------------------------------------------
Total wholly owned operations .................. 11,361 6,206 4,072
-----------------------------------------------------------------------------------------
Joint venture operations:
Equity in net income from joint ventures .......... 9,203 3,931 55
Reduction of losses provided by DSL Service Company 215 2,205 2,043
-----------------------------------------------------------------------------------------
Net joint venture operations ................... 9,418 6,136 2,098
Interest from joint venture advances ................. 1,584 1,880 2,071
-----------------------------------------------------------------------------------------
Total joint venture operations .................... 11,002 8,016 4,169
-----------------------------------------------------------------------------------------
Total .......................................... $22,363 $14,222 $ 8,241
=========================================================================================
Activity in the allowance for losses on real estate and investments in
joint ventures for 1998, 1997 and 1996 is as follows:
Real Estate Commercial Residential
Held for Real Estate Real Estate Investments
or Under Held for Held for In Joint
(In Thousands) Development Investment Investment Ventures Total
--------------------------------------------------------------------------------------------------------------
Balance at December 31, 1995 ................ $ 5,967 $ 6,683 $11,859 $ 9,829 $34,338
Provision for (reduction of) estimated losses 50 (1,567) 254 (2,043) (3,306)
Charge-offs ................................. (680) -- (272) (83) (1,035)
Recoveries .................................. -- -- -- 74 74
--------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 ................ 5,337 5,116 11,841 7,777 30,071
Provision for (reduction of) estimated losses 492 (1,403) (74) (2,205) (3,190)
Charge-offs ................................. -- (1,692) -- (3,945) (5,637)
Recoveries .................................. -- -- -- -- --
--------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997 ................ 5,829 2,021 11,767 1,627 21,244
Provision for (reduction of) estimated losses 33 (427) (4,687) (215) (5,296)
Charge-offs ................................. (1,151) -- (7,080) -- (8,231)
Recoveries .................................. -- -- -- -- --
--------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 ................ $ 4,711 $ 1,594 $ -- $ 1,412 $ 7,717
==============================================================================================================
74
Condensed financial information of joint ventures reported on the equity
method is as follows:
Condensed Combined Balance Sheets - Joint Ventures
December 31,
---------------------
(In Thousands) 1998 1997
-----------------------------------------------------------------------------------
ASSETS
Cash ...................................................... $ 2,776 $ 1,703
Projects under development ................................ 18,526 964
Completed projects ........................................ 31,372 64,138
Other assets .............................................. 3,509 5,057
-----------------------------------------------------------------------------------
$ 56,183 $ 71,862
===================================================================================
LIABILITIES AND EQUITY
Liabilities:
Notes payable to the Bank .............................. $ 46,544 $ 52,992
Notes payable to others ................................ 3,633 13,858
Other .................................................. 6,996 9,940
Equity (deficit):
DSL Service Company (1) ................................ 7,883 7,084
Allowance for losses recorded by DSL Service Company (2) 1,412 1,627
Other partners' (2) .................................... (10,285) (13,639)
-----------------------------------------------------------------------------------
Net deficit .......................................... (990) (4,928)
-----------------------------------------------------------------------------------
$ 56,183 $ 71,862
===================================================================================
(1) Included in these amounts are interest-bearing joint venture advances
with priority interest payments from joint ventures to DSL Service
Company.
(2) The aggregate other partners' deficit of $10 million and $14 million
at December 31, 1998 and 1997, respectively, represents their equity
interest in the accumulated retained earnings (deficit) of the
respective joint ventures. Those results include not only the net
profit on sales and the operating results of the real estate assets,
but depreciation expense and funding costs as well. Except for any
secured financing which has been obtained, DSL Service Company has
provided all other financing. As part of Downey's internal asset
review process, the fair value of the joint venture real estate assets
is compared to the secured notes payable to the Bank and others and
DSL Service Company's investment. To the extent the fair value of the
real estate assets is less than the aggregate of those amounts, a
provision is made to create a valuation allowance. Those allowances
totaled $1 million and $2 million at December 31, 1998 and 1997,
respectively. At December 31, 1998, the fair value of the real estate
assets of certain joint venture partnerships in which the other
partners' equity was a deficit exceeded the amount of third party
notes and DSL Service Company's investment thereby eliminating the
need for a valuation allowance since the sale of the real estate would
allow DSL Service Company to realize its investment and provide a
profit to the partners. Thus, the other partners' deficit of $10
million and $14 million at December 31, 1998 and 1997, respectively,
exceeds the amount of aforementioned valuation allowances established
of $1 million and $2 million at December 31, 1998 and 1997,
respectively.
75
Condensed Combined Statements of Operations - Joint Ventures
(In Thousands) 1998 1997 1996
---------------------------------------------------------------------------------------
Real estate sales:
Sales ......................................... $ 59,095 $ 82,696 $ 2,901
Cost of sales ................................. (39,261) (72,255) (1,401)
---------------------------------------------------------------------------------------
Net gains on sales ........................... 19,834 10,441 1,500
---------------------------------------------------------------------------------------
Rental operations:
Rental income ................................. 6,252 8,280 13,674
Operating expenses ............................ (2,409) (1,729) (1,781)
Interest, depreciation and other expenses ..... (5,271) (9,130) (14,784)
---------------------------------------------------------------------------------------
Net loss on rental operations ................ (1,428) (2,579) (2,891)
---------------------------------------------------------------------------------------
Net income (loss) ................................. 18,406 7,862 (1,391)
Less other partners' share of net income (loss) ... 9,203 3,931 (1,446)
---------------------------------------------------------------------------------------
DSL Service Company's share of net income ......... 9,203 3,931 55
Reduction of losses provided by DSL Service Company 215 2,205 2,043
---------------------------------------------------------------------------------------
DSL Service Company's share of net income ......... $ 9,418 $ 6,136 $ 2,098
=======================================================================================
(9) REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS
The type and amount of real estate acquired in settlement of loans is
summarized as follows:
December 31,
-------------------
(In Thousands) 1998 1997
--------------------------------------------------------------------------------
One-to-four unit residential ............................ $5,008 $ 9,295
Commercial shopping centers ............................. -- 477
Land .................................................... -- 693
--------------------------------------------------------------------------------
Total real estate acquired in settlement of loans .... 5,008 10,465
Allowance for estimated losses .......................... (533) (839)
--------------------------------------------------------------------------------
Total real estate acquired in settlement of loans, net $4,475 $ 9,626
================================================================================
A summary of net operation of real estate acquired in settlement of loans
included in Downey's results of operations follows:
(In Thousands) 1998 1997 1996
-------------------------------------------------------------------------------------------------
Net gains on sales (1) ......................................... $(1,417) $(1,299) $ (389)
Net operating expense .......................................... 1,222 1,376 1,298
Provision for estimated losses ................................. 455 1,107 1,658
-------------------------------------------------------------------------------------------------
Net operations of real estate acquired in settlement of loans $ 260 $ 1,184 $2,567
=================================================================================================
(1) Includes $1.1 million in 1997 associated with the sale of a shopping
center.
76
Activity in the allowance for estimated losses on real estate acquired
through foreclosure for 1998, 1997 and 1996 is as follows:
(In Thousands) 1998 1997 1996
-------------------------------------------------------------
Balance at beginning of period $ 839 $ 1,078 $ 1,217
Provision .................... 455 1,107 1,658
Charge-offs .................. (761) (1,346) (1,797)
-------------------------------------------------------------
Balance at end of period ..... $ 533 $ 839 $ 1,078
=============================================================
(10) PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
December 31,
----------------------
(In Thousands) 1998 1997
-------------------------------------------------------------------
Land .................................... $ 24,471 $ 23,413
Building and improvements ............... 88,384 86,444
Furniture, fixtures and equipment ....... 52,080 46,970
Construction in progress ................ 196 705
Other ................................... 62 76
-------------------------------------------------------------------
Total premises and equipment ......... 165,193 157,608
Accumulated depreciation and amortization (61,214) (55,707)
-------------------------------------------------------------------
Total premises and equipment, net .... $103,979 $101,901
===================================================================
Downey has commitments under long term operating leases, principally for
building space and land. Lease terms generally cover a five-year period.
Rental expense was $1.7 million in 1998, $1.4 million in 1997 and $0.8
million in 1996. The following table summarizes future minimum rental
commitments under noncancelable leases.
(In Thousands)
----------------------------------------------------------
1999 ............................................ $1,662
2000 ............................................ 1,364
2001 ............................................ 1,022
2002 ............................................ 586
2003 ............................................ 465
Thereafter (1) .................................. 398
----------------------------------------------------------
Total future lease commitments $5,497
==========================================================
(1) There are no lease commitments beyond the year 2009 though options to
renew at that time are available.
(11) FEDERAL HOME LOAN BANK STOCK
The Bank's required investment in FHLB stock, based on December 31, 1998
financial data, was $52 million. The investment in FHLB stock amounted to
$49 million and $44 million at December 31, 1998 and 1997, respectively.
The Bank received a $1 million stock dividend and will purchase additional
stock amounting to $2 million in the first quarter of 1999 thereby
increasing the Bank's investment to the required amount.
77
(12) OTHER ASSETS
Other assets are summarized as follows:
December 31,
-----------------
(In Thousands) 1998 1997
-------------------------------------------------------------------
Accounts receivable ........................... $ 4,151 $ 3,798
Accrued interest receivable:
Loans ...................................... 27,949 27,279
Mortgage-backed securities ................. 182 281
Investment securities ...................... 2,618 2,824
Prepaid expenses .............................. 10,172 8,598
Excess of purchase price over fair value of
assets acquired and liabilities assumed, net 4,543 5,054
Core deposit premium .......................... -- 214
Mortgage servicing rights, net ................ 7,793 1,955
Repossessed automobiles, net .................. 569 795
Other ......................................... 1,660 462
-------------------------------------------------------------------
Total other assets ......................... $59,637 $51,260
===================================================================
(13) DEPOSITS
Deposits are summarized as follows:
December 31,
---------------------------------------------
1998 1997
---------------------------------------------
Weighted Weighted
Average Average
(Dollars in Thousands) Rate Amount Rate Amount
----------------------------------------------------------------------------------
Transaction accounts (1) ......... 2.30% $1,238,062 2.15% $ 935,869
Certificates of deposit:
Less than 3.00% ............... 2.62 25,126 2.64 30,623
3.00-3.49 ..................... 3.01 593 3.02 766
3.50-3.99 ..................... 3.88 51,474 - --
4.00-4.49 ..................... 4.39 428,316 4.31 60,095
4.50-4.99 ..................... 4.80 668,204 4.87 40,356
5.00-5.99 ..................... 5.53 2,421,333 5.63 2,896,291
6.00-6.99 ..................... 6.06 204,065 6.06 901,920
7.00 and greater .............. 7.24 2,560 7.22 4,058
----------------------------------------------------------------------------------
Total certificates of deposit 5.26 3,801,671 5.68 3,934,109
----------------------------------------------------------------------------------
Total deposits .............. 4.53% $5,039,733 5.00% $4,869,978
==================================================================================
(1) Included in these amounts is $155 million and $107 million of
non-interest bearing accounts at December 31, 1998 and 1997,
respectively
78
The aggregate amount of jumbo certificates of deposit with a minimum
denomination of $100,000 was $1.3 billion and $1.1 billion at December 31,
1998 and 1997, respectively.
At December 31, 1998, scheduled maturities of certificates of deposit are
as follows:
Weighted
(Dollars in Thousands) Average Rate Amount
-------------------------------------------------------------------------
1999 ............................................ 5.26 $3,419,719
2000 ............................................ 5.23 309,909
2001 ............................................ 5.69 29,000
2002 ............................................ 5.88 19,863
2003 ............................................ 5.37 21,540
Thereafter ...................................... 4.96 1,640
-------------------------------------------------------------------------
Total ........................................ 5.26 $3,801,671
=========================================================================
The weighted average cost of deposits averaged 4.87%, 4.96% and 4.74%
during 1998, 1997 and 1996, respectively.
As of December 31, 1998 and 1997, public funds of approximately $5 million
and $6 million, respectively, are secured by mortgage loans with a carrying
value of approximately $7 million and $9 million, respectively.
Interest expense on deposits by type is summarized as follows:
(In Thousands) 1998 1997 1996
---------------------------------------------------------------
Transaction accounts ............ $ 22,866 $ 18,239 $ 16,087
Certificate accounts ............ 225,471 209,282 168,315
---------------------------------------------------------------
Total deposit interest expense $248,337 $227,521 $184,402
===============================================================
Accrued interest on deposits, which is included in accounts payable and
accrued liabilities, was $2 million at both December 31, 1998 and 1997.
(14) SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase are summarized as follows:
(Dollars in Thousands) 1998 1997 1996
-----------------------------------------------------------------------------------------
Balance at year end ....................................... $ -- $34,803 $ --
Average balance outstanding during the year ............... 1,877 4,029 11,761
Maximum amount outstanding at any month-end during the year 50,088 34,803 70,015
Weighted average interest rate during the year ............ 5.90% 5.61% 5.19%
Weighted average interest rate at year end ................ -- 6.65 --
As of year end secured by:
U.S. Treasury note ..................................... $ -- $34,798 $ --
=========================================================================================
The securities collateralizing these transactions were delivered to major
national brokerage firms who
79
arranged the transactions. Securities sold under agreements to repurchase
generally mature within 30 days of the various dates of sale.
(15) FEDERAL HOME LOAN BANK ADVANCES
FHLB advances are summarized as follows:
(Dollars in Thousands) 1998 1997 1996
--------------------------------------------------------------------------------------------
Balance at year end ....................................... $695,012 $352,458 $386,883
Average balance outstanding during the year ............... 247,521 444,408 266,252
Maximum amount outstanding at any month-end during the year 695,012 550,736 397,147
Weighted average interest rate during the year ............ 5.85% 6.02% 5.85%
Weighted average interest rate at year end ................ 5.47 6.11 5.80
As of year end secured by:
Loans receivable ....................................... $789,588 $368,480 $345,463
Mortgage-backed securities ............................. -- 25,527 31,651
FHLB stock ............................................. -- -- 41,447
============================================================================================
In addition to the collateral securing existing advances, Downey had an
additional $227 million in loans available as collateral for any future
advances as of December 31, 1998.
FHLB advances have the following maturities at December 31, 1998:
(In Thousands)
----------------------------------------------------------------------
1999 ....................................................... $163,105
2000 ....................................................... 28,796
2001 ....................................................... 16,056
2002 ....................................................... 55,921
2003 ....................................................... 134
Thereafter ................................................. 431,000
----------------------------------------------------------------------
Total ................................................... $695,012
======================================================================
(16) COMMERCIAL PAPER
Commercial paper borrowings are summarized as follows:
(Dollars in Thousands) 1998 1997 1996
--------------------------------------------------------------------------------------------
Balance at year end ....................................... $ -- $ 83,811 $198,113
Average balance outstanding during the year ............... 30,589 182,296 174,739
Maximum amount outstanding at any month-end during the year 103,749 272,818 198,113
Weighted average interest rate during the year ............ 6.32% 5.75% 5.74%
Weighted average interest rate at end of year ............. - 5.61 5.45
As of year end secured by:
FHLB Letter of Credit .................................. $ -- $300,000 $200,000
============================================================================================
The commercial paper program was discontinued during 1998.
80
(17) OTHER BORROWINGS
Other borrowings are summarized as follows:
December 31,
---------------
(Dollars In Thousands) 1998 1997
-----------------------------------------------------------------------------------------
Long-term notes payable to banks, secured by real estate and mortgage
loans with a carrying value of $13,319 at December 31, 1998, bearing
interest rates from 7.50% to 9.21% ................................. $8,708 $12,663
=========================================================================================
Other borrowings have the following maturities at December 31, 1998:
(In Thousands)
----------------------------------------------------------------------
1999 ........................................................ $2,775
2000 ........................................................ 2,403
2001 ........................................................ 687
2002 ........................................................ 546
2003 ........................................................ 599
Thereafter .................................................. 1,698
----------------------------------------------------------------------
Total .................................................... $8,708
======================================================================
(18) INCOME TAXES
Income taxes are summarized as follows:
(In Thousands) 1998 1997 1996
---------------------------------------------------------------------------
Federal:
Current ............................... $38,474 $26,681 $ 8,310
Deferred .............................. (5,848) (886) 3,317
---------------------------------------------------------------------------
$32,626 $25,795 $11,627
===========================================================================
State:
Current ............................... $10,955 $ 7,373 $ 2,602
Deferred .............................. (413) 1,032 1,521
---------------------------------------------------------------------------
$10,542 $ 8,405 $ 4,123
===========================================================================
Total:
Current ............................... $49,429 $34,054 $10,912
Deferred .............................. (6,261) 146 4,838
---------------------------------------------------------------------------
Total .............................. $43,168 $34,200 $15,750
===========================================================================
Current income taxes payable were $8 million and $11 million at December
31, 1998 and 1997, respectively.
81
Deferred tax liabilities (assets) are comprised of the following temporary
differences between the financial statement carrying amounts and the tax
bases of assets:
December 31,
--------------------
(In Thousands) 1998 1997
--------------------------------------------------------------------------------
Deferred tax liabilities:
Tax reserves in excess of base year .................. $ 16,438 $ 21,095
Deferred loan fees ................................... -- 19,498
Equity in joint ventures ............................. 4,783 7,260
FHLB stock dividends ................................. 5,607 5,600
Installment sales .................................... 268 5,011
Depreciation on premises and equipment ............... 3,812 4,497
Capitalized interest ................................. 978 1,530
Accrual to cash adjustment ........................... 164 259
Unrealized gains on investment securities (1) ........ 568 86
SAIF insurance premiums .............................. 86 62
Other deferred income items .......................... 18 54
--------------------------------------------------------------------------------
32,722 64,952
--------------------------------------------------------------------------------
Deferred tax assets:
Loan valuation allowances, net of bad debt charge-offs (14,447) (32,875)
Real estate and joint venture valuation allowances ... (4,010) (15,190)
California franchise tax ............................. (3,704) (2,941)
Deferred compensation ................................ (1,924) (1,899)
Deferred loan fees ................................... (1,564) --
Mark to market adjustment on loans held for sale ..... (923) (217)
Interest expense on deferred gain .................... -- (131)
Other deferred expense items ......................... (739) (512)
--------------------------------------------------------------------------------
(27,311) (53,765)
Deferred tax assets valuation allowance .................. -- --
--------------------------------------------------------------------------------
Net deferred tax liability ............................... $ 5,411 $ 11,187
================================================================================
(1) Generally accepted accounting principles require the tax effect of
unrealized gains and losses on securities available for sale to be
reported as a separate component of stockholders' equity as
accumulated other comprehensive income.
A reconciliation of income taxes (benefits) to the expected statutory
federal corporate income taxes follows:
1998 1997 1996
------------------------------------------------------------
(Dollars in Thousands) Amount Percent Amount Percent Amount Percent
--------------------------------------------------------------------------------------------------------------
Expected statutory income taxes ............... $35,399 35.0% $27,802 35.0% $12,759 35.0%
California franchise tax, net of federal income
tax benefit ................................ 6,880 6.8 5,461 6.9 2,680 7.4
Increase (decrease) resulting from:
Amortization of goodwill ................... 253 0.3 291 0.4 295 0.8
Interest on municipal bonds ................ (107) (0.1) (103) (0.1) (103) (0.3)
Other ...................................... 743 0.7 749 0.9 119 0.3
--------------------------------------------------------------------------------------------------------------
Income taxes .................................. $43,168 42.7% $34,200 43.1% $15,750 43.2%
==============================================================================================================
82
The Small Business Job Protection Act of 1996 repealed the reserve method
of accounting for bad debts by savings institutions for years beginning
after 1995. Under prior law, savings associations calculated additions to
reserves using either a percentage-of-taxable-income or historical loan
loss experience. The new law allows deductions for bad debts only when such
debts are actually charged off against income (the "specific charge-off"
method). Downey calculated its bad debt deduction for 1998, 1997 and 1996
under the specific charge-off method.
Downey made income tax payments, net of refunds, amounting to $52.8
million, $23.6 million, and $19.8 million in 1998, 1997 and 1996,
respectively.
Downey and its wholly owned subsidiaries file a consolidated federal income
tax return and various state income and franchise tax returns on a calendar
year basis. The Internal Revenue Service and state taxing authorities have
examined Downey's tax returns for all tax years through 1995. Adjustments
totaling $15 million proposed by the Internal Revenue Service relating to
the sale and leaseback of computer equipment in 1990 have been protested by
Downey, and are currently moving through the government appeals process.
Downey believes that substantial legal authority exists for the positions
taken on the tax returns and intends to vigorously defend those positions,
and that adequate provisions have been provided for the potential exposure.
Tax years subsequent to 1995 remain open to review by federal and state tax
authorities.
83
(19) STOCKHOLDERS' EQUITY
Regulatory Capital
Downey is not subject to any regulatory capital requirements. However, the
Bank is subject to regulation by the Office of Thrift Supervision ("OTS")
which has adopted regulations ("Capital Regulations") that contain a
capital standard for savings institutions. The Bank is in compliance with
the Capital Regulations at December 31, 1998 and 1997.
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
---------------- ------------------- --------------------
(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio
----------------------------------------------------------------------------------------------
1998
Risk-based capital
(to risk-weighted assets) $454,960 12.88% $282,556 8.00% $353,195 10.00%
Core capital
(to adjusted assets) .... 423,693 6.83 186,107 3.00 310,178 5.00
Tangible capital
(to adjusted assets) .... 423,693 6.83 93,053 1.50 -- - (1)
Tier I capital
(to risk-weighted assets) 423,693 12.00 -- - (1) 211,917 6.00
==============================================================================================
1997
Risk-based capital
(to risk-weighted assets) $413,392 12.64% $261,567 8.00% $326,959 10.00%
Core capital
(to adjusted assets) .... 381,679 6.61 173,229 3.00 288,715 5.00
Tangible capital
(to adjusted assets) .... 381,679 6.61 86,614 1.50 -- - (1)
Tier I capital
(to risk-weighted assets) 381,679 11.67 -- - (1) 196,175 6.00
==============================================================================================
(1) Ratio is not specified under capital regulations.
Capital Distributions
The OTS rules impose certain limitations regarding stock repurchases and
redemptions, cash-out mergers and any other distributions charged against
an institution's capital accounts. The payment of dividends by the Bank is
subject to OTS regulations. Safe-harbor amounts of capital distributions
can be made after providing notice to the OTS, but without needing prior
approval. For institutions, such as the Bank, that meet their capital
requirements, the safe-harbor amount is the greater of (a) 75% of net
income for the prior four quarters, or (b) the sum of (1) the current
year's net income and (2) the amount that causes the excess of the
institution's total capital-to-risk weighted assets ratio over 8% to be
only one-half of such excess at the beginning of the year. Institutions can
distribute amounts in excess of the safe-harbor amounts only with the prior
approval of the OTS.
As of December 31, 1998, the Bank had the capacity to declare dividends
totaling $88 million under the safe-harbor limitations.
84
Stock Dividend
On April 22, 1998, the Board of Directors declared a five percent stock
dividend on Downey's common stock payable on May 22, 1998 to stockholders
of record on May 7, 1998. The stock dividend resulted in the issuance of
1,337,271 shares and the par value of the common stock remained at $0.01.
Accordingly, $13,000 and $45,702,000 were transferred from retained
earnings to common stock and additional paid-in-capital, respectively. All
share and per share data, including stock option plan information, have
been restated to reflect this distribution.
Employee Stock Option Plans
During 1994, the Bank adopted and the stockholders approved the Downey
Savings and Loan Association 1994 Long Term Incentive Plan (the "LTIP").
The LTIP provides for the granting of stock appreciation rights, restricted
stock, performance awards and other awards. The LTIP specifies an
authorization of 434,110 shares (adjusted for stock dividends and splits)
of the Bank's common stock available for issuance under the LTIP. Effective
January 23, 1995, Downey Financial Corp. and the Bank executed an amendment
to the LTIP by which Downey Financial Corp. adopted and ratified the LTIP
such that shares of Downey Financial Corp. shall be issued upon exercise of
options or payment of other awards, for which payment is to be made in
stock, in lieu of the Bank's common stock.
During 1998, options to purchase 120,335 shares were granted under the
LTIP, while in 1997 no options were granted.
Options outstanding under the LTIP at December 31, 1998 and 1997 are
summarized as follows:
Outstanding Options
--------------------
Number Average
of Option
Shares Price
-------------------------------------------------------------------
December 31, 1995 ........................... 360,523 $12.74
Options granted ............................. 16,538 15.42
Options canceled and exercised .............. (33,902) 13.23
-------------------------------------------------------------------
December 31, 1996 ........................... 343,159 12.82
Options granted ............................. -- -
Options canceled and exercised .............. (199,273) 12.40
-------------------------------------------------------------------
December 31, 1997 ........................... 143,886 13.40
Options granted ............................. 120,335 25.44
Options canceled and exercised .............. (44,770) 13.28
-------------------------------------------------------------------
December 31, 1998 ........................... 219,451 $20.03
===================================================================
Under the LTIP, options are exercisable over vesting periods specified in
each grant and, unless exercised, the options terminate between five or ten
years from the date of the grant. Further, under the LTIP, the option price
shall at least equal or exceed the fair market value of such shares on the
date the options are granted.
At December 31, 1998, 78,439 options were exercisable at a weighted average
option price per share of $13.26, with 127,722 shares available for future
grants under the LTIP. At December 31, 1997 and 1996, exercisable options
of 76,692 and 146,768, respectively, were exercisable at a weighted average
option price per share of $13.21 and $12.61, respectively.
85
Downey measures its employee stock-based compensation arrangements under
the provisions of APB 25. Accordingly, no compensation expense has been
recognized for the stock option plan. Had compensation expense for Downey's
stock option plan been determined based on the fair value at the grant date
for awards in 1998 and 1996, Downey's net income and income per share would
have been reduced to the pro forma amounts indicated below:
(In Thousands, Except Per Share Data) 1998 1997 1996
---------------------------------------------------------------------------
Net income:
As reported ............................ $57,973 $45,234 $20,704
Pro forma .............................. 57,954 45,195 20,673
Earnings per share - Basic:
As reported ............................ $2.06 $1.61 $0.74
Pro forma .............................. 2.06 1.61 0.74
Earnings per share - Diluted:
As reported ............................ 2.05 1.61 0.74
Pro forma .............................. 2.05 1.61 0.74
===========================================================================
The weighted average fair value at date of grant of options granted was
$7.77 and $3.71 per option during 1998 and 1996, respectively. The fair
value of options at date of grant was estimated using the Black-Scholes
model with the following weighted average assumptions:
1998 1997 (1) 1996
--------------------------------------------------------------------------
Expected life (years) ....................... 3.11 - 3.79
Interest rate ............................... 4.65% -% 6.08%
Volatility .................................. 40.31 - 24.58
Dividend yield .............................. 1.23 - 1.88
==========================================================================
(1) No options were granted during the period.
(20) EARNINGS PER SHARE
A reconciliation of the components used to derive basic and diluted
earnings per share for 1998, 1997 and 1996 follows:
Net Weighted Average Per-Share
(Dollars in Thousands, Except Per Share Data) Income Shares Outstanding Amount
------------------------------------------------------------------------------------
1998:
Basic earnings per share ................. $57,973 28,111,855 $2.06
Effect of dilutive stock options ......... -- 64,388 0.01
------------------------------------------------------------------------------------
Diluted earnings per share ............... $57,973 28,176,243 $2.05
====================================================================================
1997:
Basic earnings per share ................. $45,234 28,076,556 $1.61
Effect of dilutive stock options ......... -- 63,644 -
------------------------------------------------------------------------------------
Diluted earnings per share ............... $45,234 28,140,200 $1.61
====================================================================================
1996:
Basic earnings per share ................. $20,704 28,068,104 $0.74
Effect of dilutive stock options ......... -- 35,187 -
------------------------------------------------------------------------------------
Diluted earnings per share ............... $20,704 28,103,291 $0.74
====================================================================================
86
(21) EMPLOYEE BENEFIT PLANS
Retirement and Savings Plan
In August 1993, Downey amended its profit sharing plan so that it qualifies
as a profit sharing and savings plan under Section 401(k) of the Internal
Revenue Code ("the Plan"), covering substantially all salaried employees.
Under the Plan, employee contributions are partially matched by Downey.
Downey's matching contribution is equal to 25% of an employee's pretax
contributions which do not exceed 4% of the employee's annual compensation.
In addition, Downey makes an annual retirement contribution based on the
employee's age and salary. Downey's contributions to the Plan totaled $1.9
million for 1998, compared to $1.5 million in 1997 and $1.3 million in
1996.
During 1995, Downey approved the implementation of a Deferred Compensation
Plan for key management employees and directors. The Deferred Compensation
Plan is considered to be an essential element in a comprehensive
competitive benefits package designed to attract and retain individuals who
contribute to the success of Downey. Participants are eligible to defer
compensation on a pre-tax basis, including director fees, and earn a
competitive interest rate on the amounts deferred. Currently, 82 management
employees and six directors are eligible to participate in the program.
During 1998, 17 management employees and one director elected to defer
compensation pursuant to the plan. Downey's expense related to the Deferred
Compensation Plan has been less than $0.1 million each year since
inception.
Group Benefit Plan
Downey provides certain health and welfare benefits for active employees
under a cafeteria plan ("the Benefit Plan") as defined by section 125 of
the Internal Revenue Code. Under the Benefit Plan, employees make
appropriate selections as to the type of benefits and the amount of
coverage desired. The benefits are provided through insurance companies and
other health organizations and are funded by contributions from Downey,
employees and retirees and include deductibles, co-insurance provisions and
other limitations. Downey's expense for health and welfare benefits was
$3.1 million, $2.5 million and $3.1 million in 1998, 1997 and 1996,
respectively.
(22) COMMITMENTS AND CONTINGENCIES
Litigation
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.
Financial Instruments With Off-balance-sheet Risk
Downey is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers
and to reduce its own exposure to fluctuations in interest rates. These
financial instruments include commitments to originate fixed and variable
rate mortgage loans, letters of credit, lines of credit and loans in
process. The contract or notional amounts of those instruments reflect the
extent of involvement Downey has in particular classes of financial
instruments.
Downey uses the same credit policies in making commitments to originate
loans, lines of credit and letters of credit as it does for
on-balance-sheet instruments. For commitments to originate fixed rate
loans, the contract amounts represent exposure to loss from market
fluctuations as well as credit loss. Downey controls the credit risk of its
commitments to originate fixed rate loans through credit approvals, limits
and monitoring procedures.
87
The following is a summary of commitments and contingent liabilities:
December 31,
------------------
(In Thousands) 1998 1997
-----------------------------------------------------------------------------------
Commitments to originate loans and mortgage-backed securities:
Adjustable ................................................ $390,556 $ 90,136
Fixed ..................................................... 550,339 35,225
Commitments to sell loans and mortgage-backed securities ...... 621,753 50,893
Commitments to purchase mortgage-backed securities ............ 34,000 7,600
Undisbursed loan funds and unused lines of credit ............. 169,738 126,135
Standby letters of credit and other contingent liabilities .... 3,851 3,080
===================================================================================
Commitments to originate fixed and variable rate mortgage loans are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a
fee. Since some of the commitments may expire without being drawn upon, the
total commitment amounts do not necessarily represent future cash
requirements. The credit risk involved in issuing lines and letters of
credit requires the same creditworthiness evaluation as that involved in
extending loan facilities to customers. Downey evaluates each customer's
creditworthiness on a case-by-case basis. Undisbursed loan funds and unused
lines of credit include home equity lines of credit and funds not
disbursed, but committed to construction and commercial lending by the
Bank.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party.
Downey receives collateral to support commitments for which collateral is
deemed necessary. The most significant categories of collateral include
real estate properties underlying mortgage loans, liens on personal
property, and cash on deposit with Downey. At December 31, 1998, the extent
of collateral supporting mortgage and other loans varied from nothing to
100% of the maximum credit exposure.
In connection with its interest rate risk management, Downey occasionally
enters into interest rate exchange agreements ("swap contracts") with
certain national investment banking firms under terms that provide mutual
payment of interest on the outstanding notional amount of the swap. The
effect of these swaps serve to reduce Downey's interest rate risk between
repricing assets and liabilities. At December 31, 1998, no swap contracts
were outstanding.
(23) RISK MANAGEMENT
Derivative financial instruments are utilized to minimize the effect of
future fluctuations in interest rates as part of its secondary marketing
activities. Downey utilizes forward sale and purchase contracts to hedge
the value of loans originated for sale against adverse changes in interest
rates. At December 31, 1998, such sales and purchase contracts amounted to
$622 million and $34 million, respectively.
88
(24) FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value estimates are made at a specific point in time based upon
relevant market information and other information about the financial
instrument. The estimates do not necessarily reflect the price Downey might
receive if it were to sell at one time its entire holding of a particular
financial instrument. Because no active market exists for a significant
portion of Downey's financial instruments, fair value estimates are based
upon the following methods and assumptions, some of which are subjective in
nature. Changes in assumptions could significantly affect the estimates.
Cash, Federal Funds Sold, and Securities Purchased Under Resale Agreements
The carrying amounts reported in the balance sheet for these items
approximate fair value.
Investment Securities Including U.S. Treasuries and Mortgage-backed
Securities
Fair value is based upon bid prices published in financial newspapers or
bid quotations received from securities dealers.
Loans Receivable
For residential mortgage loans, fair value is estimated based upon market
prices obtained from readily available market quote systems. The remaining
portfolio was segregated into those loans with variable rates of interest
and those with fixed rates of interest. For non-residential variable rate
loans which reprice frequently, fair values approximate carrying values.
For non-residential fixed rate loans, fair values are based on discounting
future contractual cash flows using the current rate offered for such loans
with similar remaining maturities and credit risk. The amounts so
determined for each category of loan are reduced by the associated
allowance for loan losses which thereby takes into consideration changes in
credit risk.
Interest-bearing Advances to Joint Ventures
The carrying amounts approximate fair value as the interest earned is based
upon a variable rate.
Mortgage Servicing Rights
The fair value of MSRs related to loans serviced for others is determined
by computing the present value of the expected net servicing income from
the portfolio.
Deposits
The fair value of deposits with no stated maturity such as regular passbook
accounts, money market accounts, and checking accounts, is the carrying
amount reported in the balance sheet. The fair value of deposits with a
stated maturity such as certificates of deposit is based on discounting
future contractual cash flows by the current rate offered for such deposits
with similar remaining maturities.
Borrowings
For short-term borrowings, fair value approximates carrying value. The fair
value of long-term borrowings is based on their interest rate
characteristics. For variable rate borrowings, fair values approximate
carrying values. For fixed rate borrowings, fair value is based on
discounting future contractual cash flows by the current rate paid on such
borrowings with similar remaining maturities.
89
Off-balance-sheet Financial Instruments
Outstanding commitments to sell loans and mortgage-backed securities,
commitments to purchase mortgage-backed securities, standby letters of
credit and other contingent liabilities, unused lines of credit,
commitments to originate loans and mortgage-backed securities are
essentially carried at zero which approximates fair value. See Note 22 on
page 87, for information concerning the notional amount of such financial
instruments.
Based on the above methods and assumptions, the following table presents
the estimated fair value of Downey's financial instruments:
December 31,1998 December 31,1997
----------------------------------------------
Carrying Estimated Carrying Estimated
(In Thousands) Amount (1) Fair Value Amount (1) Fair Value
-------------------------------------------------------------------------------------------------------------------
ASSETS:
Cash .............................................................. $ 58,510 $ 58,510 $ 48,823 $ 48,823
Federal funds ..................................................... 33,751 33,751 6,095 6,095
U.S. Government and agency obligations and other
investment securities available for sale ...................... 116,061 116,061 159,398 159,398
Municipal securities held to maturity ............................. 6,764 6,745 6,885 6,865
Loans held for sale ............................................... 447,382 447,468 35,100 35,395
Mortgage-backed securities available for sale ..................... 32,146 32,146 49,299 49,348
Loans receivable held for investment: Loans secured by real estate:
Residential:
Adjustable ................................................ 4,333,023 4,474,114 4,463,525 4,501,037
Fixed ..................................................... 356,209 368,737 180,581 185,348
Other ....................................................... 207,728 210,172 238,215 237,429
Non-mortgage loans:
Commercial .................................................. 19,154 19,154 17,343 17,343
Consumer .................................................... 392,723 396,421 382,333 386,070
Interest-bearing advances to joint ventures ....................... 25,540 25,540 32,122 32,122
MSRs and loan servicing portfolio ................................. 7,793 11,976 1,955 7,584
LIABILITIES:
Deposits:
Transaction accounts .......................................... 1,238,062 1,238,062 935,869 935,869
Certificates of deposit ....................................... 3,801,671 3,804,269 3,934,109 3,947,913
Borrowings ........................................................ 703,720 709,223 483,735 485,558
===================================================================================================================
(1) The carrying amount of loans is stated net of undisbursed loan funds,
unearned fees and discounts and allowances for losses.
90
(25) BUSINESS SEGMENT REPORTING
Downey views its business as consisting of two reportable business
segments--banking and real estate investment. The accounting policies of
the segments are the same as those described in Note 1, Summary of
Significant Accounting Policies on page 61. Downey evaluates performance
based on the net income generated by each segment. Internal expense
allocations between segments are independently negotiated and, where
possible, service and price is measured against comparable services
available in the external marketplace.
The following describes the two business segments.
Banking
The principal business activities of this segment are attracting funds from
the general public and institutions, and originating and investing in
loans, primarily residential real estate mortgage loans, mortgage-backed
securities, and investment securities.
This segment's primary sources of revenue are interest earned on mortgage
loans and mortgage-backed securities, income from investment securities,
gains on sales of loans and mortgage-backed securities, fees earned in
connection with loans and deposits and income earned on its portfolio of
loans and mortgage-backed securities serviced for investors.
This segment's principal expenses are interest incurred on interest-bearing
liabilities, including deposits and borrowings, and general and
administrative costs.
Real Estate Investment
Real estate development and joint venture operations are conducted
principally through the Bank's wholly owned service corporation subsidiary,
DSL Service Company. However, Downey Financial Corp. owns one investment in
land which it purchased from DSL Service Company at fair value in 1995.
DSL Service Company participates as an owner of, or a partner in, a variety
of real estate development projects, principally retail neighborhood
shopping center developments, most of which are located in California. Most
of the real estate development projects have been completed and are
substantially leased.
In its joint ventures, DSL Service Company is entitled to interest on its
equity invested in the project on a priority basis after third-party debt,
and shares profits and losses with the developer partner, generally on an
equal basis. Partnership equity (deficit) accounts are affected by current
period results of operations, additional partner advances, partnership
distributions and partnership liquidations.
This segment's primary sources of revenue are net rental income and gains
from the sale of real estate investment assets. This segment's principal
expenses are interest expense and general and administrative expense.
91
Operating Results and Assets
The following presents the operating results and selected financial data by
major business segments for 1998, 1997 and 1996:
Real Estate
(In Thousands) Banking Investment Elimination Totals
---------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31 1998:
Net interest income (expense) ....... $ 174,967 $ (620) $ -- $ 174,347
Provision (reduction) for loan losses 3,918 (19) -- 3,899
Other income ........................ 24,617 22,736 -- 47,353
Operating expense ................... 113,954 2,706 -- 116,660
Net intercompany income (expense) ... (107) 107 -- --
---------------------------------------------------------------------------------------
Income before income tax expense .... 81,605 19,536 -- 101,141
Income tax expense .................. 34,869 8,299 -- 43,168
---------------------------------------------------------------------------------------
Net income ...................... $ 46,736 $11,237 $ -- $ 57,973
=======================================================================================
ASSETS AT DECEMBER 31 1998:
Loans ........................... $5,788,365 $ -- $ -- $5,788,365
Real estate held for investment . -- 49,447 -- 49,447
Other ........................... 463,960 11,224 (42,577) 432,607
---------------------------------------------------------------------------------------
Total assets ................. 6,252,325 60,671 (42,577) 6,270,419
---------------------------------------------------------------------------------------
Equity .............................. $ 480,566 $42,577 $(42,577) $ 480,566
=======================================================================================
YEAR ENDED DECEMBER 31 1997:
Net interest income (expense) ....... $ 154,799 $ (641) $ -- $ 154,158
Provision for loan losses ........... 8,522 118 -- 8,640
Other income ........................ 20,783 14,405 -- 35,188
Operating expense ................... 98,803 2,469 -- 101,272
Net intercompany income (expense) ... (357) 357 -- --
---------------------------------------------------------------------------------------
Income before income tax expense .... 67,900 11,534 -- 79,434
Income tax expense .................. 29,238 4,962 -- 34,200
---------------------------------------------------------------------------------------
Net income ...................... $ 38,662 $ 6,572 $ -- $ 45,234
=======================================================================================
ASSETS AT DECEMBER 31 1997:
Loans ........................... $5,366,396 $ -- $ -- $5,366,396
Real estate held for investment . -- 41,356 -- 41,356
Other ........................... 449,174 14,455 (35,556) 428,073
---------------------------------------------------------------------------------------
Total assets ................. 5,815,570 55,811 (35,556) 5,835,825
---------------------------------------------------------------------------------------
Equity .............................. $ 430,346 $35,556 $(35,556) $ 430,346
=======================================================================================
YEAR ENDED DECEMBER 31 1996:
Net interest income (expense) ....... $ 134,808 $ (213) $ -- $ 134,595
Provision for loan losses ........... 9,026 111 -- 9,137
Other income ........................ 16,956 8,243 -- 25,199
Operating expense ................... 87,275 2,284 -- 89,559
SAIF special assessment ............. 24,644 -- -- 24,644
Net intercompany income (expense) ... (574) 574 -- --
---------------------------------------------------------------------------------------
Income before income tax expense .... 30,245 6,209 -- 36,454
Income tax expense .................. 13,054 2,696 -- 15,750
---------------------------------------------------------------------------------------
Net income ...................... $ 17,191 $ 3,513 $ -- $ 20,704
=======================================================================================
ASSETS AT DECEMBER 31 1996:
Loans ........................... $4,729,846 $ -- $ -- $4,729,846
Real estate held for investment . -- 46,498 -- 46,498
Other ........................... 446,975 14,514 (39,676) 421,813
---------------------------------------------------------------------------------------
Total assets ................. 5,176,821 61,012 (39,676) 5,198,157
---------------------------------------------------------------------------------------
Equity .............................. $ 391,571 $39,676 $(39,676) $ 391,571
=======================================================================================
92
(26) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data are presented below by quarter for the
years ended December 31, 1998 and 1997:
December 31, September 30, June 30, March 31,
(In Thousands, Except Per Share Data) 1998 1998 1998 1998
----------------------------------------------------------------------------------------------------------
Total interest income ................................ $111,902 $108,982 $109,797 $109,723
Total interest expense ............................... 66,158 66,195 66,607 67,097
----------------------------------------------------------------------------------------------------------
Net interest income ............................... 45,744 42,787 43,190 42,626
Provision for loan losses ............................ 1,180 985 1,462 272
----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 44,564 41,802 41,728 42,354
Total other income ................................... 10,806 9,672 11,949 14,926
Total operating expense .............................. 33,834 28,949 27,280 26,597
----------------------------------------------------------------------------------------------------------
Income before income taxes ........................... 21,536 22,525 26,397 30,683
Income taxes ........................................ 8,884 9,757 11,409 13,118
----------------------------------------------------------------------------------------------------------
Net income ........................................... $ 12,652 $ 12,768 $ 14,988 $ 17,565
==========================================================================================================
Net income per share:
Basic ............................................. $ 0.45 $ 0.45 $ 0.53 $ 0.63
Diluted ........................................... $ 0.45 $ 0.45 $ 0.53 $ 0.62
==========================================================================================================
Market range:
High bid .......................................... $ 26.38 $ 35.00 $ 34.50 $ 30.95
Low bid ........................................... 17.75 23.06 30.83 23.58
End of period ..................................... 25.44 23.81 32.69 30.83
==========================================================================================================
December 31, September 30, June 30, March 31,
1997 1997 1997 1997
----------------------------------------------------------------------------------------------------------
Total interest income ................................ $110,457 $109,101 $103,276 $97,584
Total interest expense ............................... 69,254 71,547 65,993 59,466
----------------------------------------------------------------------------------------------------------
Net interest income ............................... 41,203 37,554 37,283 38,118
Provision for loan losses ............................ 3,034 1,578 1,873 2,155
----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 38,169 35,976 35,410 35,963
Total other income ................................... 10,826 8,018 5,353 10,991
Total operating expense .............................. 24,339 25,477 26,280 25,176
----------------------------------------------------------------------------------------------------------
Income before income taxes ........................... 24,656 18,517 14,483 21,778
Income taxes ......................................... 10,619 7,960 6,173 9,448
----------------------------------------------------------------------------------------------------------
Net income ........................................... $ 14,037 $ 10,557 $ 8,310 $12,330
==========================================================================================================
Net income per share:
Basic ............................................. $ 0.50 $ 0.37 $ 0.30 $ 0.44
Diluted ........................................... $ 0.50 $ 0.37 $ 0.30 $ 0.44
==========================================================================================================
Market range:
High bid .......................................... $ 27.63 $ 23.33 $ 22.50 $ 21.42
Low bid ........................................... 23.03 20.47 17.23 17.23
End of period ..................................... 27.08 23.22 22.50 18.38
==========================================================================================================
93
(27) PARENT COMPANY FINANCIAL INFORMATION
Downey Financial Corp. was incorporated in Delaware on October 21, 1994. On
January 23, 1995, after obtaining necessary stockholder and regulatory
approvals, Downey Financial Corp. acquired 100% of the issued and
outstanding capital stock of the Bank, and the Bank's stockholders became
stockholders of Downey Financial Corp. The transaction was accounted for in
a manner similar to a pooling-of-interests under generally accepted
accounting principles. Downey Financial Corp. was thereafter funded by a
$15 million dividend from the Bank. Condensed financial statements of
Downey Financial Corp. only are as follows:
Condensed Balance Sheets
December 31,
--------------------
(In Thousands) 1998 1997
-----------------------------------------------------------
ASSETS
Cash ................................ $ 5 $ 11
Due from Bank - interest bearing .... 8,521 6,635
Investment in subsidiaries:
Bank ............................. 470,504 421,230
Downey Affiliated Insurance Agency 213 182
Real estate held for investment ..... 458 551
Other assets ........................ 1,124 1,862
-----------------------------------------------------------
$480,825 $430,471
===========================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and accrued expenses $ 259 $ 125
-----------------------------------------------------------
Total liabilities ................ 259 125
-----------------------------------------------------------
Stockholders' equity ................ 480,566 430,346
-----------------------------------------------------------
$480,825 $430,471
===========================================================
94
Condensed Statements of Income
and Other Comprehensive Income
Years Ended December 31,
------------------------------
(In Thousands) 1998 1997 1996
--------------------------------------------------------------------------------------------------
INCOME:
Dividends from the Bank ....................................... $ 9,537 $ 8,891 $ 8,406
Interest income ............................................... 374 380 382
Other income .................................................. 60 57 82
--------------------------------------------------------------------------------------------------
Total income ............................................... 9,971 9,328 8,870
--------------------------------------------------------------------------------------------------
EXPENSE:
Provision for losses on real estate ........................... 24 153 --
General and administrative expense ............................ 793 805 883
--------------------------------------------------------------------------------------------------
Total expense .............................................. 817 958 883
--------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED
NET INCOME OF SUBSIDIARIES .................................... 9,154 8,370 7,987
Income tax benefit ............................................... 157 215 168
--------------------------------------------------------------------------------------------------
INCOME BEFORE EQUITY IN UNDISTRIBUTED NET INCOME
OF SUBSIDIARIES ............................................... 9,311 8,585 8,155
Equity in undistributed net income of subsidiaries ............... 48,662 36,649 12,549
--------------------------------------------------------------------------------------------------
NET INCOME .................................................... 57,973 45,234 20,704
OTHER COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES:
Unrealized gains (losses) on securities available for sale:
U.S. Treasury and agency obligations and other investment
securities available for sale, at fair value ............. 1,104 1,331 (2,160)
Less reclassification of realized gains net of losses
included in income ....................................... (39) -- (2,550)
Mortgage-backed securities available for sale, at fair value (422) 338 (344)
--------------------------------------------------------------------------------------------------
Other comprehensive income (loss) ............................. 643 1,669 (5,054)
--------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME .......................................... $58,616 $46,903 $15,650
==================================================================================================
95
Condensed Statements of Cash Flows
Years Ended December 31,
-------------------------------
(In Thousands) 1998 1997 1996
--------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ................................................... $ 57,973 $ 45,234 $ 20,704
Equity in undistributed net income of subsidiaries ........... (48,662) (36,649) (12,549)
Provision for losses on real estate .......................... 24 153 --
Increase (decrease) in liabilities ........................... 134 7 (69)
Other, net ................................................... 807 (1,304) (296)
--------------------------------------------------------------------------------------------------
Net cash provided by operating activities ................. 10,276 7,441 7,790
--------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Increase) decrease in due from Bank - interest bearing ...... (1,886) 698 346
--------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ...... (1,886) 698 346
--------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Exercise of stock options .................................... 510 335 --
Dividends on common stock .................................... (8,889) (8,454) (8,147)
Other ........................................................ (17) (9) (4)
--------------------------------------------------------------------------------------------------
Net cash used for financing activities .................... (8,396) (8,128) (8,151)
--------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents ............ (6) 11 (15)
Cash and cash equivalents at beginning of year .................. 11 -- 15
--------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ...................... $ 5 $ 11 $ --
==================================================================================================
96
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Downey Financial Corp. intends to file with the Securities and Exchange
Commission a definitive proxy statement (the "Proxy Statement") pursuant to
Regulation 14A, which will involve the election of directors, within 120 days of
the end of the year covered by this Form 10-K. Information regarding directors
of Downey Financial Corp. will appear under the caption "Election of Directors"
in the Proxy Statement for the Annual Meeting of Stockholders to be held on
April 28, 1999, and is incorporated herein by reference. Information regarding
executive officers of Downey Financial Corp. will appear under the caption
"Executive Officers" in the Proxy Statement and is incorporated herein by this
reference.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation will appear under the caption
"Executive Compensation" in the Proxy Statement and is incorporated herein by
this reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information to be included under the captions "Securities Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement is incorporated herein
by this reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information to be included under the caption "Certain Relationships and Related
Transactions" in the Proxy Statement is incorporated herein by this reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements. These documents are listed in the Index to
Consolidated Financial Statements under Item 8.
2. Financial Statement Schedules. Financial Statement Schedules have been
omitted because they are not applicable or the required information is
shown in the Consolidated Financial Statements or Notes thereto.
(b) Reports on Form 8-K during the last quarter of 1998.
The Registrant filed with the Commission two Current Reports on Form
8-K, the first dated November 20, 1998, with respect to senior
management transition and the second dated December 17, 1998,
announcing a new director.
97
(c) Exhibits.
EXHIBIT
NUMBER DESCRIPTION
3.1 (1) Certificate of Incorporation of Downey Financial Corp.
3.3 (2) Bylaws of Downey Financial Corp.
10.1 (3) Downey Savings and Loan Association, F.A. Employee Stock Purchase
Plan (Amended and Restated as of January 1, 1996).
10.2 (3) Amendment No. 1, Downey Savings and Loan Association, F.A.
Employee Stock Purchase Plan. Amendment No. 1, Effective and
Adopted January 22, 1997.
10.3 (3) Downey Savings and Loan Association, F.A. Employees' Retirement
and Savings Plan (October 1, 1997 Restatement).
10.4 (3) Amendment No. 1, Downey Savings and Loan Association, F.A.
Employees' Retirement and Savings Plan (October 1, 1997
Restatement) Amendment No. 1, Effective and Adopted January 28,
1998.
10.5 (3) Trust Agreement for Downey Savings and Loan Association, F.A.
Employees' Retirement and Savings Plan, Effective October 1,
1997 between Downey Savings and Loan Association, F.A. and
Fidelity Management Trust Company.
10.6 (1) Downey Savings and Loan Association 1994 Long-Term Incentive Plan
(as amended).
10.7 (2) Asset Purchase Agreement among Butterfield Savings and Loan
Association, FSA, Mortgage Investment, Inc., Property Management
Service, Inc. and Butterfield Capital Corporation, dated September
1, 1988.
10.8 (2) Assistance Agreement between and among the Federal Savings and
Loan Insurance Corporation, Butterfield Savings and Loan
Association, FSA and Downey Savings and Loan Association, dated
September 29, 1988 (confidential treatment requested due to
contractual prohibition against disclosure).
10.9 (2) Merger of Butterfield Savings and Loan Association, FSA, into
Downey Savings and Loan Association, dated September 29, 1989.
10.10(2) Founder Retirement Agreement of Maurice L. McAlister, dated
December 21, 1989.
10.11(2) Founder Retirement Agreement of Gerald H. McQuarrie, dated
December 21, 1989.
10.12 Employment Agreement of James W. Lokey dated February 6, 1998.
10.13 Severance Agreement and General Release, dated November 20, 1998
by and among, Downey Financial Corp. Downey Savings and Loan
Association, F.A., and James W. Lokey.
22. (2) Subsidiaries.
23.1 Consent of Independent Auditors.
27 Financial Data Schedule.
(1) Filed as part of Downey's report on Form S-8 filed February 3, 1995.
(2) Filed as part of Downey's report on Form 8-B/A filed January 17, 1995.
(3) Filed as part of Downey's report on Form 10-K filed March 14, 1997.
Downey Financial Corp. will furnish any or all of the non-confidential exhibits
upon payment of a reasonable fee. Please send request for exhibits and/or fee
information to:
Downey Financial Corp.
3501 Jamboree Road
Newport Beach, California 92660
Attention: Corporate Secretary
98
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
DOWNEY FINANCIAL CORP.
By: /s/ DANIEL D. ROSENTHAL
------------------------------
Daniel D. Rosenthal
President and Chief Executive Officer
Director
DATED: March 16, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ MAURICE L. McALISTER Chairman of the Board March 16, 1999
- ------------------------ Director
Maurice L. McAlister
/s/ CHERYL E. OLSON Vice Chairman of the Board March 16, 1999
- ------------------------ Director
Cheryl E. Olson
/s/ DANIEL D. ROSENTHAL President and March 16, 1999
- ------------------------ Chief Executive Officer
Daniel D. Rosenthal Director
/s/ THOMAS E. PRINCE Executive Vice President, March 16, 1999
- ----------------------- Chief Financial Officer
Thomas E. Prince (Principal Financial and
Accounting Officer)
/s/ BRENT MCQUARRIE Director March 16, 1999
- -----------------------
Brent McQuarrie
/s/ DR. PAUL KOURI Director March 16, 1999
- -----------------------
Dr. Paul Kouri
/s/ LESTER C. SMULL Director March 16, 1999
- -----------------------
Lester C. Smull
/s/ SAM YELLEN Director March 16, 1999
- -----------------------
Sam Yellen
99