At Downey Savings, a Shake-Up as Losses Mount

Maybe relying on pay-option ARM mortgage wasn’t such a good idea, after all.

Ailing savings & loan Downey Financial Corp. (DSL: 0.33 0.00%) said Thursday morning before market open that it lost $218.9 million during the quarter — that’s a loss of $7.86 per share — as the number of bad loans on its books continued to spiral higher. The quarterly loss represents a huge swing into the red for the Newport Beach, Calif.-based lender, which one year ago reported earnings of $32.7 million, or $1.17 per share.

On the heels of yet another quarterly loss amid a housing slump that shows no signs of slowing down, the bank also said it had sacked key members of its board and executive team — including CEO Daniel Rosenthal, and current chairman and company founder Maurice McAlister (who the company said had decided to retire).

Thomas Price, the bank’s current COO, will serve as interim CEO while the search for a successor is undergoing. The move to replace Rosenthal comes a month after the bank also ousted former president Frederic McGill.

Choosing retirement might prove to be easier than facing up to non-performing assets that continue to skyrocket at the troubled bank, as borrowers stuck in option ARMs find themselves increasingly unable to manage their loans with home prices continuing to fall sharply in California.

NPAs increased during the quarter by $395 million to $1.96 billion, Downey said, and now represent a stunning 15.5 percent of total assets, compared with 7.77 percent at year-end 2007 and 1.53 a year ago.

The bank has been working to restructure troubled debt via what the bank calls “a borrower retention program” — of the 15.5 percent in NPAs at the end of Q2, 4.3 percent of that total were tied to this program, where Downey restructures a borrower’s note before their option ARM recasts, and does so at a lower interest rate, without re-underwriting the loan.

It’s worth noting that the percentage of “retentions” in overall NPAs has been decreasing during the past quarter.

Against this rising tide of bad debt, Downey’s allowance for credit losses reached $733.7 million by the end of Q2 — just 38 percent of total non-performing assets. The bank holds a $10.9 billion in residential single-family mortgages; 57 percent of that total, or $6.2 billion, is in the form of option ARMs, compared to 76 percent one year ago.

Downey said that roughly 5.5 percent of its performing option ARMs were accruing negative amortization at the end of Q2 — telling, given the high level of NPAs alraedy being absorbed. Roughly 15 percent of the bank’s interest income in Q2 represented negative amortization, it said.

Banks holding pay-option ARMs book any negative amortization on loans as interest income, a feature that made the loans very attractive during the recent housing boom. However, as home prices fall, the loans become extremely vulnerable to defaults; and the banks the relied heavily on the loans — Downey and Wachovia Corp. (WB: 5.27 0.00%) in particular — have found themselves holding a loan portfolio turning increasingly more toxic by the month.

Disclosure: The author held various put option contracts on WB and no other relevant positions when this story was published; further indirect holdings may exist, however, via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.