Downey Financial (DSL): What Comes Next
Disclosure: I am short DSL. I may add to or close this position at any time without notice. I am not a professional bank analyst and I may have made errors in the following analysis. Please feel free to point them out.
Downey Financial (DSL) is a large California Savings and Loan that made the mistake of making all its loans pay-option ARMS. Most of its borrowers have used the option to pay less than the interest-only rate, meaning that their mortgage balance keeps increasing over time. This, combined with the falling prices of California real estate, could destroy the bank.
I will start this with Cramer's take from a year ago:
How's that working out for you, Cramer? Here's a chart of Downey's stock over the last year.
One could say that Downey has had its share of bad news over the last year. I would argue that the bad news has only just begun.
Beres Hammond - "Bad News"
The question is, what is next for Downey? I will begin the analysis by quoting a commentator who is a bit smarter than Cramer, anchak from CAPS. He is also more knowledgeable about banks than I am. The following are his main reasons for being bearish about Downey; they come from his bear pitch on DSL on CAPS.
"(1) There's a very simple one : They have done the riskiest product possible. Neg-Am, Interest Only Option ARMS - a lot of it , it seems. $6BN with possibly >10% underwater valuation. Just this, if they had to take a Mark-to-Market would probably be enough to wipe them out. However, they are not required as long as the cash keeps coming in.
(2) Hence their life-line is on the Liability side. $1BN of FHLB advance maturing this year - they have to roll this over - I do not think they are in a position to repay. They can barely service the interest. And obviously their depositors also have to keep faith.
(3) There are also a myriad of other factors - Huge Monoline exposure ( FGIC and RMIC) - about $500MM as well as high OREO book ($200MM) - which they have to Mark-to-Market and if it keeps growing , they'll bleed more and more. "
Anchak brought up some bull arguments and I will deal with them in due course (but not point by point, because that is boring).
The Loan Portfolio
At the end of 2007, the total allowance was $349.4 million. Take a look at pages 46 and 47 of the 2007 10k: $7,530 million in loans are subject to possible negative amortization (meaning they are pay-option ARMS). Of those, 86% have a balance higher than when the loan was originated. That is $6,501 million in loans where the owners cannot afford to even pay the full interest due on their loans. A total of $379 million of negative amortization is included in the total loan balance. The total average loan to value (LTV) ratio has gone from 73% to 77% since loan origination (and at the same time prices have been falling; across most of California prices are below 2005 levels and will soon be below 2004 levels).
In the most recent quarter, Downey had $35 million in negative amortization "income".In 2007, the total was $245 million. While this might seem good, it is not. This means two things: (1) that many loans are non-accrual now and (2) that Downey's loans are starting to recast and require payment of principal. By the way, since the beginning of 2005, Downey has "earned" $673 million in negative amortization. Much of that will never be recovered.
The Balance Sheet
Downey's balance sheet is a nightmare for both shorts and longs. It is a nightmare for longs because book value will take a huge hit over the next year. It is already down to $1,090 million as of March 31 from $1,334 million as of December 31. That is an 18% decrease in just three months. The balance sheet is a nightmare for shorts because Downey's price to book ratio is only 0.11. If Downey can avoid receivership, the stock could easily double, even after a dilutive share offering. The question is whether Downey can avoid receivership. Here are my estimates.
I am more pessimistic than anchak: I believe that fully 30% (vs. anchak's 20% estimate) of Downey's pay-option loans will go non-performing (why do I belive this? It is really just a SWAG; see below for a better methodology). 10% will be restructured while 20% will not. I will charitably assume that Downey will reduce the principal on the restructured loans by 30%. This will give it a hit of $226 million. Furthermore, of the 20% that do not get restructured, I will assume that 80% go to foreclosure. With house prices down over 20% already (actually, the median is down 30% in California, but I will charitably assume that 1/3 of the drop is due to a the foreclosure discount on REO houses sold), these people are already underwater. With an average price drop of 40% over the initial value of the house, and loan to (original) values at around 80% at foreclosure, the bank will take a 36% loss on the original house value (20% loss of equity plus 10% carrying costs and 6% selling costs), which comes to 49% of the loan book value (80% * 64% = 51%).
I will round down and call that 50% for simplicity's sake. So that means a 10% loss on $7,530million, or $753 million. Add this to the restructuring loss and we get $979 million in losses. We subract from this $546 million in loan loss allowances, so we get $433 in un-reserved losses. Subtracting this from the book value we get an adjusted book value of $657 million. From this we subtract another $35m to account for a 20% loss on Downey's REO assets. We end up with adjusted book value of $622 million. This loss would likely drive the bank under the well-capitalized level for both core capital and risk-based capital, requiring the bank to raise assets at a highly-dilutive price. Assuming the share price remains the same, though, the bank could raise $200m at only 200% dilution. The bank would still be trading at about 60% of adjusted book value even accounting for dilution. These estimates could be wildly optimistic, though ...
Things are not getting better
Take a look at this chart of NPAs by month.
Here is the increase in NPAs per month over hte last five months:
Max Priest and Beres Hammond - "How can we ease the pain?"
From the most recent 10Q:
"A higher incidence of delinquency is expected when the minimum payments reset on our adjustable rate loans subject to negative amortization or interest only payments, whereby the interest rate is fixed for the first three to five years. For example, as of March 31, 2008, there were $976 million of loans subject to negative amortization or with interest only payments within our loans held for investment that have not been modified but had first time payment recasts since December 31, 2006, of which 36.1% were delinquent 30 or more days at March 31, 2008." (emphasis mine)
A different way to analyze Downey's balance sheet is to look at the proportion of recast loans that become non-performing. A loan recasts when the total LTV hits 110% or after an initial interest-only period ends. At this point, the minimum payment changes from negative-amortization or interest-only to fully-amortizing. This can double or even triple payments. Unsurprisingly, 36% of loans that have been recast in the last two years are delinquent by more than 30 days. Downey estimates (see page 30 of its 10Q) that $824 million in loans will recast in Q2 2008, then $741m in Q3, and $548m in Q4 (and an additional $1,800m in 2009 and 1,040m in 2010). Using a 36% delinquency rate on these loans and applying my above loan loss assumptions (20% cure rate and 50% loss on uncured loans), I estimate that Downey will have to write-down 14.4% of the value of these loans, or $304 million for 2008 recasts, $205m for 2009 recasts, and $150m for 2010 recasts.
Applying these total losses of $659 million to the $35m in losses on current REO inventory and subtracting it from current book value, we get the adjusted book value (we don't add the loan-loss allowances back in because those are to account for loans that are already past due). We end up with an adjusted book value of $396 million. Assume a 200% dilutive offering (which would not even raise enough money to keep Downey well-capitalized), and at current market prices we get a $347m market cap. In other words, even with optimistic assumptions about raising money, Downey is trading at about adjusted book value. With more realistic assumptions of a 400% dilutive offering at a discount to the current $4.15 stock price, things start to look rather grim for equity holders. More Information:
2008 Q1 10Q
13 month loan performance
Bank run in "It's a Wonderful Life"
Disclosure: I am short DSL. I may add to or close this position at any time without notice.