CD rates, mortgages, oh my……

Downey Savings is a federally chartered financial institution that is in need of additional capital. 

In spite of this, Downey Savings offers some of the best short term CD rates in California.  The 6 month CD rate is at 3.90% and the one year CD rate is at 4.00%.  The minimum to open these accounts is $1,000.00.  The 6 month rate is one of the best CD rates in the nation and the one year rate is one of the best CD rates in California.

The problem with Downey is the same problem underlying the current credit crisis and economic slowdown, housing and mortgages.  In their particular case it is the worst type of mortgages in the most over inflated housing markets.  The poor performing loan portfolio was the primary reason for the continued operating losses at the bank.

On October 22, 2008 Downey Financial Corp. reported their third quarter earnings.  The company reported a net loss for third quarter 2008 of $81.1 million compared to a net loss of $23.4 million in the year-ago third quarter.

Here is a snapshot from the 10Q regarding the home loan portfolio at the bank.

Most of Downey’s adjustable rate mortgages adjust the interest rate monthly and the payment amount annually.  These monthly adjustable rate mortgages allow for negative amortization, which is the addition to loan principal of accrued interest that exceeds the required monthly loan payments.  At September 30, 2008, loans subject to negative amortization represented 52% of Downey’s residential one-to-four unit adjustable rate portfolio held for investment, of which $318 million represented the amount of negative amortization included in the loan balance.  This compares to 69% and $379 million, respectively, at December 31, 2007.  During the third quarter of 2008, approximately 10% of our loan interest income represented negative amortization, down from 15% in the second quarter of 2008 and 26% from the year-ago third quarter.

These are negative amortization ARMs that were probably appropriate for less that 5% of homeowners in our nation.  Negative amortization by itself is of little value to a homeowner unless they really, really want a low payment at all costs.  The terms of these types of home loans were some of the worst terms available.  Most negative amortization adjustable rate mortgages have a very low start rate.  However, as soon as the start rate ends the adjustable rate mortgage rate and payment adjusts.  The adjustment is based on the index plus a margin to get the new interest rate the mortgage will be based on.  When the interest rate adjusts the borrower has the option to pay the full payment based on the fully adjusted rate or a payment that has negative amortization and does not pay the full interest and principal.  All is well if this is a product you want.  A home loan with a low start payment that will adjust up quickly but allows the option to defer part of the payment.  Perhaps a borrower fresh out of college who expects their income to jump rapidly may want this type of mortgage.  But these loans adjust frequently and have rates that are high once the first adjustment period kicks in.

The key is to price one of these loans at the time a borrower applies.  The negative amortization adjustable arte mortgage has the low start rate for anywhere form 3 months to one year, more often it is less than a year.  To truly compare the rate on this products a borrower should look at the rate on a 30 year fixed rate mortgage and the rate that would occur when the adjustable rate mortgage adjusts.  Approximately 3 years ago when we compared these products, the rate on the adjustable rate mortgage upon the first adjustment period was equal to or greater than a 30 year fixed rate mortgage.  So, after the first adjustment period in about 6 months after the loan is taken out the fully adjusted new rate is higher than a 30 year fixed rate loan. The question we pondered was why so many customers were taking out a loan that would adjust in a few months at a rate that exceeded the present 30 year fixed rate. 

Now we can fuel the fire on the debate over the existence of these products by telling a little story about mortgage pricing.  In the mortgage broker business the brokers solicits customers and delivers processed loan applications to the bank or lender to fund the loans.  Mortgage brokers mostly facilitate loan processing and customer acquisition, they do not normally fund loans.  The broker chooses a lender to fund the loans for their customers based primarily on service and rate.  Rate would generally be the largest premium paid to the broker based on a given loan rate.  As an example, “abc” bank may offer the broker a 1% fee when it funds a loan for Mr. Smith at 6.5% on a 30 year $225,000.00 loan.  Bank “def” may offer a 1.25% fee on that same loan.  Most all brokers will choose bank def for the higher fee.  On a negative amortization adjustable rate mortgage some of the best fees to the broker involved the loan that had a prepayment penalty as opposed to those that did not.  An apparent incentive to the broker to offer loans with prepayment penalties.  Loans most likely not in the best interest of the consumer.  This is not to say that Downey in any way shape or form engaged in bad lending practices.  These loans just shouldn’t have been created.

Here is some information regarding the end result for these troubling loans for Downey taken from Downey Savings SEC 10Q filing:

On September 5, 2008, the Holding Company and the Bank each entered into a Consent Order with the OTS, effective as of the same date. The Bank Order requires the Bank to, among other things:

• meet and maintain a minimum Tier I Core Capital ratio of 7% and a minimum Total Risk-Based Capital ratio of 14% at each quarter-end;
• submit to the OTS an updated capital augmentation and strategy plan addressing how the Bank will meet and maintain the foregoing capital ratios and that provides for the raising of new equity and a capital infusion by no later than December 31, 2008, together with an alternative strategy to meet and maintain the Bank’s capital and ensure its safe and sound operation if the plan to raise additional capital is not successful;
• submit for OTS approval within prescribed time periods (i) a comprehensive classified asset reduction plan, (ii) a real estate owned disposition plan, (iii) an updated business plan containing strategies for a reduction in concentration of payment option adjustable rate mortgage and stated income loans and (iv) a plan to strengthen executive management;
• notify, or in certain cases receive the approval or non-objection of, the OTS prior to (i) increasing its total assets in any quarter in excess of an amount equal to net interest credited on deposits during the quarter; (ii) making certain changes to its directors or senior executive officers; (iii) entering into, renewing, extending or revising any contractual arrangement related to compensation or benefits with any director or senior executive officer of the Bank; (iv) making any golden parachute or prohibited indemnification payments; (v) paying dividends or making other capital distributions; and (vi) entering into certain transactions with affiliates;
• refrain from any unsafe and unsound practices regarding lending and from resuming payment option adjustable rate mortgage or stated income lending programs; and
• comply with the OTS’ most recent report of examination with respect to the Bank.

In light of the capital directive set forth in the Bank Consent Order, the Bank is deemed to be “adequately capitalized” rather than “well capitalized” despite exceeding all “well capitalized” regulatory ratios.

At September 30, 2008, the Bank was above the minimum capital ratios required by its Consent Order, with core and tangible capital ratios of 7.48% and a total risk-based capital ratio of 14.50%. In addition, the Bank’s Consent Order requires the Bank to complete a capital raising initiative by December 31, 2008.

In the current economic environment, there is a significant risk that the Bank will not be able to raise sufficient additional capital to ensure compliance with the capital requirements of the Bank Consent Order by year-end.

The circumstances described above, raise substantial doubt concerning the ability of the Holding Company and the Bank to continue as going concerns for a reasonable period of time.

This is certainly not pleasant reading material.

This entry was posted on Wednesday, November 12th, 2008 at 12:46 pm and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.