Downey Financial - The Next IndyMac?

Well, in my post from July where I predicted the demise of WaMu I also identified three other depository insitutions that I viewed as at risk. Those were Downey Financial, BankUnited Financial, and Sterling Financial. As of now, those are seeming like a good hit-list.

Subsequent to that post, BankUnited chose to sue Dick X. Bove and his employer for its inclusion on a list he published post-IndyMac about who is next. If that doesn't that just scream "confident" to the BankUnited depositor base, I don't know what will (perhaps a government takeover?). So much for "sticks and stones may break my bones, but words will never hurt me."

Downey, however, has taken it a step further by actually suffering a variety of real damages. Since my post, Moody's has cut Downey's primary operating subsidiary's financial strength rating to D rating, it reported a substantial quarterly loss and, last night, Downey announced in its 10-Q that it has been suffering net withdrawals from its deposit base and that the OTS is beginning to limit its activities. Wow.

This language is fascinating to read (from Note 10 - Subsequent Events in Downey's June 30, 2008 10-Q filing). My comments are inserted in [brackets] and italicized:

In addition to its deposits, Downey’s principal source of liquidity is its ability to utilize borrowings, as needed. The Bank’s primary source of borrowings is the FHLB. At June 30, 2008, the Bank’s FHLB borrowings totaled $1.5 billion, representing 12.1% of total assets. As of August 8, 2008, the Bank’s FHLB borrowings totaled $2.8 billion [holy crap. After grwoing just $400 million in the prior twelve months, Downey has tapped an additional $1.3 billion of FHLB borrowings in the last six weeks?]. Approximately half of the Bank’s increase in FHLB borrowings subsequent to June 30, 2008 is being held in cash equivalents and short-term investment securities to meet our liquidity needs [that means the other half went to fund deposit withdrawals]. The Bank currently is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional $0.2 billion of borrowing capacity from the FHLB as of August 8 [set the bankruptcy clock to T minus six weeks]. The amount the FHLB is willing to advance differs based on the quality and character of qualifying collateral offered by the Bank, and the advance rates for qualifying collateral may be adjusted upwards or downwards by the FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank as a back-up source of liquidity. As of August 8, 2008, the Bank had no outstanding borrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying collateral would have permitted it to borrow up to an additional $1.5 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is obligated to lend to us under these loan facilities. To the extent deposit renewals and deposit growth are not sufficient to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans and investment securities and otherwise fund working capital needs and capital expenditures, the Bank may utilize additional borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements.

After the end of the second quarter, the Bank experienced elevated levels of deposit withdrawals [no sh!t]. More recently, in response to steps taken by management to address the situation, the Bank has experienced net deposit inflows. If the Bank’s deposit levels continue to stabilize with withdrawals at historical levels, Downey believes its current sources of funds, including deposits; advances from the FHLB and other borrowings; proceeds from the sale of loans and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments would enable Downey to meet its obligations while maintaining liquidity at appropriate levels. However, if elevated levels of net deposit outflows resume, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional financing arrangements.[Prediction: if the press picks up on this language, it is game over. Thusly, it is game over.]

Management believes that the Holding Company, on a stand-alone basis, currently has adequate liquid assets to meet its current obligations, which are primarily interest payments on $199 million of senior notes. Limitations imposed by the Office of Thrift Supervision (“OTS”) discussed below currently prohibit the Bank from providing a dividend to the Holding Company without prior OTS approval, and the Holding Company from paying dividends (other than the quarterly dividend payable in August 2008), and incurring and renewing debt, without prior non-objection of the OTS. At June 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $53 million, down from $102 million at the end of 2007 due primarily to a $50 million capital contribution to the Bank.

Downey’s stockholders’ equity totaled $0.9 billion at June 30, 2008, down from $1.3 billion at December 31, 2007 and $1.5 billion at June 30, 2007. The Board reduced the quarterly per share dividend payment from $0.12 to $0.01 for the dividend payable in August 2008 [I love this whole concept that banks, etc. are employing of cutting dividends to one or five cents. Lord forbid that you cut to zero - then you cannot tell people "we've paid dividends every quarter for 105 years" etc.], after which no future dividends will be paid without prior non-objection of the OTS.

In light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have been working closely with the Bank’s federal banking regulators. In that regard, the OTS, the Bank’s principal regulator, has also imposed the following limitations on the Holding Company and the Bank: the Bank may not pay dividends to the Holding Company without prior OTS approval, and the Holding Company may not pay dividends without prior non-objection of the OTS; the Bank may not increase its assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities without prior OTS approval; the Holding Company may not issue or renew debt without the prior non-objection of the OTS; the Holding Company and the Bank must provide prior notice to the OTS regarding any additions or changes to directors or senior executive officers (or changes in the responsibilities of senior executive officers); the Holding Company and the Bank may not pay certain kinds of severance and other forms of compensation without regulatory approval; the Bank may not enter into, renew, extend or revise any contract related to compensation or benefits with any director or senior executive officer without prior regulatory approval; the Bank must provide prior notice to the OTS (and not receive any objection) before engaging in transactions with any affiliate or subsidiary. In addition, Downey is subject to higher regulatory assessments and FDIC deposit insurance premiums than those prevailing in prior periods. [emphasis added]

In response to the challenges facing Downey in the current operating environment, Downey has formed a special Board committee to explore a range of strategic alternatives, including the raising of additional capital to levels deemed by the Board to be appropriate under the circumstances. [the end is nigh]

It is worth noting that Downey is a $12.6 billion asset base bank. If it were to be taken into FDIC receivership and the loss metrics of recent failures applied (15-28% of assets are losses that the FDIC absorbs), then the FDIC will take another $1.9B to $3.5B of losses. Also, if this list is to be trusted, IndyMac is #3 and would bump all of the others down one spot. Downey, if it were to go, would bump Homefed and all the banks below it down another notch putting Downey at #9. Not a trivial matter.