Securities and Exchange Commission Form 10-Q dated September 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 September 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 September 30, 2004, 27,853,783 shares of the Registrant’s Common Stock, $0.01 par value were outstanding.


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DOWNEY FINANCIAL CORP.

SEPTEMBER 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           

50

SIGNATURES           

50


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PART I

ITEM 1. – FINANCIAL INFORMATION

DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

September 30,

December 31,

September 30,

(Dollars in Thousands, Except Per Share Data)

2004

2003

2003


Assets

Cash

$

107,038

$

111,667

$

113,075

Federal funds

-

1,500

4,001


Cash and cash equivalents

107,038

113,167

117,076

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

securities available for sale, at fair value

732,878

690,347

635,825

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

845,913

279,657

335,437

Mortgage-backed securities available for sale, at fair value

315

334

1,590

Loans receivable held for investment

13,411,146

10,116,519

9,650,441

Investments in real estate and joint ventures

44,242

35,716

32,435

Real estate acquired in settlement of loans

2,819

5,803

7,436

Premises and equipment

107,429

110,316

111,201

Federal Home Loan Bank stock, at cost

209,063

123,089

121,813

Investment in Downey Financial Capital Trust I

-

3,711

3,711

Mortgage servicing rights, net

82,295

82,175

70,400

Other assets

96,326

85,146

75,729


$

15,639,464

$

11,645,980

$

11,163,094


Liabilities and Stockholders’ Equity

Deposits

$

9,551,333

$

8,293,758

$

8,608,068

Securities sold under agreements to repurchase

251,875

-

-

Federal Home Loan Bank advances

4,418,729

2,125,150

1,259,150

Real estate notes

-

4,161

4,178

Senior notes

197,886

-

-

Junior subordinated debentures

-

123,711

123,711

Accounts payable and accrued liabilities

115,971

63,584

180,885

Deferred income taxes

138,045

118,598

92,892


Total liabilities

14,673,839

10,728,962

10,268,884


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 September 30, 2004, December 31, 2003 and

September 30, 2003; outstanding 27,853,783 shares at September 30, 2004

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

282

282

282

Additional paid-in capital

93,792

93,792

93,792

Accumulated other comprehensive income (loss)

1,926

807

(757

)

Retained earnings

886,417

834,307

813,063

Treasury stock, at cost, 381,239 shares at September 30, 2004 and 306,300

shares at both December 31, 2003 and September 30, 2003

(16,792

)

(12,170

)

(12,170

)


Total stockholders’ equity

965,625

917,018

894,210


$

15,639,464

$

11,645,980

$

11,163,094


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Income

 

Three Months Ended

Nine Months Ended

September 30,

September 30,


(Dollars in Thousands, Except Per Share Data)

2004

2003

2004

2003


Interest income

Loans receivable

$

141,458

$

119,990

$

380,301

$

393,363

U.S. Treasury securities and agency obligations

5,765

2,497

16,161

7,520

Mortgage-backed securities

3

16

9

51

Other investments

1,975

1,196

4,767

4,336


Total interest income

149,201

123,699

401,238

405,270


Interest expense

Deposits

40,715

38,010

107,977

128,229

Federal Home Loan Bank advances and other borrowings

22,490

14,304

54,738

44,280

Senior notes

3,294

-

3,586

-

Junior subordinated debentures

765

3,133

7,033

9,401


Total interest expense

67,264

55,447

173,334

181,910


Net interest income

81,937

68,252

227,904

223,360

Provision for (reduction of) loan losses

1,186

(1,104

)

4,448

(3,437

)


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

80,751

69,356

223,456

226,797


Other income, net

Loan and deposit related fees

15,828

14,405

42,703

40,032

Real estate and joint ventures held for investment, net

365

5,864

8,339

8,876

Secondary marketing activities:

Loan servicing income (loss), net

(16,890

)

1,550

(17,349

)

(33,828

)

Net gains on sales of loans and mortgage-backed securities

14,637

23,467

31,684

55,882

Net gains on sales of mortgage servicing rights

-

-

-

23

Net losses on trading securities

-

(11,040

)

-

(10,449

)

Net gains (losses) on sales of investment securities

-

-

(19,159

)

8

Litigation award

-

-

-

2,717

Loss on extinguishment of debt

(4,111

)

-

(4,111

)

-

Other

393

(654

)

1,248

863


Total other income, net

10,222

33,592

43,355

64,124


Operating expense

Salaries and related costs

36,629

34,312

109,773

101,466

Premises and equipment costs

8,771

8,291

25,179

23,975

Advertising expense

1,494

835

4,367

2,644

SAIF insurance premiums and regulatory assessments

825

787

2,326

2,443

Professional fees

387

798

1,111

1,844

Other general and administrative expense

9,909

7,718

27,823

23,722


Total general and administrative expense

58,015

52,741

170,579

156,094

Net operation of real estate acquired in settlement of loans

36

(376

)

(273

)

(190

)


Total operating expense

58,051

52,365

170,306

155,904


Income before income taxes

32,922

50,583

96,505

135,017

Income taxes

8,412

21,332

35,262

57,034


Net income

$

24,510

$

29,251

$

61,243

$

77,983


PER SHARE INFORMATION

Basic

$

0.88

$

1.05

$

2.19

$

2.79


Diluted

$

0.88

$

1.05

$

2.19

$

2.79


Cash dividends declared and paid

$

0.10

$

0.09

$

0.30

$

0.27


Weighted average diluted shares outstanding

27,943,512

27,963,374

27,970,788

27,962,012


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

Three Months Ended

Nine Months Ended

September 30,

September 30,


(In Thousands)

2004

2003

2004

2003


Net income

$

24,510

$

29,251

$

61,243

$

77,983


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

6,849

536

562

(103

)

Mortgage-backed securities available for sale, at fair value

-

(4

)

(1

)

(16

)

Reclassification of realized amounts included in net income

-

-

173

(5

)

Unrealized gains (losses) on cash flow hedges:

Net derivative instruments

144

8,786

2,651

1,051

Reclassification of realized amounts included in net income

678

(11,210

)

(2,266

)

(262

)


Total other comprehensive income (loss), net of income taxes (benefits)

7,671

(1,892

)

1,119

665


Comprehensive income

$

32,181

$

27,359

$

62,362

$

78,648


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Nine Months Ended

September 30,


(In Thousands)

2004

2003


Cash flows from operating activities

Net income

$

61,243

$

77,983

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

Depreciation and amortization

68,474

65,989

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

19,811

16,979

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

trading and investment securities, real estate and other assets

(19,194

)

(62,866

)

Interest capitalized on loans (negative amortization)

(11,555

)

(7,284

)

Federal Home Loan Bank stock dividends

(4,027

)

(4,250

)

Loans originated for sale

(4,261,617

)

(5,334,724

)

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

as mortgage-backed securities

3,697,463

5,673,264

Other, net

(108,295

)

(61,914

)


Net cash provided by (used for) operating activities

(557,697

)

363,177


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

15,275

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

19,406

21,327

Redemption of common securities in Downey Financial Capital Trust I

3,711

-

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

and other investment securities available for sale

540,086

558,474

Purchase of:

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

available for sale

(1,845,066

)

(645,822

)

Loans receivable held for investment

(198,609

)

(694,719

)

Federal Home Loan Bank stock

(81,947

)

-

Premises and equipment

(9,579

)

(11,870

)

Originations of loans receivable held for investment (net of refinances of $486,388 for the

nine months ended September 30, 2004 and $254,283 for the nine months ended

September 30, 2003)

(6,168,018

)

(2,359,137

)

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

securities available for sale

2,995,570

3,752,848

Net change in undisbursed loan funds

185,721

(11,764

)

Investments in real estate held for investment

(14,816

)

(1,485

)

Other, net

1,236

3,273


Net cash provided by (used for) investing activities

(3,313,089

)

626,400


See accompanying notes to consolidated financial statements.

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DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Continued)

Nine Months Ended

September 30,


(In Thousands)

2004

2003


Cash flows from financing activities

Net increase (decrease) in deposits

$

1,257,575

$

(630,282

)

Proceeds from Federal Home Loan Bank advances and other borrowings

15,148,370

7,606,478

Repayments of Federal Home Loan Bank advances and other borrowings

(12,601,756

)

(7,967,234

)

Proceeds from the issuance of senior notes

197,934

-

Redemption of junior subordinated debentures

(123,711

)

-

Purchase of treasury stock

(6,211

)

-

Proceeds from reissuance of treasury stock for exercise of stock options

843

-

Cash dividends

(8,387

)

(7,542

)


Net cash provided by (used for) financing activities

3,864,657

(998,580

)


Net decrease in cash and cash equivalents

(6,129

)

(9,003

)

Cash and cash equivalents at beginning of period

113,167

126,079


Cash and cash equivalents at end of period

$

107,038

$

117,076


Supplemental disclosure of cash flow information:

Cash paid during the period for:

Interest

$

169,700

$

181,910

Income taxes

21,254

55,588

Supplemental disclosure of non-cash investing:

Loans transferred to held for investment from held for sale

3,940

8,406

Loans transferred from held for investment to held for sale

283

3,655

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

available for sale, purchased and not settled

14,999

100,000

Loans exchanged for mortgage-backed securities

1,464,424

4,808,110

Real estate acquired in settlement of loans

3,315

11,493

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

98

3,990


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 September 30, 2004, December 31, 2003 and September 30, 2003, the results of operations and comprehensive income for the three months and nine months ended September 30, 2004 and 2003, and changes in cash flows for the nine months ended September 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. For further information concerning mortgage servicing rights, see Note 9 – Subsequent Events on page 14.

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2004

2004

2004

2003

2003


Gross balance at beginning of period

$

95,813

$

91,766

$

95,183

$

92,665

$

89,948

Additions

12,114

12,074

5,968

9,091

21,660

Amortization

(5,190

)

(4,082

)

(5,519

)

(5,001

)

(5,051

)

Sales

-

-

-

-

-

Impairment write-down

(3,610

)

(3,945

)

(3,866

)

(1,572

)

(13,892

)


Gross balance at end of period

99,127

95,813

91,766

95,183

92,665


Allowance balance at beginning of period

3,764

22,045

13,008

22,265

41,226

Provision for (reduction of) impairment

16,678

(14,336

)

12,903

(7,685

)

(5,069

)

Impairment write-down

(3,610

)

(3,945

)

(3,866

)

(1,572

)

(13,892

)


Allowance balance at end of period

16,832

3,764

22,045

13,008

22,265


Total mortgage servicing rights, net

$

82,295

$

92,049

$

69,721

$

82,175

$

70,400


As a percentage of associated mortgage loans

0.82

%

1.00

%

0.76

%

0.89

%

0.78

%

Estimated fair value (a)

$

82,401

$

92,483

$

69,721

$

82,314

$

70,401

Weighted average expected life (in months)

57

67

49

59

50

Custodial account earnings rate

2.24

%

2.10

%

1.47

%

1.65

%

1.49

%

Weighted average discount rate

9.27

8.97

8.98

8.95

8.91


At period end

Mortgage loans serviced for others:

Total

$

10,568,339

$

9,279,359

$

9,167,834

$

9,313,948

$

9,125,469

With capitalized mortgage servicing rights:(a)

Amount

10,075,028

9,242,641

9,126,444

9,268,308

9,068,209

Weighted average interest rate

5.52

%

5.61

%

5.73

%

5.79

%

5.87

%

Total loans sub-serviced without mortgage

servicing rights

459,307

-

-

-

5,002


Custodial account balances

$

229,704

$

238,914

$

359,146

$

232,562

$

352,161


(a) The estimated fair value may exceed book value for certain asset strata and excluded loans sold or securitized prior to 1996 and loans sub-serviced without capitalized mortgage servicing rights.
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Nine Months Ended September 30,


(Dollars in Thousands)

2004

2003


Gross balance at beginning of period

$

95,183

$

90,584

Additions

30,156

52,019

Amortization

(14,791

)

(19,773

)

Sales

-

-

Impairment write-down

(11,421

)

(30,165

)


Gross balance at end of period

99,127

92,665


Allowance balance at beginning of period

13,008

32,855

Provision for impairment

15,245

19,575

Impairment write-down

(11,421

)

(30,165

)


Allowance balance at end of period

16,832

22,265


Total mortgage servicing rights, net

$

82,295

$

70,400


          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

$

19,994

$

4,781

$

(2,967

)

$

20,356

Reduction of (increase in) valuation allowance

6,614

4,645

(2,922

)

7,981

Decrease rates 100 basis points: (b)

Increase (decrease) in fair value

(35,286

)

(4,921

)

2,994

(39,971

)

Reduction of (increase in) valuation allowance

(35,180

)

(4,816

)

2,948

(39,866

)


(a) The weighted-average expected life of the mortgage servicing rights portfolio is 77 months.
(b) The weighted-average expected life of the mortgage servicing rights portfolio is 28 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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Net cash servicing fees

$

6,031

$

5,615

$

5,704

$

5,681

$

5,401

Payoff and curtailment interest cost (a)

(1,053

)

(2,083

)

(1,527

)

(1,597

)

(3,869

)

Amortization of MSRs

(5,190

)

(4,082

)

(5,519

)

(5,001

)

(5,051

)

(Provision for) reduction of impairment

of MSRs

(16,678

)

14,336

(12,903

)

7,685

5,069


Total loan servicing income (loss), net

$

(16,890

)

$

13,786

$

(14,245

)

$

6,768

$

1,550


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and 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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Nine Months Ended September 30,


(In Thousands)

2004

2003


Net cash servicing fees

$

17,350

$

15,534

Payoff and curtailment interest cost (a)

(4,663

)

(10,014

)

Amortization of MSRs

(14,791

)

(19,773

)

Provision for impairment of MSRs

(15,245

)

(19,575

)


Total loan servicing loss, net

$

(17,349

)

$

(33,828

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and 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 September 30, 2004, Downey had a notional amount of expected rate lock commitments identified to sell as part of its secondary marketing activities of $462 million, with a change in fair value resulting in a gain of $0.3 million.

Derivative Hedging Activities

          As part of secondary marketing activities, Downey typically utilizes short-term forward sale and purchase contracts—derivatives—that mature in less than one year to offset the impact of changes in market interest rates on the value of residential one-to-four unit expected rate lock commitments and loans held for sale. 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 September 30, 2004, the notional amount of forward sale contracts amounted to $1.288 billion, with a change in fair value resulting in a loss of $0.3 million, of which $839 million were designated as cash flow hedges. There were no forward purchase contracts at September 30, 2004.

          In connection with its interest rate risk management, Downey from time-to-time enters 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. These swap contracts help Downey 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

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advances that are attributable to changes in market interest rates. The payment and maturity dates of the swap contracts match those of the advances. This hedge effectively converts fixed interest rate advances into debt that adjusts quarterly to movements in 3-month Libor. Because the terms of the swap contracts match those of the advances, the hedge has no ineffectiveness and results are reported in interest expense. The fair value of interest rate swap contracts is based on observable market prices acquired from third parties and represents the estimated amount Downey would receive or pay upon terminating the contracts, taking into consideration current interest rates and the remaining contract terms. The fair value of the swap contracts is recorded on the balance sheet in either other assets or accounts payable and accrued liabilities. With no ineffectiveness, the recorded swap contract values will essentially act as fair value adjustments to the advances being hedged. At September 30, 2004, swap contracts with a notional amount totaling $430 million were outstanding and had a fair value loss of $5.3 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 September 30, 2004:

Weighted

Notional

Average

(Dollars in Thousands)

Amount

Interest Rate

Term


Pay – Variable (3-month Libor)

$

(100,000

)

1.78

%

March 2004 – October 2008

Receive – Fixed

100,000

3.20

Pay – Variable (3-month Libor)

(130,000

)

1.78

March 2004 – October 2008

Receive – Fixed

130,000

3.21

Pay – Variable (3-month Libor)

(100,000

)

1.78

March 2004 – November 2008

Receive – Fixed

100,000

3.26

Pay – Variable (3-month Libor)

(100,000

)

1.78

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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Net gains (losses) on non-qualifying hedge transactions

$

2,595

$

3,352

$

(3,282

)

$

1,016

$

1,121

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)

2,595

3,352

(3,282

)

1,016

1,121

Other comprehensive income (loss)

822

(1,694

)

1,257

1,673

(2,424

)


Notional amount or balance at period end

Non-qualifying hedge transactions:

Expected rate lock commitments

$

462,441

$

541,358

$

441,747

$

163,737

$

381,948

Associated forward sale contracts

448,999

374,462

429,066

153,436

391,234

Associated forward purchase contracts

-

-

4,000

-

35,000

Qualifying cash flow hedge transactions:

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

845,913

661,481

529,085

279,657

335,437

Associated forward sale contracts

838,567

652,796

509,710

275,009

334,031

Qualifying fair value hedge transactions:

Designated FHLB advances – pay-fixed

430,000

430,000

430,000

-

-

Associated interest rate swap contracts –

pay-variable, receive-fixed

430,000

430,000

430,000

-

-


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Nine Months Ended September 30,


(In Thousands)

2004

2003


Net gains (losses) on non-qualifying hedge transactions

$

2,665

$

(1,954

)

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)

2,665

(1,954

)

Other comprehensive income

385

789


          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.

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Commitments to originate loans held for investment:

Adjustable

$

683,429

$

479,968

$

650,948

$

528,981

$

414,823

Fixed

-

-

-

-

380

Commitments to purchase loans

-

-

495

-

-

Undisbursed loan funds and unused lines of credit

426,055

372,464

281,821

240,226

178,202

Letters of credit and other contingent liabilities

-

-

-

-

2,703

Commitments to invest in affordable housing funds

5,771

5,226

3,090

3,153

3,393


          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 September 30, in both 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, loan servicing, 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 September 30, 2004, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, 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

$

3,951,709

$

1,056,192

$

216,005

$

-

$

5,223,906

FHLB advances and other borrowings

3,921,304

290,300

430,000

29,000

4,670,604

Senior notes

-

-

-

197,886

197,886

Operating leases

4,375

6,463

3,070

701

14,609


Total other contractual obligations

$

7,877,388

$

1,352,955

$

649,075

$

227,587

$

10,107,005


Litigation

          On July 23, 2004, two former in-store banking employees brought an action against the Bank in Los Angeles Superior Court, Case No. BC318964, entitled “Michelle Cox and Mary Ann Tierra et al. v. Downey Savings and Loan Association.” The complaint seeks unspecified damages for alleged unpaid overtime wages, inadequate meal and rest breaks, and other unlawful business practices and related claims. The plaintiffs also seek class action status to represent all other current and former California employees who held the position of branch manager or assistant manager at the in-store branches who (a) were treated as exempt and not paid overtime between July 23, 2000 and November 2002 and (b) allegedly received inadequate meal/rest periods since October 1, 2000. With the Court’s approval, the parties have reached an informal agreement to participate in a mediation in early 2005 and to stay the lawsuit, including discovery, until the completion of the mediation. Based on a review of the current facts and circumstances with retained counsel, management has provided for what is believed to be a reasonable estimate of the loss exposure for this matter. While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of this matter will not have a material adverse effect on its operations, cash flows or financial position.

          Downey has been named as a defendant in other 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 has examined Downey’s tax returns for all tax years through 2002, while state taxing authorities have reviewed tax returns through 2000. Downey’s management believes it has adequately provided for potential exposure to issues that may be raised by tax auditors in years which remain open to review.

          During the third quarter of 2004, Downey resolved prior-year tax return issues that resulted in a reduction to federal tax expense of $5.6 million.

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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 September 30, 2004, Downey had 381,239 shares of treasury stock that may be used to satisfy the exercise of options or for payment of other awards. No other stock-based compensation plan exists.

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

NOTE (6) – Earnings Per Share

          Earnings per share is calculated on both a basic and diluted basis, excluding common shares in treasury. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted from the issuance of common stock that then shared in earnings.

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

Three Months Ended September 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

$

24,510

27,918,124

$

0.88

$

29,251

27,928,722

$

1.05

Effect of dilutive stock options

-

25,388

-

-

34,652

-


Diluted earnings per share

$

24,510

27,943,512

$

0.88

$

29,251

27,963,374

$

1.05


Nine Months Ended September 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

$

61,243

27,941,520

$

2.19

$

77,983

27,928,722

$

2.79

Effect of dilutive stock options

-

29,268

-

-

33,290

-


Diluted earnings per share

$

61,243

27,970,788

$

2.19

$

77,983

27,962,012

$

2.79


          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 September 30, 2004

Net interest income

$

81,924

$

13

$

-

$

81,937

Provision for loan losses

1,186

-

-

1,186

Other income

9,557

665

-

10,222

Operating expense

57,742

309

-

58,051

Net intercompany income (expense)

(48

)

48

-

-


Income before income taxes

32,505

417

-

32,922

Income taxes

8,243

169

-

8,412


Net income

$

24,262

$

248

$

-

$

24,510


At September 30, 2004

Assets:

Loans and mortgage-backed securities

$

14,257,374

$

-

$

-

$

14,257,374

Investments in real estate and joint ventures

-

44,242

-

44,242

Other

1,374,840

2,883

(39,875

)

1,337,848


Total assets

15,632,214

47,125

(39,875

)

15,639,464


Equity

$

965,625

$

39,875

$

(39,875

)

$

965,625


Three months ended September 30, 2003

Net interest income (expense)

$

68,302

$

(50

)

$

-

$

68,252

Reduction of loan losses

(1,104

)

-

-

(1,104

)

Other income

27,116

6,476

-

33,592

Operating expense

52,126

239

-

52,365

Net intercompany income (expense)

43

(43

)

-

-


Income before income taxes

44,439

6,144

-

50,583

Income taxes

18,818

2,514

-

21,332


Net income

$

25,621

$

3,630

$

-

$

29,251


At September 30, 2003

Assets:

Loans and mortgage-backed securities

$

9,987,468

$

-

$

-

$

9,987,468

Investments in real estate and joint ventures

-

32,435

-

32,435

Other

1,165,611

4,617

(27,037

)

1,143,191


Total assets

11,153,079

37,052

(27,037

)

11,163,094


Equity

$

894,210

$

27,037

$

(27,037

)

$

894,210


Real Estate

(In Thousands)

Banking

Investment

Elimination

Totals


Nine months ended September 30, 2004

Net interest income (expense)

$

228,210

$

(306

)

$

-

$

227,904

Provision for loan losses

4,448

-

-

4,448

Other income

33,972

9,383

-

43,355

Operating expense

169,349

957

-

170,306

Net intercompany income (expense)

(129

)

129

-

-


Income before income taxes

88,256

8,249

-

96,505

Income taxes

31,881

3,381

-

35,262


Net income

$

56,375

$

4,868

$

-

$

61,243


Nine months ended September 30, 2003

Net interest income (expense)

$

223,415

$

(55

)

$

-

$

223,360

Reduction of loan losses

(3,437

)

-

-

(3,437

)

Other income

53,586

10,538

-

64,124

Operating expense

155,217

687

-

155,904

Net intercompany income (expense)

127

(127

)

-

-


Income before income taxes

125,348

9,669

-

135,017

Income taxes

53,077

3,957

-

57,034


Net income

$

72,271

$

5,712

$

-

$

77,983


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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 March 31, 2004 and is to be applied prospectively. There is no financial impact of SAB 105 on Downey, as Downey’s accounting for expected interest rate lock commitments has been in accordance with the bulletin.

NOTE (9) – Subsequent Events

Sale of Mortgage Servicing Rights

          In October of 2004, Downey entered into definitive agreements to sell approximately 80% of the mortgage servicing rights related to loans serviced for others in order to reduce earnings volatility. The net book value of the associated mortgage servicing rights was $64 million at September 30, 2004, and the underlying loans being serviced for others totaled $8.136 billion. Downey does not anticipate a material gain or loss in the fourth quarter of 2004 from these sales.

Sale of Partial Economic Hedge

          Downey established a partial economic hedge against future value changes in its mortgage servicing rights just prior to the end of the first quarter of 2004 by purchasing securities classified as available for sale. At September 30, 2004, those securities totaled $248 million. In connection with the sale of mortgage servicing rights mentioned above, those securities were sold in October 2004. A pre-tax gain of $2.8 million was realized from the sale.

Sale of Portfolio Loans

          In October 2004, Downey entered into an agreement to sell at the end of November approximately $1 billion of its residential one-to-four unit loans on a servicing released basis from its $13.4 billion portfolio held for investment. These are seasoned adjustable rate mortgages tied to the 12-month moving average of annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year. Downey expects to record a gain on the sale of these loans in the fourth quarter of 2004.

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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 third quarter of 2004 totaled $24.5 million or $0.88 per share on a diluted basis, down 16.2% from $29.3 million or $1.05 per share in the third quarter of 2003.

          The decline in our net income between third quarters primarily reflected:

Those negative factors were partially offset by:

          For the first nine months of 2004, our net income totaled $61.2 million or $2.19 per share on a diluted basis, down from $78.0 million or $2.79 per share for the first nine months of 2003. The decline between nine-month periods was primarily associated with lower net income from our banking operations. The decline primarily reflected lower gains from sales of loans and mortgage-backed securities, higher operating expense, an unfavorable change in securities gains/losses, an unfavorable change in our provision for loan losses and a loss on extinguishment of debt. Those unfavorable items were partially offset by an improvement in our loan servicing activities and higher net interest income.

          For the current quarter, our return on average assets was 0.66%, down from 1.02% a year ago, while our return on average equity was 10.30%, down from 13.16% a year ago. For the first nine-month periods, our return on average assets declined from 0.90% a year ago to 0.61%, while our return on average equity declined from 12.07% to 8.74%.

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          Our loan originations, including purchases, totaled a record $4.290 billion in the current quarter, up from the $2.679 billion we originated in the third quarter of 2003. Loans originated for sale increased $488 million to $2.055 billion, while single family loans originated for portfolio increased by $1.063 billion to $2.073 billion. Of the current quarter total originated for portfolio, $232 million represented subprime credits. In addition to single family loans, we originated $162 million of other loans in the quarter.

          At quarter end, our assets totaled $15.6 billion, up $4.5 billion or 40.1% from a year ago and up $4.0 billion or 34.3% from year-end 2003. During the current quarter, portfolio originations exceeded loan payoffs, resulting in an increase of $1.1 billion in our loans held for investment. In addition, our loans held for sale increased by $184 million and securities available for sale increased by $102 million.

          At September 30, 2004, our deposits totaled $9.6 billion, up 11.0% from the year-ago level and up $1.3 billion or 15.2% since year-end 2003. During the quarter, one traditional branch was opened to replace an in-store branch closed during the second quarter of 2004. This brings our total branches at quarter end to 168, of which 95 were in-store. A year ago, we had 171 branches, of which 99 were in-store. During the fourth quarter of 2004, we expect two in-store branches to be moved to other branch locations due to a decision by the grocery company to close the stores in which they are located. The deposits associated with these branch closings totaled $8 million at quarter end.

          In June 2004, we issued $200 million 6.5% 10-year senior notes. On July 23, 2004, we used a portion of the net proceeds 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 incurred in the current quarter a pre-tax charge of $4.1 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 as well as other cash at the holding company was used during the current quarter to make a $117 million equity contribution into Downey Savings and Loan Association, F.A. (the “Bank”) to support its asset growth.

          Our non-performing assets declined $1 million during the quarter to $39 million or 0.25% of total assets. The decline occurred in our prime residential loan category.

          At September 30, 2004, the Bank, our primary subsidiary, exceeded all regulatory capital tests, with capital-to-asset ratios of 6.94% for both tangible and core capital and 13.62% 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.

Subsequent Events

          As we entered the fourth quarter of 2004, we decided to slow our asset growth to maintain a strong capital position and expect to manage asset growth more in line with the growth in our retained earnings. In October, we entered into an agreement to sell at the end of November approximately $1 billion of our residential one-to-four unit loans on a servicing released basis from our $13.4 billion portfolio held for investment. These are seasoned adjustable rate mortgages tied to the 12-month moving average of annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year (“MTA”) that we expect to replace with higher yielding adjustable rate product. While this sale may temporarily result in assets growing more slowly than the growth of our retained earnings, we expect to achieve before the end of first quarter 2005 asset growth more in line with the growth of our retained earnings, to include the replacement of the MTA loans being sold. Initially, the sale will result in a reduction of net interest income until the loans are replaced. However, a breakeven point for the lost net interest income is expected to occur within approximately six months following the sale date, when considering the expected 2004 fourth quarter gain from this loan sale. After the initial approximate six month period, overall profits should be enhanced from the higher yielding loans. We will continue to originate significant volumes of adjustable rate mortgages to the extent we can profitably sell the amount in excess of our balance sheet needs in the secondary markets.

          In October 2004, we also entered into definitive agreements to sell approximately 80% of the mortgage servicing rights related to loans serviced for others in order to reduce earnings volatility. We do not expect a material gain or loss in the fourth quarter from these sales. Due to the reduced risk, we sold the securities previously purchased as a partial economic hedge against future value changes in our mortgage servicing rights at a pre-tax gain of $2.8 million. For further information, see Note 9 of Notes to Consolidated Financial Statements on page 14.

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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 $81.9 million in the current quarter, up $13.7 million or 20.1% from the same period last year. The increase reflected higher interest-earning assets, which averaged $14.5 billion during the quarter, up 31.4% from the year-ago level. The effective interest rate spread averaged 2.26% in the current quarter, down from 2.48% a year ago and 2.36% in the previous quarter. The decline between third 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 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 nine months of 2004, net interest income totaled $227.9 million, up $4.5 million from a year ago. The increase was due to higher interest-earning asset levels, partially offset by a lower effective interest rate spread.

          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 September 30,


2004

2003


Average

Average

Average

Average

(Dollars in Thousands)

Balance

Interest

Yield/Rate

Balance

Interest

Yield/Rate


Interest-earning assets:

Loans

$

13,653,221

$

141,458

4.14

%

$

10,421,746

$

119,990

4.61

%

Mortgage-backed securities

319

3

3.76

1,660

16

3.86

Investment and trading securities

829,598

7,740

3.71

599,065

3,693

2.45


Total interest-earning assets

14,483,138

149,201

4.12

11,022,471

123,699

4.49

Non-interest-earning assets

417,840

397,200


Total assets

$

14,900,978

$

11,419,671


Transaction accounts:

Non-interest-bearing checking

$

501,808

$

-

-

%

$

436,087

$

-

-

%

Interest-bearing checking (a)

541,225

512

0.38

456,023

292

0.25

Money market

148,072

390

1.05

133,736

350

1.04

Regular passbook

3,306,857

9,056

1.09

4,131,975

12,874

1.24


Total transaction accounts

4,497,962

9,958

0.88

5,157,821

13,516

1.04

Certificates of deposit

4,847,385

30,757

2.52

3,699,164

24,494

2.63


Total deposits

9,345,347

40,715

1.73

8,856,985

38,010

1.70

FHLB advances and other borrowings (b)

4,167,680

22,490

2.15

1,322,837

14,304

4.29

Senior notes and junior subordinated debentures (c)

227,245

4,059

7.14

123,711

3,133

10.13


Total deposits and borrowings

13,740,272

67,264

1.95

10,303,533

55,447

2.13

Other liabilities

208,535

227,027

Stockholders’ equity

952,171

889,111


Total liabilities and stockholders’ equity

$

14,900,978

$

11,419,671


Net interest income/interest rate spread

$

81,937

2.17

%

$

68,252

2.36

%

Excess of interest-earning assets over deposits and borrowings

$

742,866

$

718,938

Effective interest rate spread

2.26

2.48


Nine Months Ended September 30,


Interest-earning assets:

Loans

$

12,199,645

$

380,301

4.16

%

$

10,566,127

$

393,363

4.96

%

Mortgage-backed securities

325

9

3.69

1,825

51

3.73

Investment and trading securities

777,683

20,928

3.59

543,076

11,856

2.92


Total interest-earning assets

12,977,653

401,238

4.12

11,111,028

405,270

4.86

Non-interest-earning assets

413,144

405,516


Total assets

$

13,390,797

$

11,516,544


Transaction accounts:

Non-interest-bearing checking

$

481,290

$

-

-

%

$

407,452

$

-

-

%

Interest-bearing checking (a)

537,018

1,507

0.37

440,581

874

0.27

Money market

144,157

1,130

1.05

128,364

1,119

1.17

Regular passbook

3,689,602

30,201

1.09

3,931,071

40,957

1.39


Total transaction accounts

4,852,067

32,838

0.90

4,907,468

42,950

1.17

Certificates of deposit

4,053,102

75,139

2.48

3,998,283

85,279

2.85


Total deposits

8,905,169

107,977

1.62

8,905,751

128,229

1.93

FHLB advances and other borrowings (b)

3,208,849

54,738

2.28

1,435,378

44,280

4.12

Senior notes and junior subordinated debentures (c)

164,125

10,619

8.63

123,711

9,401

10.13


Total deposits and borrowings

12,278,143

173,334

1.89

10,464,840

181,910

2.32

Other liabilities

178,257

189,919

Stockholders’ equity

934,397

861,785


Total liabilities and stockholders’ equity

$

13,390,797

$

11,516,544


Net interest income/interest rate spread

$

227,904

2.23

%

$

223,360

2.54

%

Excess of interest-earning assets over deposits and borrowings

$

699,510

$

646,188

Effective interest rate spread

2.34

2.68


(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 September 30,

Nine Months Ended September 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

$

37,207

$

(12,014

)

$

(3,725

)

$

21,468

$

60,814

$

(63,984

)

$

(9,892

)

$

(13,062

)

Mortgage-backed securities

(13

)

-

-

(13

)

(42

)

-

-

(42

)

Investment securities

1,414

1,901

732

4,047

5,132

2,752

1,188

9,072


Change in interest income

38,608

(10,113

)

(2,993

)

25,502

65,904

(61,232

)

(8,704

)

(4,032

)


Interest expense:

Transaction accounts:

Interest-bearing checking

54

140

26

220

191

363

79

633

Money market

37

3

-

40

152

(126

)

(15

)

11

Regular passbook

(2,588

)

(1,537

)

307

(3,818

)

(2,509

)

(8,787

)

540

(10,756

)


Total transaction accounts

(2,497

)

(1,394

)

333

(3,558

)

(2,166

)

(8,550

)

604

(10,112

)

Certificates of deposit

7,503

(946

)

(294

)

6,263

1,161

(11,149

)

(152

)

(10,140

)


Total interest-bearing deposits

5,006

(2,340

)

39

2,705

(1,005

)

(19,699

)

452

(20,252

)

FHLB advances and other

borrowings

30,442

(7,113

)

(15,143

)

8,186

54,927

(19,860

)

(24,609

)

10,458

Senior notes and junior

subordinated debentures

2,630

(928

)

(776

)

926

3,057

(1,386

)

(453

)

1,218


Change in interest expense

38,078

(10,381

)

(15,880

)

11,817

56,979

(40,945

)

(24,610

)

(8,576

)


Change in net interest income

$

530

$

268

$

12,887

$

13,685

$

8,925

$

(20,287

)

$

15,906

$

4,544


Provision for Loan Losses

          Provision for loan losses totaled $1.2 million in the current quarter, compared to a $1.1 million reversal in the year-ago quarter. The provision was due to growth in our loan portfolio, whereas the year-ago reversal primarily reflected a decline in our loan portfolio.

          For the first nine months of 2004, provision for loan losses totaled $4.4 million, compared to a $3.4 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 $10.2 million in the current quarter, compared to $33.6 million in the year-ago quarter. The $23.4 million decline between third quarters primarily reflected:

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Those negative factors were partially offset by:

          For the first nine months of 2004, our total other income was $43.4 million, down $20.8 million from a year ago. The decline primarily reflected lower gains from sales of loans and mortgage-backed securities, an unfavorable change in securities gains/losses, a loss on extinguishment of debt and a decline in income from a litigation award. Those unfavorable items were partially offset by an improvement in our loan servicing activities and higher loan and deposit related fees.

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

Loan and Deposit Related Fees

          Loan and deposit related fees totaled $15.8 million in the current quarter, up $1.4 million from a year ago. The increase was primarily in our loan related fees which were up $1.0 million or 13.0% due primarily to an increase in loan prepayment fees.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Loan related fees:

Prepayment fees

$

6,435

$

5,090

$

3,799

$

4,320

$

4,756

Other fees

2,175

2,215

2,000

2,117

2,863

Deposit related fees:

Automated teller machine fees

2,418

2,455

2,243

2,187

2,472

Other fees

4,800

4,659

4,414

4,420

4,314


Total loan and deposit related fees

$

15,828

$

14,419

$

12,456

$

13,044

$

14,405


          For the first nine months of 2004, loan and deposit related fees totaled $42.7 million, up $2.7 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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Loan related fees:

Prepayment fees

$

15,324

$

12,460

Other fees

6,390

8,362

Deposit related fees:

Automated teller machine fees

7,116

6,738

Other fees

13,873

12,472


Total loan and deposit related fees

$

42,703

$

40,032


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Real Estate and Joint Ventures Held for Investment

          Income from our real estate and joint ventures held for investment totaled $0.4 million in the current quarter, down $5.5 million from the year-ago quarter due primarily to lower gains from sales.

          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Rental operations, net of expenses

$

113

$

172

$

576

$

290

$

168

Net gains on sales of wholly owned real estate

-

5,616

40

-

2,160

Equity in net income from joint ventures

(2

)

1,014

80

451

3,308

Interest from joint venture advances

254

246

230

218

568

Provision for losses on real estate

and joint ventures

-

-

-

-

(340

)


Total income from real estate and joint ventures

held for investment, net

$

365

$

7,048

$

926

$

959

$

5,864


          For the first nine months of 2004, income from real estate and joint ventures held for investment totaled $8.3 million, down $0.5 million from the same period of 2003 due primarily to lower gains from sales, a portion of which we reflected in equity in net income from joint ventures.

          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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Rental operations, net of expenses

$

861

$

923

Net gains on sales of wholly owned real estate

5,656

3,317

Equity in net income from joint ventures

1,092

3,928

Interest from joint venture advances

730

1,236

Provision for losses on real estate and joint ventures

-

(528

)


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

$

8,339

$

8,876


Secondary Marketing Activities

          We service loans for others and those activities generated a loss of $16.9 million in the current quarter, compared to income of $1.6 million in the year-ago quarter. The primary reason for the $18.4 million unfavorable change was that the current quarter included an addition for impairment of mortgage servicing rights of $16.7 million, whereas the year-ago quarter included a $5.1 million reduction of impairment. Partially offsetting that unfavorable change was a decline of $2.8 million in payoff and curtailment interest costs and a $0.6 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 September 30, 2004, we serviced $10.6 billion of loans for others, up from $9.3 billion at December 31, 2003 and $9.1 billion at September 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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Net cash servicing fees

$

6,031

$

5,615

$

5,704

$

5,681

$

5,401

Payoff and curtailment interest cost (a)

(1,053

)

(2,083

)

(1,527

)

(1,597

)

(3,869

)

Amortization of MSRs

(5,190

)

(4,082

)

(5,519

)

(5,001

)

(5,051

)

(Provision for) reduction of impairment

of MSRs

(16,678

)

14,336

(12,903

)

7,685

5,069


Total loan servicing income (loss), net

$

(16,890

)

$

13,786

$

(14,245

)

$

6,768

$

1,550


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and 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 nine months of 2004, a loss of $17.3 million was recorded in loan servicing, an improvement over the $33.8 million loss for the same period of 2003. The smaller loss reflected lower payoff and curtailment interest costs, a decline in amortization of MSRs, a favorable change in provision for impairment 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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Net cash servicing fees

$

17,350

$

15,534

Payoff and curtailment interest cost (a)

(4,663

)

(10,014

)

Amortization of MSRs

(14,791

)

(19,773

)

(Provision for) reduction of impairment of MSRs

(15,245

)

(19,575

)


Total loan servicing loss, net

$

(17,349

)

$

(33,828

)


(a) Represents the difference between the contractual obligation to pay interest to the investor for an entire month and 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 on page 6 and Note 9 on page 14 of Notes to Consolidated Financial Statements.

          Sales of loans and mortgage-backed securities declined slightly from $1.938 billion a year ago to $1.871 billion in the current quarter. Net gains associated with these sales totaled $14.6 million in the current quarter, down from $23.5 million a year ago. The decline was primarily due to a lower gain per dollar of loan sold. Excluding the impact of SFAS 133, a gain of 0.64% of secondary market sales was realized which is below 1.15% a year ago. Net gains in the current quarter included the capitalization of MSRs of $12.1 million, compared to $21.7 million 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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Mortgage servicing rights

$

12,114

$

12,074

$

5,968

$

9,091

$

21,660

All other components excluding SFAS 133

(72

)

249

(1,314

)

(4,553

)

686

SFAS 133

2,595

3,352

(3,282

)

1,016

1,121


Total net gains on sales of loans

and mortgage-backed securities

$

14,637

$

15,675

$

1,372

$

5,554

$

23,467


Secondary marketing gain excluding SFAS

133 as a percentage of associated sales

0.64

%

1.08

%

0.69

%

0.48

%

1.15

%


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          For the first nine months of 2004, sales of loans and mortgage-backed securities totaled $3.689 billion, down from $5.640 billion a year ago. Net gains associated with these sales totaled $31.7 million, $24.2 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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Mortgage servicing rights

$

30,156

$

52,019

All other components excluding SFAS 133

(1,137

)

5,817

SFAS 133

2,665

(1,954

)


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

$

31,684

$

55,882


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

0.79

%

1.03

%


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 securities classified as available for sale. At September 30, 2004, securities available for sale included $248 million, net of an unrealized gain of $1 million, associated with the partial economic hedge. No securities gains or losses were recorded in the current quarter, whereas the year-ago quarter included losses of $11.0 million from trading securities which were purchased for the same economic purpose.

          For the first nine months of 2004, we recorded losses on sales of securities of $19.2 million, compared to the year-ago period loss of $10.4 million from trading securities which were purchased for the same economic purpose. For further information, see Asset/Liability Management and Market Risk on page 36.

          Subsequent to quarter end, we sold the securities established as a partial economic hedge for our mortgage servicing rights at a pre-tax gain of $2.8 million due to entering into definitive agreements to sell approximately 80% of our mortgage servicing rights. See Note 9 on page 14 of Notes to Consolidated Financial Statements.

Operating Expense

          Our operating expense totaled $58.1 million in the current quarter, up $5.7 million or 10.9% from a year ago. The increase was primarily due to a $2.3 million or 6.8% increase in salaries and related costs and a $2.2 million increase in our other general administrative expense category, which included an accrual for pending litigation. For further information on the pending litigation, see Note 3 of Notes to Consolidated Financial Statements on page 8.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Salaries and related costs

$

36,629

$

37,575

$

35,569

$

33,144

$

34,312

Premises and equipment costs

8,771

8,200

8,208

8,286

8,291

Advertising expense

1,494

1,165

1,708

1,068

835

SAIF insurance premiums and regulatory

assessments

825

744

757

762

787

Professional fees

387

356

368

539

798

Other general and administrative expense

9,909

9,432

8,482

8,106

7,718


Total general and administrative expense

58,015

57,472

55,092

51,905

52,741

Net operation of real estate acquired in

settlement of loans

36

(237

)

(72

)

(739

)

(376

)


Total operating expense

$

58,051

$

57,235

$

55,020

$

51,166

$

52,365


          For the first nine months of 2004, operating expenses totaled $170.3 million, up $14.4 million or 9.2% from the same period of 2003, primarily reflecting higher salaries and related costs and other general administrative expense, which included an accrual for pending litigation. For further information on the pending litigation, see Note 3 of Notes to Consolidated Financial Statements on page 8.

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

Nine Months Ended September 30,


(In Thousands)

2004

2003


Salaries and related costs

$

109,773

$

101,466

Premises and equipment costs

25,179

23,975

Advertising expense

4,367

2,644

SAIF insurance premiums and regulatory assessments

2,326

2,443

Professional fees

1,111

1,844

Other general and administrative expense

27,823

23,722


Total general and administrative expense

170,579

156,094

Net operation of real estate acquired in settlement of loans

(273

)

(190

)


Total operating expense

$

170,306

$

155,904


Provision for Income Taxes

          Income taxes for the third quarter totaled $8.4 million, compared to $21.3 million a year ago. Our effective tax rate was 25.6% for the current quarter and 36.5% for the year-to-date period of 2004, compared to 42.2% for the respective periods a year ago. The decline in the effective tax rates reflects a reduction to federal tax expense of $5.6 million in the current quarter from the settlement of prior-year tax return issues. 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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Banking net income

$

24,262

$

23,726

$

8,387

$

23,188

$

25,621

Real estate investment net income

248

4,095

525

570

3,630


Total net income

$

24,510

$

27,821

$

8,912

$

23,758

$

29,251


Nine Months Ended September 30,


(In Thousands)

2004

2003


Banking net income

$

56,375

$

72,271

Real estate investment net income

4,868

5,712


Total net income

$

61,243

$

77,983


Banking

          Net income from our banking operations for the current quarter totaled $24.3 million, down $1.4 million from a year ago. The decline between third quarters primarily reflected:

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Those negative factors were partially offset by:

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Net interest income

$

81,924

$

76,842

$

69,444

$

65,325

$

68,302

Provision for (reduction of) loan losses

1,186

1,458

1,804

(281

)

(1,104

)

Other income

9,557

22,724

1,691

25,498

27,116

Operating expense

57,742

56,908

54,699

50,925

52,126

Net intercompany income (expense)

(48

)

(43

)

(38

)

42

43


Income before income taxes

32,505

41,157

14,594

40,221

44,439

Income taxes

8,243

17,431

6,207

17,033

18,818


Net income

$

24,262

$

23,726

$

8,387

$

23,188

$

25,621


At period end

Assets:

Loans and mortgage-backed securities

$

14,257,374

$

12,971,737

$

11,594,098

$

10,396,510

$

9,987,468

Other

1,374,840

1,239,475

1,919,401

1,237,858

1,165,611


Total assets

15,632,214

14,211,212

13,513,499

11,634,368

11,153,079


Equity

$

965,625

$

942,452

$

924,557

$

917,018

$

894,210


          For the first nine months of 2004, net income from our banking operations totaled $56.4 million, down $15.9 million from the same period a year ago. The decline primarily reflected lower gains from sales of loans and mortgage-backed securities, higher operating expense, an unfavorable change in securities gains/losses, an unfavorable change in our provision for loan losses and a loss on extinguishment of debt. Those unfavorable items were partially offset by an improvement in our loan servicing activities and higher net interest income.

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

Nine Months Ended September 30,


(In Thousands)

2004

2003


Net interest income

$

228,210

$

223,415

Provision for (reduction of) loan losses

4,448

(3,437

)

Other income

33,972

53,586

Operating expense

169,349

155,217

Net intercompany income (expense)

(129

)

127


Income before income taxes

88,256

125,348

Income taxes

31,881

53,077


Net income

$

56,375

$

72,271


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Real Estate Investment

          Net income from our real estate investment operations totaled $0.2 million in the current quarter, down from $3.6 million a year ago. The decline primarily reflected lower gains from sales.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Net interest income (expense)

$

13

$

(231

)

$

(88

)

$

(72

)

$

(50

)

Other income

665

7,456

1,262

1,320

6,476

Operating expense

309

327

321

241

239

Net intercompany income (expense)

48

43

38

(42

)

(43

)


Income before income taxes

417

6,941

891

965

6,144

Income taxes

169

2,846

366

395

2,514


Net income

$

248

$

4,095

$

525

$

570

$

3,630


At period end

Assets:

Investments in real estate and joint ventures

$

44,242

$

31,517

$

35,768

$

35,716

$

32,435

Other

2,883

11,845

3,994

3,503

4,617


Total assets

47,125

43,362

39,762

39,219

37,052


Equity

$

39,875

$

32,227

$

28,132

$

27,607

$

27,037


          For the first nine months of 2004, our net income from real estate investment operations totaled $4.9 million, down $0.8 million from the same period of 2003. The decline primarily reflected lower gains from sales.

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

Nine Months Ended September 30,


(In Thousands)

2004

2003


Net interest expense

$

(306

)

$

(55

)

Other income

9,383

10,538

Operating expense

957

687

Net intercompany income (expense)

129

(127

)


Income before income taxes

8,249

9,669

Income taxes

3,381

3,957


Net income

$

4,868

$

5,712


          Our investments in real estate and joint ventures amounted to $44 million at September 30, 2004, $36 million at December 31, 2003 and $32 million at September 30, 2003. During the quarter, an additional $7 million of capital was invested into our real estate investment business for a new shopping center development project. That additional investment is deducted in determining the Bank’s regulatory capital.

          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 $1.3 billion during the current quarter to a total of $14.3 billion or 91.2% of assets at September 30, 2004. The increase primarily occurred in our loans held for investment, which increased $1.1 billion or 8.9% during the current quarter. The increase primarily occurred in our single family portfolio, as portfolio originations remained high and our annualized prepayment speed in the current quarter declined to 36% from 59% a year ago and 47% in the second quarter of 2004. Since year-end 2003, our loans held for investment have increased $3.3 billion or 32.6%.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

1,903,602

$

1,390,834

$

854,367

$

381,699

$

157,322

MTA

38,363

699,445

721,138

878,153

486,146

Libor

130,425

299,470

203,502

207,303

88,658

Adjustable – fixed for 3-5 years

-

-

124,008

106,412

275,755

Fixed

482

-

-

885

1,976


Total residential one-to-four units

2,072,872

2,389,749

1,903,015

1,574,452

1,009,857

Other

162,069

200,017

125,391

145,175

102,618


Total for investment portfolio

2,234,941

2,589,766

2,028,406

1,719,627

1,112,475

Sale portfolio(a)

2,054,632

1,279,208

927,777

889,144

1,566,423


Total for investment and sale portfolios

$

4,289,573

$

3,868,974

$

2,956,183

$

2,608,771

$

2,678,898


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

Nine Months Ended September 30,


(In Thousands)

2004

2003


Loans originated and purchased

Investment portfolio:

Residential one-to-four units:

Adjustable by index:

COFI

$

4,148,803

$

696,027

MTA

1,458,946

917,475

Libor

633,397

197,777

Adjustable – fixed for 3-5 years

124,008

1,246,908

Fixed

482

21,762


Total residential one-to-four units

6,365,636

3,079,949

Other

487,477

232,180


Total for investment portfolio

6,853,113

3,312,129

Sale portfolio (a)

4,261,617

5,334,724


Total for investment and sale portfolios

$

11,114,730

$

8,646,853


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

          Loan originations, including loans purchased, totaled a record $4.290 billion in the current quarter, up 60.1% from the $2.679 billion we originated in the third quarter of 2003 and 10.9% above the $3.869 billion we originated in the second quarter of 2004. Loans originated for sale increased $488 million from the year-ago third quarter to $2.055 billion, while single family loans originated for portfolio increased $1.063 billion to $2.073 billion. Of the current quarter originations for portfolio, $232 million represented subprime credits. During the current quarter, 73% of our residential one-to-four unit originations represented refinance transactions. This is down from 77% in the second quarter of 2004 and 85% in the year-ago quarter. In addition to single family loans, we originated $162 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 $2.073 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.

September 30, 2004

June 30, 2004

March 31, 2004

December 31, 2003

September 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

$

7,179,528

62

%

$

5,845,753

56

%

$

5,095,707

57

%

$

4,819,852

61

%

$

5,163,897

71

%

MTA

3,362,196

29

3,563,210

35

3,074,120

35

2,503,336

32

1,761,516

24

Libor

934,728

8

857,211

8

589,621

7

403,450

5

249,320

3

Other, primarily CMT

108,612

1

142,796

1

126,154

1

185,437

2

171,039

2


Total adjustable loans (a)

$

11,585,064

100

%

$

10,408,970

100

%

$

8,885,602

100

%

$

7,912,075

100

%

$

7,345,772

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. Our loan contracts limit the amount of negative amortization that can occur. In our loan portfolio, the highest loan contract limit of principal plus negative amortization is 125% of the original loan amount. 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%, the principal plus negative amortization cannot exceed 110% of the original loan amount. At September 30, 2004, loans with the higher 125% limit on negative amortization represented 14% of our adjustable rate one-to-four unit residential portfolio, while those with 110% limit represented 71%. Our current practice imposes a limit on the amount of negative amortization on all our loans we originate to 110% of the original loan amount.

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          At September 30, 2004, $10.8 billion or 85% 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 virtually unchanged from the June 30, 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 $1.871 billion of loans and mortgage-backed securities in the current quarter, compared to $1.139 billion in the second quarter of 2004 and $1.938 billion in the year-ago third quarter. All but minor amounts were secured by residential one-to-four unit property, and at September 30, 2004, loans held for sale totaled $846 million.

          At September 30, 2004, our unfunded loan application pipeline totaled $3.1 billion. Within that pipeline, we had commitments to borrowers for short-term interest rate locks, excluding expected fallout, of $1.3 billion, of which $610 million were related to residential one-to-four unit loans being originated for sale in the secondary market. Furthermore, at September 30, 2004, we had commitments on undrawn lines of credit of $378 million and loans in process of $48 million. We believe our current sources of funds will enable us to meet these obligations.

Subsequent Event

          As we entered the fourth quarter of 2004, we decided to slow our asset growth to maintain a strong capital position and expect to manage asset growth more in line with the growth in our retained earnings. In October, we entered into an agreement to sell at the end of November approximately $1 billion of our residential one-to-four unit loans on a servicing released basis from our $13.4 billion portfolio held for investment. These are seasoned adjustable rate mortgages tied to MTA that we expect to replace with higher yielding adjustable rate product. While this sale may temporarily result in assets growing more slowly than the growth of our retained earnings, we expect to achieve before the end of first quarter 2005 asset growth more in line with the growth of our retained earnings, to include the replacement of the MTA loans being sold. Initially, the sale will result in a reduction of net interest income until the loans are replaced. However, a breakeven point for the lost net interest income is expected to occur within approximately six months following the sale date, when considering the expected 2004 fourth quarter gain from this loan sale. After the initial approximate six month period, overall profits should be enhanced from the higher yielding loans. We will continue to originate significant volumes of adjustable rate mortgages to the extent we can profitably sell the amount in excess of our balance sheet needs in the secondary markets.

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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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Investment Portfolio

Loans originated:

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

1,788,864

$

2,114,055

$

1,550,101

$

1,335,998

$

675,135

Adjustable – subprime

228,110

198,731

163,927

119,989

55,778

Adjustable – fixed for 3-5 years

-

-

124,008

106,412

275,755

Adjustable – fixed for 3-5 years – subprime

-

-

-

-

-


Total adjustable residential one-to-four units

2,016,974

2,312,786

1,838,036

1,562,399

1,006,668

Fixed

284

-

-

885

1,976

Fixed – subprime

-

-

-

-

-

Residential five or more units – adjustable

2,695

9,029

8,452

11,629

12,789


Total residential

2,019,953

2,321,815

1,846,488

1,574,913

1,021,433

Commercial real estate

875

1,070

8,094

-

575

Construction

4,858

8,165

6,330

36,320

12,025

Land

-

25,953

-

-

19,589

Non-mortgage:

Commercial

1,000

-

375

1,260

1,200

Automobile

-

-

-

-

21

Other consumer

152,641

155,305

101,582

95,966

30,107


Total loans originated

2,179,327

2,512,308

1,962,869

1,708,459

1,084,950

Real estate loans purchased:

One-to-four units

51,476

71,006

56,361

10,038

594

One-to-four units – subprime

4,138

5,957

8,618

1,130

619

Other (a)

-

495

558

-

26,312


Total real estate loans purchased

55,614

77,458

65,537

11,168

27,525


Total loans originated and purchased

2,234,941

2,589,766

2,028,406

1,719,627

1,112,475

Loan repayments

(1,123,307

)

(1,294,340

)

(1,064,293

)

(1,205,610

)

(1,526,563

)

Other net changes (b)

(10,423

)

(50,177

)

(15,946

)

(47,939

)

15,168


Net increase (decrease) in loans held for investment

1,101,211

1,245,249

948,167

466,078

(398,920

)


Sale Portfolio

Originated whole loans:

Residential one-to-four units

2,016,218

1,273,042

927,047

886,572

1,565,841

Non-mortgage loans

-

-

730

2,572

582

Loans purchased

38,414

6,166

-

-

-

Loans transferred from (to) the investment portfolio

-

(3,940

)

283

(2,523

)

(7,759

)

Originated whole loans sold

(1,560,485

)

(508,482

)

(155,610

)

(107,060

)

(335,589

)

Loans exchanged for mortgage-backed securities

(310,741

)

(630,547

)

(523,136

)

(834,373

)

(1,602,297

)

Other net changes

(2,875

)

(1,582

)

(968

)

(1,979

)

(1,079

)

Capitalized basis adjustment (c)

3,901

(2,261

)

1,082

1,011

(6,191

)


Net increase (decrease) in loans held for sale

184,432

132,396

249,428

(55,780

)

(386,492

)


Mortgage-backed securities, net:

Received in exchange for loans

310,741

630,547

523,136

834,373

1,602,297

Sold

(310,741

)

(630,547

)

(523,136

)

(834,373

)

(1,602,297

)

Repayments

(6

)

(6

)

(6

)

(1,247

)

(140

)

Other net changes

-

-

(1

)

(9

)

(6

)


Net decrease in mortgage-backed securities

available for sale

(6

)

(6

)

(7

)

(1,256

)

(146

)


Net increase (decrease) in loans held for sale and

mortgage-backed securities available for sale

184,426

132,390

249,421

(57,036

)

(386,638

)


Total net increase (decrease) in loans and

mortgage-backed securities

$

1,285,637

$

1,377,639

$

1,197,588

$

409,042

$

(785,558

)


(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.

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Investment Portfolio

Loans secured by real estate:

Residential one-to-four units:

Adjustable

$

10,422,234

$

9,342,177

$

7,878,316

$

6,945,106

$

6,328,674

Adjustable – subprime

1,140,995

1,043,557

982,696

940,655

987,509

Adjustable – fixed for 3-5 years

1,152,604

1,302,726

1,650,521

1,687,323

1,809,803

Adjustable – fixed for 3-5 years – subprime

22,882

28,938

35,861

42,952

57,910

Fixed

70,524

76,913

90,993

105,042

123,413

Fixed – subprime

3,688

4,028

3,515

4,432

4,790


Total residential one-to-four units

12,812,927

11,798,339

10,641,902

9,725,510

9,312,099

Residential five or more units:

Adjustable

95,555

102,176

99,321

91,024

79,778

Fixed

1,808

1,840

1,875

1,904

2,213

Commercial real estate:

Adjustable

37,641

37,075

36,298

36,142

37,860

Fixed

4,838

5,465

6,016

13,144

14,580

Construction

72,599

80,608

88,676

105,706

90,233

Land

25,764

26,770

1,587

16,855

18,931

Non-mortgage:

Commercial

5,990

5,083

5,150

4,975

5,235

Automobile

1,297

1,911

2,816

3,823

5,085

Other consumer

235,113

179,793

130,549

95,319

70,593


Total loans held for investment

13,293,532

12,239,060

11,014,190

10,094,402

9,636,607

Increase (decrease) for:

Undisbursed loan funds

(50,709

)

(62,478

)

(50,950

)

(56,543

)

(52,841

)

Net deferred costs and premiums

202,874

166,803

133,518

108,990

97,445

Allowance for losses

(34,551

)

(33,450

)

(32,072

)

(30,330

)

(30,770

)


Total loans held for investment, net

13,411,146

12,309,935

11,064,686

10,116,519

9,650,441


Sale Portfolio, Net

Loans held for sale:

Residential one-to-four units

842,853

662,321

526,311

276,295

335,594

Non-mortgage

63

64

1,420

3,090

582

Capitalized basis adjustment (a)

2,997

(904

)

1,354

272

(739

)


Total loans held for sale

845,913

661,481

529,085

279,657

335,437

Mortgage-backed securities available for sale:

Adjustable

315

321

327

334

1,590

Fixed

-

-

-

-

-


Total mortgage-backed securities available for sale

315

321

327

334

1,590


Total loans held for sale and mortgage-backed

securities available for sale

846,228

661,802

529,412

279,991

337,027


Total loans and mortgage-backed securities

$

14,257,374

$

12,971,737

$

11,594,098

$

10,396,510

$

9,987,468


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

          At September 30, 2004, our residential one-to-four units subprime portfolio totaled $1.2 billion and consisted of 94% “Alt. A and A-” credit, 5% “B” credit and 1% “C” credit loans. The average loan-to-value ratio at origination for these loans was 71%.

          We carry mortgage-backed securities available for sale at fair value which, at September 30, 2004, reflected an unrealized gain of $5,000. 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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Investment Securities

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

September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Federal funds

$

-

$

-

$

2,300

$

1,500

$

4,001

U.S. Treasury and agency securities available for sale

732,813

630,719

872,037

690,281

635,759

Other investment securities available for sale

65

66

66

66

66


Total investment securities

$

732,878

$

630,785

$

874,403

$

691,847

$

639,826


          The fair value of temporarily impaired securities, the amount of unrealized losses and the length of time these unrealized losses existed as of September 30, 2004 are presented in the following table. The $73,000 unrealized loss on the security that has been in a loss position for 12 months or longer is due to changes in market interest rates. We have the intent and ability to hold the security until that temporary impairment is eliminated.

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

$

45,728

$

124

$

5,708

$

73

$

51,436

$

197

Other investment securities

-

-

-

-

-

-


Total temporarily impaired securities

$

45,728

$

124

$

5,708

$

73

$

51,436

$

197


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

-

-

89,002

2.72

643,876

4.13

732,878

3.96


Total investment securities

$

-

-

%

$

89,002

2.72

%

$

643,876

4.13

%

$

732,878

3.96

%


Deposits

          At September 30, 2004, our deposits totaled $9.6 billion, up $943 million or 11.0% from the year-ago level and up $603 million or 6.7% since June 30, 2004. Compared to the year-ago period, our certificates of deposit increased $1.7 billion or 47.4%, which was partially offset by a decrease in our lower-rate transaction accounts—i.e., checking, money market and regular passbook—of $737 million or 14.6%. 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 short-term market interest rates have begun to rise, those monies are now beginning to flow back into certificates of deposit.

          During the quarter, one traditional branch was opened to replace an in-store branch closed during the second quarter of 2004. This brings our total branches at quarter end to 168, of which 95 were in-store. A year ago, we had 171 branches, of which 99 were in-store. At September 30, 2004, the average deposit size of our 73 traditional branches was $106 million, while the average deposit size of our 95 in-store branches was $19 million. During the fourth quarter of 2004, we expect two in-store branches to be moved to other branch locations due to a decision by the grocery company to close the stores in which they are located. The deposits associated with these branch closings totaled $8 million at quarter end.

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

September 30, 2004

June 30, 2004

March 31, 2004

December 31, 2003

September 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

-

%

$

506,981

-

%

$

483,566

-

%

$

489,213

-

%

$

429,743

-

%

$

411,839

Interest-bearing

checking (a)

0.34

525,124

0.35

532,682

0.37

542,963

0.21

462,733

0.21

453,547

Money market

1.05

150,716

1.05

146,756

1.05

142,092

1.05

142,418

1.05

136,981

Regular passbook

1.08

3,144,606

1.10

3,578,383

1.08

3,898,369

1.12

4,036,464

1.18

4,062,067


Total transaction

accounts

0.86

4,327,427

0.90

4,741,387

0.90

5,072,637

0.94

5,071,358

0.99

5,064,434

Certificates of deposit:

Less than 2.00%

1.46

1,131,677

1.33

1,480,511

1.22

1,532,376

1.17

1,548,398

1.24

1,533,630

2.00-2.49

2.37

2,711,948

2.39

1,463,613

2.38

962,827

2.23

338,763

2.22

374,684

2.50-2.99

2.77

363,305

2.71

263,753

2.71

211,296

2.73

222,436

2.75

233,258

3.00-3.49

3.28

200,480

3.28

211,428

3.30

233,922

3.27

305,258

3.32

560,853

3.50-3.99

3.85

93,163

3.83

87,374

3.79

106,554

3.78

106,861

3.80

133,807

4.00-4.49

4.25

262,531

4.27

240,864

4.27

240,903

4.27

240,459

4.27

241,388

4.50-4.99

4.83

425,352

4.83

423,229

4.83

420,966

4.83

420,262

4.83

423,728

5.00 and greater

5.62

35,450

5.62

36,079

5.61

35,692

5.59

39,963

5.60

42,286


Total certificates

of deposit

2.58

5,223,906

2.49

4,206,851

2.45

3,744,536

2.44

3,222,400

2.56

3,543,634


Total deposits

1.80

%

$

9,551,333

1.65

%

$

8,948,238

1.56

%

$

8,817,173

1.52

%

$

8,293,758

1.64

%

$

8,608,068


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

Borrowings

          During the current quarter, our borrowings increased $751 million to $4.9 billion, due primarily to an increase of $863 million in FHLB advances. That increase was partially offset by a decline of $124 million due to the redemption of our junior subordinated debentures prior to their maturity. This followed increases of $1.1 billion in FHLB advances and $198 million from the issuance of 10-year senior notes during the second quarter of 2004, partially offset by a decline in securities sold under agreements to repurchase of $267 million.

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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2004

2004

2004

2003

2003


Securities sold under agreements to repurchase

$

251,875

$

239,688

$

507,027

$

-

$

-

Federal Home Loan Bank advances

4,418,729

3,556,087

2,424,230

2,125,150

1,259,150

Real estate notes

-

-

4,144

4,161

4,178

Senior notes

197,886

198,179

-

-

-

Junior subordinated debentures (a)

-

123,711

123,711

123,711

123,711


Total borrowings

$

4,868,490

$

4,117,665

$

3,059,112

$

2,253,022

$

1,387,039


Weighted average rate on borrowings during

the quarter (b)

2.40

%

2.37

%

3.25

%

4.07

%

4.78

%

Total borrowings as a percentage of total assets

31.13

28.95

22.62

19.35

12.43


(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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          On July 23, 2004, we redeemed our junior subordinated debentures before their maturity. These debentures had a principal amount of $124 million 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, paid quarterly cumulative cash distributions at an annual rate of 10.00% of the liquidation value of $25 per share. The capital securities represented undivided beneficial interests in the Trust. We owned 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 was the junior subordinated debentures. The debentures carried an interest rate of 10.00% and were due September 15, 2029.

          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 having been used to make a capital investment in the Bank to support its asset growth. 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 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 mortgage servicing right (“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. For further information regarding our MSRs and associated economic hedge, see Note 9 of Notes to Consolidated Financial Statements on page 14.

          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 September 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.

September 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)

$

245,727

$

97,534

$

350,633

$

248,047

$

-

$

941,941

Loans and mortgage-backed securities:(b)

Loans secured by real estate:

Residential:

Adjustable

12,661,201

308,985

762,940

-

-

13,733,126

Fixed

139,652

13,598

38,158

4,605

974

196,987

Commercial real estate

29,593

2,044

9,173

406

-

41,216

Construction

40,727

-

-

-

-

40,727

Land

7,711

7

653

-

-

8,371

Non-mortgage loans:

Commercial

2,473

-

-

-

-

2,473

Consumer

233,236

320

603

-

-

234,159

Mortgage-backed securities

315

-

-

-

-

315


Total loans and mortgage-backed securities

13,114,908

324,954

811,527

5,011

974

14,257,374


Total interest-earning assets

$

13,360,635

$

422,488

$

1,162,160

$

253,058

$

974

$

15,199,315


Transaction accounts:

Non-interest-bearing checking

$

506,981

$

-

$

-

$

-

$

-

$

506,981

Interest-bearing checking(c)

525,124

-

-

-

-

525,124

Money market (d)

150,716

-

-

-

-

150,716

Regular passbook (d)

3,144,606

-

-

-

-

3,144,606


Total transaction accounts

4,327,427

-

-

-

-

4,327,427

Certificates of deposit(e)

2,101,744

1,849,965

1,272,197

-

-

5,223,906


Total deposits

6,429,171

1,849,965

1,272,197

-

-

9,551,333

FHLB advances and other borrowings

3,919,554

1,750

720,300

29,000

-

4,670,604

Senior notes

-

-

-

197,886

-

197,886

Impact of swap contracts hedging borrowings

430,000

-

(430,000

)

-

-

-


Total deposits and borrowings

$

10,778,725

$

1,851,715

$

1,562,497

$

226,886

$

-

$

14,419,823


Excess (shortfall) of interest-earning assets over

deposits and borrowings

$

2,581,910

$

(1,429,227

)

$

(400,337

)

$

26,172

$

974

$

779,492

Cumulative gap

2,581,910

1,152,683

752,346

778,518

779,492

Cumulative gap–as a percentage of total assets:

September 30, 2004

16.51

%

7.37

%

4.81

%

4.98

%

4.98

%

December 31, 2003

14.95

13.42

6.95

6.76

5.74

September 30, 2003

18.17

18.16

11.86

7.85

6.79


(a) Includes FHLB stock and Investment in Downey Financial Capital Trust I. Based upon contractual maturity and repricing date.
(b) Based upon contractual maturity, repricing date and projected repayment and prepayments of principal.
(c) Included amounts swept into money market deposit accounts and is subject to immediate repricing.
(d) Subject to immediate repricing.
(e) Based upon contractual maturity and repricing date.
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          Our six-month gap at September 30, 2004 was a positive 16.51%. This means that more interest-earning assets mature or reprice within six months than total deposits and borrowings. This gap position is similar to our positive six-month gap of 14.95% at December 31, 2003 and 18.17% a year ago.

          We continue to emphasize the origination of adjustable rate mortgages for our investment portfolio and plan to sell the originations in excess of our balance sheet needs into the secondary markets to the extent we can do so profitably. For the twelve months ended September 30, 2004, we originated and purchased for investment $8.6 billion of adjustable rate loans which represented essentially all of the loans we originated and purchased for investment during the period.

          At September 30, 2004, 98% of our interest-earning assets mature, reprice or are estimated to prepay within five years, compared to essentially 100% at both December 31, 2003 and September 30, 2003. At September 30, 2004, $13.2 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 $9.5 billion or 99% 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.

September 30,

June 30,

March 31,

December 31,

September 30,

2004

2004

2004

2003

2003


Weighted average yield: (a)

Loans and mortgage-backed securities

4.46

%

4.37

%

4.51

%

4.61

%

4.98

%

Federal Home Loan Bank stock

3.90

4.42

3.85

4.18

4.34

Investment securities

3.96

3.61

3.44

3.02

2.63


Interest-earning assets yield

4.43

4.34

4.43

4.51

4.84


Weighted average cost:

Deposits

1.80

1.65

1.56

1.52

1.64

Borrowings:

Securities sold under agreements to repurchase

1.60

0.60

0.45

-

-

Federal Home Loan Bank advances (b)

2.32

2.06

2.44

3.08

4.42

Real estate notes

-

-

6.63

6.63

6.63

Senior notes

6.50

6.50

-

-

-

Junior subordinated debentures (c)

-

10.00

10.00

10.00

10.00


Total borrowings

2.45

2.43

2.43

3.46

4.92


Combined funds cost

2.02

1.90

1.78

1.94

2.09


Interest rate spread

2.41

%

2.44

%

2.65

%

2.57

%

2.75

%


(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 4.46% at September 30, 2004, down from 4.61% at December 31, 2003 and 4.98% at September 30, 2003. At September 30, 2004, our adjustable rate mortgage portfolio of single family residential loans, including mortgage-backed securities, totaled $13.6 billion with a weighted average rate of 4.40%, compared to $9.8 billion with a weighted average rate of 4.55% at December 31, 2003, and $9.4 billion with a weighted average rate of 4.89% at September 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 $1 million during the current quarter to $39 million or 0.25% of total assets. The decline occurred in our prime residential loan category.

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

September 30,

June 30,

March 31,

December 31,

September 30,

(Dollars in Thousands)

2004

2004

2004

2003

2003


Non-accrual loans:

Residential one-to-four units

$

23,091

$

24,445

$

31,037

$

26,325

$

32,430

Residential one-to-four units – subprime

12,870

12,615

16,846

15,980

22,101

Other

464

475

516

523

576


Total non-accrual loans

36,425

37,535

48,399

42,828

55,107

Real estate acquired in settlement of loans

2,819

2,424

5,189

5,803

7,436

Repossessed automobiles

-

9

7

-

15


Total non-performing assets

$

39,244

$

39,968

$

53,595

$

48,631

$

62,558


Allowance for loan losses:

Amount

$

34,551

$

33,450

$

32,072

$

30,330

$

30,770

As a percentage of non-performing loans

94.86

%

89.12

%

66.27

%

70.82

%

55.84

%

Non-performing assets as a percentage of total assets

0.25

0.28

0.40

0.42

0.56


Delinquent Loans

          Loans delinquent 30 days or more as a percentage of total loans was 0.34% at September 30, 2004, down from 0.40% at June 30, 2004 and 0.71% a year ago. The declines 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.

September 30, 2004

June 30, 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

$

9,858

$

6,480

$

16,283

$

32,621

$

11,844

$

6,333

$

18,004

$

36,181

One-to-four units – subprime

4,650

3,818

5,940

14,408

3,935

2,427

7,854

14,216

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

14,508

10,298

22,223

47,029

15,779

8,760

25,858

50,397

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

1

-

-

1

-

11

8

19

Other consumer

30

43

36

109

309

13

39

361


Total delinquent loans

$

14,539

$

10,341

$

22,687

$

47,567

$

16,088

$

8,784

$

26,333

$

51,205


Delinquencies as a percentage of total loans

0.11

%

0.07

%

0.16

%

0.34

%

0.13

%

0.07

%

0.20

%

0.40

%


March 31, 2004

December 31, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

13,066

$

4,805

$

23,995

$

41,866

$

15,501

$

7,244

$

20,081

$

42,826

One-to-four units – subprime

3,458

3,852

10,279

17,589

6,084

2,801

9,283

18,168

Five or more units

-

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

-


Total real estate loans

16,524

8,657

34,274

59,455

21,585

10,045

29,364

60,994

Non-mortgage:

Commercial

-

-

428

428

-

-

428

428

Automobile

5

14

8

27

34

4

7

45

Other consumer

221

12

80

313

41

22

88

151


Total delinquent loans

$

16,750

$

8,683

$

34,790

$

60,223

$

21,660

$

10,071

$

29,887

$

61,618


Delinquencies as a percentage of total loans

0.14

%

0.08

%

0.30

%

0.52

%

0.20

%

0.10

%

0.29

%

0.59

%


September 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

14,942

$

5,246

$

26,259

$

46,447

One-to-four units – subprime

5,582

4,813

12,961

23,356

Five or more units

-

-

-

-

Commercial real estate

-

-

-

-

Construction

-

-

-

-

Land

-

-

-

-


Total real estate loans

20,524

10,059

39,220

69,803

Non-mortgage:

Commercial

-

-

428

428

Automobile

24

20

36

80

Other consumer

42

29

112

183


Total delinquent loans

$

20,590

$

10,108

$

39,796

$

70,494


Delinquencies as a percentage of total loans

0.21

%

0.10

%

0.40

%

0.71

%


(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 the carrying value of our 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 $36 million at September 30, 2004, compared to $35 million at June 30, 2004, and $32 million a year ago.

          In the current quarter, our provision for loan losses was $1.2 million and net loan charge-offs totaled $0.1 million, resulting in an increase in the allowance for loan losses to $35 million at September 30, 2004. The current quarter increase in the allowance reflected an increase of $1.8 million in the general valuation allowance due to an increase in the loan portfolio, partially offset by a $0.7 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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Balance at beginning of period

$

33,450

$

32,072

$

30,330

$

30,770

$

32,247

Provision (reduction)

1,186

1,458

1,804

(281

)

(1,104

)

Charge-offs

(94

)

(86

)

(96

)

(334

)

(378

)

Recoveries

9

6

34

175

5


Balance at end of period

$

34,551

$

33,450

$

32,072

$

30,330

$

30,770


          Since year-end 2003, our allowance for loan losses increased by $4.2 million, reflecting an increase in the general valuation allowances of $5.4 million and a decline in allocated allowances of $1.2 million.

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

Nine Months Ended September 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

30,330

$

34,999

Provision (reduction)

4,448

(3,437

)

Charge-offs

(276

)

(805

)

Recoveries

49

13


Balance at end of period

$

34,551

$

30,770


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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

Nine Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

  September 30,  

(Dollars in Thousands)

2004

2004

2004

2003

2003

2004

2003


Gross loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

$

56

$

27

$

45

$

112

$

203

$

128

$

350

One-to-four units – subprime

-

-

-

182

85

-

206

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

20

Automobile

7

3

10

1

35

20

53

Other consumer

31

56

41

39

55

128

176


Total gross loan charge-offs

94

86

96

334

378

276

805


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

3

2

5

1

1

10

3

Other consumer

6

3

4

10

4

13

10


Total gross loan recoveries

9

6

34

175

5

49

13


Net loan charge-offs

Loans secured by real estate:

Residential:

One-to-four units

56

27

45

(52

)

203

128

350

One-to-four units – subprime

-

(1

)

(25

)

182

85

(26

)

206

Five or more units

-

-

-

-

-

-

-

Commercial real estate

-

-

-

-

-

-

-

Construction

-

-

-

-

-

-

-

Land

-

-

-

-

-

-

-

Non-mortgage:

Commercial

-

-

-

-

-

-

20

Automobile

4

1

5

-

34

10

50

Other consumer

25

53

37

29

51

115

166


Total net loan charge-offs

$

85

$

80

$

62

$

159

$

373

$

227

$

792


Net loan charge-offs as a

percentage of average loans

-

%

-

%

-

%

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.

September 30, 2004

June 30, 2004

March 31, 2004


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

$

20,562

$

11,645,362

0.18

%

$

19,547

$

10,721,816

0.18

%

$

18,507

$

9,619,830

0.19

%

One-to-four units – subprime

5,997

1,167,565

0.51

5,569

1,076,523

0.52

5,847

1,022,072

0.57

Five or more units

730

97,363

0.75

780

104,016

0.75

759

101,196

0.75

Commercial real estate

561

42,479

1.32

1,096

42,540

2.58

1,049

42,314

2.48

Construction

855

72,599

1.18

951

80,608

1.18

1,045

88,676

1.18

Land

321

25,764

1.25

333

26,770

1.24

18

1,587

1.13

Non-mortgage:

Commercial

461

5,990

7.70

460

5,083

9.05

460

5,150

8.93

Automobile

19

1,297

1.46

37

1,911

1.94

51

2,816

1.81

Other consumer

2,245

235,113

0.95

1,877

179,793

1.04

1,536

130,549

1.18

Not specifically allocated

2,800

-

-

2,800

-

-

2,800

-

-


Total loans held for investment

$

34,551

$

13,293,532

0.26

%

$

33,450

$

12,239,060

0.27

%

$

32,072

$

11,014,190

0.29

%


December 31, 2003

September 30, 2003


Loans secured by real estate:

Residential:

One-to-four units

$

17,040

$

8,737,471

0.20

%

$

17,174

$

8,261,890

0.21

%

One-to-four units – subprime

5,382

988,039

0.54

6,123

1,050,209

0.58

Five or more units

697

92,928

0.75

615

81,991

0.75

Commercial real estate

1,127

49,286

2.29

1,160

52,440

2.21

Construction

1,257

105,706

1.19

1,082

90,233

1.20

Land

209

16,855

1.24

235

18,931

1.24

Non-mortgage:

Commercial

460

4,975

9.25

461

5,235

8.81

Automobile

38

3,823

0.99

42

5,085

0.83

Other consumer

1,320

95,319

1.38

1,078

70,593

1.53

Not specifically allocated

2,800

-

-

2,800

-

-


Total loans held for investment

$

30,330

$

10,094,402

0.30

%

$

30,770

$

9,636,607

0.32

%


          At September 30, 2004, the recorded investment in loans for which we recognized impairment totaled $3 million, down from $12 milion at December 31, 2003 and $13 million a year ago. The current quarter reduction in impaired loans was due to the removal of the impaired designation for one borrower who repaid their loan in full on October 1, 2004. There was less than a $1 million allowance for losses related to impaired loans at September 30, 2004, compared to $1 million at both December 31, 2003 and September 30, 2003. During the current quarter, total interest recognized on the impaired loan portfolio was $0.2 million, bringing the year-to-date total to $0.7 million.

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

Three Months Ended


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Balance at beginning of period

$

699

$

704

$

709

$

711

$

716

Reduction

(658

)

(5

)

(5

)

(2

)

(5

)

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

41

$

699

$

704

$

709

$

711


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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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

709

$

725

Reduction

(668

)

(14

)

Charge-offs

-

-

Recoveries

-

-


Balance at end of period

$

41

$

711


          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


September 30,

June 30,

March 31,

December 31,

September 30,

(In Thousands)

2004

2004

2004

2003

2003


Balance at beginning of period

$

1,436

$

1,436

$

1,436

$

1,436

$

1,096

Provision

-

-

-

-

340

Charge-offs

-

-

-

-

-

Recoveries

-

-

-

-

-


Balance at end of period

$

1,436

$

1,436

$

1,436

$

1,436

$

1,436


          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.

Nine Months Ended September 30,


(In Thousands)

2004

2003


Balance at beginning of period

$

1,436

$

908

Provision

-

528

Charge-offs

-

-

Recoveries

-

-


Balance at end of period

$

1,436

$

1,436


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 third 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 September 30, 2004, our FHLB borrowings totaled $4.4 billion, representing 28.3% 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 $3.4 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 September 30, 2004, we had commitments to borrowers for short-term rate locks, excluding expected fallout, of $1.3 billion, undisbursed loan funds and unused lines of credit of $426 million, operating leases of $15 million and commitments to invest in affordable housing funds of $6 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 September 30, 2004, the holding company’s liquid assets, including due from Bank—interest bearing balances, totaled $28 million. The decrease from $269 million at June 30, 2004, primarily reflected the redemption of junior subordinated debentures of $124 million and a capital contribution to the Bank of $117 million to support its asset growth.

          On July 24, 2002, the Board of Directors of Downey authorized a share repurchase program of up to $50 million of our common stock. On September 27, 2004, the Board of Directors terminated the stock repurchase authorization due to significant asset growth this year. To initially fund the program, the Bank paid a special $50 million dividend during the third quarter of 2002 to the holding company. The shares were repurchased from time-to-time in open market transactions. The timing, volume and price of purchases were made at our discretion, and were contingent upon our overall financial condition, as well as market conditions in general. There were 114,500 shares repurchased in the current quarter at a weighted average price of $54.24, leaving approximately $32 million unused from the original $50 million authorized under the recently terminated stock repurchase plan.

          Stockholders’ equity totaled $966 million at September 30, 2004, up from $917 million at December 31, 2003 and $894 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. As of September 30, 2004, 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 when 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 September 30, 2004, scheduled maturities of certificates of deposit, FHLB advances and other borrowings, senior notes, 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

$

3,951,709

$

1,056,192

$

216,005

$

-

$

5,223,906

FHLB advances and other borrowings

3,921,304

290,300

430,000

29,000

4,670,604

Senior notes

-

-

-

197,886

197,886

Secondary marketing activities:

Non-qualifying hedge transactions:

Expected rate lock commitments

462,441

-

-

-

462,441

Associated forward sale contracts

448,999

-

-

-

448,999

Associated forward purchase contracts

-

-

-

-

-

Qualifying cash flow hedge transactions:

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

845,913

-

-

-

845,913

Associated forward sale contracts

838,567

-

-

-

838,567

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

683,429

-

-

-

683,429

Fixed

-

-

-

-

-

Undisbursed loan funds and unused lines of credit

39,200

6,599

-

380,256

426,055

Operating leases

4,375

6,463

3,070

701

14,609

Commitments to invest in affordable housing funds

-

-

-

5,771

5,771


Total obligations and commitments

$

11,195,937

$

1,359,554

$

1,509,075

$

613,614

$

14,678,180


Regulatory Capital Compliance

          During the current quarter, our holding company contributed $117 million of equity to the Bank to support its asset growth. That increase in regulatory capital was decreased, in part, by a $7 million equity contribution by the Bank to DSL Service Company, our real estate investment subsidiary. At September 30, 2004, our core and tangible capital ratios were both 6.94% and our risk-based capital ratio was 13.62%. 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 September 30, 2004.

Tangible Capital

Core Capital

Risk-Based Capital


(Dollars in Thousands)

Amount

Ratio

Amount

Ratio

Amount

Ratio


Stockholder’s equity

$

1,133,885

$

1,133,885

$

1,133,885

Adjustments:

Deductions:

Investment in subsidiary, primarily real estate

(39,539

)

(39,539

)

(39,539

)

Excess cost over fair value of branch acquisitions

(3,150

)

(3,150

)

(3,150

)

Non-permitted mortgage servicing rights (a)

(8,229

)

(8,229

)

(8,229

)

Unrealized gains on securities available for sale

(1,926

)

(1,926

)

(1,926

)

Additions:

General loss allowance – investment in DSL

Service Company

730

730

730

Allowance for loan losses,

net of specific allowances (b)

-

-

34,055


Regulatory capital

1,081,771

6.94

%

1,081,771

6.94

%

1,115,826

13.62

%

Well capitalized requirement

233,645

1.50

(c)

778,816

5.00

818,963

10.00

(d)


Excess

$

848,126

5.44

%

$

302,955

1.94

%

$

296,863

3.62

%


(a) In October of 2004, we entered into a definitive agreement to sell approximately 80% of our mortgage servicing rights. For further information, see Note 9 on page 14 of Notes to Consolidated Financial Statements.
(b) Limited to 1.25% of risk-weighted assets.
(c) Represents the minimum requirement for tangible capital, as no “ well capitalized” requirement has been established for this category.
(d) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%, which the Bank met and exceeded with a ratio of 13.21%.
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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 September 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

          On July 23, 2004, two former in-store banking employees brought an action against the Bank in Los Angeles Superior Court, Case No. BC318964, entitled “Michelle Cox and Mary Ann Tierra et al. v. Downey Savings and Loan Association.” The complaint seeks unspecified damages for alleged unpaid overtime wages, inadequate meal and rest breaks, and other unlawful business practices and related claims. The plaintiffs also seek class action status to represent all other current and former California employees who held the position of branch manager or assistant manager at the in-store branches who (a) were treated as exempt and not paid overtime between July 23, 2000 and November 2002 and (b) allegedly received inadequate meal/rest periods since October 1, 2000. With the Court’s approval, the parties have reached an informal agreement to participate in a mediation in early 2005 and to stay the lawsuit, including discovery, until the completion of the mediation. Based on a review of the current facts and circumstances with retained counsel, management has provided for what is believed to be a reasonable estimate of the loss exposure for this matter. While acknowledging the uncertainties of litigation, management believes that the ultimate outcome of this matter will not have a material adverse effect on its operations, cash flows or financial position.

          Downey has been named as a defendant in other 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. On September 27, 2004, the Board of Directors terminated the stock repurchase authorization due to significant asset growth this year. To initially fund the program, the Bank paid a special $50 million dividend during the third quarter of 2002 to the holding company. The shares were repurchased from time-to-time in open market transactions. The timing, volume and price of purchases were made at our discretion, and were contingent upon our overall financial condition, as well as market conditions in general. There were 114,500 shares repurchased in the current quarter at a weighted average price of $54.24, leaving approximately $32 million unused from the original $50 million authorized under the recently terminated stock repurchase plan.

          Common stock repurchases were as follows:

   Common Stock Repurchased   

Number of

Average

Available

Shares

Price

Repurchases


Authorized share repurchase program – July 24, 2002

-

$

-

$

50,000,000

August 2002

212,300

41.04

41,287,128

November 2002

94,000

36.78

37,829,808

August 2004

114,500

54.24

31,619,328


Balance at September 30, 2004 (a)

420,800

$

43.68

$

0


(a) On September 27, 2004, the Board of Directors teminated the stock repurchase authorization.

ITEM 3 – Defaults Upon Senior Securities

          None.

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

          None.

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 July 19, 2004, with respect to a press release reporting its results of operations during the three and six months ended June 30, 2004.

          2) Form 8-K filed August 13, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended July 31, 2004.

          3) Form 8-K filed August 30, 2004, with respect to a press release announcing CEO resignation and new CEO appointment.

          4) Form 8-K filed August 31, 2004, with respect to a press release announcing election of Jane Wolfe to the Board of Directors of both Downey Financial Corp. and Downey Savings and Loan Association, F.A.

          5) Form 8-K filed September 15, 2004, with respect to a press release reporting monthly selected financial data for the thirteen months ended August 31, 2004.

          6) Form 8-K filed September 20, 2004, with respect to a press release reporting the announcement of Thomas E. Prince, Executive Vice President and Chief Financial Officer, to also assume the responsibilities of Chief Operating Officer of both Downey Financial Corp. and Downey Savings and Loan Association, F.A.

          7) Form 8-K filed September 27, 2004, with respect to a press release reporting the announcement that the Board of Directors of Downey Financial Corp. terminated the authorization to repurchase common stock.

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AVAILABILITY OF REPORTS

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

          We will furnish any or all of the non-confidential exhibits upon payment of a reasonable fee. Please send request for exhibits and/or fee information to:

 

Downey Financial Corp.
3501 Jamboree Road
Newport Beach, California 92660
Attention: Corporate Secretary

SIGNATURES

          Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

DOWNEY FINANCIAL CORP.

/s/ Daniel D. Rosenthal


Date: November 2, 2004

Daniel D. Rosenthal

President and Chief Executive Officer

/s/ Thomas E. Prince


Date: November 2, 2004

Thomas E. Prince

Chief Operating Officer 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