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
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.
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
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
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,
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.
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
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.
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
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
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.
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.
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.
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.
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.
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.
ITEM 2.
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.
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
None.
PART II
ITEM 5.
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.
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.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
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
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
The following table sets forth the origination, purchase and sale activity relating to loans and MBSs during the periods indicated.
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).
The table below sets forth the scheduled contractual maturities of Downey's total loan and mortgage-backed securities portfolio as of December 31, 1998.
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.
As of December 31, 1998, the maturities of Downey's investment securities and the weighted average yield of those securities were as follows.
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.
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.
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.
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.
The following table shows as of December 31, 1998, certificates of deposit maturities by interest rate category.
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.
The following table sets forth certain information with respect to Downey's short-term borrowings.
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.
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
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.
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
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.
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.
The following table sets forth the interest rate spread between Downey's interest-earning assets and interest-bearing liabilities as of the dates indicated.
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.
The following table summarizes the non-performing assets of Downey at the dates indicated.
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
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.
The following table indicates the amounts of Downey's past due loans at the dates indicated.
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.
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.
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.
The allocation of the allowance for loan losses at the dates indicated is as set forth in the following table.
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 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.
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.
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.
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
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
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.
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.
ITEM 8.
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
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
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES Consolidated Statements of Income
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income
Consolidated Statements of Stockholders' Equity
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Continued)
See accompanying notes to consolidated financial statements.
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.
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
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.
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
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
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.
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:
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.
Proceeds, gross realized gains and losses on the sales of U.S. Treasury securities and agency obligations available for sale are summarized as follows:
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:
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.
(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:
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:
(6) LOANS RECEIVABLE
Loans receivable are summarized as follows:
Over 99% of the real estate securing Downey's loans is located in California.
A summary of activity in the allowance for loan losses for loans receivable held for investment during 1998, 1997 and 1996 follows:
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.
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.
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:
(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:
(8) INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
Investments in real estate and joint ventures are summarized as follows:
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:
A summary of real estate and joint venture operations included in Downey's results of operations follows:
Activity in the allowance for losses on real estate and investments in joint ventures for 1998, 1997 and 1996 is as follows:
Condensed financial information of joint ventures reported on the equity method is as follows:
Condensed Combined Balance Sheets - Joint Ventures
Condensed Combined Statements of Operations - Joint Ventures
(9) REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS
The type and amount of real estate acquired in settlement of loans is summarized as follows:
A summary of net operation of real estate acquired in settlement of loans included in Downey's results of operations follows:
Activity in the allowance for estimated losses on real estate acquired through foreclosure for 1998, 1997 and 1996 is as follows:
(10) PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
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.
(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.
(12) OTHER ASSETS
Other assets are summarized as follows:
(13) DEPOSITS
Deposits are summarized as follows:
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:
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:
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:
The securities collateralizing these transactions were delivered to major national brokerage firms who
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:
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:
(16) COMMERCIAL PAPER
Commercial paper borrowings are summarized as follows:
The commercial paper program was discontinued during 1998.
(17) OTHER BORROWINGS
Other borrowings are summarized as follows:
Other borrowings have the following maturities at December 31, 1998:
(18) INCOME TAXES
Income taxes are summarized as follows:
Current income taxes payable were $8 million and $11 million at December 31, 1998 and 1997, respectively.
Deferred tax liabilities (assets) are comprised of the following temporary differences between the financial statement carrying amounts and the tax bases of assets:
A reconciliation of income taxes (benefits) to the expected statutory federal corporate income taxes follows:
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.
(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.
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.
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:
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.
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:
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:
(20) EARNINGS PER SHARE
A reconciliation of the components used to derive basic and diluted earnings per share for 1998, 1997 and 1996 follows:
(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.
The following is a summary of commitments and contingent liabilities:
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.
(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.
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:
(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.
Operating Results and Assets
The following presents the operating results and selected financial data by major business segments for 1998, 1997 and 1996:
(26) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data are presented below by quarter for the years ended December 31, 1998 and 1997:
(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
Condensed Statements of Income and Other Comprehensive Income
Condensed Statements of Cash Flows
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10.
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.
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.
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.
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.
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.
(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
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