Securities and Exchange Commission Form 10-Q dated June 30, 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 June 30, 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     

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes  X    No     

          At June 30, 2004, 27,968,283 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.


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DOWNEY FINANCIAL CORP.

JUNE 30, 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           

15

ITEM 3. –

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK           

47

ITEM 4. –

CONTROLS AND PROCEDURES           

47

PART II

ITEM 1. –

LEGAL PROCEEDINGS           

48

ITEM 2. –

CHANGES IN SECURITIES AND USE OF PROCEEDS           

48

ITEM 3. –

DEFAULTS UPON SENIOR SECURITIES           

48

ITEM 4. –

SUBMISSION OF MATTERS TO A VOTE OF SECURITIY HOLDERS           

48

ITEM 5. –

OTHER INFORMATION           

48

ITEM 6. –

EXHIBITS AND REPORTS ON FORM 8-K           

49

AVAILABILITY OF REPORTS           

49

SIGNATURES           

50


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PART I

ITEM 1. – FINANCIAL INFORMATION

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

June 30,

December 31,

June 30,

(Dollars in Thousands, Except Per Share Data)

2004

2003

2003


Assets

Cash

$

126,361

$

111,667

$

136,423

Federal funds

-

1,500

89,210


Cash and cash equivalents

126,361

113,167

225,633

Trading securities, at fair value

-

-

201,781

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

securities available for sale, at fair value

630,785

690,347

276,971

Municipal securities held to maturity, at amortized cost (estimated

fair value of $6,135 at June 30, 2003)

-

-

6,148

Loans and securities purchased under resale agreements

-

-

60,000

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

661,481

279,657

721,929

Mortgage-backed securities available for sale, at fair value

321

334

1,736

Loans receivable held for investment

12,309,935

10,116,519

10,049,361

Investments in real estate and joint ventures

31,517

35,716

36,297

Real estate acquired in settlement of loans

2,424

5,803

9,464

Premises and equipment

107,277

110,316

113,434

Federal Home Loan Bank stock, at cost

167,797

123,089

120,517

Investment in Downey Financial Capital Trust I

3,711

3,711

3,711

Mortgage servicing rights, net

92,049

82,175

48,722

Other assets

88,689

85,146

75,573


$

14,222,347

$

11,645,980

$

11,951,277


Liabilities and Stockholders’ Equity

Deposits

$

8,948,238

$

8,293,758

$

8,895,452

Securities sold under agreements to repurchase

239,688

-

-

Federal Home Loan Bank advances

3,556,087

2,125,150

1,672,850

Real estate notes

-

4,161

3,121

Senior notes

198,179

-

-

Junior subordinated debentures

123,711

123,711

123,711

Accounts payable and accrued liabilities

88,608

63,584

303,937

Deferred income taxes

125,384

118,598

82,841


Total liabilities

13,279,895

10,728,962

11,081,912


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 June 30, 2004, December 31, 2003 and

June 30, 2003; outstanding 27,968,283 shares at June 30, 2004 and

27,928,722 shares at both December 31, 2003 and June 30, 2003

282

282

282

Additional paid-in capital

93,792

93,792

93,792

Accumulated other comprehensive income (loss)

(5,745

)

807

1,135

Retained earnings

864,704

834,307

786,326

Treasury stock, at cost, 266,739 shares at June 30, 2004 and 306,300 shares

at both December 31, 2003 and June 30, 2003

(10,581

)

(12,170

)

(12,170

)


Total stockholders’ equity

942,452

917,018

869,365


$

14,222,347

$

11,645,980

$

11,951,277


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income

Three Months Ended

Six Months Ended

June 30,

June 30,


(Dollars in Thousands, Except Per Share Data)

2004

2003

2004

2003


Interest income

Loans receivable

$

123,313

$

130,884

$

238,843

$

273,373

U.S. Treasury securities and agency obligations

6,332

1,886

10,396

5,023

Mortgage-backed securities

3

19

6

35

Other investments

1,594

1,485

2,792

3,140


Total interest income

131,242

134,274

252,037

281,571


Interest expense

Deposits

34,662

42,369

67,262

90,219

Federal Home Loan Bank advances and other borrowings

16,543

14,559

32,248

29,976

Senior notes

292

-

292

-

Junior subordinated debentures

3,134

3,134

6,268

6,268


Total interest expense

54,631

60,062

106,070

126,463


Net interest income

76,611

74,212

145,967

155,108

Provision for (reduction of) loan losses

1,458

(624

)

3,262

(2,333

)


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

75,153

74,836

142,705

157,441


Other income, net

Loan and deposit related fees

14,419

13,649

26,875

25,627

Real estate and joint ventures held for investment, net

7,048

2,069

7,974

3,012

Secondary marketing activities:

Loan servicing income (loss), net

13,786

(21,692

)

(459

)

(35,378

)

Net gains on sales of loans and mortgage-backed securities

15,675

12,652

17,047

32,415

Net gains on sales of mortgage servicing rights

-

18

-

23

Net gains on trading securities

-

591

-

591

Net gains (losses) on sales of investment securities

(21,271

)

-

(19,159

)

8

Litigation award

-

265

-

2,717

Other

523

938

855

1,517


Total other income, net

30,180

8,490

33,133

30,532


Operating expense

Salaries and related costs

37,575

33,028

73,144

67,154

Premises and equipment costs

8,200

7,971

16,408

15,684

Advertising expense

1,165

1,016

2,873

1,809

SAIF insurance premiums and regulatory assessments

744

825

1,501

1,656

Professional fees

356

418

724

1,046

Other general and administrative expense

9,432

8,111

17,914

16,004


Total general and administrative expense

57,472

51,369

112,564

103,353

Net operation of real estate acquired in settlement of loans

(237

)

(111

)

(309

)

186


Total operating expense

57,235

51,258

112,255

103,539


Income before income taxes

48,098

32,068

63,583

84,434

Income taxes

20,277

13,553

26,850

35,702


Net income

$

27,821

$

18,515

$

36,733

$

48,732


PER SHARE INFORMATION


Basic

$

0.99

$

0.66

$

1.31

$

1.74


Diluted

$

0.99

$

0.66

$

1.31

$

1.74


Cash dividends declared and paid

$

0.10

$

0.09

$

0.20

$

0.18


Weighted average diluted shares outstanding

27,990,588

27,970,022

27,985,565

27,968,194


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

Three Months Ended

Six Months Ended

June 30,

June 30,


(In Thousands)

2004

2003

2004

2003


Net income

$

27,821

$

18,515

$

36,733

$

48,732


Other comprehensive income (loss), net of income taxes (benefits)

Unrealized gains (losses) on securities available for sale:

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

securities available for sale, at fair value

(5,962

)

97

(6,272

)

(639

)

Mortgage-backed securities available for sale, at fair value

-

(5

)

(1

)

(12

)

Reclassification of realized amounts included in net income

158

-

158

(5

)

Unrealized gains (losses) on cash flow hedges:

Net derivative instruments

1,869

(4,437

)

2,507

(7,735

)

Reclassification of realized amounts included in net income

(3,563

)

6,059

(2,944

)

10,948


Total other comprehensive income, net of income taxes

(7,498

)

1,714

(6,552

)

2,557


Comprehensive income

$

20,323

$

20,229

$

30,181

$

51,289


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Six Months Ended

June 30,


(In Thousands)

2004

2003


Cash flows from operating activities

Net income

$

36,733

$

48,732

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

Depreciation and amortization

42,165

43,378

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

1,937

22,737

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

trading and investment securities, real estate and other assets

(4,579

)

(35,283

)

Interest capitalized on loans (negative amortization)

(4,965

)

(5,584

)

Federal Home Loan Bank stock dividends

(2,399

)

(2,954

)

Loans originated for sale

(2,206,985

)

(3,768,301

)

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

as mortgage-backed securities

1,822,422

3,724,399

Other, net

(62,748

)

(33,039

)


Net cash used for operating activities

(378,419

)

(5,915

)


Cash flows from investing activities

Proceeds from sales of:

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

available for sale

1,259,216

5,255

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

10,446

9,398

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

and other investment securities available for sale

383,746

452,630

Purchase of:

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

available for sale

(1,613,453

)

(273,618

)

Loans and securities under resale agreements

-

(60,000

)

Loans receivable held for investment

(142,995

)

(667,194

)

Federal Home Loan Bank stock

(42,309

)

-

Premises and equipment

(5,189

)

(9,022

)

Originations of loans receivable held for investment (net of refinances of $329,019, for the

six months ended June 30, 2004 and $136,471 for the six months ended June 30, 2003)

(4,146,060

)

(1,392,818

)

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

securities available for sale

2,029,626

2,343,957

Net change in undisbursed loan funds

132,137

(6,008

)

Investments in real estate held for investment

(2,916

)

(2,979

)

Other, net

922

1,907


Net cash provided by (used for) investing activities

(2,136,829

)

401,508


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

Six Months Ended

June 30,


(In Thousands)

2004

2003


Cash flows from financing activities

Net increase (decrease) in deposits

$

654,480

$

(342,898

)

Proceeds from Federal Home Loan Bank advances and other borrowings

7,815,383

6,016,721

Repayments of Federal Home Loan Bank advances and other borrowings

(6,134,856

)

(5,964,834

)

Proceeds from the issuance of senior notes

198,182

-

Proceeds from reissuance of treasury stock for exercise of stock options

843

-

Cash dividends

(5,590

)

(5,028

)


Net cash provided by (used for) financing activities

2,528,442

(296,039

)


Net increase in cash and cash equivalents

13,194

99,554

Cash and cash equivalents at beginning of period

113,167

126,079


Cash and cash equivalents at end of period

$

126,361

$

225,633


Supplemental disclosure of cash flow information:

Cash paid during the period for:

Interest

$

105,500

$

126,592

Income taxes

4,987

19,661

Supplemental disclosure of non-cash investing:

Loans transferred to held for investment from held for sale

3,940

647

Loans transferred from held for investment to held for sale

283

3,655

Loans exchanged for mortgage-backed securities

1,153,683

3,205,813

Trading and investment securities purchased and not settled

-

205,125

Real estate acquired in settlement of loans

2,508

8,532

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

98

3,171


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 normal recurring accruals unless otherwise disclosed in this Form 10-Q) necessary for a fair presentation of Downey’s financial condition as of June 30, 2004, December 31, 2003 and June 30, 2003, the results of operations and comprehensive income for the three months and six months ended June 30, 2004 and 2003, and changes in cash flows for the six months ended June 30, 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 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


June 30,

March 31,

December 31,

September 30,

June 30,

(Dollars in Thousands)

2004

2004

2003

2003

2003


Gross balance at beginning of period

$

91,766

$

95,183

$

92,665

$

89,948

$

92,178

Additions

12,074

5,968

9,091

21,660

15,405

Amortization

(4,082

)

(5,519

)

(5,001

)

(5,051

)

(9,951

)

Sales

-

-

-

-

-

Impairment write-down

(3,945

)

(3,866

)

(1,572

)

(13,892

)

(7,684

)


Gross balance at end of period

95,813

91,766

95,183

92,665

89,948


Allowance balance at beginning of period

22,045

13,008

22,265

41,226

35,672

Provision for (reduction of) impairment

(14,336

)

12,903

(7,685

)

(5,069

)

13,238

Impairment write-down

(3,945

)

(3,866

)

(1,572

)

(13,892

)

(7,684

)


Allowance balance at end of period

3,764

22,045

13,008

22,265

41,226


Total mortgage servicing rights, net

$

92,049

$

69,721

$

82,175

$

70,400

$

48,722


As a percentage of associated mortgage loans

1.00

%

0.76

%

0.89

%

0.78

%

0.55

%

Estimated fair value (a)

$

92,483

$

69,721

$

82,314

$

70,401

$

48,722

Weighted average expected life (in months)

67

49

59

50

31

Custodial account earnings rate

2.10

%

1.47

%

1.65

%

1.49

%

1.26

%

Weighted average discount rate

8.97

8.98

8.95

8.91

7.47


At period end

Mortgage loans serviced for others:

Total

$

9,279,359

$

9,167,834

$

9,313,948

$

9,125,469

$

8,980,037

With capitalized mortgage servicing rights:(a)

Amount

9,242,641

9,126,444

9,268,308

9,068,209

8,916,259

Weighted average interest rate

5.61

%

5.73

%

5.79

%

5.87

%

6.12

%


Custodial account balances

$

238,914

$

359,146

$

232,562

$

352,161

$

548,142


(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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Six Months Ended June 30,


(Dollars in Thousands)

2004

2003


Gross balance at beginning of period

$

95,183

$

90,584

Additions

18,042

30,359

Amortization

(9,601

)

(14,722

)

Sales

-

-

Impairment write-down

(7,811

)

(16,273

)


Gross balance at end of period

95,813

89,948


Allowance balance at beginning of period

13,008

32,855

Provision for (reduction of) impairment

(1,433

)

24,644

Impairment write-down

(7,811

)

(16,273

)


Allowance balance at end of period

3,764

41,226


Total mortgage servicing rights, net

$

92,049

$

48,722


          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 impacts the value of custodial accounts; and the discount rate used in valuing future cash flows. The table below 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. The table also summarizes 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

$

12,603

$

4,148

$

(3,361

)

$

12,153

Reduction of (increase in) valuation allowance

1,143

1,012

(3,029

)

1,793

Decrease rates 100 basis points: (b)

Increase (decrease) in fair value

(34,974

)

(4,277

)

3,474

(38,280

)

Reduction of (increase in) valuation allowance

(34,503

)

(3,874

)

113

(37,809

)


(a) The weighted-average expected life of the mortgage servicing rights portfolio is 81 months.
(b) The weighted-average expected life of the mortgage servicing rights portfolio is 37 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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Net cash servicing fees

$

5,615

$

5,704

$

5,681

$

5,401

$

5,117

Payoff and curtailment interest cost (a)

(2,083

)

(1,527

)

(1,597

)

(3,869

)

(3,620

)

Amortization of MSRs

(4,082

)

(5,519

)

(5,001

)

(5,051

)

(9,951

)

(Provision for) reduction of impairment

of MSRs

14,336

(12,903

)

7,685

5,069

(13,238

)


Total loan servicing income (loss), net

$

13,786

$

(14,245

)

$

6,768

$

1,550

$

(21,692

)


(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.
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Six Months Ended June 30,


(In Thousands)

2004

2003


Net cash servicing fees

$

11,319

$

10,133

Payoff and curtailment interest cost (a)

(3,610

)

(6,145

)

Amortization of MSRs

(9,601

)

(14,722

)

(Provision for) reduction of impairment of MSRs

1,433

(24,644

)


Total loan servicing loss, net

$

(459

)

$

(35,378

)


(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 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 June 30, 2004, Downey had a notional amount of expected rate lock commitments identified to sell as part of its secondary marketing activities of $541 million, with a change in fair value resulting in a gain of $0.6 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. In general, rate lock commitments associated with fixed rate loans require a higher percentage of forward sale contracts to mitigate interest rate risk than those associated with adjustable rate loans. Contracts designated as hedges for the forecasted sale of loans from the 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 June 30, 2004, the notional amount of forward sale contracts amounted to $1.027 billion, with a change in fair value resulting in a loss of $1.5 million, of which $653 million were designated as cash flow hedges. There were no forward purchase contracts at June 30, 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 Federal Home Loan Bank ("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

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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 June 30, 2004, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value loss of $14.1 million recorded on the balance sheet in other liabilities and as a decrease to the advances being hedged.

          The following table summarizes Downey’s interest rate swap contracts at June 30, 2004:

Weighted

Notional

Average

(Dollars in Thousands)

Amount

Interest Rate

Term


Pay – Variable (3-month Libor)

$

(100,000

)

1.31

%

March 2004 – October 2008

Receive – Fixed

100,000

3.20

Pay – Variable (3-month Libor)

(130,000

)

1.31

March 2004 – October 2008

Receive – Fixed

130,000

3.21

Pay – Variable (3-month Libor)

(100,000

)

1.31

March 2004 – November 2008

Receive – Fixed

100,000

3.26

Pay – Variable (3-month Libor)

(100,000

)

1.31

March 2004 – November 2008

Receive – Fixed

100,000

3.27


          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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Net gains (losses) on non-qualifying hedge transactions

$

3,352

$

(3,282

)

$

1,016

$

1,121

$

(2,936

)

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)

3,352

(3,282

)

1,016

1,121

(2,936

)

Other comprehensive income (loss)

(1,694

)

1,257

1,673

(2,424

)

1,622


Notional amount or balance at period end

Non-qualifying hedge transactions:

Expected rate lock commitments

$

541,358

$

441,747

$

163,737

$

381,948

$

950,703

Associated forward sale contracts

374,462

429,066

153,436

391,234

985,094

Associated forward purchase contracts

-

4,000

-

35,000

139,000

Qualifying cash flow hedge transactions:

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

661,481

529,085

279,657

335,437

721,929

Associated forward sale contracts

652,796

509,710

275,009

334,031

710,099

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

-

-

-


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Six Months Ended June 30,


(In Thousands)

2004

2003


Net gains (losses) on non-qualifying hedge transactions

$

70

$

(3,075

)

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)

70

(3,075

)

Other comprehensive income (loss)

(437

)

3,213


          These forward and swap contracts expose Downey to credit risk in the event of nonperformance 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 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. Downey also enters into commitments to purchase loans and mortgage-backed securities, investment securities and to invest in affordable housing funds.

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

June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Commitments to originate loans held for investment:

Adjustable

$

479,968

$

650,948

$

528,981

$

414,823

$

336,303

Fixed

-

-

-

380

235

Commitments to purchase loans

-

495

-

-

40,816

Undisbursed loan funds and unused lines of credit

372,464

281,821

240,226

178,202

183,720

Letters of credit and other contingent liabilities

-

-

-

2,703

6,044

Commitments to invest in affordable housing funds

5,226

3,090

3,153

3,393

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.

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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 June 30, 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 June 30, 2004, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, junior subordinated debentures, senior notes 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

$

2,321,889

$

1,603,524

$

281,438

$

-

$

4,206,851

FHLB advances and other borrowings

3,044,725

292,050

430,000

29,000

3,795,775

Senior notes

-

-

-

198,179

198,179

Junior subordinated debentures (a)

-

-

-

123,711

123,711

Operating leases

4,506

7,210

3,447

948

16,111


Total other contractual obligations

$

5,371,120

$

1,902,784

$

714,885

$

351,838

$

8,340,627


(a) On July 23, 2004, Downey redeemed the junior subordinated debentures before their maturity.

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 June 30, 2004, Downey had 266,739 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.

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          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 June 30,


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

$

27,821

27,962,031

$

0.99

$

18,515

27,928,722

$

0.66

Effect of dilutive stock options

-

28,557

-

-

41,300

-


Diluted earnings per share

$

27,821

27,990,588

$

0.99

$

18,515

27,970,022

$

0.66


Six Months Ended June 30,


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

$

36,733

27,953,219

$

1.31

$

48,732

27,928,722

$

1.74

Effect of dilutive stock options

-

32,346

-

-

39,472

-


Diluted earnings per share

$

36,733

27,985,565

$

1.31

$

48,732

27,968,194

$

1.74


          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 June 30, 2004

Net interest income (expense)

$

76,842

$

(231

)

$

-

$

76,611

Provision for loan losses

1,458

-

-

1,458

Other income

22,724

7,456

-

30,180

Operating expense

56,908

327

-

57,235

Net intercompany income (expense)

(43

)

43

-

-


Income before income taxes

41,157

6,941

-

48,098

Income taxes

17,431

2,846

-

20,277


Net income

$

23,726

$

4,095

$

-

$

27,821


At June 30, 2004

Assets:

Loans and mortgage-backed securities

$

12,971,737

$

-

$

-

$

12,971,737

Investments in real estate and joint ventures

-

31,517

-

31,517

Other

1,239,475

11,845

(32,227

)

1,219,093


Total assets

14,211,212

43,362

(32,227

)

14,222,347


Equity

$

942,452

$

32,227

$

(32,227

)

$

942,452


Three months ended June 30, 2003

Net interest income (expense)

$

74,232

$

(20

)

$

-

$

74,212

Reduction of loan losses

(624

)

-

-

(624

)

Other income

5,839

2,651

-

8,490

Operating expense

50,985

273

-

51,258

Net intercompany income (expense)

40

(40

)

-

-


Income before income taxes

29,750

2,318

-

32,068

Income taxes

12,605

948

-

13,553


Net income

$

17,145

$

1,370

$

-

$

18,515


At June 30, 2003

Assets:

Loans and mortgage-backed securities

$

10,773,026

$

-

$

-

$

10,773,026

Investments in real estate and joint ventures

-

36,297

-

36,297

Other

1,169,082

8,279

(35,407

)

1,141,954


Total assets

11,942,108

44,576

(35,407

)

11,951,277


Equity

$

869,365

$

35,407

$

(35,407

)

$

869,365


Real Estate

(In Thousands)

Banking

Investment

Elimination

Totals


Six months ended June 30, 2004

Net interest income (expense)

$

146,286

$

(319

)

$

-

$

145,967

Provision for loan losses

3,262

-

-

3,262

Other income

24,415

8,718

-

33,133

Operating expense

111,607

648

-

112,255

Net intercompany income (expense)

(81

)

81

-

-


Income before income taxes

55,751

7,832

-

63,583

Income taxes

23,638

3,212

-

26,850


Net income

$

32,113

$

4,620

$

-

$

36,733


Six months ended June 30, 2003

Net interest income (expense)

$

155,113

$

(5

)

$

-

$

155,108

Reduction of loan losses

(2,333

)

-

-

(2,333

)

Other income

26,470

4,062

-

30,532

Operating expense

103,091

448

-

103,539

Net intercompany income (expense)

84

(84

)

-

-


Income before income taxes

80,909

3,525

-

84,434

Income taxes

34,259

1,443

-

35,702


Net income

$

46,650

$

2,082

$

-

$

48,732


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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 Downey’s 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 June 30, 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.

NOTE (9) – Subsequent Event

Redemption of Junior Subordinated Debentures

           On July 23, 2004, Downey elected to redeem, in whole, the 10.0% junior subordinated debentures before their maturity at a redemption price of 100% of their principal amount plus accrued and unpaid interest. By shortening the maturity of the junior subordinated debentures, Downey contemporaneously caused all the outstanding capital securities and common securities held by the Downey Financial Capital Trust I, a wholly owned special purpose entity, to be redeemed. This redemption was funded from a portion of the net proceeds of a new $200 million 6.5% 10-year senior notes offering issued on June 23, 2004 and due July 1, 2014. As a result, the lower rate on the senior notes will reduce interest expense by approximately $4.2 million per year. However, Downey will incur in the third quarter of 2004 a charge of approximately $4.1 million related to the recognition of the remaining unamortized issuance cost for the capital securities.

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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 second quarter of 2004 totaled $27.8 million or $0.99 per share on a diluted basis, up 50.3% from $18.5 million or $0.66 per share in the second quarter of 2003.

          The increase in our net income between second quarters primarily reflected:

Those positive factors were partially offset by:

          For the first six months of 2004, our net income totaled $36.7 million or $1.31 per share on a diluted basis, down from $48.7 million or $1.74 per share for the first six months of 2003. The decline between six-month periods was primarily associated with lower net income from our banking operations. The decline primarily reflected an unfavorable change in securities gains/losses, lower gains from sales of loans and mortgage-backed securities, lower net interest income, higher operating expense and an unfavorable change in our provision for loan losses. Those unfavorable items were partially offset by an improvement in our loan servicing activities and higher loan and deposit related fees.

          For the second quarter of 2004, our return on average assets was 0.83%, up from 0.65% a year ago, while our return on average equity was 11.95%, up from 8.64% a year ago. For the first six-month periods, our return on average assets declined from 0.84% a year ago to 0.58%, while our return on average equity declined from 11.49% to 7.94%.

          Our loan originations, including purchases, totaled a record $3.869 billion in the second quarter of 2004, up from the $3.527 billion we originated in the second quarter of 2003. Loans originated for sale declined $882 million to $1.279 billion, while single family loans originated for portfolio increased by $1.102 billion to a quarterly record of $2.390 billion. Of the current quarter total originated for portfolio, $205 million represented subprime credits. In addition to single family loans, we originated $200 million of other loans in the quarter.

          At quarter end, our assets totaled $14.2 billion, up $2.3 billion or 19.0% from a year ago and up $2.6 billion or 22.1% from year-end 2003. During the current quarter, portfolio originations exceeded loan payoffs, resulting in an increase of $1.2 billion in our loans held for investment and our loans held for sale increased by $132 million. Those increases were

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partially offset by a decline of $241 million in our securities available for sale, as we sold a portion of the securities acquired as a partial economic hedge of our mortgage servicing rights due to changes in the price sensitivity of our mortgage servicing rights during the quarter. In addition, a decline incurred in other assets, which included a receivable at March 31, 2004, related to securities sold the last day of the first quarter for which proceeds were received the next business day.

          At June 30, 2004, our deposits totaled $8.9 billion, up 0.6% from the year-ago level and up $654 million or 7.9% since year-end 2003. During the quarter:

This brings our total branches at quarter end to 167, of which 95 were in-store. A year ago, we had 170 branches, of which 98 were in-store.

          In June 2004, we issued $200 million 6.5% 10-year senior notes. We used a portion of the net proceeds on July 23, 2004, to redeem, in whole, our 10.0% junior subordinated debentures before their maturity at a redemption price of 100% of their principal amount plus accrued and unpaid interest. By shortening the maturity of the junior subordinated debentures, we contemporaneously caused all the outstanding capital securities and common securities held by the Downey Financial Capital Trust I, a wholly owned special purpose entity, to be redeemed. In connection with our redemption of the junior subordinated debentures, we will incur in the third quarter of 2004 an after-tax charge of approximately $2.4 million. This charge represented the recognition of the remaining unamortized issuance cost for the capital securities. That charge, however, will be offset within a year due to the lower interest rate being paid on the funds that were used to redeem the junior subordinated debentures. The remaining net proceeds from the senior notes will be used for general corporate purposes, to include possible capital contributions into Downey Savings and Loan Association, F.A. (the "Bank").

          Our non-performing assets declined $14 million during the quarter to $40 million or 0.28% of total assets. The decline occurred in both our prime and subprime residential loan categories.

          At June 30, 2004, the Bank, our primary subsidiary, exceeded all regulatory capital tests, with capital-to-asset ratios of 6.68% for both tangible and core capital and 13.13% for risk-based capital. These capital levels compare favorably with 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 $76.6 million in the current quarter, up $2.4 million or 3.2% from the same period last year. The increase reflected higher interest-earning assets, which averaged $13.0 billion during the quarter, up 17.7% from the year-ago level. The effective interest rate spread averaged 2.36% in the current quarter, down from 2.70% a year ago and 2.42% in the previous quarter. The decline between second 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 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.

          For the first six months of 2004, net interest income totaled $146.0 million, down $9.1 million from a year ago. The decline was due to a lower effective interest rate spread, partially offset by higher interest-earning asset levels.

          During the latter part of the first quarter of 2004, 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 $2.2 million. For further information, see Note 3 of Notes to Consolidated Financial Statements on page 8.

          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 June 30,


2004

2003


Average

Average

Average

Average

(Dollars in Thousands)

Balance

Interest

Yield/Rate

Balance

Interest

Yield/Rate


Interest-earning assets:

Loans

$

12,120,003

$

123,313

4.07

%

$

10,517,236

$

130,884

4.98

%

Mortgage-backed securities

325

3

3.69

1,802

19

4.22

Investment and trading securities

842,703

7,926

3.78

492,782

3,371

2.74


Total interest-earning assets

12,963,031

131,242

4.05

11,011,820

134,274

4.88

Non-interest-earning assets

415,503

411,925


Total assets

$

13,378,534

$

11,423,745


Transaction accounts:

Non-interest-bearing checking

$

496,445

$

-

-

%

$

402,183

$

-

-

%

Interest-bearing checking (a)

550,258

536

0.39

439,909

283

0.26

Money market

144,344

376

1.05

127,162

355

1.12

Regular passbook

3,844,436

10,283

1.08

3,896,717

13,253

1.36


Total transaction accounts

5,035,483

11,195

0.89

4,865,971

13,891

1.15

Certificates of deposit

3,851,486

23,467

2.45

4,018,803

28,478

2.84


Total deposits

8,886,969

34,662

1.57

8,884,774

42,369

1.91

FHLB advances and other borrowings (b)

3,251,957

16,543

2.05

1,384,203

14,559

4.22

Senior notes and junior subordinated debentures (c)

141,419

3,426

9.69

123,711

3,134

10.13


Total deposits and borrowings

12,280,345

54,631

1.79

10,392,688

60,062

2.32

Other liabilities

166,886

173,451

Stockholders’ equity

931,303

857,606


Total liabilities and stockholders’ equity

$

13,378,534

$

11,423,745


Net interest income/interest rate spread

$

76,611

2.26

%

$

74,212

2.56

%

Excess of interest-earning assets over deposits and borrowings

$

682,686

$

619,132

Effective interest rate spread

2.36

2.70


Six Months Ended June 30,


Interest-earning assets:

Loans

$

11,472,856

$

238,843

4.16

%

$

10,638,317

$

273,373

5.14

%

Mortgage-backed securities

328

6

3.66

1,907

35

3.67

Investment and trading securities

751,726

13,188

3.53

515,083

8,163

3.20


Total interest-earning assets

12,224,910

252,037

4.12

11,155,307

281,571

5.05

Non-interest-earning assets

410,796

409,674


Total assets

$

12,635,706

$

11,564,981


Transaction accounts:

Non-interest-bearing checking

$

471,031

$

-

-

%

$

393,135

$

-

-

%

Interest-bearing checking (a)

534,915

996

0.37

432,860

582

0.27

Money market

142,199

740

1.05

125,678

769

1.23

Regular passbook

3,880,975

21,145

1.10

3,830,620

28,082

1.48


Total transaction accounts

5,029,120

22,881

0.91

4,782,293

29,433

1.24

Certificates of deposit

3,655,960

44,381

2.44

4,147,842

60,786

2.96


Total deposits

8,685,080

67,262

1.56

8,930,135

90,219

2.04

FHLB advances and other borrowings (b)

2,729,433

32,248

2.38

1,491,649

29,976

4.05

Senior notes and junior subordinated debentures (c)

132,565

6,560

9.90

123,711

6,268

10.13


Total deposits and borrowings

11,547,078

106,070

1.85

10,545,495

126,463

2.42

Other liabilities

163,118

171,364

Stockholders’ equity

925,510

848,122


Total liabilities and stockholders’ equity

$

12,635,706

$

11,564,981


Net interest income/interest rate spread

$

145,967

2.27

%

$

155,108

2.63

%

Excess of interest-earning assets over deposits and borrowings

$

677,832

$

609,812

Effective interest rate spread

2.39

2.78


(a) Included amounts swept into money market deposit accounts.
(b) Starting in the first quarter of 2004, the impact of interest rate swap contracts was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month LIBOR variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.
(c) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.
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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 June 30,

Six Months Ended June 30,

2004 Versus 2003

2004 Versus 2003

Changes Due To

Changes Due To


Rate/

Rate/

(In Thousands)

Volume

Rate

Volume

Net

Volume

Rate

Volume

Net


Interest income:

Loans

$

19,946

$

(23,878

)

$

(3,639

)

$

(7,571

)

$

21,444

$

(51,902

)

$

(4,072

)

$

(34,530

)

Mortgage-backed securities

(16

)

(2

)

2

(16

)

(29

)

-

-

(29

)

Investment securities

2,383

1,270

902

4,555

3,777

855

393

5,025


Change in interest income

22,313

(22,610

)

(2,735

)

(3,032

)

25,192

(51,047

)

(3,679

)

(29,534

)


Interest expense:

Transaction accounts:

Interest-bearing checking (a)

71

145

37

253

139

223

52

414

Money market

46

(22

)

(3

)

21

94

(109

)

(14

)

(29

)

Regular passbook

(179

)

(2,828

)

37

(2,970

)

366

(7,208

)

(95

)

(6,937

)


Total transaction accounts

(62

)

(2,705

)

71

(2,696

)

599

(7,094

)

(57

)

(6,552

)

Certificates of deposit

(1,201

)

(3,975

)

165

(5,011

)

(7,154

)

(10,494

)

1,243

(16,405

)


Total interest-bearing deposits

(1,263

)

(6,680

)

236

(7,707

)

(6,555

)

(17,588

)

1,186

(22,957

)

FHLB advances and other

borrowings

19,210

(7,327

)

(9,899

)

1,984

25,985

(13,007

)

(10,706

)

2,272

Senior notes and junior

subordinated debentures (b)

447

(136

)

(19

)

292

445

(143

)

(10

)

292


Change in interest expense

18,394

(14,143

)

(9,682

)

(5,431

)

19,875

(30,738

)

(9,530

)

(20,393

)


Change in net interest income

$

3,919

$

(8,467

)

$

6,947

$

2,399

$

5,317

$

(20,309

)

$

5,851

$

(9,141

)


(a) Included amounts swept into money market deposit accounts.
(b) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.

Provision for Loan Losses

          Provision for loan losses totaled $1.5 million in the current quarter, compared to a reduction in our provision for loan losses of $0.6 million in the year-ago quarter. The provision was due to growth in the loan portfolio, whereas the year-ago reversal primarily reflected an improvement in credit quality.

          For the first six months of 2004, provision for loan losses totaled $3.3 million, compared to a $2.3 million provision reduction in the year-ago period. For further information, see Allowance for Losses on Loans and Real Estate on page 41.

Other Income

          Our total other income was $30.2 million in the current quarter, compared to $8.5 million in the year-ago quarter. The $21.7 million increase between second quarters primarily reflected:

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Partially offsetting those items was a $21.9 million unfavorable change in securities gains/losses (both available for sale and trading) that we acquired as a partial economic hedge against the valuation of mortgage servicing rights.

          For the first six months of 2004, total other income was $33.1 million, up $2.6 million from a year ago. The increase from a year ago primarily reflected a reduced loss from loan servicing activities, higher income from real estate and joint ventures held for investment and higher loan and deposit related fees. Those favorable items were partially offset by an unfavorable change in securities gains/losses and lower gains from sales of loans and mortgage-backed securities.

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

Loan and Deposit Related Fees

          Loan and deposit related fees totaled $14.4 million in the current quarter, up $0.8 million from a year ago. The increase was primarily in our deposit related fees which were up $0.7 million or 10.6% 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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Loan related fees:

Prepayment fees

$

5,090

$

3,799

$

4,320

$

4,756

$

4,291

Other fees

2,215

2,000

2,117

2,863

2,925

Deposit related fees:

Automated teller machine fees

2,455

2,243

2,187

2,472

2,180

Other fees

4,659

4,414

4,420

4,314

4,253


Total loan and deposit related fees

$

14,419

$

12,456

$

13,044

$

14,405

$

13,649


          For the first six months of 2004, loan and deposit related fees totaled $26.9 million, up $1.2 million from the same period of 2003. The increase was in all categories except other loan related fees.

          The following table presents a breakdown of loan and deposit related fees during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Loan related fees:

Prepayment fees

$

8,889

$

7,704

Other fees

4,215

5,499

Deposit related fees:

Automated teller machine fees

4,698

4,266

Other fees

9,073

8,158


Total loan and deposit related fees

$

26,875

$

25,627


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Real Estate and Joint Ventures Held for Investment

          Income from our real estate and joint ventures held for investment totaled $7.0 million in the current quarter, up $5.0 million from the year-ago quarter. Net gains from sales totaled $6.2 million in the current quarter, up $5.0 million from a year ago.

          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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Rental operations, net of expenses

$

172

$

576

$

290

$

168

$

224

Net gains on sales of wholly owned real estate

5,616

40

-

2,160

1,000

Equity in net income from joint ventures

1,014

80

451

3,308

604

Interest from joint venture advances

246

230

218

568

388

Provision for losses on real estate

and joint ventures

-

-

-

(340

)

(147

)


Total income from real estate and joint ventures

held for investment, net

$

7,048

$

926

$

959

$

5,864

$

2,069


          For the first six months of 2004, income from real estate and joint ventures held for investment totaled $8.0 million, up $5.0 million from the same period of 2003. The increase primarily reflected higher gains from sales.

          The following table sets forth the key components comprising our income from real estate and joint venture operations during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Rental operations, net of expenses

$

748

$

755

Net gains on sales of wholly owned real estate

5,656

1,157

Equity in net income from joint ventures

1,094

620

Interest from joint venture advances

476

668

Provision for losses on real estate and joint ventures

-

(188

)


Total income from real estate and joint ventures held for investment, net

$

7,974

$

3,012


Secondary Marketing Activities

          We service loans for others and those activities generated income of $13.8 million in the current quarter, compared to a loss of $21.7 million in the year-ago quarter. The $35.5 million favorable change between second quarters primarily reflected a positive change associated with the valuation allowance for MSRs. The current quarter included a $14.3 million reduction of impairment, compared to a $13.2 million provision a year ago. The current quarter reduction to the valuation allowance reflected an increase in long-term mortgage interest rates, resulting in a slower projected rate at which loans we service for others are expected to prepay, thereby lengthening their average expected life. In addition, amortization of MSRs declined $5.9 million between second quarters due to a decline in prepayment speeds. Other favorable items include a decline of $1.5 million in payoff and curtailment interest costs and a $0.5 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.

          At June 30, 2004, we serviced $9.3 billion of loans for others, virtually unchanged from December 31, 2003, but up from $9.0 billion at June 30, 2003.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Net cash servicing fees

$

5,615

$

5,704

$

5,681

$

5,401

$

5,117

Payoff and curtailment interest cost (a)

(2,083

)

(1,527

)

(1,597

)

(3,869

)

(3,620

)

Amortization of MSRs

(4,082

)

(5,519

)

(5,001

)

(5,051

)

(9,951

)

(Provision for) reduction of impairment

of MSRs

14,336

(12,903

)

7,685

5,069

(13,238

)


Total loan servicing income (loss), net

$

13,786

$

(14,245

)

$

6,768

$

1,550

$

(21,692

)


(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 the first six months of 2004, a loss of $0.5 million was recorded in loan servicing, an improvement over the $35.4 million loss for the same period of 2003. The smaller loss reflected a favorable change in provision for impairment, a decline in amortization of MSRs, lower payoff and curtailment interest losses, and an increase in net cash servicing fees.

          The following table presents a breakdown of the components of our loan servicing loss during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Net cash servicing fees

$

11,319

$

10,133

Payoff and curtailment interest cost (a)

(3,610

)

(6,145

)

Amortization of MSRs

(9,601

)

(14,722

)

(Provision for) reduction of impairment of MSRs

1,433

(24,644

)


Total loan servicing loss, net

$

(459

)

$

(35,378

)


(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, see Note 2 of Notes to Consolidated Financial Statements on page 6.

          Sales of loans and mortgage-backed securities declined from $2.078 billion a year ago to $1.139 billion in the current quarter. However, net gains associated with these sales totaled $15.7 million in the current quarter, up from $12.7 million a year ago due primarily to a favorable change in the SFAS 133 impact of valuing derivatives associated with the sale of loans. Net gains in the current quarter included the capitalization of MSRs of $12.1 million, compared to $15.4 million a year ago. Excluding the impact of SFAS 133, a gain of 1.08% of secondary market sales was realized which is above 0.75% 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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Mortgage servicing rights

$

12,074

$

5,968

$

9,091

$

21,660

$

15,405

All other components excluding SFAS 133

249

(1,314

)

(4,553

)

686

183

SFAS 133

3,352

(3,282

)

1,016

1,121

(2,936

)


Total net gains on sales of loans

and mortgage-backed securities

$

15,675

$

1,372

$

5,554

$

23,467

$

12,652


Secondary marketing gain excluding SFAS

133 as a percentage of associated sales

1.08

%

0.69

%

0.48

%

1.15

%

0.75

%


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          For the first six months of 2004, sales of loans and mortgage-backed securities totaled $1.818 billion, down from $3.703 billion a year ago. Net gains associated with these sales totaled $17.0 million, $15.4 million lower than the prior year amount.

          The following table presents a breakdown of the components of our net gains on sales of loans and mortgage-backed securities during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Mortgage servicing rights

$

18,042

$

30,359

All other components excluding SFAS 133

(1,065

)

5,131

SFAS 133

70

(3,075

)


Total net gains on sales of loans and mortgage-backed securities

$

17,047

$

32,415


Secondary marketing gain excluding SFAS 133 as a percentage of associated sales

0.93

%

0.96

%


Securities available for sale and trading securities

          Just prior to the end of the first quarter of 2004, we established a partial economic hedge against future value changes in our MSRs by purchasing $517 million of securities classified as available for sale. As interest rates began to increase during the current quarter, the price sensitivity of our MSRs changed and approximately half of the securities were sold at a loss to reset the hedge. At June 30, 2004, securities available for sale included $239 million, net of an $8 million unrealized loss, associated with the partial economic hedge. The current quarter included realized losses of $21.3 million from those sales, whereas the year-ago quarter included gains of $0.6 million from trading securities which were purchased a year ago for the same economic purpose. For further information, see Asset/Liability Management and Market Risk on page 36.

Operating Expense

          Our operating expense totaled $57.2 million in the current quarter, up $6.0 million or 11.7% from a year ago. The increase was primarily due to a $4.5 million or 13.8% increase in salaries and related costs.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Salaries and related costs

$

37,575

$

35,569

$

33,144

$

34,312

$

33,028

Premises and equipment costs

8,200

8,208

8,286

8,291

7,971

Advertising expense

1,165

1,708

1,068

835

1,016

SAIF insurance premiums and regulatory

assessments

744

757

762

787

825

Professional fees

356

368

539

798

418

Other general and administrative expense

9,432

8,482

8,106

7,718

8,111


Total general and administrative expense

57,472

55,092

51,905

52,741

51,369

Net operation of real estate acquired in

settlement of loans

(237

)

(72

)

(739

)

(376

)

(111

)


Total operating expense

$

57,235

$

55,020

$

51,166

$

52,365

$

51,258


          For the first six months of 2004, operating expenses totaled $112.3 million, up $8.7 million or 8.4% from the same period of 2003, primarily reflecting higher salaries and related costs.

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          The following table presents a breakdown of key components comprising operating expense during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Salaries and related costs

$

73,144

$

67,154

Premises and equipment costs

16,408

15,684

Advertising expense

2,873

1,809

SAIF insurance premiums and regulatory assessments

1,501

1,656

Professional fees

724

1,046

Other general and administrative expense

17,914

16,004


Total general and administrative expense

112,564

103,353

Net operation of real estate acquired in settlement of loans

(309)

186


Total operating expense

$

112,255

$

103,539


Provision for Income Taxes

          Income taxes for the current quarter totaled $20.3 million, compared to $13.6 million a year ago. Our effective tax rate was 42.2% for both the second quarter and year-to-date periods of 2004, compared to 42.3% for the same periods a year ago. For further information, 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, see Note 7 of Notes to Consolidated Financial Statements on page 13.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Banking net income

$

23,726

$

8,387

$

23,188

$

25,621

$

17,145

Real estate investment net income

4,095

525

570

3,630

1,370


Total net income

$

27,821

$

8,912

$

23,758

$

29,251

$

18,515


Six Months Ended June 30,


(In Thousands)

2004

2003


Banking net income

$

32,113

$

46,650

Real estate investment net income

4,620

2,082


Total net income

$

36,733

$

48,732


Banking

          Net income from our banking operations for the current quarter totaled $23.7 million, up $6.6 million from a year ago. The increase between second quarters primarily reflected:

Those favorable items were partially offset by a $21.9 million unfavorable change in securities gains/losses, a $5.9 million increase in operating expense and a $2.1 million increase in provision for loan losses.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Net interest income

$

76,842

$

69,444

$

65,325

$

68,302

$

74,232

Provision for (reduction of) loan losses

1,458

1,804

(281

)

(1,104

)

(624

)

Other income

22,724

1,691

25,498

27,116

5,839

Operating expense

56,908

54,699

50,925

52,126

50,985

Net intercompany income (expense)

(43

)

(38

)

42

43

40


Income before income taxes

41,157

14,594

40,221

44,439

29,750

Income taxes

17,431

6,207

17,033

18,818

12,605


Net income

$

23,726

$

8,387

$

23,188

$

25,621

$

17,145


At period end

Assets:

Loans and mortgage-backed securities

$

12,971,737

$

11,594,098

$

10,396,510

$

9,987,468

$

10,773,026

Other

1,239,475

1,919,401

1,237,858

1,165,611

1,169,082


Total assets

14,211,212

13,513,499

11,634,368

11,153,079

11,942,108


Equity

$

942,452

$

924,557

$

917,018

$

894,210

$

869,365


          For the first six months of 2004, net income from our banking operations totaled $32.1 million, down $14.5 million from the same period a year ago. The decline primarily reflected an unfavorable change in securities gains/losses, lower gains from sales of loans and mortgage-backed securities, lower net interest income, higher operating expense and an unfavorable change in provision for loan losses. Those unfavorable items were partially offset by an improvement in loan servicing activities and higher loan and deposit related fees.

          The following table sets forth our banking operational results for the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Net interest income

$

146,286

$

155,113

Provision for (reduction of) loan losses

3,262

(2,333

)

Other income

24,415

26,470

Operating expense

111,607

103,091

Net intercompany income (expense)

(81

)

84


Income before income taxes

55,751

80,909

Income taxes

23,638

34,259


Net income

$

32,113

$

46,650


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Real Estate Investment

          Net income from our real estate investment operations totaled $4.1 million in the current quarter, up from $1.4 million a year ago. The improvement primarily reflected higher gains from sales.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Net interest expense

$

(231

)

$

(88

)

$

(72

)

$

(50

)

$

(20

)

Other income

7,456

1,262

1,320

6,476

2,651

Operating expense

327

321

241

239

273

Net intercompany income (expense)

43

38

(42

)

(43

)

(40

)


Income before income taxes

6,941

891

965

6,144

2,318

Income taxes

2,846

366

395

2,514

948


Net income

$

4,095

$

525

$

570

$

3,630

$

1,370


At period end

Assets:

Investments in real estate and joint ventures

$

31,517

$

35,768

$

35,716

$

32,435

$

36,297

Other

11,845

3,994

3,503

4,617

8,279


Total assets

43,362

39,762

39,219

37,052

44,576


Equity

$

32,227

$

28,132

$

27,607

$

27,037

$

35,407


          For the first six months of 2004, our net income from real estate investment operations totaled $4.6 million, up $2.5 million from the same period of 2003. The increase primarily reflected higher gains from sales.

          The following table sets forth our real estate investment operational results for the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Net interest expense

$

(319

)

$

(5

)

Other income

8,718

4,062

Operating expense

648

448

Net intercompany income (expense)

81

(84

)


Income before income taxes

7,832

3,525

Income taxes

3,212

1,443


Net income

$

4,620

$

2,082


          Our investments in real estate and joint ventures amounted to $32 million at June 30, 2004 and $36 million at both December 31, 2003 and June 30, 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 41.

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FINANCIAL CONDITION

Loans and Mortgage-Backed Securities

          Total loans and mortgage-backed securities, including those we hold for sale, increased $1.4 billion during the current quarter to a total of $13.0 billion or 91.2% of assets at June 30, 2004. The increase primarily occurred in our loans held for investment. A record volume of single family portfolio originations resulted in our loans held for investment increasing $1.2 billion or 11.3% during the current quarter, bringing our year-to-date increase to $2.2 billion or 21.7%. Our annualized prepayment speed in the current quarter declined to 47% from 53% a year ago, but was up from 41% in the first quarter of 2004.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

1,390,834

$

854,367

$

381,699

$

157,322

$

250,792

MTA

699,445

721,138

878,153

486,146

207,342

Libor

299,470

203,502

207,303

88,658

74,098

Adjustable – fixed for 3-5 years

-

124,008

106,412

275,755

748,613

Fixed

-

-

885

1,976

6,499


Total residential one-to-four units

2,389,749

1,903,015

1,574,452

1,009,857

1,287,344

Other

200,017

125,391

145,175

102,618

78,407


Total for investment portfolio

2,589,766

2,028,406

1,719,627

1,112,475

1,365,751

Sale portfolio(a)

1,279,208

927,777

889,144

1,566,423

2,161,154


Total for investment and sale portfolios

$

3,868,974

$

2,956,183

$

2,608,771

$

2,678,898

$

3,526,905


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

Six Months Ended June 30,


(In Thousands)

2004

2003


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

2,245,201

$

538,705

MTA

1,420,583

431,329

Libor

502,972

109,119

Adjustable – fixed for 3-5 years

124,008

971,153

Fixed

-

19,786


Total residential one-to-four units

4,292,764

2,070,092

Other

325,408

129,562


Total for investment portfolio

4,618,172

2,199,654

Sale portfolio (a)

2,206,985

3,768,301


Total for investment and sale portfolios

$

6,825,157

$

5,967,955


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

          Loan originations, including loans purchased, totaled a record $3.869 billion in the current quarter, up 9.7% from the $3.527 billion we originated in the second quarter of 2003 and 30.9% above the $2.956 billion we originated in the first quarter of 2004. Loans originated for sale declined $882 million from the year-ago second quarter to $1.279 billion, while single family loans originated for portfolio increased $1.102 billion to a quarterly record of $2.390 billion. Of the current quarter originations for portfolio, $205 million represented subprime credits as part of our continuing strategy to enhance the portfolio’s net yield. During the current quarter, 77% of our residential one-to-four unit originations represented refinance transactions. This is down from 78% in the first quarter of 2004 and 87% in the year-ago quarter. In addition to single family loans, we originated $200 million of other loans in the current quarter.

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          Originations of adjustable rate residential one-to-four unit loans for portfolio, including loans purchased, totaled $2.390 billion during the quarter. Of that total:

          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.

June 30, 2004

March 31, 2004

December 31, 2003

September 30, 2003

June 30, 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

$

5,845,753

56

%

$

5,095,707

57

%

$

4,819,852

61

%

$

5,163,897

71

%

$

5,883,639

78

%

MTA

3,563,210

35

3,074,120

35

2,503,336

32

1,761,516

24

1,391,864

18

Libor

857,211

8

589,621

7

403,450

5

249,320

3

143,388

2

Other, primarily CMT

142,796

1

126,154

1

185,437

2

171,039

2

180,575

2


Total adjustable loans (a)

$

10,408,970

100

%

$

8,885,602

100

%

$

7,912,075

100

%

$

7,345,772

100

%

$

7,599,466

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 June 30, 2004, loans with the higher 125% limit on negative amortization represented 17% of our adjustable rate one-to-four unit residential portfolio.

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          At June 30, 2004, $9.6 billion or 82% of the adjustable rate mortgages in our loan portfolio were subject to negative amortization, of which $33 million represented the amount of negative amortization included in the loan balance. The amount of negative amortization was $6 million or 15% below the March 31, 2004 level.

          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 expect to sell some of our production of adjustable rate loans into the secondary market to manage our balance sheet to remain in compliance with regulatory capital requirements. We sold $1.139 billion of loans and mortgage-backed securities in the current quarter, compared to $679 million in the first quarter of 2004 and $2.078 billion in the year-ago second quarter. All but minor amounts were secured by residential one-to-four unit property, and at June 30, 2004, loans held for sale totaled $661 million.

          At June 30, 2004, our unfunded loan application pipeline totaled $2.8 billion. Within that pipeline, we had commitments to borrowers for short-term interest rate locks, excluding expected fallout, of $1.2 billion, of which $709 million were related to residential one-to-four unit loans being originated for sale in the secondary market. Furthermore, at June 30, 2004, we had commitments on undrawn lines of credit of $312 million and loans in process of $60 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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Investment Portfolio

Loans originated:

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

2,114,055

$

1,550,101

$

1,335,998

$

675,135

$

468,337

Adjustable – subprime

198,731

163,927

119,989

55,778

63,903

Adjustable – fixed for 3-5 years

-

124,008

106,412

275,755

178,325

Adjustable – fixed for 3-5 years – subprime

-

-

-

-

-


Total adjustable residential one-to-four units

2,312,786

1,838,036

1,562,399

1,006,668

710,565

Fixed

-

-

885

1,976

5,721

Fixed – subprime

-

-

-

-

73

Residential five or more units – adjustable

9,029

8,452

11,629

12,789

17,956


Total residential

2,321,815

1,846,488

1,574,913

1,021,433

734,315

Commercial real estate

1,070

8,094

-

575

3,272

Construction

8,165

6,330

36,320

12,025

21,511

Land

25,953

-

-

19,589

-

Non-mortgage:

Commercial

-

375

1,260

1,200

-

Automobile

-

-

-

21

18

Other consumer

155,305

101,582

95,966

30,107

31,117


Total loans originated

2,512,308

1,962,869

1,708,459

1,084,950

790,233

Real estate loans purchased:

One-to-four units

71,006

56,361

10,038

594

570,985

One-to-four units – subprime

5,957

8,618

1,130

619

-

Other (a)

495

558

-

26,312

4,533


Total real estate loans purchased

77,458

65,537

11,168

27,525

575,518


Total loans originated and purchased

2,589,766

2,028,406

1,719,627

1,112,475

1,365,751

Loan repayments

(1,294,340

)

(1,064,293

)

(1,205,610

)

(1,526,563

)

(1,352,321

)

Other net changes (b)

(50,177

)

(15,946

)

(47,939

)

15,168

(4,075

)


Net increase (decrease) in loans held for investment

1,245,249

948,167

466,078

(398,920

)

9,355


Sale Portfolio

Originated whole loans:

Residential one-to-four units

1,273,042

927,047

886,572

1,565,841

2,161,154

Non-mortgage loans

-

730

2,572

582

-

Loans purchased

6,166

-

-

-

-

Loans transferred from (to) the investment portfolio

(3,940

)

283

(2,523

)

(7,759

)

3,549

Originated whole loans sold

(508,482

)

(155,610

)

(107,060

)

(335,589

)

(250,027

)

Loans exchanged for mortgage-backed securities

(630,547

)

(523,136

)

(834,373

)

(1,602,297

)

(1,828,344

)

Other net changes

(1,582

)

(968

)

(1,979

)

(1,079

)

(1,116

)

Capitalized basis adjustment (c)

(2,261

)

1,082

1,011

(6,191

)

3,037


Net increase (decrease) in loans held for sale

132,396

249,428

(55,780

)

(386,492

)

88,253


Mortgage-backed securities, net:

Received in exchange for loans

630,547

523,136

834,373

1,602,297

1,828,344

Sold

(630,547

)

(523,136

)

(834,373

)

(1,602,297

)

(1,828,344

)

Repayments

(6

)

(6

)

(1,247

)

(140

)

(129

)

Other net changes

-

(1

)

(9

)

(6

)

(10

)


Net decrease in mortgage-backed securities

available for sale

(6

)

(7

)

(1,256

)

(146

)

(139

)


Net increase (decrease) in loans held for sale and

mortgage-backed securities available for sale

132,390

249,421

(57,036

)

(386,638

)

88,114


Total net increase (decrease) in loans and

mortgage-backed securities

$

1,377,639

$

1,197,588

$

409,042

$

(785,558

)

$

97,469


(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.

June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Investment Portfolio

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

9,342,177

$

7,878,316

$

6,945,106

$

6,328,674

$

6,444,574

Adjustable – subprime

1,043,557

982,696

940,655

987,509

1,119,780

Adjustable – fixed for 3-5 years

1,302,726

1,650,521

1,687,323

1,809,803

1,942,446

Adjustable – fixed for 3-5 years – subprime

28,938

35,861

42,952

57,910

70,780

Fixed

76,913

90,993

105,042

123,413

157,256

Fixed – subprime

4,028

3,515

4,432

4,790

5,602


Total residential one-to-four units

11,798,339

10,641,902

9,725,510

9,312,099

9,740,438

Residential five or more units:

Adjustable

102,176

99,321

91,024

79,778

41,004

Fixed

1,840

1,875

1,904

2,213

2,251

Commercial real estate:

Adjustable

37,075

36,298

36,142

37,860

37,524

Fixed

5,465

6,016

13,144

14,580

15,507

Construction

80,608

88,676

105,706

90,233

105,858

Land

26,770

1,587

16,855

18,931

20,090

Non-mortgage:

Commercial

5,083

5,150

4,975

5,235

6,493

Automobile

1,911

2,816

3,823

5,085

6,959

Other consumer

179,793

130,549

95,319

70,593

68,012


Total loans held for investment

12,239,060

11,014,190

10,094,402

9,636,607

10,044,136

Increase (decrease) for:

Undisbursed loan funds

(62,478

)

(50,950

)

(56,543

)

(52,841

)

(67,921

)

Net deferred costs and premiums

166,803

133,518

108,990

97,445

105,393

Allowance for losses

(33,450

)

(32,072

)

(30,330

)

(30,770

)

(32,247

)


Total loans held for investment, net

12,309,935

11,064,686

10,116,519

9,650,441

10,049,361


Sale Portfolio, Net

Loans held for sale:

Residential one-to-four units

662,321

526,311

276,295

335,594

716,477

Non-mortgage

64

1,420

3,090

582

-

Capitalized basis adjustment (a)

(904

)

1,354

272

(739

)

5,452


Total loans held for sale

661,481

529,085

279,657

335,437

721,929

Mortgage-backed securities available for sale:

Adjustable

321

327

334

1,590

1,736

Fixed

-

-

-

-

-


Total mortgage-backed securities available for sale

321

327

334

1,590

1,736


Total loans held for sale and mortgage-backed

securities available for sale

661,802

529,412

279,991

337,027

723,665


Total loans and mortgage-backed securities

$

12,971,737

$

11,594,098

$

10,396,510

$

9,987,468

$

10,773,026


(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 June 30, 2004, no valuation allowance was required as the fair value exceeded book value on an aggregate basis.

          At June 30, 2004, our residential one-to-four units subprime portfolio consisted of 93% "Alt. A and A-" credit, 6% "B" credit and 1% "C" credit loans. The average loan-to-value ratio at origination for these loans was 72%.

          We carry mortgage-backed securities available for sale at fair value which, at June 30, 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.

June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Federal funds

$

-

$

2,300

$

1,500

$

4,001

$

89,210

U.S. Treasury securities held for trading

-

-

-

-

201,781

U.S. Treasury and agency securities available for sale

630,719

872,037

690,281

635,759

276,904

Other investment securities available for sale

66

66

66

66

67

Municipal securities held to maturity

-

-

-

-

6,148

Securities purchased under resale agreements

-

-

-

-

60,000


Total trading and investment securities

$

630,785

$

874,403

$

691,847

$

639,826

$

634,110


          The fair value of temporarily impaired securities, the amount of unrealized losses and the length of time these unrealized losses existed as of June 30, 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

$

497,573

$

9,827

$

-

$

-

$

497,573

$

9,827

Other investment securities

-

-

-

-

-

-


Total temporarily impaired securities

$

497,573

$

9,827

$

-

$

-

$

497,573

$

9,827


          The following table sets forth the maturities of our investment securities and their weighted average yields at June 30, 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

$

-

-

%

$

-

-

%

$

-

-

%

$

-

-

%

U.S. Treasury, agency, and other

securities available for sale (a)

-

-

99,969

2.67

530,816

3.79

630,785

3.61


Total investment securities

$

-

-

%

$

99,969

2.67

%

$

530,816

3.79

%

$

630,785

3.61

%


(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.

Deposits

          At June 30, 2004, our deposits totaled $8.9 billion, up $53 million or 0.6% from the year-ago level and up $131 million or 1.5% since March 31, 2004. Compared to the year-ago period, our certificates of deposit increased $296 million or 7.6%, which was partially offset by a decrease in our lower-rate transaction accounts—i.e., checking, money market and regular passbook—of $244 million or 4.9%. Given the relatively low level of interest rates, certain of our depositors in prior periods moved monies from certificates of deposit to transaction accounts as they seemed more interested in liquidity. Now that interest rates have begun to rise, those monies are now beginning to flow back into certificates of deposit. During the quarter:

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This brings our total branches at quarter end to 167, of which 95 were in-store. At June 30, 2004, the average deposit size of our 72 traditional branches was $102 million, while the average deposit size of our 95 in-store branches was $17 million.

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

June 30, 2004

March 31, 2004

December 31, 2003

September 30, 2003

June 30, 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

-

%

$

483,566

-

%

$

489,213

-

%

$

429,743

-

%

$

411,839

-

%

$

403,264

Interest-bearing

checking (a)

0.35

532,682

0.37

542,963

0.21

462,733

0.21

453,547

0.21

439,408

Money market

1.05

146,756

1.05

142,092

1.05

142,418

1.05

136,981

1.05

127,194

Regular passbook

1.10

3,578,383

1.08

3,898,369

1.12

4,036,464

1.18

4,062,067

1.28

4,015,045


Total transaction

accounts

0.90

4,741,387

0.90

5,072,637

0.94

5,071,358

0.99

5,064,434

1.08

4,984,911

Certificates of deposit:

Less than 2.00%

1.33

1,480,511

1.22

1,532,376

1.17

1,548,398

1.24

1,533,630

1.35

1,479,928

2.00-2.49

2.39

1,463,613

2.38

962,827

2.23

338,763

2.22

374,684

2.23

416,718

2.50-2.99

2.71

263,753

2.71

211,296

2.73

222,436

2.75

233,258

2.76

277,926

3.00-3.49

3.28

211,428

3.30

233,922

3.27

305,258

3.32

560,853

3.32

602,691

3.50-3.99

3.83

87,374

3.79

106,554

3.78

106,861

3.80

133,807

3.85

254,400

4.00-4.49

4.27

240,864

4.27

240,903

4.27

240,459

4.27

241,388

4.25

361,212

4.50-4.99

4.83

423,229

4.83

420,966

4.83

420,262

4.83

423,728

4.80

469,279

5.00 and greater

5.62

36,079

5.61

35,692

5.59

39,963

5.60

42,286

5.58

48,387


Total certificates

of deposit

2.49

4,206,851

2.45

3,744,536

2.44

3,222,400

2.56

3,543,634

2.74

3,910,541


Total deposits

1.65

%

$

8,948,238

1.56

%

$

8,817,173

1.52

%

$

8,293,758

1.64

%

$

8,608,068

1.81

%

$

8,895,452


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

Borrowings

          During the current quarter, our borrowings increased $1.1 billion to $4.1 billion, due to increases of $1.1 billion in FHLB advances and $198 million from the issuance of 10-year senior notes. Those increases were partially offset by a decline in securities sold under agreements to repurchase of $267 million. This followed an increase in securities sold under agreements to repurchase of $507 million and FHLB advances of $299 million during the first quarter of 2004.

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

June 30,

March 31,

December 31,

September 30,

June 30,

(Dollars in Thousands)

2004

2004

2003

2003

2003


Securities sold under agreements to repurchase

$

239,688

$

507,027

$

-

$

-

$

-

Federal Home Loan Bank advances

3,556,087

2,424,230

2,125,150

1,259,150

1,672,850

Real estate notes

-

4,144

4,161

4,178

3,121

Senior notes

198,179

-

-

-

-

Junior subordinated debentures (a)

123,711

123,711

123,711

123,711

123,711


Total borrowings

$

4,117,665

$

3,059,112

$

2,253,022

$

1,387,039

$

1,799,682


Weighted average rate on borrowings during

the quarter (b)

2.37

%

3.25

%

4.07

%

4.78

%

4.71

%

Total borrowings as a percentage of total assets

28.95

22.62

19.35

12.43

15.06


(a) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.
(b) Starting in the first quarter of 2004, the impact of swap contracts was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month Libor variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.
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          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. On July 23, 2004, we redeemed our junior subordinated debentures before their maturity. For further information, see Note 9 of Notes to the Consolidated Financial Statements on page 14.

          On June 23, 2004, we issued $200 million of 6.5% 10-year unsecured senior notes due July 1, 2014. Net proceeds from the sale of the notes, after deducting underwriting discounts and our offering expenses, were approximately $198 million. The net proceeds from the issue were used to redeem our junior subordinated debentures with the remainder intended for general corporate purposes, which may include advances to or investments in our subsidiaries, working capital and capital expenditures. The carrying value of the senior notes is net of the issuance costs which are being amortized to interest expense to yield an effective interest rate of 6.65%.

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, see Asset/Liability Management and Market Risk on page 36 and Note 3 of Notes to the Consolidated Financial Statements on page 8.

          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 fairly simple hedging strategy by purchasing securities classified as available for sale as a partial economic hedge against future value changes in our MSRs. During periods when long-term interest rates decline, the value of our MSRs will fall and the resultant MSR valuation addition will, in general, 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 June 30, 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.

June 30, 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)

$

343,070

$

69,450

$

150,867

$

238,906

$

-

$

802,293

Loans and mortgage-backed securities:(b)

Loans secured by real estate:

Residential:

Adjustable

11,267,683

386,925

864,271

-

-

12,518,879

Fixed

115,584

11,282

43,876

11,230

2,542

184,514

Commercial real estate

26,356

5,091

8,821

439

-

40,707

Construction

38,776

-

-

-

-

38,776

Land

5,433

7

51

604

-

6,095

Non-mortgage loans:

Commercial

2,633

-

-

-

-

2,633

Consumer

178,473

481

858

-

-

179,812

Mortgage-backed securities

321

-

-

-

-

321


Total loans and mortgage-backed securities

11,635,259

403,786

917,877

12,273

2,542

12,971,737


Total interest-earning assets

$

11,978,329

$

473,236

$

1,068,744

$

251,179

$

2,542

$

13,774,030


Transaction accounts:

Non-interest-bearing checking

$

483,566

$

-

$

-

$

-

$

-

$

483,566

Interest-bearing checking(c)

532,682

-

-

-

-

532,682

Money market (d)

146,756

-

-

-

-

146,756

Regular passbook (d)

3,578,383

-

-

-

-

3,578,383


Total transaction accounts

4,741,387

-

-

-

-

4,741,387

Certificates of deposit(e)

1,036,967

1,284,922

1,884,962

-

-

4,206,851


Total deposits

5,778,354

1,284,922

1,884,962

-

-

8,948,238

FHLB advances and other borrowings

2,754,725

290,000

722,050

29,000

-

3,795,775

Senior notes

-

-

-

-

198,179

198,179

Junior subordinated debentures (f)

123,711

-

-

-

123,711

Impact of swap contracts hedging borrowings

430,000

-

(430,000

)

-

-

-


Total deposits and borrowings

$

9,086,790

$

1,574,922

$

2,177,012

$

29,000

$

198,179

$

13,065,903


Excess (shortfall) of interest-earning assets over

deposits and borrowings

$

2,891,539

$

(1,101,686

)

$

(1,108,268

)

$

222,179

$

(195,637

)

$

708,127

Cumulative gap

2,891,539

1,789,853

681,585

903,764

708,127

Cumulative gap–as a percentage of total assets:

June 30, 2004

20.33

%

12.58

%

4.79

%

6.35

%

4.98

%

December 31, 2003

14.95

13.42

6.95

6.76

5.74

June 30, 2003

18.47

16.26

11.69

7.99

7.00


(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.
(f) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.
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          Our six-month gap at June 30, 2004 was a positive 20.33%. 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 18.47% a year ago. The increase in asset sensitivity reflects the growth in our monthly adjustable residential loan portfolio.

          We continue to emphasize the origination of adjustable rate mortgages for our investment portfolio. For the twelve months ended June 30, 2004, we originated and purchased for investment $7.4 billion of adjustable rate loans which represented essentially all of the loans we originated and purchased for investment during the period.

          At June 30, 2004, 98% 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 June 30, 2003. At June 30, 2004, $12.2 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 $9.9 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 occasionally 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.

June 30,

March 31,

December 31,

September 30,

June 30,

2004

2004

2003

2003

2003


Weighted average yield: (a)

Loans and mortgage-backed securities

4.37

%

4.51

%

4.61

%

4.98

%

5.24

%

Federal Home Loan Bank stock

4.42

3.85

4.18

4.34

4.80

Trading and investment securities

3.61

3.44

3.02

2.63

2.32


Interest-earning assets yield

4.34

4.43

4.51

4.84

5.08


Weighted average cost:

Deposits

1.65

1.56

1.52

1.64

1.81

Borrowings:

Securities sold under agreements to repurchase

0.60

0.45

-

-

-

Federal Home Loan Bank advances (b)

2.06

2.44

3.08

4.42

3.68

Real estate notes

-

6.63

6.63

6.63

6.63

Senior notes

6.50

-

-

-

-

Junior subordinated debentures (c)

10.00

10.00

10.00

10.00

10.00


Total borrowings

2.43

2.43

3.46

4.92

4.12


Combined funds cost

1.90

1.78

1.94

2.09

2.20


Interest rate spread

2.44

%

2.65

%

2.57

%

2.75

%

2.88

%


(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 was included, with notional amounts totaling $430 million of receive-fixed, pay-3-month Libor variable interest, which contracts serve as a permitted hedge against a portion of our FHLB advances.
(c) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.

          The period-end weighted average yield on our loan portfolio declined to 4.37% at June 30, 2004, down from 4.61% at December 31, 2003 and 5.24% at June 30, 2003. At June 30, 2004, our adjustable rate mortgage portfolio of single family residential loans, including mortgage-backed securities, totaled $12.4 billion with a weighted average rate of 4.30%, compared to $9.8 billion with a weighted average rate of 4.55% at December 31, 2003, and $9.8 billion with a weighted average rate of 5.16% at June 30, 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 declined $14 million during the current quarter to $40 million or 0.28% of total assets. The decrease occurred in both our prime and subprime residential loan categories.

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

June 30,

March 31,

December 31,

September 30,

June 30,

(Dollars in Thousands)

2004

2004

2003

2003

2003


Non-accrual loans:

Residential one-to-four units

$

24,445

$

31,037

$

26,325

$

32,430

$

29,758

Residential one-to-four units – subprime

12,615

16,846

15,980

22,101

26,568

Other

475

516

523

576

646


Total non-accrual loans

37,535

48,399

42,828

55,107

56,972

Real estate acquired in settlement of loans

2,424

5,189

5,803

7,436

9,464

Repossessed automobiles

9

7

-

15

3


Total non-performing assets

$

39,968

$

53,595

$

48,631

$

62,558

$

66,439


Allowance for loan losses:

Amount

$

33,450

$

32,072

$

30,330

$

30,770

$

32,247

As a percentage of non-performing loans

89.12

%

66.27

%

70.82

%

55.84

%

56.60

%

Non-performing assets as a percentage of total assets

0.28

0.40

0.42

0.56

0.56


Delinquent Loans

          Loans delinquent 30 days or more as a percentage of total loans was 0.40% at June 30, 2004, down from 0.52% at March 31, 2004 and 0.69% 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.

June 30, 2004

March 31, 2004


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

$

11,844

$

6,333

$

18,004

$

36,181

$

13,066

$

4,805

$

23,995

$

41,866

One-to-four units – subprime

3,935

2,427

7,854

14,216

3,458

3,852

10,279

17,589

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

15,779

8,760

25,858

50,397

16,524

8,657

34,274

59,455

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

-

11

8

19

5

14

8

27

Other consumer

309

13

39

361

221

12

80

313


Total delinquent loans

$

16,088

$

8,784

$

26,333

$

51,205

$

16,750

$

8,683

$

34,790

$

60,223


Delinquencies as a percentage of total loans

0.13

%

0.07

%

0.20

%

0.40

%

0.14

%

0.08

%

0.30

%

0.52

%


December 31, 2003

September 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

15,501

$

7,244

$

20,081

$

42,826

$

14,942

$

5,246

$

26,259

$

46,447

One-to-four units – subprime

6,084

2,801

9,283

18,168

5,582

4,813

12,961

23,356

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

21,585

10,045

29,364

60,994

20,524

10,059

39,220

69,803

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

34

4

7

45

24

20

36

80

Other consumer

41

22

88

151

42

29

112

183


Total delinquent loans

$

21,660

$

10,071

$

29,887

$

61,618

$

20,590

$

10,108

$

39,796

$

70,494


Delinquencies as a percentage of total loans

0.20

%

0.10

%

0.29

%

0.59

%

0.21

%

0.10

%

0.40

%

0.71

%


June 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

17,488

$

5,482

$

23,500

$

46,470

One-to-four units – subprime

4,785

4,350

18,302

27,437

Five or more units

-

-

-

-

Commercial real estate

-

-

-

-

Construction

-

-

-

-

Land

-

-

-

-


Total real estate loans

22,273

9,832

41,802

73,907

Non-mortgage:

Commercial

-

-

428

428

Automobile

94

18

44

156

Other consumer

77

16

174

267


Total delinquent loans

$

22,444

$

9,866

$

42,448

$

74,758


Delinquencies as a percentage of total loans

0.21

%

0.09

%

0.39

%

0.69

%


(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 is 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 $35 million at June 30, 2004, compared to $34 million at March 31, 2004, and $33 million a year ago.

          In the current quarter, our provision for loan losses was $1.5 million and net loan charge-offs totaled $0.1 million, resulting in an increase in the allowance for loan losses to $33 million at June 30, 2004. The current quarter increase in the allowance reflected an increase of $1.9 million in the general valuation allowance due to an increase in the loan portfolio, partially offset by a $0.4 million decline in allocated allowances due to an improvement in credit quality. 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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Balance at beginning of period

$

32,072

$

30,330

$

30,770

$

32,247

$

33,103

Provision (reduction)

1,458

1,804

(281

)

(1,104

)

(624

)

Charge-offs

(86

)

(96

)

(334

)

(378

)

(236

)

Recoveries

6

34

175

5

4


Balance at end of period

$

33,450

$

32,072

$

30,330

$

30,770

$

32,247


          Since year-end 2003, our allowance for loan losses increased by $3.1 million, from an increase in the general valuation allowances of $3.6 million and a decrease in allocated allowances of $0.5 million.

          The following table summarizes the activity in our allowance for loan losses during the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

30,330

$

34,999

Provision (reduction)

3,262

(2,333

)

Charge-offs

(182

)

(427

)

Recoveries

40

8


Balance at end of period

$

33,450

$

32,247


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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

Six Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

June 30,

(Dollars in Thousands)

2004

2004

2003

2003

2003

2004

2003


Gross loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

$

27

$

45

$

112

$

203

$

130

$

72

$

147

One-to-four units – subprime

-

-

182

85

39

-

121

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

20

Automobile

3

10

1

35

8

13

18

Other consumer

56

41

39

55

59

97

121


Total gross loan charge-offs

86

96

334

378

236

182

427


Gross loan recoveries

Loans secured by real estate:

Residential:

One-to-four units

-

-

164

-

-

-

-

One-to-four units – subprime

1

25

-

-

-

26

-

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

-

Automobile

2

5

1

1

1

7

2

Other consumer

3

4

10

4

3

7

6


Total gross loan recoveries

6

34

175

5

4

40

8


Net loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

27

45

(52

)

203

130

72

147

One-to-four units – subprime

(1

)

(25

)

182

85

39

(26

)

121

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

20

Automobile

1

5

-

34

7

6

16

Other consumer

53

37

29

51

56

90

115


Total net loan charge-offs

$

80

$

62

$

159

$

373

$

232

$

142

$

419


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.

June 30, 2004

March 31, 2004

December 31, 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

$

19,547

$

10,721,816

0.18

%

$

18,507

$

9,619,830

0.19

%

$

17,040

$

8,737,471

0.20

%

One-to-four units – subprime

5,569

1,076,523

0.52

5,847

1,022,072

0.57

5,382

988,039

0.54

Five or more units

780

104,016

0.75

759

101,196

0.75

697

92,928

0.75

Commercial real estate

1,096

42,540

2.58

1,049

42,314

2.48

1,127

49,286

2.29

Construction

951

80,608

1.18

1,045

88,676

1.18

1,257

105,706

1.19

Land

333

26,770

1.24

18

1,587

1.13

209

16,855

1.24

Non-mortgage:

Commercial

460

5,083

9.05

460

5,150

8.93

460

4,975

9.25

Automobile

37

1,911

1.94

51

2,816

1.81

38

3,823

0.99

Other consumer

1,877

179,793

1.04

1,536

130,549

1.18

1,320

95,319

1.38

Not specifically allocated

2,800

-

-

2,800

-

-

2,800

-

-


Total loans held for investment

$

33,450

$

12,239,060

0.27

%

$

32,072

$

11,014,190

0.29

%

$

30,330

$

10,094,402

0.30

%


September 30, 2003

June 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

17,174

$

8,261,890

0.21

%

$

17,447

$

8,544,276

0.20

%

One-to-four units – subprime

6,123

1,050,209

0.58

7,315

1,196,162

0.61

Five or more units

615

81,991

0.75

324

43,255

0.75

Commercial real estate

1,160

52,440

2.21

1,171

53,031

2.21

Construction

1,082

90,233

1.20

1,256

105,858

1.19

Land

235

18,931

1.24

250

20,090

1.24

Non-mortgage:

Commercial

461

5,235

8.81

504

6,493

7.76

Automobile

42

5,085

0.83

94

6,959

1.35

Other consumer

1,078

70,593

1.53

1,086

68,012

1.60

Not specifically allocated

2,800

-

-

2,800

-

-


Total loans held for investment

$

30,770

$

9,636,607

0.32

%

$

32,247

$

10,044,136

0.32

%


          At June 30, 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 June 30, 2004, December 31, 2003 and June 30, 2003. During the current quarter, total interest recognized on the impaired loan portfolio was $0.3 million, bringing the year-to-date total to $0.5 million.

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

Three Months Ended


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Balance at beginning of period

$

704

$

709

$

711

$

716

$

720

Reduction

(5

)

(5

)

(2

)

(5

)

(4

)

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

699

$

704

$

709

$

711

$

716


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          The following table summarizes the activity in our allowance for loan losses associated with impaired loans for the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

709

$

725

Reduction

(10

)

(9

)

Charge-offs

-

-

Recoveries

-

-


Balance at end of period

$

699

$

716


          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


June 30,

March 31,

December 31,

September 30,

June 30,

(In Thousands)

2004

2004

2003

2003

2003


Balance at beginning of period

$

1,436

$

1,436

$

1,436

$

1,096

$

949

Provision

-

-

-

340

147

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

1,436

$

1,436

$

1,436

$

1,436

$

1,096


          The following table summarizes the activity in our allowance for real estate and joint ventures held for investment for the year-to-date periods indicated.

Six Months Ended June 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

1,436

$

908

Provision

-

188

Charge-offs

-

-

Recoveries

-

-


Balance at end of period

$

1,436

$

1,096


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 second quarter of 2004 were from:

          We used these funds to:

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          Our principal source of liquidity is our ability to utilize borrowings, as needed. Our primary source of borrowings is from the FHLB. At June 30, 2004, our FHLB borrowings totaled $3.6 billion, representing 25.0% 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 $3.6 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 June 30, 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 $372 million, operating leases of $16 million and commitments to invest in affordable housing funds of $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 June 30, 2004, the holding company’s liquid assets, including due from Bank—interest bearing balances, totaled $269 million, of which $198 million relates to the issuance of senior notes discussed previously. For further information, see Borrowings on page 34.

          Stockholders’ equity totaled $942 million at June 30, 2004, up from $917 million at December 31, 2003 and $869 million a year ago.

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, see Asset/Liability Management and Market Risk on page 36 and Note 3 of Notes to the Consolidated Financial Statements on page 8.

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          At June 30, 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

$

2,321,889

$

1,603,524

$

281,438

$

-

$

4,206,851

FHLB advances and other borrowings

3,044,725

292,050

430,000

29,000

3,795,775

Senior notes

-

-

-

198,179

198,179

Junior subordinated debentures (a)

-

-

-

123,711

123,711

Secondary marketing activities:

Non-qualifying hedge transactions:

Expected rate lock commitments

541,358

-

-

-

541,358

Associated forward sale contracts

374,462

-

-

-

374,462

Associated forward purchase contracts

-

Qualifying cash flow hedge transactions:

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

661,481

-

-

-

661,481

Associated forward sale contracts

652,796

-

-

-

652,796

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

479,968

-

-

-

479,968

Fixed

-

-

-

-

-

Undisbursed loan funds and unused lines of credit

42,573

15,821

-

314,070

372,464

Operating leases

4,506

7,210

3,447

948

16,111

Commitments to invest in affordable housing funds

-

-

-

5,226

5,226


Total obligations and commitments

$

8,123,758

$

1,918,605

$

1,574,885

$

671,134

$

12,288,382


(a) On July 23, 2004, we redeemed our junior subordinated debentures before their maturity.

Regulatory Capital Compliance

          Our core and tangible capital ratios were both 6.68% and our risk-based capital ratio was 13.13% at June 30, 2004. The Bank’s capital ratios compare favorably with 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 June 30, 2004.

Tangible Capital

Core Capital

Risk-Based Capital


(Dollars in Thousands)

Amount

Ratio

Amount

Ratio

Amount

Ratio


Stockholder’s equity

$

986,322

$

986,322

$

986,322

Adjustments:

Deductions:

Investment in subsidiary, primarily real estate

(34,790

)

(34,790

)

(34,790

)

Excess cost over fair value of branch acquisitions

(3,150

)

(3,150

)

(3,150

)

Non-permitted mortgage servicing rights

(9,205

)

(9,205

)

(9,205

)

Additions:

Unrealized losses on securities available for sale

5,745

5,745

5,745

General loss allowance – investment in DSL

Service Company

730

730

730

Allowance for loan losses,

net of specific allowances (a)

-

-

32,992


Regulatory capital

945,652

6.68

%

945,652

6.68

%

978,644

13.13

%

Well capitalized requirement

212,446

1.50

(b)

708,153

5.00

745,254

10.00

(c)


Excess

$

733,206

5.18

%

$

237,499

1.68

%

$

233,390

3.13

%


(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 12.69%.
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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 36.

 

ITEM 4. – CONTROLS AND PROCEDURES

          As of June 30, 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 over financial reporting 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 June 30, 2004, $38 million of the original authorization remains available for future purchases.

           During the second quarter of 2004, 14,536 options were exercised resulting in the reissuance of the same amount of treasury stock shares at a weighted average price of $25.44 per share.

ITEM 3 – Defaults Upon Senior Securities

          None.

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

          On April 28, 2004, Downey held its annual meeting of shareholders to elect three Class 2 Directors for terms of three years each and to ratify the Board of Directors’ appointment of KPMG LLP as auditors for the year ending December 31, 2004. The number of votes cast at the meeting as to each matter acted upon was as follows:

1.

Election of Directors:

Nominees

Votes For

Votes Withheld

Unvoted


Brent McQuarrie

26,109,806

284,245

1,559,696

James H. Hunter

26,094,996

299,045

1,559,706

Marangal I. Domingo

21,818,607

4,575,443

1,559,697

The Directors whose terms continued and the years their terms expire are as follows:

Continuing Directors

Year Term Expires


Lester C. Smull

2006

Michael B. Abrahams

2006

Cheryl E. Olson

2006

Gerald E. Finnell

2005

Maurice L. McAlister

2005

Daniel D. Rosenthal

2005

2.

Ratification of appointment of KPMG LLP as auditors for the year ending December 31, 2004:

Votes For

Votes Against

Abstain

Unvoted


26,163,410

225,966

4,664

1,559,707


ITEM 5 – Other Information

          None.

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ITEM 6 – Exhibits and Reports on Form 8-K

(A)          Exhibits

Exhibit

Number

Description


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 April 16, 2004, with respect to a press release reporting its results of operations during the three months ended March 31, 2004.

          2) Form 8-K filed April 19, 2004, with respect to a press release announcing the retirement of Executive Vice President and Chief Administrative Officer, Jane Wolfe, as of June 1, 2004.

          3) Form 8-K filed May 17, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended April 30, 2004.

          4) Form 8-K filed June 14, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended May 31, 2004.

          5) Form 8-K filed June 22, 2004, regarding (1) Underwriting Agreement relating to the sale of an aggregate principal amount of $200 million of Downey Financial Corp.’s 6 1/2% senior notes due 2014 and (2) Form of the First Supplemental Indenture by and between Downey Financial Corp. and Wilmington Trust Company, as trustee, relating to the issuance of the Notes.

          6) Form 8-K filed June 23, 2004, with respect to a press release announcing that Downey Financial Capital Trust I, a subsidiary, will redeem on July 23, 2004 all of its outstanding $120 million 10% Capital Securities.

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

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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: August 3, 2004

Marangal I. Domingo

President and Chief Executive Officer

/s/ Thomas E. Prince


Date: August 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