Thursday, March 15, 2007

Bearish on Downey Financial (DSL), a California S&L

The worldwide glut of capital has caused low quality debt to be bid up to outrageous levels. Subprime debt has already had a severe correction. I believe this will spread to the "Alt-A" market, which is defined by slightly higher credit scores but similar programs and underwriting.

I think that Downey Financial (DSL), a California savings and loan is another possible play. Downey has branches in CA and AZ, and focuses on residential mortgage lending.

  • As of June 2006, 89% of DSL’s approximate $15.4 billion residential real estate portfolio was secured by properties located in southern California
  • 78% of the residential mortgages were based on borrower stated income. 10% were underwritten with no verification of borrower income and/or assets.
  • This is especially bad because mortgage fraud is so prevalent in southern California.
  • 19% of the Company’s loans were originated in 2006 and 40% were originated in 2005
  • In 2005, approximately 81% DSL’s one-to-four unit residential real estate loans were originated or purchased through outside mortgage brokers. Of course, this creates severe moral hazard.
  • 85% of its residential portfolio consists of adjustable rate mortgages subject to negative amortization with the majority structured as option-ARMs
  • They sell the conservative, fixed rate loans and keep the toxic loans as investments.
  • They claim to have mortgage insurance for the portions of any loans that exceeded 80% LTV when originated. However, they do not purchase mortgage insurance when negative amortization pushes loan balances above 80% LTV, nor when declining property values increase the LTV. Furthermore, we know how pervasive bad appraisals are. Finally, the mortgage insurers will be able to claim fraud and negligence on Downey's part. Downey's insurers will be able to stall and avoid paying claims when Downey needs liquidity. Also, the mortgage insurers might themselves go bankrupt.
  • Property values are set to fall so far in CA that even the uninsured 80% will experience losses.
  • For every dollar's worth of assets, the company has $0.91 cents in debt. In itself, this is a reasonable amount of leverage for a bank to have. However, if the assets depreciate by 9%, the company's equity will be wiped out.

Risks to the trade:

  • Trades at about 1.3 times book value. Publicly traded S&L's trade at about 2.9x BV and financials at about 3x. (Track these multiples here.) People could look at DSL as a "deal" and so it is a takeover candidate. Of course, there were rumors about a New Century buyout [at a multiple of book value] as recently as December 2006.
  • High short interest.
  • Hedge fund presence. (I think it's clear by now that some of these managers were out of touch with residential real estate conditions on the ground in the southwestern US.)
  • The real estate market might have bottomed. We might be entering a strong selling season.

Downey has fallen only 15.5% from its all time high. I'm short.


Anonymous said...
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Anonymous said...

Well written article.