Downey Financial (DSL) Warning Shouldn't Come as a Surprise

This morning Downey warned that it will suffer a third quarter operating loss. The cause:

• An approximate $82 million provision for credit losses, which will increase the allowance for loan losses to approximately $144 million or 1.22% of loans held for investment.
• An approximate $9 million valuation reduction to real estate held for development to reflect declines in the value of single family home lots in which the company is a joint venture partner.

As a result, single family loan delinquencies, as well as losses from foreclosures, rose significantly during the third quarter and led to this quarter's large increase to the allowance for losses.

The loss evidently caught analysts by surprise.

The ramping up of loss provisions is not much of a surprise, but the size and acceleration of the increase was greater than expected, RiskMetrics Group analyst Zach Gast said.

The $82 million provision is likely being made to avoid having to make other large provisions in future quarters, Gast said. Gast is forecasting Downey Financial's loss provision in the fourth quarter will be closer to first quarter provision, which were less than $1 million.

Previously on Credit Bubble Stocks, I noted that Downey Financial's Non-Performing Assets were Increasing Exponentially. (That's part of my continuing coverage of Downey.)

I can't see how any analyst could look at this graph and be surprised by the size and increase in credit loss provisions. You can see it is following an exponential function very closely: the number of months it takes for non-performing assets to cross a threshold keeps decreasing.

I disagree with Mr. Gast's forecast that there will be a negligible increase in loss provisions in the 4th quarter for two reasons:

• First, they are probably under reserving for loan losses. On Aug 31, their NPA's were 1.96% or about $282 million but their provision is only going to be 1.22% or $144 million. That's in the face of increasing foreclosures and decreasing property values.
  
• Second, there is nothing to indicate that this or any other piece of bad Downey news is an outlier. The exponential trend is consistent with worsening anecdotal reports and broader market statistics.
  

At this time, I would also like to point out that Downey is down 18% since I recommended selling it in March. Also, here is its performance since I released my analysis of exponential NPA trends on September 19.



If you are trading Downey, I recommend that you subscribe to this blog, as we have a regular early-warning report on Downey's non-performing assets. It has proven to be a great leading indicator.

Mr. Gast actually put it pretty well himself in February:

“When there is good home price appreciation, you can get away with a lot of mistakes, but home price appreciation has stopped.