Securities and Exchange Commission Form 10-Q dated March 31, 2004

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SECURITITES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

___________________________

FORM 10-Q

(Mark One)

[X]

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED

For the quarterly period ended March 31, 2004

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM __________ TO __________

Commission File Number 1-13578

DOWNEY FINANCIAL CORP.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)

33-0633413
(I.R.S. Employer Identification No.)

3501 Jamboree Road, Newport Beach, CA
(Address of principal executive office)

92660
(Zip Code)

Registrant’s telephone number, including area code

(949) 854-0300

Securities registered pursuant to Section 12(b) of the Act:

 


Title of each class
Common Stock, $0.01 Par Value

Name of each exchange
on which registered
New York Stock Exchange
Pacific Exchange

          Securities registered pursuant to Section 12(g) of the Act:

None

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  X    No     

          At March 31, 2004, 27,953,747 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.


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DOWNEY FINANCIAL CORP.

MARCH 31, 2004 QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

 

PART I

ITEM 1. –

FINANCIAL INFORMATION           

1

Consolidated Balance Sheets          

1

Consolidated Statements of Income           

2

Consolidated Statements of Comprehensive Income          

3

Consolidated Statements of Cash Flows           

4

Notes To Consolidated Financial Statements           

6

ITEM 2. –

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS           

14

ITEM 3. –

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK           

45

ITEM 4. –

CONTROLS AND PROCEDURES           

45

PART II

ITEM 1. –

LEGAL PROCEEDINGS           

46

ITEM 2. –

CHANGES IN SECURITIES AND USE OF PROCEEDS           

46

ITEM 3. –

DEFAULTS UPON SENIOR SECURITIES           

46

ITEM 4. –

SUBMISSION OF MATTERS TO A VOTE OF SECURITIY HOLDERS           

46

ITEM 5. –

OTHER INFORMATION           

46

ITEM 6. –

EXHIBITS AND REPORTS ON FORM 8-K           

46

AVAILABILITY OF REPORTS           

48

SIGNATURES           

48


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PART I

ITEM 1. – FINANCIAL INFORMATION

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

 

March 31,

December 31,

March 31,

(Dollars in Thousands, Except Per Share Data)

2004

2003

2003


Assets

Cash

$

115,905

$

111,667

$

136,461

Federal funds

2,300

1,500

1,201


Cash and cash equivalents

118,205

113,167

137,662

U.S. Treasury securities, agency obligations and other investment

securities available for sale, at fair value

872,103

690,347

214,516

Municipal securities held to maturity, at amortized cost (estimated

fair value of $6,135 at March 31, 2003)

-

-

6,148

Loans held for sale, at lower of cost or fair value

529,085

279,657

633,676

Mortgage-backed securities available for sale, at fair value

327

334

1,875

Loans receivable held for investment

11,064,686

10,116,519

10,040,006

Investments in real estate and joint ventures

35,768

35,716

34,307

Real estate acquired in settlement of loans

5,189

5,803

10,205

Premises and equipment

108,372

110,316

114,201

Federal Home Loan Bank stock, at cost

124,277

123,089

119,125

Investment in Downey Financial Capital Trust I

3,711

3,711

3,711

Mortgage servicing rights, net

69,721

82,175

56,506

Other assets

593,685

85,146

69,712


$

13,525,129

$

11,645,980

$

11,441,650


Liabilities and Stockholders’ Equity

Deposits

$

8,817,173

$

8,293,758

$

8,997,558

Securities sold under agreements to repurchase

507,027

-

-

Federal Home Loan Bank advances

2,424,230

2,125,150

1,300,850

Real estate notes

4,144

4,161

-

Junior subordinated debentures

123,711

123,711

123,711

Accounts payable and accrued liabilities

604,757

63,584

91,839

Deferred income taxes

119,530

118,598

76,042


Total liabilities

12,600,572

10,728,962

10,590,000


Stockholders’ equity:

Preferred stock, par value of $0.01 per share; authorized 5,000,000

shares; outstanding none

-

-

-

Common stock, par value of $0.01 per share; authorized 50,000,000 shares;

issued 28,235,022 shares at March 31, 2004, December 31, 2003

and March 31, 2003; outstanding 27,953,747 shares at March 31, 2004 and

27,928,722 shares at both December 31, 2003 and March 31, 2003

282

282

282

Additional paid-in capital

93,792

93,792

93,792

Accumulated other comprehensive income (loss)

1,753

807

(579

)

Retained earnings

839,898

834,307

770,325

Treasury stock, at cost, 281,275 shares at March 31, 2004 and 306,300 shares

at both December 31, 2003 and March 31, 2003

(11,168

)

(12,170

)

(12,170

)


Total stockholders’ equity

924,557

917,018

851,650


$

13,525,129

$

11,645,980

$

11,441,650


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income

 

Three Months Ended

March 31,


(Dollars in Thousands, Except Per Share Data)

2004

2003


Interest income

Loans receivable

$

115,530

$

142,489

U.S. Treasury securities and agency obligations

4,064

3,137

Mortgage-backed securities

3

16

Other investments

1,198

1,655


Total interest income

120,795

147,297


Interest expense

Deposits

32,600

47,850

Federal Home Loan Bank advances and other borrowings

15,705

15,417

Junior subordinated debentures

3,134

3,134


Total interest expense

51,439

66,401


Net interest income

69,356

80,896

Provision for (reduction of) loan losses

1,804

(1,709

)


Net interest income after provision for (reduction of) loan losses

67,552

82,605


Other income, net

Loan and deposit related fees

12,456

11,978

Real estate and joint ventures held for investment, net

926

943

Secondary marketing activities:

Loan servicing loss, net

(14,245

)

(13,686

)

Net gains on sales of loans and mortgage-backed securities

1,372

19,763

Net gains on sales of mortgage servicing rights

-

5

Net gains on sales of investment securities

2,112

8

Litigation award

-

2,452

Other

332

579


Total other income, net

2,953

22,042


Operating expense

Salaries and related costs

35,569

34,126

Premises and equipment costs

8,208

7,713

Advertising expense

1,708

793

SAIF insurance premiums and regulatory assessments

757

831

Professional fees

368

628

Other general and administrative expense

8,482

7,893


Total general and administrative expense

55,092

51,984

Net operation of real estate acquired in settlement of loans

(72

)

297


Total operating expense

55,020

52,281


Income before income taxes

15,485

52,366

Income taxes

6,573

22,149


Net income

$

8,912

$

30,217


PER SHARE INFORMATION

Basic

$

0.32

$

1.08


Diluted

$

0.32

$

1.08


Cash dividends declared and paid

$

0.10

$

0.09


Weighted average diluted shares outstanding

27,980,542

27,966,367


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

 

Three Months Ended

March 31,


(In Thousands)

2004

2003


Net income

$

8,912

$

30,217


Other comprehensive income, net of income taxes

Unrealized gains (losses) on securities available for sale:

U.S. Treasury securities, agency obligations and other investment

securities available for sale, at fair value

(310

)

(736

)

Mortgage-backed securities available for sale, at fair value

(1

)

(7

)

Less reclassification of realized gains included in net income

-

(5

)

Unrealized gains (losses) on cash flow hedges:

Net derivative instruments

638

(3,298

)

Less reclassification of realized losses included in net income

619

4,889


Total other comprehensive income, net of income taxes

946

843


Comprehensive income

$

9,858

$

31,060


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

 

Three Months Ended

March 31,


(In Thousands)

2004

2003


Cash flows from operating activities

Net income

$

8,912

$

30,217

Adjustments to reconcile net income to net cash used for operating activities:

Depreciation and amortization

19,771

18,000

Provision for losses on loans, real estate acquired in settlement of loans, investments

in real estate and joint ventures, mortgage servicing rights and other assets

14,757

9,945

Net gains on sales of loans and mortgage-backed securities, mortgage servicing rights,

investment securities, real estate and other assets

(3,670

)

(20,146

)

Interest capitalized on loans (negative amortization)

(1,553

)

(3,523

)

Federal Home Loan Bank stock dividends

(1,188

)

(1,562

)

Loans originated for sale

(927,777

)

(1,607,147

)

Proceeds from sales of loans held for sale, including those sold

as mortgage-backed securities

677,001

1,635,811

Other, net

(24,760

)

(11,925

)


Net cash provided by (used for) operating activities

(238,507

)

49,670


Cash flows from investing activities

Proceeds from sales of:

U.S. Treasury securities, agency obligations and other investment securities

available for sale

4,150

5,250

Wholly owned real estate and real estate acquired in settlement of loans

1,979

5,095

Proceeds from maturities of U.S. Treasury securities, agency obligations

and other investment securities available for sale

377,746

378,710

Purchase of:

U.S. Treasury securities, agency obligations and other investment securities

available for sale

(539,057

)

(141,575

)

Loans receivable held for investment

(65,537

)

(91,676

)

Premises and equipment

(2,164

)

(5,599

)

Originations of loans receivable held for investment (net of refinances of $153,812 for the

three months ended March 31, 2004 and $59,537 for the three months ended

March 31, 2003)

(1,808,959

)

(680,009

)

Principal payments on loans receivable held for investment and mortgage-backed

securities available for sale

910,487

1,068,441

Net change in undisbursed loan funds

41,560

(10,939

)

Investments in real estate held for investment

(145

)

(620

)

Other, net

379

1,375


Net cash provided by (used for) investing activities

(1,079,561

)

528,453


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

 

Three Months Ended

March 31,


(In Thousands)

2004

2003


Cash flows from financing activities

Net increase (decrease) in deposits

$

523,415

$

(240,792

)

Proceeds from Federal Home Loan Bank advances and other borrowings

3,630,560

3,634,000

Repayments of Federal Home Loan Bank advances and other borrowings

(2,828,550

)

(3,957,234

)

Proceeds from reissuance of treasury stock and exercise of stock options

474

-

Cash dividends

(2,793

)

(2,514

)


Net cash provided by (used for) financing activities

1,323,106

(566,540

)


Net increase in cash and cash equivalents

5,038

11,583

Cash and cash equivalents at beginning of period

113,167

126,079


Cash and cash equivalents at end of period

$

118,205

$

137,662


Supplemental disclosure of cash flow information:

Cash paid during the period for:

Interest

$

51,281

$

66,497

Income taxes

347

22,695

Supplemental disclosure of non-cash investing:

Loans transferred to held for investment from held for sale

-

541

Loans transferred from held for investment to held for sale

283

-

Loans exchanged for mortgage-backed securities

523,136

1,377,469

Investment securities purchased and not settled

529,802

-

Investment securities sold and not settled

506,718

-

Real estate acquired in settlement of loans

1,422

5,675

Loans to facilitate the sale of real estate acquired in settlement of loans

98

2,681


See accompanying notes to consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE (1) – Basis of Financial Statement Presentation

          In the opinion of Downey Financial Corp. and subsidiaries ("Downey," "we," "us" and "our"), the accompanying consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of Downey’s financial condition as of March 31, 2004, December 31, 2003 and March 31, 2003, and the results of operations, comprehensive income and changes in cash flows for the three months ended March 31, 2004 and 2003. Certain prior period amounts have been reclassified to conform to the current period presentation.

          The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and are in compliance with the instructions for Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial condition, results of operations, comprehensive income and cash flows. The following information under the heading Management’s Discussion and Analysis of Financial Condition and Results of Operations presumes that the interim consolidated financial statements will be read in conjunction with Downey’s Annual Report on Form 10-K for the year ended December 31, 2003, which contains among other things, a description of the business, the latest audited consolidated financial statements and notes thereto, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2003 and for the year then ended. Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Part I.

NOTE (2) – Mortgage Servicing Rights

          The following table summarizes the activity in mortgage servicing rights and its related allowance for the periods indicated and other related financial data.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(Dollars in Thousands)

2004

2003

2003

2003

2003


Gross balance at beginning of period

$

95,183

$

92,665

$

89,948

$

92,178

$

90,584

Additions

5,968

9,091

21,660

15,405

14,954

Amortization

(5,519

)

(5,001

)

(5,051

)

(9,951

)

(4,771

)

Sales

-

-

-

-

-

Impairment write-down

(3,866

)

(1,572

)

(13,892

)

(7,684

)

(8,589

)


Gross balance at end of period

91,766

95,183

92,665

89,948

92,178


Allowance balance at beginning of period

13,008

22,265

41,226

35,672

32,855

Provision for (reduction of) impairment

12,903

(7,685

)

(5,069

)

13,238

11,406

Impairment write-down

(3,866

)

(1,572

)

(13,892

)

(7,684

)

(8,589

)


Allowance balance at end of period

22,045

13,008

22,265

41,226

35,672


Total mortgage servicing rights, net

$

69,721

$

82,175

$

70,400

$

48,722

$

56,506


As a percentage of associated mortgage loans

0.76

%

0.89

%

0.78

%

0.55

%

0.67

%

Estimated fair value (a)

$

69,721

$

82,314

$

70,401

$

48,722

$

56,506

Weighted average expected life (in months)

49

59

50

31

39

Custodial account earnings rate

1.47

%

1.65

%

1.49

%

1.26

%

1.58

%

Weighted average discount rate

8.98

8.95

8.91

7.47

7.39


At period end

Mortgage loans serviced for others:

Total

$

9,167,834

$

9,313,948

$

9,125,469

$

8,980,037

$

8,535,480

With capitalized mortgage servicing rights:(a)

Amount

9,126,444

9,268,308

9,068,209

8,916,259

8,460,152

Weighted average interest rate

5.73

%

5.79

%

5.87

%

6.12

%

6.35

%


Custodial account balances

$

359,146

$

232,562

$

352,161

$

548,142

$

452,980


(a) The estimated fair value may exceed book value for certain asset strata and excluded loans sold or securitized prior to 1996 and loans temporarily sub-serviced without capitalized mortgage servicing rights.
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          Key assumptions, which vary due to changes in market interest rates and are used to determine the fair value of mortgage servicing rights, include: expected prepayment speeds, which impact the average life of the portfolio; the earnings rate on custodial accounts, which impact the value of custodial accounts; and the discount rate used in valuing future cash flows. The following table summarizes the estimated changes in the fair value of mortgage servicing rights for changes in those assumptions individually and in combination associated with an immediate 100 basis point increase or decrease in market rates. Also summarized is the earnings impact associated with provisions for or reductions of the valuation allowance for mortgage servicing rights. Impairment is measured on a disaggregated basis based upon the predominant risk characteristics of the underlying mortgage loans, such as term and interest rate. Certain stratum may have impairment, while other stratum may not. Therefore, changes in overall fair value may not equal provisions for or reductions of the valuation allowance.

          The sensitivity analysis in the table below is hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 100 basis point variation in assumptions generally cannot be easily extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumptions. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

Expected

Custodial

Prepayment

Accounts

Discount

(Dollars in Thousands)

Speeds

Rate

Rate

Combination


Increase rates 100 basis points: (a)

Increase (decrease) in fair value

$

30,808

$

5,306

$

(840

)

$

30,409

Reduction of (increase in) valuation allowance

20,458

4,318

(1,010

)

20,518

Decrease rates 100 basis points: (b)

Increase (decrease) in fair value

(34,452

)

(4,734

)

1,454

(38,592

)

Reduction of (increase in) valuation allowance

(34,452

)

(4,734

)

1,454

(38,592

)


(a) The weighted-average expected life of the mortgage servicing rights portfolio is 79 months.
(b) The weighted-average expected life of the mortgage servicing rights portfolio is 22 months.

          The following table presents a breakdown of the components of loan servicing income (loss), net included in Downey’s results of operations for the periods indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Net cash servicing fees

$

5,704

$

5,681

$

5,401

$

5,117

$

5,016

Payoff and curtailment interest cost (a)

(1,527

)

(1,597

)

(3,869

)

(3,620

)

(2,525

)

Amortization of MSRs

(5,519

)

(5,001

)

(5,051

)

(9,951

)

(4,771

)

(Provision for) reduction of impairment

of MSRs

(12,903

)

7,685

5,069

(13,238

)

(11,406

)


Total loan servicing income (loss), net

$

(14,245

)

$

6,768

$

1,550

$

(21,692

)

$

(13,686

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month, less the actual interest received when a loan prepays prior to the end of the month. This does not include the benefit of the use of repaid loan funds to increase net interest income.

NOTE (3) – Derivatives, Derivative Hedging Activities, Off-Balance Sheet Arrangements and Contractual Obligations (Risk Management)

Derivatives

          Downey offers short-term interest rate lock commitments to help attract potential home loan borrowers. The commitments guarantee a specified interest rate for a loan if underwriting standards are met, but do not obligate the potential borrower. Accordingly, some commitments never become loans and merely expire. The residential one-to-four unit rate lock commitments Downey ultimately expects to result in loans and sell in the secondary market are treated as derivatives. Consequently, as derivatives, the hedging of the expected rate lock commitments do not qualify for hedge accounting. Associated fair value adjustments to the notional amount of the expected rate lock commitments are recorded in current earnings under net gains (losses) on sales of loans and mortgage-backed securities with an offset to the balance sheet in either other assets, or accounts payable and accrued liabilities. Fair values for the notional amount of expected rate lock commitments are based on observable market prices acquired from third parties. The carrying amount of loans held for sale

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includes a basis adjustment to the loan balance at funding resulting from the change in fair value of the rate lock derivative from the date of commitment to the date of funding. At March 31, 2004, Downey had a notional amount of expected rate lock commitments identified to sell as part of its secondary marketing activities of $442 million, with a change in fair value resulting in a loss of $1.3 million.

Derivative Hedging Activities

          As part of secondary marketing activities, Downey typically utilizes short-term forward sale and purchase contracts—derivatives—that mature in less than one year to offset the impact of changes in market interest rates on the value of residential one-to-four unit expected rate lock commitments and loans held for sale. Contracts designated as hedges for the forecasted sale of loans from our held for sale portfolio are accounted for as cash flow hedges because these contracts have a high correlation to the price movement of the loans being hedged (within a range of 80% - 125%). The measurement approach for determining the ineffective aspects of the hedge is established at the inception of the hedge. Changes in fair value of the notional amount of forward sale contracts not designated as cash flow hedges and the ineffectiveness of hedge transactions that are not perfectly correlated are recorded in net gains (losses) on sales of loans and mortgage-backed securities. Changes in fair value of the notional amount of forward sale contracts designated as cash flow hedges for loans held for sale are recorded in other comprehensive income, net of tax, provided cash flow hedge requirements are met. The offset to these changes in fair value of the notional amount of forward sale contracts are recorded in the balance sheet as either other assets, or accounts payable and accrued liabilities. The amounts recorded in accumulated other comprehensive income will be recognized in the income statement when the hedged forecasted transactions settle. Downey estimates that all of the related unrealized gains or losses in accumulated other comprehensive income will be reclassified into earnings within the next three months. Fair values for the notional amount of forward sale contracts are based on observable market prices acquired from third parties. At March 31, 2004, the notional amount of forward sale contracts amounted to $939 million, with a change in fair value resulting in a loss of $2.2 million, of which $510 million were designated as cash flow hedges. The notional amount of forward purchase contracts amounted to $4 million with virtually no change in fair value at March 31, 2004.

          In connection with its interest rate risk management, Downey may enter into interest rate exchange agreements ("swap contracts") with certain national investment banking firms or the FHLB under terms that provide mutual payment of interest on the outstanding notional amount of swap contracts. The purpose for entering into swap contracts is to manage the effects of adverse changes in interest rates on net interest income. Downey has interest rate swap contracts on which Downey pays variable interest based on the 3-month London Inter-Bank Offered Rate ("Libor") while receiving fixed interest. The swaps were designated as a hedge of changes in the fair value of certain FHLB fixed rate advances that are attributable to changes in market interest rates. The payment and maturity dates of the swap contracts match those of the advances. This hedge effectively converts fixed interest rate advances into debt that adjusts quarterly to movements in 3-month Libor. Because the terms of the swap contracts match those of the advances, the hedge has no ineffectiveness and results are reported in interest expense. The fair value of interest rate swap contracts is based on observable market prices acquired from third parties and represents the estimated amount Downey would receive or pay upon terminating the contracts, taking into consideration current interest rates and the remaining contract terms. The fair value of the swap contracts is recorded on the balance sheet in either other assets or accounts payable and accrued liabilities. With no ineffectiveness, the recorded swap contract values will essentially act as fair value adjustments to the advances being hedged. At March 31, 2004, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value gain of $4.1 million recorded on the balance sheet in other assets and as an increase to the advances being hedged.

          The following table summarizes Downey’s interest rate swap contracts at March 31, 2004:

Weighted

Notional

Average

(Dollars in Thousands)

Amount

Interest Rate

Term


Pay – Variable (3-month Libor)

$

(100,000

)

1.12

%

March 2004 – October 2008

Receive – Fixed

100,000

3.20

Pay – Variable (3-month Libor)

(130,000

)

1.12

March 2004 – October 2008

Receive – Fixed

130,000

3.21

Pay – Variable (3-month Libor)

(100,000

)

1.12

March 2004 – November 2008

Receive – Fixed

100,000

3.26

Pay – Variable (3-month Libor)

(100,000

)

1.12

March 2004 – November 2008

Receive – Fixed

100,000

3.27


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          Downey has not discontinued any designated derivative instruments associated with hedges due to a change in the probability of settling a transaction.

          Downey does not generally enter into derivative transactions for purely speculative purposes.

          The following table shows the impact from non-qualifying hedges and qualifying cash flow and fair value hedges including balances of the hedged items and notional amounts of their associated hedging derivatives.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Net gains (losses) on non-qualifying hedge transactions

$

(3,282

)

$

1,016

$

1,121

$

(2,936

)

$

(139

)

Net gains (losses) on qualifying cash flow hedge transactions:

Unrealized hedge ineffectiveness

-

-

-

-

-

Less reclassification of realized hedge ineffectiveness

-

-

-

-

-


Total net gains (losses) recognized in sales of loans and

mortgage-backed securities (SFAS 133 effect)

(3,282

)

1,016

1,121

(2,936

)

(139

)

Other comprehensive income (loss)

1,257

1,673

(2,424

)

1,622

1,591


Notional amount or balance at period end

Non-qualifying hedge transactions:

Expected rate lock commitments

$

441,747

$

163,737

$

381,948

$

950,703

$

957,549

Associated forward sale contracts

429,066

153,436

391,234

985,094

913,034

Associated forward purchase contracts

4,000

-

35,000

139,000

6,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value

529,085

279,657

335,437

721,929

633,676

Associated forward sale contracts

509,710

275,009

334,031

710,099

624,002

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed

430,000

-

-

-

-

Associated interest rate swap contracts –

pay-variable, receive-fixed

430,000

-

-

-

-


          These forward and swap contracts expose Downey to credit risk in the event of nonperformance to such agreements by the other parties—primarily government-sponsored enterprises such as Federal National Mortgage Association and the FHLB. This risk consists primarily of the termination value of agreements where Downey is in an unfavorable position. Downey controls the credit risk associated with its other parties to the various derivative agreements through credit review, exposure limits and monitoring procedures. Downey does not anticipate nonperformance by the other parties.

Financial Instruments with Off-Balance Sheet Risk

          Downey utilizes 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 held for investment, undisbursed loan funds, lines and letters of credit, commitments to purchase loans and mortgage-backed securities for our portfolio and commitments to invest in affordable housing funds. The contract or notional amounts of those instruments reflect the extent of involvement Downey has in particular classes of financial instruments.

          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 commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Undisbursed loan funds and unused lines of credit include funds not disbursed, but committed to construction projects and home equity and commercial lines of credit. Letters of credit are conditional commitments issued by Downey to guarantee the performance of a customer to a third party. We also enter into commitments to purchase loans and mortgage-backed securities, investment securities and to invest in affordable housing funds.

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          The following is a summary of commitments and contingent liabilities with off-balance sheet risk at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Commitments to originate loans held for investment:

Adjustable

$

650,948

$

528,981

$

414,823

$

336,303

$

190,737

Fixed

-

-

380

235

117

Commitments to purchase loans

495

-

-

40,816

5,200

Undisbursed loan funds and unused lines of credit

281,821

240,226

178,202

183,720

178,754

Letters of credit and other contingent liabilities

-

-

2,703

6,044

6,031

Commitments to invest in affordable housing funds

3,090

3,153

3,393

2,400

2,400


          Downey uses the same credit policies in making commitments to originate loans held for investment, lines of credit and letters of credit as it does for on-balance sheet instruments. For commitments to originate loans held for investment, the contract amounts represent exposure to loss from market fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. Downey controls the credit risk of its commitments to originate loans held for investment through credit approvals, limits and monitoring procedures. 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.

          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.

Other Contractual Obligations

          Downey sells all loans without recourse. When a loan sold to an investor without recourse fails to perform according to the contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred and whether such defects give rise to a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, Downey may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, Downey has no commitment to repurchase the loan. There have been no indemnification losses related to any loan repurchases since 2002. These sale contracts may also contain provisions to refund purchase price premiums to the investor if the loans prepay during a period not to exceed 120 days from the sale settlement date. Downey reserved less than $1 million at both March 31, 2004 and 2003 to cover the estimated loss exposure related to early payoffs.

          Through the normal course of operations, Downey has entered into certain contractual obligations. Downey’s obligations generally relate to the funding of operations through deposits and borrowings as well as leases for premises and equipment. Downey also has contractual vendor relationships, but the contracts are not considered to be material.

          Downey has obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period with options to extend, and are non-cancelable.

          At March 31, 2004, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, junior subordinated debentures and future operating minimum lease commitments were as follows:

Within

1 – 3

4 – 5

Over

Total

(In Thousands)

1 Year

Years

Years

5 Years

Balance


Certificates of deposit

$

1,734,064

$

1,627,447

$

383,025

$

-

$

3,744,536

FHLB advances and other borrowings

2,180,207

292,050

430,000

33,144

2,935,401

Junior subordinated debentures (a)

-

-

-

123,711

123,711

Operating leases

4,561

7,494

3,610

1,257

16,922


Total other contractual obligations

$

3,918,832

$

1,926,991

$

816,635

$

158,112

$

6,820,570


(a) These securities may be called at Downey’s option beginning in July of 2004.
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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.

NOTE (4) – Income Taxes

          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 1997. Downey’s management believes it has adequately provided for potential exposure to issues that may be raised by tax auditors in the years subsequent to 1997, which remain open to review.

NOTE (5) – Employee Stock Option Plans

          Downey has a Long Term Incentive Plan (the "LTIP"), which 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 common stock to be available for issuance, of which 131,851 shares are available for future grants. Under the LTIP, options are exercisable over vesting periods specified in each grant and, unless exercised, the options terminate in 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. No shares have been granted under the LTIP since 1998. At March 31, 2004, Downey had 281,275 shares of treasury stock that may be used to satisfy the exercise of options or for payment of other awards. No other stock-based compensation plan exists.

          Downey measures its employee stock-based compensation arrangements under the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, no compensation expense has been recognized for the stock options, as stock options were granted at fair value at the date of grant. Had compensation expense for stock options been determined based on the fair value at the grant date for previous awards, stock-based compensation would have been fully expensed as of December 31, 2002.

NOTE (6) – Earnings Per Share

          Earnings per share is calculated on both a basic and diluted basis, excluding common shares in treasury. Basic earnings per share 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 earnings per share 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 the issuance of common stock that then shared in earnings.

          The following table presents a reconciliation of the components used to derive basic and diluted earnings per share for the periods indicated.

Three Months Ended March 31,


2004

2003


Weighted

Weighted

Average

Average

Net

Shares

Per Share

Net

Shares

Per Share

(Dollars in Thousands, Except Per Share Data)

Income

Outstanding

Amount

Income

Outstanding

Amount


Basic earnings per share

$

8,912

27,944,406

$

0.32

$

30,217

27,928,722

$

1.08

Effect of dilutive stock options

-

36,136

-

-

37,645

-


Diluted earnings per share

$

8,912

27,980,542

$

0.32

$

30,217

27,966,367

$

1.08


          There were no options excluded from the computation of earnings per share due to anti-dilution.

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NOTE (7) – Business Segment Reporting

          The following table presents the operating results and selected financial data by major business segments for the periods indicated.

Real Estate

(In Thousands)

Banking

Investment

Elimination

Totals


Three months ended March 31, 2004

Net interest income (loss)

$

69,444

$

(88

)

$

-

$

69,356

Provision for loan losses

1,804

-

-

1,804

Other income

1,691

1,262

-

2,953

Operating expense

54,699

321

-

55,020

Net intercompany income (expense)

(38

)

38

-

-


Income before income taxes

14,594

891

-

15,485

Income taxes

6,207

366

-

6,573


Net income

$

8,387

$

525

$

-

$

8,912


At March 31, 2004

Assets:

Loans and mortgage-backed securities

$

11,594,098

$

-

$

-

$

11,594,098

Investments in real estate and joint ventures

-

35,768

-

35,768

Other

1,919,401

3,994

(28,132

)

1,895,263


Total assets

13,513,499

39,762

(28,132

)

13,525,129


Equity

$

924,557

$

28,132

$

(28,132

)

$

924,557


Three months ended March 31, 2003

Net interest income

$

80,881

$

15

$

-

$

80,896

Reduction of loan losses

(1,709

)

-

-

(1,709

)

Other income

20,631

1,411

-

22,042

Operating expense

52,106

175

-

52,281

Net intercompany income (expense)

44

(44

)

-

-


Income before income taxes

51,159

1,207

-

52,366

Income taxes

21,654

495

-

22,149


Net income

$

29,505

$

712

$

-

$

30,217


At March 31, 2003

Assets:

Loans and mortgage-backed securities

$

10,675,557

$

-

$

-

$

10,675,557

Investments in real estate and joint ventures

-

34,307

-

34,307

Other

760,182

5,641

(34,037

)

731,786


Total assets

11,435,739

39,948

(34,037

)

11,441,650


Equity

$

851,650

$

34,037

$

(34,037

)

$

851,650


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NOTE (8) – Current Accounting Issues

Interest Rate Lock Derivatives

          In accordance with Statement of Financial Accounting Standards No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"), expected interest rate lock commitments on mortgage loans that will be held for sale must be accounted for as derivatives and marked to market in accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). All other interest rate lock commitments are excluded from SFAS 133, pursuant to SFAS 149. In October 2003, the FASB decided to add a project to its agenda that would clarify how fair value should be measured for interest rate lock derivatives. To our knowledge, no timetable has been established yet for the completion of this project.

          In the meantime, the Securities and Exchange Commission ("SEC") issued guidance in Staff Accounting Bulletin No. 105 ("SAB 105"). SAB 105 requires that fair-value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. Servicing assets are to be recognized only once the servicing asset has been contractually separated from the underlying loan by sale or securitization of the loan with servicing retained. The guidance in SAB 105 must be applied to interest rate locks initiated after March 31, 2004 and is to be applied prospectively. There is no financial impact of SAB 105 on Downey, as Downey’s accounting for expected interest rate lock commitments has been in accordance with the bulletin.

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ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

          Certain statements under this caption may constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995, which involve risks and uncertainties. Forward-looking statements do not relate strictly to historical information or current facts. Some forward-looking statements may be identified by use of terms such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may." Our 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 we conduct our operations, fluctuations in interest rates, credit quality and government regulation. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made.

OVERVIEW

          Our net income for the first quarter of 2004 totaled $8.9 million or $0.32 per share on a diluted basis, down from $30.2 million or $1.08 per share in the first quarter of 2003.

          The decline in our net income between first quarters primarily reflected the following:

The loss from loan servicing was $0.6 million greater than a year ago. However, that increased loss was more than offset by a $2.1 million gain in the current quarter from the sale of investment securities that were acquired as a partial economic hedge against value changes in our mortgage servicing rights. For further information regarding the partial economic hedge, see Asset/Liability Management and Market Risk on page 34.

          For the first quarter of 2004, our return on average assets was 0.30%, down from 1.03% a year ago, while our return on average equity was 3.88%, down from 14.41% a year ago.

          Our loan originations, including purchases, totaled $2.956 billion in the first quarter of 2004, up from the $2.441 billion we originated in the first quarter of 2003. Loans originated for sale declined $679 million to $928 million, while single family loans originated for portfolio increased by $1.120 billion to a quarterly record of $1.903 billion. Of the current quarter total originated for portfolio, $173 million represented subprime credits. In addition to single family loans, we originated $125 million of other loans in the quarter.

          At quarter end, our assets totaled $13.5 billion, up $2.1 billion or 18.2% from a year ago and up $1.9 billion or 16.1% from year-end 2003. During the current quarter, portfolio originations exceeded loan payoffs, resulting in an increase of $948 million in loans held for investment. In addition, loans held for sale were $249 million higher, while securities available for sale increased $182 million. Included within securities available for sale at quarter end were $517 million associated with the previously mentioned partial economic hedge against value changes in our mortgage servicing rights. Also, other assets were higher and included a receivable of $507 million related to securities sold the last day of the quarter, for which proceeds were received the next business day.

          Our deposits totaled $8.8 billion at March 31, 2004, down 2.0% from the year-ago level but up 6.3% from year-end 2003. During the quarter, we closed one in-store branch due to the sale of the grocery store in which it was located. The associated deposits have been temporarily transferred to another branch pending the opening of a replacement location expected in the second quarter. This brings our total branches at quarter end to 171, of which 99 were in-store. A year ago, we had 165 branches, of which 93 were in-store. Subsequent to March 31, 2004, we consolidated two traditional branches that were located near each other. We currently have five in-store branches with deposits totaling $105 million at March 31, 2004 that are affected by Ralph Grocery Company’s decision to close supermarkets in Southern California during the second quarter. We are looking for replacement locations for these branches to maintain and increase customer relationships in those areas.

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          Our non-performing assets increased $5 million during the quarter to $54 million or 0.40% of total assets. The increase was primarily in our prime residential loan category.

          At March 31, 2004, our primary subsidiary, Downey Savings and Loan Association, F.A. (the "Bank") exceeded all regulatory capital tests, with capital-to-asset ratios of 6.90% for both tangible and core capital and 13.36% for risk-based capital. These capital levels are significantly above the "well capitalized" standards defined by the federal banking regulators of 5% for core and tangible capital and 10% for risk-based capital.

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CRITICAL ACCOUNTING POLICIES

          We have established various accounting policies which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in Downey’s Annual Report on Form 10-K for the year ended December 31, 2003. Certain accounting policies require us to make significant estimates and assumptions which have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and our results of operations for the reporting periods. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors.

          We believe the following are critical accounting policies that require the most significant estimates and assumptions, which are particularly susceptible to significant change in the preparation of our financial statements:

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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"). The spread between the yield on interest-earning assets and the cost of interest-bearing liabilities and the relative dollar amounts of these assets and liabilities principally affects net interest income.

          Our net interest income totaled $69.4 million in the current quarter, down $11.5 million or 14.3% from the same period last year. The decline reflected a lower effective interest rate spread, as our interest-earning assets averaged $11.5 billion during the quarter, up 1.7% from the year-ago level. The effective interest rate spread averaged 2.42% in the current quarter, down from 2.86% a year ago but up from 2.40% in the previous quarter. The decline between first quarters was due to our yield on interest-earning assets declining more rapidly than our cost of funds. The more rapid decline in our yield on interest-earning assets primarily reflected our positive interest rate gap (i.e., more interest-earning assets reprice to market interest rates within one year than do interest-bearing liabilities). In addition, the decline in our effective interest rate spread also reflected a higher proportion of lower yielding investment securities, a higher proportion of adjustable rate mortgages tied to the 12-month moving average of annual yields on actively traded U.S. Treasury securities to a constant maturity of one year ("MTA") that currently have lower fully-indexed yields than those tied to the Federal Home Loan Bank ("FHLB") Eleventh District Cost of Funds Index ("COFI") and a lower percentage of higher yielding subprime loans.

          During the latter part of the current quarter, we entered into interest rate swap contracts that mature in the fourth quarter of 2008 as a fair value hedge against certain existing fixed rate borrowings. These swaps effectively convert the borrowings from fixed to adjustable rate and better match the adjustable rate loans now being funded with those borrowings. During the current quarter, these swaps reduced interest expense by $0.8 million. For further information regarding the swaps, see Note 3 of Notes to Consolidated Financial Statements on page 7.

          The following table presents for the periods indicated the total dollar amount of:

          The table also sets forth our net interest income, interest rate spread and effective interest rate spread. The effective interest rate spread reflects the relative level of interest-earning assets to interest-bearing liabilities and equals:

          The table also sets forth our net interest-earning balance—the difference between the average balance of interest-earning assets and the average balance of total deposits and borrowings—for the quarters indicated. We included non-accrual loans in the average interest-earning assets balance. We included interest from non-accrual loans in interest income only to the extent we received payments and believe we will recover the remaining principal balance of the loans. We computed average balances for the quarter using the average of each month’s daily average balance during the periods indicated.

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Three Months Ended


March 31, 2004

December 31, 2003

March 31, 2003


Average

Average

Average

Average

Yield/

Average

Yield/

Average

Yield/

(Dollars in Thousands)

Balance

Interest

Rate

Balance

Interest

Rate

Balance

Interest

Rate


Interest-earning assets:

Loans

$

10,825,710

$

115,530

4.27

%

$

10,084,352

$

111,117

4.41

%

$

10,759,397

$

142,489

5.30

%

Mortgage-backed securities

331

3

3.63

1,384

10

2.89

2,012

16

3.18

Investment securities

660,750

5,262

3.20

803,792

6,053

2.99

537,386

4,792

3.62


Total interest-earning assets

11,486,791

120,795

4.21

10,889,528

117,180

4.30

11,298,795

147,297

5.21

Non-interest-earning assets

406,088

396,662

407,422


Total assets

$

11,892,879

$

11,286,190

$

11,706,217


Transaction accounts:

Non-interest-bearing checking

$

445,618

$

-

-

%

$

441,624

$

-

-

%

$

384,088

$

-

-

%

Interest-bearing checking (a)

519,572

459

0.36

464,583

290

0.25

425,810

299

0.28

Money market

140,055

364

1.05

139,445

367

1.04

124,194

414

1.35

Regular passbook

3,917,514

10,863

1.12

4,041,057

12,154

1.19

3,764,522

14,829

1.60


Total transaction accounts

5,022,759

11,686

0.94

5,086,709

12,811

1.00

4,698,614

15,542

1.34

Certificates of deposit

3,460,434

20,914

2.43

3,347,441

20,785

2.46

4,276,882

32,308

3.06


Total deposits

8,483,193

32,600

1.55

8,434,150

33,596

1.58

8,975,496

47,850

2.16

FHLB advances and other borrowings (b)

2,206,909

15,705

2.86

1,662,003

15,197

3.63

1,599,094

15,417

3.91

Junior subordinated debentures

123,711

3,134

10.13

123,711

3,134

10.13

123,711

3,134

10.13


Total deposits and borrowings

10,813,813

51,439

1.91

10,219,864

51,927

2.02

10,698,301

66,401

2.52

Other liabilities

159,349

159,479

169,277

Stockholders’ equity

919,717

906,847

838,639


Total liabilities and stockholders’ equity

$

11,892,879

$

11,286,190

$

11,706,217


Net interest income/interest rate spread

$

69,356

2.30

%

$

65,253

2.28

%

$

80,896

2.69

%

Excess of interest-earning assets over

deposits and borrowings

$

672,978

$

669,664

$

600,494

Effective interest rate spread

2.42

2.40

2.86


(a) Included amounts swept into money market deposit accounts.
(b) Starting in the first quarter of 2004, the impact of swap contracts were included, with notional amounts totaling $430 million of receive-fixed, pay-3-month Libor variable interest, which serve as a permitted hedge against a portion of our FHLB advances.
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          Changes in our net interest income are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities. The following table sets forth information regarding changes in our interest income and expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, we have provided information on changes attributable to:

Interest-earning asset and interest-bearing liability balances used in the calculations represent quarterly average balances computed using the average of each month’s daily average balance during the period indicated.

Three Months Ended

March 31, 2004 Versus March 31, 2003

Changes Due To


Rate/

(In Thousands)

Volume

Rate

Volume

Net


Interest income:

Loans

$

878

$

(27,666

)

$

(171

)

$

(26,959

)

Mortgage-backed securities

(13

)

2

(2

)

(13

)

Investment securities

1,212

(603

)

(139

)

470


Change in interest income

2,077

(28,267

)

(312

)

(26,502

)


Interest expense:

Transaction accounts:

Interest-bearing checking (a)

67

77

16

160

Money market

49

(88

)

(11

)

(50

)

Regular passbook

590

(4,378

)

(178

)

(3,966

)


Total transaction accounts

706

(4,389

)

(173

)

(3,856

)

Certificates of deposit

(6,076

)

(6,573

)

1,255

(11,394

)


Total interest-bearing deposits

(5,370

)

(10,962

)

1,082

(15,250

)

FHLB advances and other

borrowings

10,565

(7,553

)

(2,724

)

288

Junior subordinated debentures

-

-

-

-


Change in interest expense

5,195

(18,515

)

(1,642

)

(14,962

)


Change in net interest income

$

(3,118

)

$

(9,752

)

$

1,330

$

(11,540

)


(a) Included amounts swept into money market deposit accounts.

Provision for Loan Losses

          Provision for loan losses totaled $1.8 million in the current quarter, compared to a reduction in provision for loan losses of $1.7 million in the year-ago quarter. The higher provision was due to growth in the loan portfolio, whereas the reversal a year ago reflected both a decline in the loan portfolio, as well as an improvement in credit quality.

Other Income

          Our total other income was $3.0 million in the current quarter, compared to $22.0 million in the year-ago quarter. The $19.1 million decline between first quarters primarily reflected:

Partially offsetting those items was a $2.1 million gain from the sale of securities purchased as a partial economic hedge against the valuation of mortgage servicing rights. In addition, loan and deposit related fees were $0.5 million higher.

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          Below is a further discussion of the major other income categories.

Loan and Deposit Related Fees

          Loan and deposit related fees totaled $12.5 million in the current quarter, up $0.5 million from a year ago. The increase was primarily in our deposit related fees that were up $0.7 million or 11.1% from a year ago due to higher fees from both our checking accounts and automated teller machines.

          The following table presents a breakdown of loan and deposit related fees for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Loan related fees:

Prepayment fees

$

3,799

$

4,320

$

4,756

$

4,291

$

3,413

Other fees

2,000

2,117

2,863

2,925

2,574

Deposit related fees:

Automated teller machine fees

2,243

2,187

2,472

2,180

2,086

Other fees

4,414

4,420

4,314

4,253

3,905


Total loan and deposit related fees

$

12,456

$

13,044

$

14,405

$

13,649

$

11,978


Real Estate and Joint Ventures Held for Investment

          Income from our real estate and joint ventures held for investment totaled $0.9 million in the current quarter, essentially unchanged from the year-ago quarter.

          The following table sets forth the key components comprising our income from real estate and joint venture operations for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Rental operations, net of expenses

$

576

$

290

$

168

$

224

$

531

Net gains on sales of wholly owned real estate

40

-

2,160

1,000

157

Equity in net income from joint ventures

80

451

3,308

604

16

Interest from joint venture advances

230

218

568

388

280

Provision for losses on real estate

and joint ventures

-

-

(340

)

(147

)

(41

)


Total income from real estate and joint ventures

held for investment, net

$

926

$

959

$

5,864

$

2,069

$

943


Secondary Marketing Activities

          We service loans for others and those activities generated a loss of $14.2 million in the current quarter, compared to a loss of $13.7 million in the year-ago quarter. The $0.6 million unfavorable change between first quarters was more than offset by a $2.1 million gain in the current quarter from the sale of investment securities that were acquired as a partial economic hedge against value changes in our mortgage servicing rights. Our higher loss this quarter from servicing activities primarily reflected a $1.5 million larger addition to the valuation allowance for mortgage servicing rights, as $12.9 million was added in the current quarter compared to a $11.4 million addition a year ago. The current quarter increase to the valuation allowance reflected a decline in long-term mortgage interest rates, resulting in a faster projected rate at which loans we service for others are expected to prepay, thereby shortening their average expected life. In addition, amortization of mortgage servicing rights increased $0.7 million between first quarters. Those two unfavorable items were partially offset by a decrease of $1.0 million in payoff and curtailment interest costs and a $0.7 million increase in net cash servicing fees. Most of our loan servicing agreements require us to pay interest to the investor for an entire month, even if the loan we service for others prepays prior to the end of a month. That additional interest cost is what we call payoff and curtailment interest cost. However, we benefit from the use of those proceeds from the time of repayment until we are required to remit the funds to the investor. That benefit results in an increase to our net interest income.

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          At March 31, 2004, we serviced $9.2 billion of loans for others, compared to $9.3 billion at December 31, 2003, and $8.5 billion at March 31, 2003.

          The following table presents a breakdown of the components of our loan servicing income (loss), net for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Net cash servicing fees

$

5,704

$

5,681

$

5,401

$

5,117

$

5,016

Payoff and curtailment interest cost (a)

(1,527

)

(1,597

)

(3,869

)

(3,620

)

(2,525

)

Amortization of MSRs

(5,519

)

(5,001

)

(5,051

)

(9,951

)

(4,771

)

(Provision for) reduction of impairment

of MSRs

(12,903

)

7,685

5,069

(13,238

)

(11,406

)


Total loan servicing income (loss), net

$

(14,245

)

$

6,768

$

1,550

$

(21,692

)

$

(13,686

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month, less the actual interest received when a loan prepays prior to the end of the month. This does not include the benefit of the use of repaid loan funds to increase net interest income.

          For further information regarding mortgage servicing rights, see Note 2 of Notes to Consolidated Financial Statements on page 6.

          Sales of loans and mortgage-backed securities declined from $1.624 billion a year ago to $679 million in the current quarter. Net gains associated with these sales totaled $1.4 million in the current quarter, down from $19.8 million a year ago due primarily to a lower volume of fixed rate loans being originated and sold. Net gains in the current quarter included the capitalization of mortgage servicing rights of $6.0 million, compared to $15.0 million a year ago. Excluding the impact of SFAS 133, a gain of 0.69% of secondary market sales was realized which is below 1.23% a year ago.

          The following table presents a breakdown of the components of our net gains (losses) on sales of loans and mortgage-backed securities for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Mortgage servicing rights

$

5,968

$

9,091

$

21,660

$

15,405

$

14,954

All other components excluding SFAS 133

(1,314

)

(4,553

)

686

183

4,948

SFAS 133

(3,282

)

1,016

1,121

(2,936

)

(139

)


Total net gains on sales of loans

and mortgage-backed securities

$

1,372

$

5,554

$

23,467

$

12,652

$

19,763


Secondary marketing gain excluding SFAS

133 as a percentage of associated sales

0.69

%

0.48

%

1.15

%

0.75

%

1.23

%


Securities available for sale

          Just prior to the end of the current quarter, we established a partial economic hedge against future MSR value declines by purchasing approximately $500 million of securities classified as available for sale. We sold the designated securities at the end of the current quarter for a gain of $2.1 million. On the same day, we reset the hedge amount for the second quarter. For further information regarding our hedging strategy, see Asset/Liability Management and Market Risk on page 34.

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Operating Expense

          Our operating expense totaled $55.0 million in the current quarter, up $2.7 million or 5.2% from a year ago. The increase was primarily due to a $1.4 million increase in salaries and related costs and a $0.9 million increase in advertising expense.

          The following table presents a breakdown of key components comprising operating expense for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Salaries and related costs

$

35,569

$

33,144

$

34,312

$

33,028

$

34,126

Premises and equipment costs

8,208

8,286

8,291

7,971

7,713

Advertising expense

1,708

1,068

835

1,016

793

SAIF insurance premiums and regulatory

assessments

757

762

787

825

831

Professional fees

368

539

798

418

628

Other general and administrative expense

8,482

8,106

7,718

8,111

7,893


Total general and administrative expense

55,092

51,905

52,741

51,369

51,984

Net operation of real estate acquired in

settlement of loans

(72

)

(739

)

(376

)

(111

)

297


Total operating expense

$

55,020

$

51,166

$

52,365

$

51,258

$

52,281


Provision for Income Taxes

          Income taxes for the current quarter totaled $6.6 million, resulting in an effective tax rate of 42.4%, compared to $22.1 million and 42.3% for the year-ago quarter. For further information regarding income taxes, see Note 4 of Notes to Consolidated Financial Statements on page 11.

Business Segment Reporting

          The previous discussion and analysis of the Results of Operations pertained to our consolidated results. This section discusses and analyzes the results of operations of our two business segments—banking and real estate investment. For further information regarding business segments, see Note 7 of Notes to Consolidated Financial Statements on page 12.

          The following table presents by business segment our net income for the periods indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Banking net income

$

8,387

$

23,188

$

25,621

$

17,145

$

29,505

Real estate investment net income

525

570

3,630

1,370

712


Total net income

$

8,912

$

23,758

$

29,251

$

18,515

$

30,217


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Banking

          Net income from our banking operations for the current quarter totaled $8.4 million, down $21.1 million from a year ago. The decrease between first quarters primarily reflected:

Our loss from loan servicing was $0.6 million higher. However, that increased loss was more than offset by a $2.1 million gain in the current quarter from the sale of investment securities that we acquired as a partial economic hedge against value changes in our mortgage servicing rights.

          The following table sets forth our banking operational results and selected financial data for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Net interest income

$

69,444

$

65,325

$

68,302

$

74,232

$

80,881

Provision for (reduction of) loan losses

1,804

(281

)

(1,104

)

(624

)

(1,709

)

Other income

1,691

25,498

27,116

5,839

20,631

Operating expense

54,699

50,925

52,126

50,985

52,106

Net intercompany income (expense)

(38

)

42

43

40

44


Income before income taxes

14,594

40,221

44,439

29,750

51,159

Income taxes

6,207

17,033

18,818

12,605

21,654


Net income

$

8,387

$

23,188

$

25,621

$

17,145

$

29,505


At period end

Assets:

Loans and mortgage-backed securities

$

11,594,098

$

10,396,510

$

9,987,468

$

10,773,026

$

10,675,557

Other

1,919,401

1,237,858

1,165,611

1,169,082

760,182


Total assets

13,513,499

11,634,368

11,153,079

11,942,108

11,435,739


Equity

$

924,557

$

917,018

$

894,210

$

869,365

$

851,650


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Real Estate Investment

          Net income from our real estate investment operations totaled $0.5 million in the current quarter, down slightly from $0.7 million a year ago.

          The following table sets forth real estate investment operational results and selected financial data for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Net interest income (loss)

$

(88

)

$

(72

)

$

(50

)

$

(20

)

$

15

Other income

1,262

1,320

6,476

2,651

1,411

Operating expense

321

241

239

273

175

Net intercompany income (expense)

38

(42

)

(43

)

(40

)

(44

)


Income before income taxes

891

965

6,144

2,318

1,207

Income taxes

366

395

2,514

948

495


Net income

$

525

$

570

$

3,630

$

1,370

$

712


At period end

Assets:

Investments in real estate and joint ventures

$

35,768

$

35,716

$

32,435

$

36,297

$

34,307

Other

3,994

3,503

4,617

8,279

5,641


Total assets

39,762

39,219

37,052

44,576

39,948


Equity

$

28,132

$

27,607

$

27,037

$

35,407

$

34,037


          Our investments in real estate and joint ventures amounted to $36 million at both March 31, 2004 and December 31, 2003 but up from $34 million at March 31, 2003.

          For information on valuation allowances associated with real estate and joint venture loans, see Allowances for Losses on Loans and Real Estate on page 39.

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FINANCIAL CONDITION

Loans and Mortgage-Backed Securities

          Total loans and mortgage-backed securities, including those we hold for sale, increased $1.2 billion during the current quarter to a total of $11.6 billion or 85.7% of assets at March 31, 2004. The increase occurred in both loans held for investment and loans held for sale. A record volume of single family portfolio originations and a moderate decline in loan repayments resulted in our loans held for investment increasing $948 million or 9.4% during the current quarter. Loans held for sale increased $249 million, as the volume of new single family fixed rate applications rose due to the decline in mortgage interest rates since the end of 2003. Our annualized prepayment speed in the current quarter declined to 41%, compared to 43% a year ago and 50% during the fourth quarter of 2003.

          The following table sets forth loans originated, including purchases, for investment and for sale for the periods indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

854,367

$

381,699

$

157,322

$

250,792

$

287,913

MTA

721,138

878,153

486,146

207,342

223,987

Libor

203,502

207,303

88,658

74,098

35,021

Adjustable – fixed for 3-5 years

124,008

106,412

275,755

748,613

222,540

Fixed

-

885

1,976

6,499

13,287


Total residential one-to-four units

1,903,015

1,574,452

1,009,857

1,287,344

782,748

Other

125,391

145,175

102,618

78,407

51,155


Total for investment portfolio

2,028,406

1,719,627

1,112,475

1,365,751

833,903

Sale portfolio(a)

927,777

889,144

1,566,423

2,161,154

1,607,147


Total for investment and sale portfolios

$

2,956,183

$

2,608,771

$

2,678,898

$

3,526,905

$

2,441,050


(a) Primarily fixed rate residential one-to-four unit loans.

          Loan originations, including loans purchased, totaled $2.956 billion in the current quarter, up 21.1% from the $2.441 billion we originated in the first quarter of 2003 and 13.3% above the $2.609 billion we originated in the fourth quarter of 2003. Loans originated for sale declined $679 million from the year-ago first quarter to $928 million, while single family loans originated for portfolio increased $1.120 billion to a quarterly record of $1.903 billion. Of the current quarter originations for portfolio, $173 million represented subprime credits as part of our continuing strategy to enhance the portfolio’s net yield. During the current quarter, 78% of our residential one-to-four unit originations represented refinance transactions. This is up from 75% in the fourth quarter of 2003 but down from 87% in the year-ago quarter. In addition to single family loans, we originated $125 million of other loans in the current quarter.

          Originations of adjustable rate residential one-to-four unit loans for portfolio, including loans purchased, totaled $1.903 billion during the quarter. Of that total:

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          The following table sets forth our investment portfolio of residential one-to-four unit adjustable rate loans by index, excluding our adjustable–fixed for 3-5 year loans which are still in their initial fixed rate period, at the dates indicated.

March 31, 2004

December 31, 2003

September 30, 2003

June 30, 2003

March 31, 2003


% of

% of

% of

% of

% of

(Dollars in Thousands)

Amount

Total

Amount

Total

Amount

Total

Amount

Total

Amount

Total


Investment Portfolio

Residential one-to-four units:

Adjustable by index:

COFI

$

5,095,707

57

%

$

4,819,852

61

%

$

5,163,897

71

%

$

5,883,639

78

%

$

6,458,588

81

%

MTA

3,074,120

35

2,503,336

32

1,761,516

24

1,391,864

18

1,258,982

16

Libor

589,621

7

403,450

5

249,320

3

143,388

2

54,931

1

Other, primarily CMT

126,154

1

185,437

2

171,039

2

180,575

2

195,309

2


Total adjustable loans (a)

$

8,885,602

100

%

$

7,912,075

100

%

$

7,345,772

100

%

$

7,599,466

100

%

$

7,967,810

100

%


(a) Excludes residential one-to-four unit adjustable–fixed for 3-5 year loans still in their initial fixed rate period.

          Our adjustable rate mortgages:

          Most of our adjustable rate mortgages adjust the interest rate monthly and the payment amount annually. These monthly adjustable rate mortgages:

If a loan incurs significant negative amortization, the loan-to-value ratio could increase which also increases credit risk, as the fair value of the underlying collateral could be insufficient to satisfy fully the outstanding loan obligation. A loan-to-value ratio is the ratio of the principal amount of the loan to the lower of the sales price or appraised value of the property securing the loan at origination. We currently impose a limit on the amount of negative amortization. The principal plus the negative amortization cannot exceed 125% of the original loan amount, except for subprime loans and loans with loan-to-value ratios of greater than 80% where the borrower has obtained private mortgage insurance to reduce the effective loan-to-value ratio to between 67% and 80%. In those two instances, the principal plus negative amortization cannot exceed 110% of the original loan amount. At March 31, 2004, loans with the higher 125% limit on negative amortization represented 22% of our adjustable rate one-to-four unit residential portfolio.

          At March 31, 2004, $7.9 billion or 75% of the adjustable rate mortgages in our loan portfolio were subject to negative amortization, of which $39 million represented the amount of negative amortization included in the loan balance. The amount of negative amortization was $9 million or 20% below the December 31, 2003 level.

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          We also will continue to originate residential fixed interest rate mortgage loans to meet consumer demand, but we intend to sell the majority of these loans. We sold $679 million of loans and mortgage-backed securities in the current quarter, compared to $941 million in the fourth quarter of 2003 and $1.624 billion in the year-ago first quarter. All but minor amounts were secured by residential one-to-four unit property, and at March 31, 2004, loans held for sale totaled $529 million.

          At March 31, 2004, our unfunded loan application pipeline totaled $2.5 billion. Within that pipeline, we had commitments to borrowers for short-term interest rate locks, excluding expected fallout, of $1.2 billion, of which $569 million were related to residential one-to-four unit loans being originated for sale in the secondary market. Furthermore, at March 31, 2004, we had commitments on undrawn lines of credit of $233 million, loans in process of $49 million and commitments to purchase loans of $0.5 million. We believe our current sources of funds will enable us to meet these obligations.

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          The following table sets forth the origination, purchase and sale activity relating to our loans and mortgage-backed securities for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Investment Portfolio

Loans originated:

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

1,550,101

$

1,335,998

$

675,135

$

468,337

$

479,506

Adjustable – subprime

163,927

119,989

55,778

63,903

62,268

Adjustable – fixed for 3-5 years

124,008

106,412

275,755

178,325

132,143

Adjustable – fixed for 3-5 years – subprime

-

-

-

-

11,683


Total adjustable residential one-to-four units

1,838,036

1,562,399

1,006,668

710,565

685,600

Fixed

-

885

1,976

5,721

11,865

Fixed – subprime

-

-

-

73

1,395

Residential five or more units – adjustable

8,452

11,629

12,789

17,956

4,400


Total residential

1,846,488

1,574,913

1,021,433

734,315

703,260

Commercial real estate

8,094

-

575

3,272

-

Construction

6,330

36,320

12,025

21,511

10,345

Land

-

-

19,589

-

-

Non-mortgage:

Commercial

375

1,260

1,200

-

125

Automobile

-

-

21

18

79

Other consumer

101,582

95,966

30,107

31,117

28,418


Total loans originated

1,962,869

1,708,459

1,084,950

790,233

742,227

Real estate loans purchased:

One-to-four units

56,361

10,038

594

570,985

82,746

One-to-four units – subprime

8,618

1,130

619

-

1,142

Other (a)

558

-

26,312

4,533

7,788


Total real estate loans purchased

65,537

11,168

27,525

575,518

91,676


Total loans originated and purchased

2,028,406

1,719,627

1,112,475

1,365,751

833,903

Loan repayments

(1,064,293

)

(1,205,610

)

(1,526,563

)

(1,352,321

)

(1,127,612

)

Other net changes (b)

(15,946

)

(47,939

)

15,168

(4,075

)

11,078


Net increase (decrease) in loans held for investment

948,167

466,078

(398,920

)

9,355

(282,631

)


Sale Portfolio

Originated whole loans:

Residential one-to-four units

927,047

886,572

1,565,841

2,161,154

1,606,085

Non-mortgage loans

730

2,572

582

-

-

Loans purchased

-

-

-

-

1,062

Loans transferred from (to) the investment portfolio

283

(2,523

)

(7,759

)

3,549

(541

)

Originated whole loans sold

(155,610

)

(107,060

)

(335,589

)

(250,027

)

(246,697

)

Loans exchanged for mortgage-backed securities

(523,136

)

(834,373

)

(1,602,297

)

(1,828,344

)

(1,377,469

)

Other net changes

(968

)

(1,979

)

(1,079

)

(1,116

)

(1,143

)

Capitalized basis adjustment (c)

1,082

1,011

(6,191

)

3,037

327


Net increase (decrease) in loans held for sale

249,428

(55,780

)

(386,492

)

88,253

(18,376

)


Mortgage-backed securities, net:

Received in exchange for loans

523,136

834,373

1,602,297

1,828,344

1,377,469

Sold

(523,136

)

(834,373

)

(1,602,297

)

(1,828,344

)

(1,377,469

)

Repayments

(6

)

(1,247

)

(140

)

(129

)

(366

)

Other net changes

(1

)

(9

)

(6

)

(10

)

(12

)


Net decrease in mortgage-backed securities

available for sale

(7

)

(1,256

)

(146

)

(139

)

(378

)


Net increase (decrease) in loans held for sale and

mortgage-backed securities available for sale

249,421

(57,036

)

(386,638

)

88,114

(18,754

)


Total net increase (decrease) in loans and

mortgage-backed securities

$

1,197,588

$

409,042

$

(785,558

)

$

97,469

$

(301,385

)


(a) Included five or more unit residential loans.
(b) Primarily included changes in undisbursed funds for lines of credit and construction loans, changes in loss allowances, loans transferred to real estate acquired in settlement of loans or from (to) the held for sale portfolio, and the change in interest capitalized on loans (negative amortization).
(c) Reflected the change in fair value of the rate lock derivative from the date of commitment to the date of funding.
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          The following table sets forth the composition of our loan and mortgage-backed securities portfolio at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Investment Portfolio

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

7,878,316

$

6,945,106

$

6,328,674

$

6,444,574

$

6,711,548

Adjustable – subprime

982,696

940,655

987,509

1,119,780

1,212,905

Adjustable – fixed for 3-5 years

1,650,521

1,687,323

1,809,803

1,942,446

1,543,478

Adjustable – fixed for 3-5 years – subprime

35,861

42,952

57,910

70,780

80,247

Fixed

90,993

105,042

123,413

157,256

187,888

Fixed – subprime

3,515

4,432

4,790

5,602

7,266


Total residential one-to-four units

10,641,902

9,725,510

9,312,099

9,740,438

9,743,332

Residential five or more units:

Adjustable

99,321

91,024

79,778

41,004

19,048

Fixed

1,875

1,904

2,213

2,251

2,292

Commercial real estate:

Adjustable

36,298

36,142

37,860

37,524

34,530

Fixed

6,016

13,144

14,580

15,507

23,613

Construction

88,676

105,706

90,233

105,858

100,767

Land

1,587

16,855

18,931

20,090

39,962

Non-mortgage:

Commercial

5,150

4,975

5,235

6,493

14,922

Automobile

2,816

3,823

5,085

6,959

9,165

Other consumer

130,549

95,319

70,593

68,012

61,744


Total loans held for investment

11,014,190

10,094,402

9,636,607

10,044,136

10,049,375

Increase (decrease) for:

Undisbursed loan funds

(50,950

)

(56,543

)

(52,841

)

(67,921

)

(72,765

)

Net deferred costs and premiums

133,518

108,990

97,445

105,393

96,499

Allowance for losses

(32,072

)

(30,330

)

(30,770

)

(32,247

)

(33,103

)


Total loans held for investment, net

11,064,686

10,116,519

9,650,441

10,049,361

10,040,006


Sale Portfolio, Net

Loans held for sale:

Residential one-to-four units

526,311

276,295

335,594

716,477

631,261

Non-mortgage

1,420

3,090

582

-

-

Capitalized basis adjustment (a)

1,354

272

(739

)

5,452

2,415


Total loans held for sale

529,085

279,657

335,437

721,929

633,676

Mortgage-backed securities available for sale:

Adjustable

327

334

1,590

1,736

1,875

Fixed

-

-

-

-

-


Total mortgage-backed securities available for sale

327

334

1,590

1,736

1,875


Total loans held for sale and mortgage-backed

securities available for sale

529,412

279,991

337,027

723,665

635,551


Total loans and mortgage-backed securities

$

11,594,098

$

10,396,510

$

9,987,468

$

10,773,026

$

10,675,557


(a) Reflected the change in fair value of the rate lock derivative from the date of commitment to the date of funding.

          We carry loans for sale at the lower of cost or fair value. At March 31, 2004, no valuation allowance was required as the fair value exceeded book value on an aggregate basis.

          At March 31, 2004, our residential one-to-four units subprime portfolio consisted of 92% "Alt. A and A-" credit, 7% "B" credit and 1% "C" credit loans. The average loan-to-value ratio at origination for these loans was 73%.

          We carry mortgage-backed securities available for sale at fair value which, at March 31, 2004, reflected an unrealized gain of $6,000. The current quarter-end unrealized gain, less the associated tax effect, is reflected as a separate component of other comprehensive income until realized.

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Trading and Investment Securities

          The following table sets forth the composition of our trading and investment securities portfolios at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Federal funds

$

2,300

$

1,500

$

4,001

$

89,210

$

1,201

U.S. Treasury securities held for trading

-

-

-

201,781

-

U.S. Treasury and agency securities available for sale

872,037

690,281

635,759

276,904

214,449

Other investment securities available for sale

66

66

66

67

67

Municipal securities held to maturity

-

-

-

6,148

6,148

Securities purchased under resale agreements

-

-

-

60,000

-


Total trading and investment securities

$

874,403

$

691,847

$

639,826

$

634,110

$

221,865


          The fair value of temporarily impaired securities, the amount of unrealized losses and the length of time these unrealized losses existed as of March 31, 2004 are as follows:

Less than 12 months

12 months or longer

Total


Unrealized

Unrealized

Unrealized

(In Thousands)

Fair Value

Losses

Fair Value

Losses

Fair Value

Losses


U.S. Treasury and agency securities

$

608,497

$

477

$

-

$

-

$

608,497

$

477

Other investment securities

-

-

-

-

-

-


Total temporarily impaired securities

$

608,497

$

477

$

-

$

-

$

608,497

$

477


          The following table sets forth the maturities of our investment securities and their weighted average yields at March 31, 2004.

After 1 Year

1 Year or Less

Through 5 Years

After 5 Years

Total


Weighted

Weighted

Weighted

Weighted

Average

Average

Average

Average

(Dollars in Thousands)

Amount

Yield

Amount

Yield

Amount

Yield

Amount

Yield


Federal funds

$

2,300

0.87

%

$

-

-

%

$

-

-

%

$

2,300

0.87

%

U.S. Treasury, agency, and other

securities available for sale (a)

-

-

87,277

2.32

784,826

3.57

872,103

3.45


Total investment securities

$

2,300

0.87

%

$

87,277

2.32

%

$

784,826

3.57

%

$

874,403

3.44

%


(a) Includes within the category of maturities after five years, $125 million with yields that adjust every three months based on movements of the 3-month Libor.
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Deposits

          At March 31, 2004, our deposits totaled $8.8 billion, down $180 million or 2.0% from the year-ago level but up $523 million or 6.3% since year-end 2003. Compared to the year-ago period, our certificates of deposit declined $372 million or 9.0%, which was partially offset by an increase in our lower-rate transaction accounts—i.e., checking, money market and regular passbook—of $192 million or 3.9%. As depositors seemed more interested in liquidity given the relatively low level of interest rates, they moved monies from certificates of deposit to transaction accounts. During the quarter, we closed one in-store branch due to the sale of the grocery store in which it was located. The associated deposits have been temporarily transferred to another branch pending the opening of a replacement location expected in the second quarter. This brings our total branches at quarter end to 171, of which 99 were in-store, an increase of 6 branches from a year ago, all of which were in-store. At March 31, 2004, the average deposit size of our 72 traditional branches was $102 million, while the average deposit size of our 99 in-store branches was $15 million. Subsequent to March 31, 2004, we consolidated two traditional branches that were located near each other. We currently have five in-store branches with deposits totaling $105 million at March 31, 2004 that are affected by Ralph Grocery Company’s decision to close supermarkets in Southern California during the second quarter. We are looking for replacement locations for these branches to maintain and increase customer relationships in those areas.

          The following table sets forth information concerning our deposits and weighted average rates paid at the dates indicated.

March 31, 2004

December 31, 2003

September 30, 2003

June 30, 2003

March 31, 2003


Weighted

Weighted

Weighted

Weighted

Weighted

Average

Average

Average

Average

Average

(Dollars in Thousands)

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount


Transaction accounts:

Non-interest-bearing

checking

-

%

$

489,213

-

%

$

429,743

-

%

$

411,839

-

%

$

403,264

-

%

$

446,668

Interest-bearing

checking (a)

0.37

542,963

0.21

462,733

0.21

453,547

0.21

439,408

0.21

434,148

Money market

1.05

142,092

1.05

142,418

1.05

136,981

1.05

127,194

1.19

127,257

Regular passbook

1.08

3,898,369

1.12

4,036,464

1.18

4,062,067

1.28

4,015,045

1.45

3,872,525


Total transaction

accounts

0.90

5,072,637

0.94

5,071,358

0.99

5,064,434

1.08

4,984,911

1.20

4,880,598

Certificates of deposit:

Less than 2.00%

1.22

1,532,376

1.17

1,548,398

1.24

1,533,630

1.35

1,479,928

1.45

1,292,664

2.00-2.49

2.38

962,827

2.23

338,763

2.22

374,684

2.23

416,718

2.24

241,833

2.50-2.99

2.71

211,296

2.73

222,436

2.75

233,258

2.76

277,926

2.80

436,352

3.00-3.49

3.30

233,922

3.27

305,258

3.32

560,853

3.32

602,691

3.32

706,952

3.50-3.99

3.79

106,554

3.78

106,861

3.80

133,807

3.85

254,400

3.89

545,453

4.00-4.49

4.27

240,903

4.27

240,459

4.27

241,388

4.25

361,212

4.25

368,490

4.50-4.99

4.83

420,966

4.83

420,262

4.83

423,728

4.80

469,279

4.80

471,542

5.00 and greater

5.61

35,692

5.59

39,963

5.60

42,286

5.58

48,387

5.57

53,674


Total certificates

of deposit

2.45

3,744,536

2.44

3,222,400

2.56

3,543,634

2.74

3,910,541

2.97

4,116,960


Total deposits

1.56

%

$

8,817,173

1.52

%

$

8,293,758

1.64

%

$

8,608,068

1.81

%

$

8,895,452

2.01

%

$

8,997,558


(a) Included amounts swept into money market deposit accounts.
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Borrowings

          During the current quarter, our borrowings increased $806 million to $3.1 billion, due primarily to increases in securities sold under agreements to repurchase of $507 million and FHLB advances of $299 million. This followed an increase in FHLB advances of $866 million during the fourth quarter of 2003.

          The following table sets forth information concerning our FHLB advances and other borrowings at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

(Dollars in Thousands)

2004

2003

2003

2003

2003


Securities sold under agreements to repurchase

$

507,027

$

-

$

-

$

-

$

-

Federal Home Loan Bank advances

2,424,230

2,125,150

1,259,150

1,672,850

1,300,850

Real estate notes

4,144

4,161

4,178

3,121

-

Junior subordinated debentures

123,711

123,711

123,711

123,711

123,711


Total borrowings

$

3,059,112

$

2,253,022

$

1,387,039

$

1,799,682

$

1,424,561


Weighted average rate on borrowings during

the quarter (a)

3.25

%

4.07

%

4.78

%

4.71

%

4.37

%

Total borrowings as a percentage of total assets

22.62

19.35

12.43

15.06

12.45


(a) Starting in the first quarter of 2004, the impact of swap contracts were included, with notional amounts totaling $430 million of receive-fixed, pay-3-month Libor variable interest, which serve as a permitted hedge against a portion of our FHLB advances.

          Our junior subordinated debentures with a principal amount of $124 million are payable by Downey Financial Corp. to Downey Financial Capital Trust I ("Trust"), a wholly owned special purpose entity. On July 23, 1999, we issued through the Trust $120 million in 10.00% capital securities. The capital securities, which were sold in a public underwritten offering, pay quarterly cumulative cash distributions at an annual rate of 10.00% of the liquidation value of $25 per share. The capital securities represent undivided beneficial interests in the Trust. We own all of the issued and outstanding common securities of the Trust aggregating $4 million and reported them separately on our balance sheet. Proceeds from the offering and from the issuance of common securities were invested by the Trust in the junior subordinated debentures issued by Downey Financial Corp. The sole asset of the Trust is the junior subordinated debentures. The debentures carry an interest rate of 10.00% and are due September 15, 2029. We may redeem, in whole or in part, the junior subordinated debentures before their maturity at a redemption price of 100% of their principal amount plus accrued and unpaid interest on or after July 23, 2004. If we elect to shorten the maturity of the junior subordinated debentures, we will also cause the capital securities to be redeemed on an earlier maturity date. We fully and unconditionally guaranteed the obligations of the Trust with respect to the securities. The payment of distributions on the capital securities may be deferred if we defer payments of interest on the junior subordinated debentures. We will have the right, on one or more occasions, to defer payments of interest on the junior subordinated debentures for up to 20 consecutive quarterly periods. During the time we defer interest payments, interest on the junior subordinated debentures will continue to accrue and distributions on the capital securities will continue to accumulate and the deferred interest and deferred distributions will themselves accrue interest at an annual rate of 10.00%, compounded quarterly, to the extent permitted by applicable law.

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Off-Balance Sheet Arrangements

          We consolidate majority-owned subsidiaries that we control. We account for other affiliates, including joint ventures, in which we do not exhibit significant control or have majority ownership, by the equity method of accounting. For those relationships in which we own less than 20%, we generally carry them at cost. In the course of our business, we participate in real estate joint ventures through our wholly-owned subsidiary, DSL Service Company. Our real estate joint ventures do not require consolidation as a result of applying the provisions of the recently issued Financial Accounting Standards Board Interpretation 46 (revised December 2003).

          We also utilize financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to originate fixed and variable rate mortgage loans held for investment, undisbursed loan funds, lines of credit and letters of credit, commitments to purchase loans and mortgage-backed securities for our portfolio. The contract or notional amounts of these instruments reflect the extent of involvement we have in particular classes of financial instruments. For further information regarding these commitments, see Asset/Liability Management and Market Risk on page 34 and Note 3 of Notes to the Consolidated Financial Statements on page 7.

          We use the same credit policies in making commitments to originate or purchase loans, lines of credit and letters of credit as we do for on-balance sheet instruments. For commitments to originate loans held for investment, the contract amounts represent exposure to loss from market fluctuations as well as credit loss. In regard to these commitments, adverse changes from market fluctuations are generally not hedged. We control the credit risk of our commitments to originate loans held for investment through credit approvals, limits and monitoring procedures.

          We do not dispose of troubled loans or problem assets by means of unconsolidated special purpose entities.

Transactions with Related Parties

          There are no related party transactions required to be disclosed in accordance with FASB Statement No. 57, Related Party Disclosures. Loans to our executive officers and directors were made in the ordinary course of business and on substantially the same terms as comparable transactions.

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Asset/Liability Management and Market Risk

          Market risk is the risk of loss from adverse changes in market prices and interest rates. Our market risk arises primarily from interest rate risk in our lending and deposit taking activities. Interest rate risk primarily occurs to the degree that our interest-bearing liabilities reprice or mature on a different basis—generally more rapidly—than our interest-earning assets. Since our earnings depend primarily on our 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, our principal objectives are to actively monitor and manage the effects of adverse changes in interest rates on net interest income while maintaining asset quality. Our primary strategy to manage interest rate risk is to emphasize the origination of adjustable rate mortgages or loans with relatively short maturities. Interest rates on adjustable rate mortgages are primarily tied to COFI, MTA, Libor and CMT. We also may execute swap contracts to change interest rate characteristics of our interest-earning assets or interest-bearing liabilities to better manage interest rate risk.

          In addition to the interest rate risk associated with our lending and deposit taking activities, we also have market risk associated with our secondary marketing activities. Changes in mortgage interest rates, primarily fixed rate mortgages, impact the fair value of loans held for sale as well as our interest rate lock commitment derivatives, where we have committed to an interest rate with a potential borrower for a loan we intend to sell. Our objective is to hedge against fluctuations in interest rates through use of forward sale and purchase contracts with government-sponsored enterprises and whole loan sale contracts with various parties. These contracts are typically obtained at the time the interest rate lock commitments are made. Therefore, as interest rates fluctuate, the changes in the fair value of our interest rate lock commitments and loans held for sale tend to be offset by changes in the fair value of the hedge contracts. We continue to hedge as previously done before the issuance of SFAS 133. As applied to our risk management strategies, SFAS 133 may increase or decrease reported net income and stockholders’ equity, depending on interest rates and other variables affecting the fair values of derivative instruments and hedged items, but will have no effect on the overall economics of the transactions. The method used for assessing the effectiveness of a hedging derivative, as well as the measurement approach for determining the ineffective aspects of the hedge, is established at the inception of the hedge. We generally do not enter into hedging contracts for speculative purposes.

          Changes in mortgage interest rates also impact the value of our MSRs. Rising interest rates typically result in slower prepayment speeds on the loans being serviced for others which increase the value of MSRs. Declining interest rates typically result in faster prepayment speeds which decrease the value of MSRs. During the first quarter of 2004, we implemented a partial economic hedge against future value changes in our MSRs by purchasing approximately $500 million of securities classified as available for sale. We have implemented a fairly simple hedging strategy. During periods when long-term interest rates decline, the value of our MSRs will fall and the resultant MSR valuation addition will be partially offset by securities gains. However, if long-term interest rates rise causing MSR values to improve, the securities will be in a loss position and may be sold at a loss, with the intention to reset the hedge at a higher market interest rate. Any realized loss from the securities sales will be mitigated by the favorable earnings impact associated with the recapture of any existing MSR valuation allowance. While this strategy is not constructed to be a perfect hedge, it is expected to reduce earnings volatility from changing MSR values. Over time, we may use derivatives in lieu of securities, or a combination of both, to provide an economic hedge against value changes in our MSRs. In addition, the dollar amount used as an economic hedge may vary as we reset the hedge due to changes in the volume of MSRs or their sensitivity to changes in market interest rates.

          There has been no significant change in our market risk since December 31, 2003.

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          One measure of our exposure to differential changes in interest rates between assets and liabilities is shown in the following table which sets forth the repricing frequency of our major asset and liability categories as of March 31, 2004, as well as other information regarding the repricing and maturity differences between our interest-earning assets and total deposits and borrowings in future periods. We refer to these differences as "gap." We have determined the repricing frequencies 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. We assume prepayment rates on substantially all of our loan portfolio based upon our historical loan prepayment experience and anticipated future prepayments. Repricing mechanisms on a number of our assets are subject to limitations, such as caps on the amount that interest rates and payments on our loans may adjust, and accordingly, these assets do not normally respond to changes in market interest rates as completely or rapidly as our liabilities. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if we used different assumptions or if actual experience differed from the assumptions set forth.

March 31, 2004


Within

7 – 12

1 – 5

6 – 10

Over

Total

(Dollars in Thousands)

6 Months

Months

Years

Years

10 Years

Balance


Interest-earning assets:

Investment securities and stock(a)

$

307,699

$

10,148

$

163,540

$

517,293

$

3,711

$

1,002,391

Loans and mortgage-backed securities:(b)

Loans secured by real estate:

Residential:

Adjustable

9,443,540

382,839

1,211,640

-

-

11,038,019

Fixed

278,270

21,563

37,248

1,703

805

339,589

Commercial real estate

27,442

5,057

7,513

543

-

40,555

Construction

39,128

-

-

-

-

39,128

Land

7

7

51

556

-

621

Non-mortgage loans:

Commercial

2,695

-

-

-

-

2,695

Consumer

131,212

730

1,222

-

-

133,164

Mortgage-backed securities

327

-

-

-

-

327


Total loans and mortgage-backed securities

9,922,621

410,196

1,257,674

2,802

805

11,594,098


Total interest-earning assets

$

10,230,320

$

420,344

$

1,421,214

$

520,095

$

4,516

$

12,596,489


Transaction accounts:

Non-interest-bearing checking

$

489,213

$

-

$

-

$

-

$

-

$

489,213

Interest-bearing checking(c)

542,963

-

-

-

-

542,963

Money market (d)

142,092

-

-

-

-

142,092

Regular passbook (d)

3,898,369

-

-

-

-

3,898,369


Total transaction accounts

5,072,637

-

-

-

-

5,072,637

Certificates of deposit(e)

1,069,816

664,248

2,010,472

-

-

3,744,536


Total deposits

6,142,453

664,248

2,010,472

-

-

8,817,173

FHLB advances and other borrowings

1,781,107

399,100

722,050

33,144

-

2,935,401

Junior subordinated debentures

-

-

-

-

123,711

123,711

Impact of swap contracts hedging borrowings

430,000

-

(430,000

)

-

-

-


Total deposits and borrowings

$

8,353,560

$

1,063,348

$

2,302,522

$

33,144

$

123,711

$

11,876,285


Excess (shortfall) of interest-earning assets over

deposits and borrowings

$

1,876,760

$

(643,004

)

$

(881,308

)

$

486,951

$

(119,195

)

$

720,204

Cumulative gap

1,876,760

1,233,756

352,448

839,399

720,204

Cumulative gap–as a percentage of total assets:

March 31, 2004

13.88

%

9.12

%

2.61

%

6.21

%

5.32

%

December 31, 2003

14.95

13.42

6.95

6.76

5.74

March 31, 2003

19.10

14.94

10.02

6.26

5.23


(a) Includes FHLB stock and Investment in Downey Financial Capital Trust I. Based upon contractual maturity and repricing date.
(b) Based upon contractual maturity, repricing date and projected repayment and prepayments of principal.
(c) Included amounts swept into money market deposit accounts and is subject to immediate repricing.
(d) Subject to immediate repricing.
(e) Based upon contractual maturity and repricing date.
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          Our six-month gap at March 31, 2004 was a positive 13.88%. This means that more interest-earning assets mature or reprice within six months than total deposits and borrowings. This compares to a positive six-month gap of 14.95% at December 31, 2003 and 19.10% a year ago.

          We continue to pursue our strategy of emphasizing the origination of adjustable rate mortgages for our investment portfolio. For the twelve months ended March 31, 2004, we originated and purchased for investment $6.2 billion of adjustable rate loans which represented essentially all of the loans we originated and purchased for investment during the period.

          At March 31, 2004, 96% of our interest-earning assets mature, reprice or are estimated to prepay within five years, compared to essentially all at both December 31, 2003 and March 31, 2003. At March 31, 2004, $10.9 billion or 99% of our loans held for investment and mortgage-backed securities portfolios consisted of adjustable rate loans and loans with a due date of five years or less, compared to $10.0 billion or 99% at December 31, 2003, and $9.8 billion or 98% a year ago. During the current quarter, we continued to offer residential fixed rate loan products to our customers primarily for sale in the secondary market. We price and originate fixed rate mortgage loans for sale into the secondary market to increase opportunities to originate adjustable rate mortgages and to generate fees and servicing income. We also originate a small number of fixed rate loans for portfolio to facilitate the sale of real estate acquired in settlement of loans and which meet specific yield and other approved guidelines.

          The following table sets forth the interest rate spread between our interest-earning assets and interest-bearing liabilities at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

2004

2003

2003

2003

2003


Weighted average yield: (a)

Loans and mortgage-backed securities

4.51

%

4.61

%

4.98

%

5.24

%

5.53

%

Federal Home Loan Bank stock

3.85

4.18

4.34

4.80

5.31

Trading and investment securities

3.44

3.02

2.63

2.32

2.34


Interest-earning assets yield

4.43

4.51

4.84

5.08

5.46


Weighted average cost:

Deposits

1.56

1.52

1.64

1.81

2.01

Borrowings:

Securities sold under agreements to repurchase

0.45

-

-

-

-

Federal Home Loan Bank advances (b)

2.44

3.08

4.42

3.68

4.50

Real estate notes

6.63

6.63

6.63

6.63

-

Junior subordinated debentures

10.00

10.00

10.00

10.00

10.00


Total borrowings

2.43

3.46

4.92

4.12

4.98


Combined funds cost

1.78

1.94

2.09

2.20

2.42


Interest rate spread

2.65

%

2.57

%

2.75

%

2.88

%

3.04

%


(a) Excludes adjustments for non-accrual loans, amortization of net deferred costs to originate loans, amortization of premiums and accretion of discounts.
(b) Starting in the first quarter of 2004, the impact of swap contracts were included, with notional amounts totaling $430 million of receive-fixed, pay-3-month Libor variable interest, which serve as a permitted hedge against a portion of our FHLB advances.

 

          The period-end weighted average yield on our loan portfolio declined to 4.51% at March 31, 2004, down from 4.61% at December 31, 2003 and 5.53% at March 31, 2003. At March 31, 2004, our adjustable rate mortgage portfolio of single family residential loans, including mortgage-backed securities, totaled $10.9 billion with a weighted average rate of 4.42%, compared to $9.8 billion with a weighted average rate of 4.55% at December 31, 2003, and $9.7 billion with a weighted average rate of 5.44% at March 31, 2003.

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Problem Loans and Real Estate

Non-Performing Assets

          Non-performing assets consist of loans on which we have ceased accruing interest (which we refer to as non-accrual loans), loans restructured at a below market rate, real estate acquired in settlement of loans and repossessed automobiles. Our non-performing assets increased $5 million during the current quarter to $54 million or 0.40% of total assets. The increase was primarily in our prime residential loan category.

          The following table summarizes our non-performing assets at the dates indicated.

March 31,

December 31,

September 30,

June 30,

March 31,

(Dollars in Thousands)

2004

2003

2003

2003

2003


Non-accrual loans:

Residential one-to-four units

$

31,037

$

26,325

$

32,430

$

29,758

$

34,426

Residential one-to-four units – subprime

16,846

15,980

22,101

26,568

30,086

Other

516

523

576

646

683


Total non-accrual loans

48,399

42,828

55,107

56,972

65,195

Real estate acquired in settlement of loans

5,189

5,803

7,436

9,464

10,205

Repossessed automobiles

7

-

15

3

-


Total non-performing assets

$

53,595

$

48,631

$

62,558

$

66,439

$

75,400


Allowance for loan losses:

Amount

$

32,072

$

30,330

$

30,770

$

32,247

$

33,103

As a percentage of non-performing loans

66.27

%

70.82

%

55.84

%

56.60

%

50.78

%

Non-performing assets as a percentage of total assets

0.40

0.42

0.56

0.56

0.66


Delinquent Loans

          Loans delinquent 30 days or more as a percentage of total loans was 0.52% at March 31, 2004, down from 0.59% at December 31, 2003 and 0.80% a year ago. The decline from a year ago primarily occurred in our residential one-to-four units category.

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          The following table indicates the amounts of our past due loans at the dates indicated.

March 31, 2004

December 31, 2003


30-59

60-89

90+

30-59

60-89

90+

(Dollars in Thousands)

Days

Days

Days (a)

Total

Days

Days

Days (a)

Total


Loans secured by real estate:

Residential:

One-to-four units

$

13,066

$

4,805

$

23,995

$

41,866

$

15,501

$

7,244

$

20,081

$

42,826

One-to-four units – subprime

3,458

3,852

10,279

17,589

6,084

2,801

9,283

18,168

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

16,524

8,657

34,274

59,455

21,585

10,045

29,364

60,994

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

5

14

8

27

34

4

7

45

Other consumer

221

12

80

313

41

22

88

151


Total delinquent loans

$

16,750

$

8,683

$

34,790

$

60,223

$

21,660

$

10,071

$

29,887

$

61,618


Delinquencies as a percentage of total loans

0.14

%

0.08

%

0.30

%

0.52

%

0.20

%

0.10

%

0.29

%

0.59

%


September 30, 2003

June 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

14,942

$

5,246

$

26,259

$

46,447

$

17,488

$

5,482

$

23,500

$

46,470

One-to-four units – subprime

5,582

4,813

12,961

23,356

4,785

4,350

18,302

27,437

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

20,524

10,059

39,220

69,803

22,273

9,832

41,802

73,907

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

24

20

36

80

94

18

44

156

Other consumer

42

29

112

183

77

16

174

267


Total delinquent loans

$

20,590

$

10,108

$

39,796

$

70,494

$

22,444

$

9,866

$

42,448

$

74,758


Delinquencies as a percentage of total loans

0.21

%

0.10

%

0.40

%

0.71

%

0.21

%

0.09

%

0.39

%

0.69

%


March 31, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

18,566

$

7,771

$

26,054

$

52,391

One-to-four units – subprime

7,835

6,943

17,496

32,274

Five or more units

-

-

-

-

Commercial real estate

-

-

-

-

Construction

-

-

-

-

Land

-

-

-

-


Total real estate loans

26,401

14,714

43,550

84,665

Non-mortgage:

Commercial

-

-

428

428

Automobile

158

23

15

196

Other consumer

141

70

240

451


Total delinquent loans

$

26,700

$

14,807

$

44,233

$

85,740


Delinquencies as a percentage of total loans

0.25

%

0.14

%

0.41

%

0.80

%


(a) All 90 day or greater delinquencies are on non-accrual status and reported as part of non-performing assets.
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Allowance for Losses on Loans and Real Estate

          We maintain a valuation allowance for losses on loans and real estate to provide for losses inherent in those portfolios. Management evaluates the adequacy of the allowance quarterly to maintain the allowance at levels sufficient to provide for inherent losses.

          We use an internal asset review system and loss allowance methodology to provide for timely recognition of problem assets and adequate general valuation allowances to cover asset losses. The amount of the allowance is based upon the total of general valuation allowances, allocated allowances and an unallocated allowance. General valuation allowances relate to assets with no well-defined deficiency or weakness and take into consideration losses that are imbedded within the portfolio but have not yet been realized. Allocated allowances relate to assets with well-defined deficiencies or weaknesses. Included in these allowances are those amounts associated with assets where it is probable that the value of the asset has been impaired and the loss can be reasonably estimated. If we determine our carrying value of the asset exceeds the net fair value and no alternative payment source exists, then a specific allowance i s recorded for the amount of that difference. The unallocated allowance is more subjective and is reviewed quarterly to take into consideration estimation errors and economic trends that are not necessarily captured in determining the general valuation and allocated allowances.

          Allowances for losses on all assets were $34 million at March 31, 2004, compared to $32 million at December 31, 2003, and $34 million a year ago.

          In the current quarter, our provision for loan losses was $1.8 million and net loan charge-offs totaled $0.1 million, resulting in an increase in the allowance for loan losses to $32 million at March 31, 2004. The current quarter increase in the allowance reflected an increase of $1.8 million in the general valuation allowance due to an increase in the loan portfolio. There was no change in our unallocated allowance of $2.8 million.

          The following table summarizes the activity in our allowance for loan losses for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Balance at beginning of period

$

30,330

$

30,770

$

32,247

$

33,103

$

34,999

Provision (reduction)

1,804

(281

)

(1,104

)

(624

)

(1,709

)

Charge-offs

(96

)

(334

)

(378

)

(236

)

(191

)

Recoveries

34

175

5

4

4


Balance at end of period

$

32,072

$

30,330

$

30,770

$

32,247

$

33,103


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          The following table presents gross charge-offs, gross recoveries and net charge-offs by category of loan for the periods indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(Dollars in Thousands)

2004

2003

2003

2003

2003


Gross loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

$

45

$

112

$

203

$

130

$

17

One-to-four units – subprime

-

182

85

39

82

Five or more units

-

-

-

-

-

Commercial real estate

-

-

-

-

-

Construction

-

-

-

-

-

Land

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

20

Automobile

10

1

35

8

10

Other consumer

41

39

55

59

62


Total gross loan charge-offs

96

334

378

236

191


Gross loan recoveries

Loans secured by real estate:

Residential:

One-to-four units

-

164

-

-

-

One-to-four units – subprime

25

-

-

-

-

Five or more units

-

-

-

-

-

Commercial real estate

-

-

-

-

-

Construction

-

-

-

-

-

Land

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

Automobile

5

1

1

1

1

Other consumer

4

10

4

3

3


Total gross loan recoveries

34

175

5

4

4


Net loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

45

(52

)

203

130

17

One-to-four units – subprime

(25

)

182

85

39

82

Five or more units

-

-

-

-

-

Commercial real estate

-

-

-

-

-

Construction

-

-

-

-

-

Land

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

20

Automobile

5

-

34

7

9

Other consumer

37

29

51

56

59


Total net loan charge-offs

$

62

$

159

$

373

$

232

$

187


Net loan charge-offs as a

percentage of average loans

-

%

0.01

%

0.01

%

0.01

%

0.01

%


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          The following table indicates our allocation of the allowance for loan losses to the various categories of loans at the dates indicated.

March 31, 2004

December 31, 2003

September 30, 2003


Gross

Allowance

Gross

Allowance

Gross

Allowance

Loan

Percentage

Loan

Percentage

Loan

Percentage

Portfolio

to Loan

Portfolio

to Loan

Portfolio

to Loan

(Dollars in Thousands)

Allowance

Balance

Balance

Allowance

Balance

Balance

Allowance

Balance

Balance


Loans secured by real estate:

Residential:

One-to-four units

$

18,507

$

9,619,830

0.19

%

$

17,040

$

8,737,471

0.20

%

$

17,174

$

8,261,890

0.21

%

One-to-four units – subprime

5,847

1,022,072

0.57

5,382

988,039

0.54

6,123

1,050,209

0.58

Five or more units

759

101,196

0.75

697

92,928

0.75

615

81,991

0.75

Commercial real estate

1,049

42,314

2.48

1,127

49,286

2.29

1,160

52,440

2.21

Construction

1,045

88,676

1.18

1,257

105,706

1.19

1,082

90,233

1.20

Land

18

1,587

1.13

209

16,855

1.24

235

18,931

1.24

Non-mortgage:

Commercial

460

5,150

8.93

460

4,975

9.25

461

5,235

8.81

Automobile

51

2,816

1.81

38

3,823

0.99

42

5,085

0.83

Other consumer

1,536

130,549

1.18

1,320

95,319

1.38

1,078

70,593

1.53

Not specifically allocated

2,800

-

-

2,800

-

-

2,800

-

-


Total loans held for investment

$

32,072

$

11,014,190

0.29

%

$

30,330

$

10,094,402

0.30

%

$

30,770

$

9,636,607

0.32

%


June 30, 2003

March 31, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

17,447

$

8,544,276

0.20

%

$

17,553

$

8,442,914

0.21

%

One-to-four units – subprime

7,315

1,196,162

0.61

7,965

1,300,418

0.61

Five or more units

324

43,255

0.75

160

21,340

0.75

Commercial real estate

1,171

53,031

2.21

1,226

58,143

2.11

Construction

1,256

105,858

1.19

1,197

100,767

1.19

Land

250

20,090

1.24

498

39,962

1.25

Non-mortgage:

Commercial

504

6,493

7.76

564

14,922

3.78

Automobile

94

6,959

1.35

82

9,165

0.89

Other consumer

1,086

68,012

1.60

1,058

61,744

1.71

Not specifically allocated

2,800

-

-

2,800

-

-


Total loans held for investment

$

32,247

$

10,044,136

0.32

%

$

33,103

$

10,049,375

0.33

%


          At March 31, 2004, the recorded investment in loans for which we recognized impairment totaled $12 million, unchanged from December 31, 2003 but down from $13 million a year ago. The allowance for losses related to these loans was $1 million at March 31, 2004, December 31, 2003 and March 31, 2003. During the current quarter, total interest recognized on the impaired loan portfolio was $0.3 million.

          The following table summarizes the activity in our allowance for loan losses associated with impaired loans for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Balance at beginning of period

$

709

$

711

$

716

$

720

$

725

Reduction

(5

)

(2

)

(5

)

(4

)

(5

)

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

704

$

709

$

711

$

716

$

720


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          The following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the quarters indicated.

Three Months Ended


March 31,

December 31,

September 30,

June 30,

March 31,

(In Thousands)

2004

2003

2003

2003

2003


Balance at beginning of period

$

1,436

$

1,436

$

1,096

$

949

$

908

Provision

-

-

340

147

41

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

1,436

$

1,436

$

1,436

$

1,096

$

949


Capital Resources and Liquidity

          Our sources of funds include deposits, advances from the FHLB and other borrowings; proceeds from the sale of loans, mortgage-backed securities and real estate; payments of loans and mortgage-backed securities and payments for and sales of loan servicing; and income from other investments. Interest rates, real estate sales activity and general economic conditions significantly affect repayments on loans and mortgage-backed securities and deposit inflows and outflows.

          Our primary sources of funds generated in the first quarter of 2004 were from:

          We used these funds to:

          Our principal source of liquidity is our ability to utilize borrowings, as needed. Our primary source of borrowings is from the FHLB. At March 31, 2004, our FHLB borrowings totaled $2.4 billion, representing 17.9% of total assets. We currently are approved by the FHLB to borrow up to 50% of total assets to the extent we provide qualifying collateral and hold sufficient FHLB stock. That approved limit would have permitted us, as of quarter end, to borrow an additional $4.3 billion. To the extent deposit growth over the remainder of 2004 falls short of satisfying ongoing commitments to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans, make investments, and continue branch improvement programs, we may utilize our FHLB borrowing arrangement or other sources. As of March 31, 2004, we had commitments to borrowers for short-term rate locks, excluding expected fallout, of $1.2 billion, undisbursed loan funds and unused lines of credit of $282 million, operating leases of $17 million, commitments to invest in affordable housing funds of $3 million and commitments to purchase loans of $0.5 million. We believe our current sources of funds, including repayments of existing loans, enable us to meet our obligations while maintaining liquidity at appropriate levels.

          The holding company currently has adequate liquid assets to meet its obligations and can obtain further funds by means of dividends from subsidiaries, subject to certain limitations, or issuance of further debt or equity. At March 31, 2004, the holding company’s liquid assets, including due from Bank—interest bearing balances, totaled $70 million.

          Stockholders’ equity totaled $925 million at March 31, 2004, up from $917 million at December 31, 2003 and $852 million a year ago.

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Contractual Obligations and Other Commitments

          Through the normal course of operations, we have entered into certain contractual obligations and other commitments. Our obligations generally relate to funding of our operations through deposits and borrowings as well as leases for premises and equipment, and our commitments generally relate to our lending operations.

          We have obligations under long-term operating leases, principally for building space and land. Lease terms generally cover a five-year period, with options to extend, and are non-cancelable. Currently, we have no significant contractual vendor obligations.

          Our 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 commitment. Undisbursed loan funds and unused lines of credit include funds not disbursed, but committed to construction projects and home equity and commercial lines of credit. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party.

          Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments 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. We evaluate each customer’s creditworthiness.

          We receive 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 us.

          We enter into derivative financial instruments as part of our interest rate risk management process, including forward sale and purchase contracts related to our sale of loans in the secondary market as well as interest rate swap contracts. The associated fair value changes to the notional amount of the derivative instruments are recorded on-balance sheet. The total notional amount of our derivative financial instruments do not necessarily represent future cash requirements. For further information regarding our derivative instruments and swap contracts, see Asset/Liability Management and Market Risk on page 34 and Note 3 of Notes to the Consolidated Financial Statements on page 7.

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          At March 31, 2004, scheduled maturities of certificates of deposit, FHLB advances and junior subordinated debentures, secondary marketing activities, fair value hedges, loans held for investment, future operating minimum lease commitments and other contractual obligations were as follows:

Within

1 – 3

4 – 5

Over

Total

(In Thousands)

1 Year

Years

Years

5 Years

Balance


Certificates of deposit

$

1,734,064

$

1,627,447

$

383,025

$

-

$

3,744,536

FHLB advances and other borrowings

2,180,207

292,050

430,000

33,144

2,935,401

Junior subordinated debentures (a)

-

-

-

123,711

123,711

Secondary marketing activities:

Non-qualifying hedge transactions:

Expected rate lock commitments

441,747

-

-

-

441,747

Associated forward sale contracts

429,066

-

-

-

429,066

Associated forward purchase contracts

4,000

-

-

-

4,000

Qualifying cash flow hedge transactions:

Loans held for sale, at lower of cost or fair value

529,085

-

-

-

529,085

Associated forward sale contracts

509,710

-

-

-

509,710

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed

-

-

430,000

-

430,000

Associated interest rate swap contracts –

pay-variable, receive-fixed

-

-

430,000

-

430,000

Commitments to originate loans held for investment:

Adjustable

650,948

-

-

-

650,948

Commitments to purchase loans

495

-

-

-

495

Undisbursed loan funds and unused lines of credit

41,725

5,403

-

234,693

281,821

Operating leases

4,561

7,494

3,610

1,257

16,922

Commitments to invest in affordable housing funds

-

-

-

3,090

3,090


Total obligations and commitments

$

6,525,608

$

1,932,394

$

1,676,635

$

395,895

$

10,530,532


(a) These securities may be called at our option beginning in July of 2004.

Regulatory Capital Compliance

          Our core and tangible capital ratios were both 6.90% and our risk-based capital ratio was 13.36% at March 31, 2004. The Bank’s capital ratios exceed the "well capitalized" standards of 5.00% for core capital and 10.00% for risk-based capital, as defined by regulation.

          The following table is a reconciliation of the Bank’s stockholder’s equity to federal regulatory capital as of March 31, 2004.

Tangible Capital

Core Capital

Risk-Based Capital


(Dollars in Thousands)

Amount

Ratio

Amount

Ratio

Amount

Ratio


Stockholder’s equity

$

969,479

$

969,479

$

969,479

Adjustments:

Deductions:

Investment in subsidiary, primarily real estate

(29,688

)

(29,688

)

(29,688

)

Excess cost over fair value of branch acquisitions

(3,150

)

(3,150

)

(3,150

)

Non-permitted mortgage servicing rights

(6,972

)

(6,972

)

(6,972

)

Unrealized gains on securities available for sale

(1,753

)

(1,753

)

(1,753

)

Additions:

General loss allowance – investment in DSL

Service Company

730

730

730

Allowance for loan losses,

net of specific allowances (a)

-

-

31,554


Regulatory capital

928,646

6.90

%

928,646

6.90

%

960,200

13.36

%

Well capitalized requirement

201,986

1.50

(b)

673,286

5.00

718,516

10.00

(c)


Excess

$

726,660

5.40

%

$

255,360

1.90

%

$

241,684

3.36

%


(a) Limited to 1.25% of risk-weighted assets.
(b) Represents the minimum requirement for tangible capital, as no "well capitalized" requirement has been established for this category.
(c) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%, which the Bank met and exceeded with a ratio of 12.92%.
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ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

          For information regarding quantitative and qualitative disclosures about market risk, see Asset/Liability Management and Market Risk on page 34.

 

ITEM 4. – CONTROLS AND PROCEDURES

          As of March 31, 2004, Downey carried out an evaluation, under the supervision and with the participation of Downey’s management, including Downey’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Downey’s disclosure controls and procedures pursuant to Securities and Exchange Commission ("SEC") rules. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that Downey’s disclosure controls and procedures are effective in timely alerting them to material information relating to Downey, which is required to be included in Downey’s periodic SEC filings. There has been no significant changes in Downey’s internal controls or in other factors that could significantly affect these controls subsequent to the evaluation date.

          Disclosure controls and procedures are defined in SEC rules as controls and other procedures designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Downey’s disclosure controls and procedures were designed to ensure that material information related to Downey, including subsidiaries, is made known to management, including the Chief Executive Officer and Chief Financial Officer, in a timely manner.

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PART II – OTHER INFORMATION

ITEM 1 – Legal Proceedings

          We have 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 2 – Changes in Securities and Use of Proceeds

          On July 24, 2002, the Board of Directors of Downey authorized a share repurchase program of up to $50 million of our common stock. To fund this program, the Bank paid a special $50 million dividend during the third quarter of 2002 to the holding company. The shares are being repurchased from time-to-time in open market transactions. The timing, volume and price of purchases will be made at our discretion, and will also be contingent upon our overall financial condition, as well as market conditions in general. There have been no shares repurchased since the fourth quarter of 2002 and, at March 31, 2004, $38 million of the original authorization remains available for future purchases.

           During the first quarter of 2004, 25,025 options were exercised resulting in the reissuance of the same amount of treasury stock shares at a weighted average price of $18.92 per share.

ITEM 3 – Defaults Upon Senior Securities

          None.

ITEM 4 – Submission of Matters to a Vote of Security Holders

          None.

ITEM 5 – Other Information

          None.

ITEM 6 – Exhibits and Reports on Form 8-K

(A)          Exhibits

Exhibit

Number

Description


10.17

Director Retirement Benefits (Revised).

31.1

Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1

Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2

Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002.


(B)          Reports on Form 8-K

          1) Form 8-K filed January 16, 2004, with respect to a press release reporting its results of operations during the three and twelve months ended December 31, 2003.

          2) Form 8-K filed January 23, 2004, with respect to a press release announcing the appointment of Marangal I. Domingo, President and Chief Executive Officer.

          3) Form 8-K filed February 18, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended January 31, 2004.

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(B)          Reports on Form 8-K (Continued)

          4) Form 8-K filed March 16, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended February 29, 2004.

          5) Form 8-K filed March 23, 2004, with respect to a press release announcing five branch relocations due to Ralphs’ store closures.

AVAILABILITY OF REPORTS

          Corporate governance guidelines, charters for the audit, compensation, and nominating and corporate governance committees of the Board of Directors and codes of business conduct and ethics are available free of charge from our internet site, www.downeysavings.com by clicking on "Investor Relations" on our home page and proceeding to "Corporate Governance." Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are posted on our internet site as soon as reasonably practical after we file them with the SEC and available free of charge under "Corporate Filings" on our "Investor Relations" page.

          We 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.

/s/ Marangal I. Domingo


Date: May 3, 2004

Marangal I. Domingo

President and Chief Executive Officer

/s/ Thomas E. Prince


Date: May 3, 2004

Thomas E. Prince

Executive Vice President and Chief Financial Officer


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NAVIGATION   LINKS

FORM 10-Q COVER

PART I

ITEM 1. – FINANCIAL INFORMATION

ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITME 4. – CONTROLS AND PROCEDURES

PART II – OTHER INFORMATION

ITEM 1. – Legal Proceedings

ITEM 2. – Changes in Securities and Use of Proceeds

ITEM 3. – Defaults Upon Senior Securities

ITEM 4. – Submission of Matters to a Vote of Security Holders

ITEM 5. – Other Information

ITEM 6. – Exhibits and Reports on Form 8-K

AVAILABILITY OF REPORTS

SIGNATURES