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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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(Mark One)
|X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 for the fiscal year ended December 31, 2002.
| | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from ______________ to
______________.
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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)
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3501 Jamboree Road, Newport Beach, California 92660
(Address of principal executive offices) (Zip Code)
I.R.S. Employer Identification No.: 33-0633413
Registrant's telephone number, including area code: (949) 854-0300
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE
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Common Stock, $0.01 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the registrant's outstanding Common Stock
held by non-affiliates on June 28, 2002, based upon the closing sale price on
that date of $47.30, as quoted on the New York Stock Exchange, was
$1,016,518,482.
At February 28, 2003, 27,928,722 shares of the Registrant's Common Stock,
$0.01 par value, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's Proxy
Statement to be filed with the Securities and Exchange Commission in connection
with the Annual Meeting of Stockholders to be held April 23, 2003 are
incorporated by reference in Part III hereof.
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TABLE OF CONTENTS
ITEM
PAGE
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PART I
1. BUSINESS ........................................................... 1
General ......................................................... 1
Banking Activities .............................................. 2
Lending Activities ........................................... 2
Loan and Mortgage-Backed Securities Portfolio ....... 3
Residential Real Estate Lending ..................... 3
Secondary Marketing and Loan Servicing Activities ... 5
Multi Family and Commercial Real Estate Lending ..... 6
Construction Lending ................................ 6
Commercial Lending .................................. 6
Consumer Lending .................................... 6
Investment Activities ........................................ 7
Deposit Activities ........................................... 7
Borrowing Activities ......................................... 7
Capital Securities ........................................... 7
Earnings Spread .............................................. 8
Asset/Liability Management ................................... 8
Insurance Agency Activities .................................. 8
Real Estate Investment Activities ............................... 8
Competition ..................................................... 9
Employees ..................................................... 9
Regulation ..................................................... 9
General ..................................................... 9
Regulation of Downey ......................................... 9
Regulation of the Bank ....................................... 11
Regulation of DSL Service Company ............................ 17
Taxation ........................................................ 18
Factors That May Affect Future Results Of Operations ............ 18
2. PROPERTIES ......................................................... 20
Branches ........................................................ 20
Electronic Data Processing ...................................... 20
3. LEGAL PROCEEDINGS .................................................. 20
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ................ 20
PART II
5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS ............................................. 21
6. SELECTED FINANCIAL DATA ............................................ 22
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ....................................... 24
Overview ........................................................ 24
Critical Accounting Policies ................................. 25
Results of Operations ........................................... 26
Net Interest Income .......................................... 26
Provision for Loan Losses .................................... 28
Other Income ................................................. 28
Loan and Deposit Related Fees ....................... 29
Real Estate and Joint Ventures Held for Investment .. 29
Secondary Marketing Activities ...................... 30
Other Category ...................................... 31
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TABLE OF CONTENTS
ITEM
PAGE
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PART II----(CONTINUED)
Operating Expense ............................................ 31
Provision for Income Taxes ................................... 31
Business Segment Reporting ................................... 31
Banking ............................................... 32
Real Estate Investment ................................ 33
Financial Condition ............................................. 34
Loans and Mortgage-Backed Securities ......................... 34
Investment Securities ........................................ 38
Investments in Real Estate and Joint Ventures ................ 39
Deposits ..................................................... 41
Borrowings ................................................... 42
Capital Securities ........................................... 43
Off-Balance Sheet Arrangements ............................... 43
Transactions with Related Parties ..................... 44
Asset/Liability Management and Market Risk ................... 44
Problem Loans and Real Estate ................................ 49
Non-Performing Assets ................................. 49
Delinquent Loans ...................................... 51
Allowance for Losses on Loans and Real Estate ......... 53
Capital Resources and Liquidity .............................. 59
Contractual Obligations and Other Commitments ......... 60
Regulatory Capital Compliance ................................ 61
Newly Adopted Accounting Principles .......................... 61
Current Accounting Issues .................................... 62
Sale of Subsidiary ........................................... 63
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ......... 64
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ........................ 65
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES ............................ 112
PART III
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ................. 112
11. EXECUTIVE COMPENSATION ............................................. 112
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS ...................... 112
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ..................... 112
14. CONTROLS AND PROCEDURES ............................................ 112
PART IV
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K ...................................................... 112
AVAILABILITY OF REPORTS ............................................ 114
SIGNATURES ......................................................... 115
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY
ACT OF 2002 ..................................................... 116
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PART I
Certain matters discussed in this Annual Report may constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 and, as such, may involve risks and uncertainties.
These forward-looking statements relate to, among other things, expectations of
the business environment in which Downey Financial Corp. ("Downey," "we," "us"
and "our") operates, projections of future performance, perceived opportunities
in the market and statements regarding Downey's mission and vision. Downey's
actual results, performance or achievements may differ significantly from the
results, performance or achievements expressed or implied in such
forward-looking statements. For discussion of the factors that might cause such
a difference, see Business--Factors That May Affect Future Results on page 18.
ITEM 1. BUSINESS
GENERAL
We were incorporated in Delaware on October 21, 1994. On January 23, 1995,
after we obtained necessary stockholder and regulatory approvals, we acquired
100% of the issued and outstanding capital stock of Downey Savings and Loan
Association (the "Bank") and the Bank's stockholders became holders of our
stock. Downey was thereafter funded by the Bank and presently operates as the
Bank's holding company. Our stock is traded on the New York Stock Exchange and
Pacific Exchange under the trading symbol "DSL." 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 available free of charge from our internet site,
www.downeysavings.com, by clicking on "Investor Relations" located on our home
page and proceeding to "Corporate Filings."
The Bank was formed in 1957 as a California-licensed savings and loan
association and converted to a federal charter in 1995. As of December 31, 2002,
it conducts its business through 165 retail deposit branches, including 93
full-service, in-store branches. Residential loans are originated or purchased:
o by branch managers and loan officers in our branches;
o by loan officers who solicit loans from realtors and other business
sources, including the internet;
o by wholesale loan representatives who obtain loans submitted by
mortgage brokers; and
o by purchases of loans from correspondent banking institutions and
mortgage bankers.
The Bank is regulated or affected by the following governmental entities
and laws:
o As a federally chartered savings association, the Bank's activities
and investments are generally governed by the Home Owners' Loan Act,
as amended, and regulations and policies of the Office of Thrift
Supervision (the "OTS").
o The Bank and Downey are subject to the primary regulatory and
supervisory jurisdiction of the OTS.
o As a federally insured depository institution, the Bank is regulated
and supervised by the Federal Deposit Insurance Corporation (the
"FDIC") with respect to some of its activities and investments.
o The Bank is a member of the Federal Home Loan Bank (the "FHLB") of San
Francisco, which is one of the 12 regional banks for federally insured
depository institutions comprising the Federal Home Loan Bank System.
o The Bank's savings deposits are insured through the Savings
Association Insurance Fund ("SAIF") of the FDIC, an instrumentality of
the United States government.
o The Bank is regulated by the Federal Reserve with respect to reserves
the Bank is required to maintain against deposits and other matters.
General economic conditions, the monetary and fiscal policies of the
federal government and the regulatory policies of governmental authorities
significantly influence our operations. Additionally, interest rates on
competing investments and general market interest rates influence our deposit
flows and the costs we incur on interest-bearing liabilities, which represents
our cost of funds. Similarly, market interest rates and other factors that
affect the supply of and demand for housing and the availability of funds affect
our loan volume and our yields on loans and mortgage-backed securities.
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Our primary business is banking and we are also involved in real estate
investments, each of which we discuss further below.
BANKING ACTIVITIES
Our primary business is banking. Our banking activities focus on:
o attracting funds from the general public and institutions; and
o originating and investing in loans, primarily residential real estate
mortgage loans, investment securities and mortgage-backed securities.
These mortgage-backed securities include mortgage pass-through securities issued
by other entities and securities issued or guaranteed by government-sponsored
enterprises like the Federal National Mortgage Association, the Federal Home
Loan Mortgage Corporation and the Government National Mortgage Association.
Our primary sources of revenue from our banking business are:
o interest we earn on loans, investment securities and mortgage-backed
securities;
o fees we earn in connection with loans and deposits;
o gains on sales of our loans, investment securities and mortgage-backed
securities; and
o income we earn on loans and mortgage-backed securities we service for
investors.
Our principal expenses in connection with our banking business are:
o interest we incur on our interest-bearing liabilities, including
deposits, borrowings and capital securities; and
o general and administrative costs.
Our primary sources of funds from our banking business are:
o deposits;
o principal and interest payments on our loans and mortgage-backed
securities;
o proceeds from sales of our loans and mortgage-backed securities; and
o borrowings and capital securities.
Scheduled payments we receive on our loans and mortgage-backed securities are a
relatively stable source of funds. However, the funds we receive from deposits
and the prepayment of loans and mortgage-backed securities vary widely. Below is
a detailed discussion of our banking activities.
LENDING ACTIVITIES
Historically, our lending activities have primarily emphasized our
origination of first mortgage loans secured by residential properties and retail
neighborhood shopping centers. To a lesser extent, our lending activities have
emphasized our origination of real estate loans secured by multi-family and
commercial properties, including land and other properties with income producing
capabilities. In addition, we have provided construction loan financing for
single family and multi-family residential properties and commercial retail
neighborhood shopping center projects. These construction loan financings have
included loans to joint ventures, which were being engaged in by DSL Service
Company, a wholly owned subsidiary of the Bank, with other participants. We also
originate loans to businesses through our commercial banking operations.
We originate automobile loans directly through our branch network. We also
conducted an indirect auto-lending program through our purchase of new or used
automobile sales contracts from auto dealers in California and other western
states. Downey Auto Finance Corp., a previous wholly owned subsidiary of the
Bank, operated this indirect auto-lending program, but was sold in February
2000. For more information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Sale of
Subsidiary on page 63.
2
Our primary focus continues to be our origination of adjustable rate single
family mortgage loans for portfolio, including subprime loans which carry higher
interest rates. In addition, we will originate for portfolio other loans
including:
o multi-family loans;
o commercial real estate loans;
o construction loans to developers;
o loans to individuals for the construction and permanent financing of
single family homes; and
o consumer loans.
We will also continue our secondary marketing activities of originating and
selling single family mortgage loans to various investors.
For more information, see below under the caption entitled Secondary
Marketing and Loan Servicing Activities on page 5. For additional information on
the composition of our loan and mortgage-backed securities portfolio, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Loans and Mortgage-Backed Securities on page
34.
LOAN AND MORTGAGE-BACKED SECURITIES PORTFOLIO
We carry loans receivable held for investment at cost. Our net loans
receivable are adjusted for amortization of premiums and accretion of discounts
which are recognized in interest income using the interest method. Our
investments in mortgage-backed securities represent participating interests in
pools of first mortgage loans originated and serviced by the issuers of the
securities. We carry mortgage-backed securities held to maturity at unpaid
principal balances, which are adjusted for unamortized premiums and unearned
discounts. We amortize premiums and discounts on mortgage-backed securities by
using the interest method over the remaining period to contractual maturity,
adjusted for anticipated prepayments.
We identify loans that may be sold before their maturity. In our balance
sheets, we classify these as loans held for sale and record them at the lower of
amortized cost or fair value. Amortized cost includes a basis adjustment to the
loan at funding resulting from the change in the fair value of the associated
interest rate lock derivative from the date of commitment to the date of
funding. We recognize net unrealized losses on these loans, if any, in a
valuation allowance by making charges to our income.
We carry mortgage-backed securities available for sale at fair value. We
report net unrealized gains or losses on these securities net of income taxes in
stockholders' equity and as a separate component of our other comprehensive
income until realized.
RESIDENTIAL REAL ESTATE LENDING
Our primary lending activity is our origination of mortgage loans secured
by single family residential properties consisting of one-to-four units located
primarily in California. We provide these mortgage loans for borrowers to
purchase residences or to refinance their existing mortgages. The residential
mortgage loans we originate typically have contractual maturities at origination
of 15 to 40 years. To limit the interest rate risk associated with these 15- to
40-year maturities, we, among other things, principally originate adjustable
rate mortgages for our own loan portfolio. For more information, see
Asset/Liability Management on page 8. We also originate residential fixed rate
mortgage loans to meet consumer demand, but we intend to sell the majority of
these loans in the secondary market, rather than hold them in our portfolio. We
may, however, place residential fixed rate loans in our portfolio of loans held
for investment if these fixed rate loans are funded with long-term funds to
mitigate interest rate risk. In addition, we originate a small volume of fixed
rate loans for our own investment if they meet specific yield and other approved
guidelines, or to facilitate our sale of real estate acquired in settlement of
loans. The average term of these fixed rate mortgage loans we originate for our
own portfolio historically has been significantly shorter than their contractual
maturity due to loan payoffs as a result of home sales or refinancings and
prepayments. For more information, see Secondary Marketing and Loan Servicing
Activities on page 5.
3
Our adjustable rate mortgages:
o generally either begin with an incentive interest rate, which is an
interest rate below the current market rate, that adjusts to the
applicable index plus a defined spread, subject to periodic and
lifetime caps, after one, three, six or twelve months, or are fixed
for a period of three to five years then adjust semi-annually or
annually thereafter;
o generally provide that the maximum interest rate we can charge
borrowers cannot exceed the incentive rate by more than six to nine
percentage points, depending on the type of loan and the initial rate
offered; and
o limit interest rate adjustments, for loans that adjust both the
interest rate and payment amount simultaneously, to 1% per adjustment
period for those that adjust semi-annually and 2% per adjustment
period for those that adjust annually.
Most of our adjustable rate mortgages adjust the interest rate monthly and
the payment amount annually. These monthly adjustable rate mortgages:
o have a lifetime interest rate cap, but no specified periodic interest
rate adjustment cap;
o have a periodic cap on changes in required monthly payments; and
o allow for negative amortization, which is the addition to loan
principal of accrued interest that exceeds the required monthly loan
payments.
If a loan incurs significant negative amortization, the loan-to-value ratio
could increase which creates an increased risk that the fair value of the
underlying collateral on the loan could be insufficient to satisfy fully the
outstanding principal and interest. A loan-to-value ratio is the ratio of the
principal amount of the loan to the lower of the sales price or appraised value
of the property securing the loan at origination. We currently impose a limit on
the amount of negative amortization. The principal plus the negative
amortization cannot exceed 125% of the original loan amount, except for subprime
loans and loans with loan-to-value ratios of greater than 80% where the borrower
has obtained private mortgage insurance to reduce the effective loan-to-value
ratio to between 67% and 80%. In those two instances, the principal plus
negative amortization cannot exceed 110% of the original loan amount. At
year-end 2002, loans with the higher 125% limit on negative amortization
represented 38% of our adjustable rate one-to-four unit residential portfolio.
We permit adjustable rate mortgages to be assumed by qualified borrowers.
During 2002, approximately 79% of our one-to-four unit residential real
estate loans were originated or purchased through outside mortgage brokers.
These mortgage brokers do not operate from our offices and are not our
employees. Our branch managers and residential loan officers originated
approximately 21% of our one-to-four unit residential loans during 2002.
We require that our residential real estate loans be approved at various
levels of management, depending upon the amount of the loan. On a single family
residential loan we originate for our portfolio, the maximum amount we generally
will lend is $1 million. Our average loan size, however, is much lower. In 2002,
our average loan size was $331,000. We generally make loans with loan-to-value
ratios not exceeding 80%. We will make loans with loan-to-value ratios of over
80%, if the borrower obtains private mortgage insurance to reduce the effective
loan-to-value ratio to between 67% and 80%, consistent with secondary marketing
requirements. In addition, we require that borrowers obtain hazard insurance for
all residential real estate loans covering the lower of the loan amount or the
replacement value of the residence.
In our approval process for the loans we originate or purchase, we assess
both the value of the property securing the loan and the applicant's ability to
repay the loan. Qualified appraisers on our staff or approved outside appraisers
establish the value of the collateral through appraisals or alternative
valuation formats that meet regulatory requirements. Appraisal reports prepared
by outside appraisers are selectively reviewed by our staff appraisers or by
approved fee appraisers. We generally obtain information about the applicant's
income, financial condition, employment and credit history. Typically, we will
verify an applicant's credit information for loans originated by our retail loan
representatives. For loans submitted from outside mortgage brokers, we require
the mortgage broker to obtain, review and verify the applicant's credit
information and employment.
We offer one-to-four unit residential loans to borrowers who have or, in
the case of purchases, will have equity in their homes but whose credit rating
contains exceptions which preclude them from qualifying for lower or better
market interest rates and terms. We refer to these lower rated credits, which we
characterize as "A-," "B"
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and "C" loans, as subprime loans in our loan portfolio. Our subprime loans are
characterized by lower loan-to-value ratios and higher average interest rates
than higher credit grade loans or "A" loans. We believe these lower credit rated
borrowers represent an opportunity for us to earn a higher net return for the
risks we assume. For further information, see Regulation--Regulation of the
Bank--Regulatory Capital Requirements on page 11.
We currently qualify applicants of our adjustable rate mortgages at the
higher of the fully-indexed rate or:
o for prime borrowers:
o 6.25% for owner occupied; or
o 6.50% for non-owner occupied.
o for subprime borrowers:
o 7.25% for owner occupied; or
o 7.50% for non-owner occupied.
SECONDARY MARKETING AND LOAN SERVICING ACTIVITIES
As part of our secondary marketing activities, we originate residential
real estate adjustable rate mortgages and fixed rate mortgages that we intend to
sell. Accordingly, we classify these loans as held for sale and carry them at
the lower of cost or fair value. Amortized cost includes a basis adjustment to
the loan at funding resulting from the change in the fair value of the
associated interest rate lock derivative from the date of commitment to the date
of funding. These loans are secured by first liens on one-to-four unit
residential properties and generally have maturities of 30 years or less.
We believe that servicing loans for others can be an important
asset/liability management tool because it produces operating results which, in
response to changes in market interest rates, tend to move opposite to changes
in net interest income. Because yields on adjustable rate mortgages take longer
to adjust to market interest rates than their funding sources, net interest
income associated with these loans is expected to decline in periods of rising
interest rates and increase in periods of falling rates. In contrast, the value
of a loan servicing portfolio normally:
o increases as interest rates rise and loan prepayments decrease;
and
o declines as interest rates fall and loan prepayments increase.
In addition, increased levels of servicing activities and the opportunity to
offer our other financial services in servicing loans for others can provide us
with additional income with minimal additional overhead costs.
Depending upon market pricing for servicing, we sell loans either servicing
retained or servicing released. When we sell loans servicing retained, we record
gains or losses from these loans at the time of sale. We calculate gains or
losses from our sale as the difference between the net sales proceeds and the
allocated basis of the loans sold. We capitalize mortgage servicing rights we
acquire through either our purchase or origination of mortgage loans we intend
to sell with servicing rights retained. We allocate the total cost of the
mortgage loans sold to both the mortgage servicing rights and to the mortgage
loans without mortgage servicing rights based on their relative fair values. We
disclose our mortgage servicing rights in our financial statements and include
them as a component of the gain on sale of loans. We recognize impairment losses
on the mortgage servicing rights through a valuation allowance and record any
associated provision as a component of loan servicing income (loss), net
category. For further information, see Note 1 on page 72 and Note 10 on page 89
of Notes to the Consolidated Financial Statements.
Generally, we use hedging programs to manage the interest rate risk of our
secondary marketing activities. However, to-date we have not hedged our mortgage
servicing rights. For further information, see Asset/Liability Management and
Market Risk on page 44.
We may exchange loans we originate for sale with government-sponsored
agencies for mortgage-backed securities collateralized by these loans. Our cost
for the exchange, a monthly guaranty fee, is expressed as a percentage of the
unpaid principal balance and is deducted from interest income. The securities we
receive can be used to collateralize various types of our borrowings at rates
that frequently are more favorable than rates on other types of liabilities and
also carry a lower risk-based capital requirement than whole loans. We carry
these mortgage-backed securities available for sale at fair value. However, we
record no gain or loss on the exchange
5
in our statement of income until the securities are sold to a third party.
Before we sell these securities to third parties, we show all changes in fair
value as a separate component of stockholders' equity as accumulated other
comprehensive income, net of income taxes.
MULTI-FAMILY AND COMMERCIAL REAL ESTATE LENDING
We have provided permanent loans secured by multi-family and retail
neighborhood shopping center properties. Our major loan officers conduct our
multi-family and commercial real estate lending activities.
Multi-family and commercial real estate loans generally entail additional
risks as compared to single family residential mortgage lending. We subject each
loan, including loans to facilitate the sale of real estate we own, to our
underwriting standards, which generally include:
o our evaluation of the creditworthiness and reputation of the borrower;
and
o the amount of the borrower's equity in the project as determined on
the basis of appraisal, sales and leasing information on the property
and cash flow projections.
To protect the value of the security for our loan, we require borrowers to
maintain casualty insurance for the loan amount or replacement cost. In
addition, for non-residential loans in excess of $500,000, we require the
borrower to obtain comprehensive general liability insurance. All commercial
real estate loans we originate must be approved by at least two of our officers,
one of whom must be the originating loan account officer and the other a
designated officer with appropriate loan approval authority.
CONSTRUCTION LENDING
We have provided construction loan financing for single family and
multi-family residential properties and commercial real estate projects, like
retail neighborhood shopping centers. Our major loan officers principally
originate these loans. We generally make construction loans at floating interest
rates based upon the prime or reference rate of a major commercial bank.
Generally, we require a loan-to-value ratio of 75% or less on construction
lending and we subject each loan to our underwriting standards.
Construction loans involve risks different from completed project lending
because we advance loan funds based upon the security of the completed project
under construction. If the borrower defaults on the loan, then we may have to
advance additional funds to finance the project's completion before the project
can be sold. Moreover, construction projects are affected by uncertainties
inherent in estimating:
o construction costs;
o potential delays in construction time;
o market demand; and
o the accuracy of the value on the completed project.
When providing construction loans, we require the general contractor to,
among other things, carry contractor's liability insurance equal to specific
prescribed minimum amounts, carry builder's risk insurance and have a blanket
bond against employee misappropriation.
COMMERCIAL LENDING
We originate commercial loans and revolving lines of credit and issue
standby letters of credit for our middle market commercial customers. We offer
the various credit products on both a secured and unsecured basis with interest
rates being either fixed or variable. Our portfolio emphasis is toward secured,
floating rate credit facilities. Our commercial banking group directs these
activities and focuses on our long-term, relationship-based customers. We also
utilize our retail branch network as a source of commercial customers, with the
lending to these customers being typically managed by the branch manager.
CONSUMER LENDING
The Bank originates direct automobile loans, home equity loans and home
equity lines of credit, and other consumer loan products. Before we make a
consumer loan, we assess the applicant's ability to repay the loan and, if
applicable, the value of the collateral securing the loan. The risk involved
with home equity loans and home
6
equity lines of credit is similar to the risk involved with residential real
estate loans. We offer customers a credit card through a third party, who
extends the credit and services the loans made to our customers.
INVESTMENT ACTIVITIES
As a federally chartered savings association, the Bank's ability to make
securities investments is prescribed under the OTS regulations and the Home
Owners' Loan Act. The Bank's authorized officers make investment decisions
within guidelines established by the Bank's Board of Directors. The Bank manages
these investments in an effort to produce the highest yield, while at the same
time maintaining safety of principal, minimizing interest rate risk and
complying with applicable regulations.
We carry securities held to maturity at amortized cost. We adjust these
costs for amortization of premiums and accretion of discounts, which we
recognize in interest income using the interest method. We carry securities
available for sale at fair value. We exclude unrealized holding gains and
losses, or valuation allowances established for net unrealized losses, from our
earnings and report them as a separate component of our stockholders' equity as
accumulated other comprehensive income, net of income taxes, unless the security
is deemed other than temporarily impaired. If the security is determined to be
other than temporarily impaired, we charge the amount of the impairment to
operations. For further information on the composition of our investment
portfolio, see Management's Discussion and Analysis of Financial Condition and
Results of Operations--Financial Condition--Investment Securities on page 38.
DEPOSIT ACTIVITIES
We prefer to use deposits raised through our retail branch system as our
principal source of funds for supporting our lending activities, because the
cost of these funds generally is less than that of borrowings or other funding
sources with comparable maturities. We traditionally have obtained our deposits
primarily from areas surrounding the Bank's branch offices. However, we
occasionally raise some retail deposits through Wall Street activities.
General economic conditions affect deposit flows. Funds may flow from
depository institutions such as savings associations into direct vehicles like
government and corporate securities or other financial intermediaries. Our
ability to attract and retain deposits will continue to be affected by money
market conditions, prevailing interest rates and available competing investment
vehicles. Generally, state or federal regulation does not restrict interest
rates we pay on deposits.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Deposits on
page 41.
BORROWING ACTIVITIES
Besides deposits, we have utilized other sources to fund our loan
origination and other business activities. We have at times relied upon our
borrowings from the FHLB of San Francisco as an additional source of funds. The
FHLB of San Francisco makes advances to us through several different credit
programs it offers.
From time to time, we obtain additional sources of funds by selling some of
our securities and mortgage loans under agreements to repurchase. These reverse
repurchase agreements are generally short-term and are collateralized by our
mortgage-backed or investment securities and our mortgage loans. We only deal
with investment banking firms that are recognized as primary dealers in U.S.
government securities or major commercial banks in connection with these reverse
repurchase agreements. In addition, we limit the amounts of our borrowings from
any single institution.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Borrowings
on page 42.
CAPITAL SECURITIES
On July 23, 1999, we issued $120 million in capital securities through
Downey Financial Capital Trust I. The capital securities pay quarterly
cumulative cash distributions at an annual rate of 10.00% of the liquidation
value of $25 per share. Of the $115 million of net proceeds, we invested $108
million as additional common stock of the Bank thereby increasing the Bank's
regulatory core/tangible capital by that same amount. The balance of the net
proceeds have been used for general corporate purposes. For further information
regarding our capital securities,
7
see Note 16 on page 96 of Notes to Consolidated Financial Statements.
EARNINGS SPREAD
Our primary source of earnings comes from our net interest income. We
determine our net interest income or the interest rate spread by calculating the
difference between:
o the yield we earn on our interest-earning assets like loans,
mortgage-backed securities and investment securities; and
o the cost we pay on our interest-bearing liabilities like deposits,
borrowings and capital securities.
Our net interest income is also determined by the relative dollar amounts of our
interest-earning assets and interest-bearing liabilities.
Our effective interest rate spread, which reflects the relative level of
our interest-earning assets to our interest-bearing liabilities, equals:
o the difference between interest income on our interest-earning assets
and interest expense on our interest-bearing liabilities, divided by
o our average interest-earning assets for the period.
For information regarding our net income and the components thereof and for
management's analysis of our financial condition and results of operations, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations beginning on page 24. For information regarding the return on our
assets and other selected financial data, see Selected Financial Data on page
22.
ASSET/LIABILITY MANAGEMENT
Savings institutions are affected by interest rate risks to the degree that
their interest-bearing liabilities, consisting principally of customer deposits,
FHLB advances, other borrowings and capital securities, mature or reprice on a
different basis than their interest-earning assets, which consist predominantly
of intermediate or long-term real estate loans. While having liabilities that on
average mature or reprice more frequently than assets may be beneficial in times
of declining interest rates, this asset/liability structure may result in
declining net earnings during periods of rising interest rates. Our principal
objectives are to actively monitor and manage the effects of adverse changes in
interest rates on our net interest income while maintaining our asset quality.
To improve the rate sensitivity and maturity balance of our interest-earning
assets and liabilities, we have emphasized the origination of loans with
adjustable interest rates or relatively short maturities. Loans with adjustable
interest rates have the beneficial effect of allowing the yield on our assets to
increase during periods of rising interest rates, although these loans have
contractual limitations on the frequency and extent of interest rate
adjustments.
For further information, see Lending Activities on page 2 and Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Asset/Liability Management and Market Risk on
page 44.
INSURANCE AGENCY ACTIVITIES
Downey Affiliated Insurance Agency was incorporated on January 25, 1995, as
Downey's wholly owned subsidiary. We capitalized Downey Affiliated Insurance
Agency on February 24, 1995 with $400,000. In the 1995 second quarter, Downey
Affiliated Insurance Agency commenced operations at which time representatives
of Downey Affiliated Insurance Agency were available in our branches to offer
annuity products. During 1996, Downey Affiliated Insurance Agency began offering
forced-placed casualty insurance policies on mortgage loans and stopped offering
annuity products. The offering of forced-placed casualty insurance policies
ceased in April 1999.
REAL ESTATE INVESTMENT ACTIVITIES
In addition to our primary business of banking, which has been described
above, we are also involved in real estate investment activities, which are
conducted primarily through DSL Service Company, a wholly owned subsidiary of
the Bank. DSL Service Company is a diversified real estate development company
which was
8
established in 1966 as a neighborhood shopping center and residential tract
developer. Today its capabilities include development, construction and property
management activities relating to its portfolio of projects primarily within
California, but also in Arizona. In addition to DSL Service Company developing
its own real estate projects, it associates with other qualified developers to
engage in joint ventures. The primary revenue sources of our real estate
investment activities include net rental income and gains from the sale of real
estate investments. The primary expenses of our real estate investment
activities are interest expense and general and administrative expense.
Due to federal law, the Bank is prohibited from making new investments in
real estate development and joint venture operations and is required to deduct
the full amount of its investment in DSL Service Company in calculating its
applicable ratios under the core, tangible and risk-based capital standards.
Savings associations generally may invest in service corporation subsidiaries,
like DSL Service Company, to the extent of 2% of the association's assets, plus
up to an additional 1% of assets for investments which serve primarily
community, inner-city or community development purposes. In addition,
"conforming loans" by the Bank to DSL's joint venture partnerships are limited
to 50% of the Bank's risk-based capital. "Conforming loans" are those generally
limited to 80% of appraised value, bear a market rate of interest and require
payments sufficient to amortize the principal balance of the loan. We are in
compliance with each of these investment limitations.
To the extent Downey or a subsidiary of Downey, other than the Bank or its
subsidiaries, makes real estate investments, the above-mentioned capital
deductions and limitations do not apply, as they only pertain to the specific
investments by savings associations or their subsidiaries.
For further information, see Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition--Investments
in Real Estate and Joint Ventures on page 39.
COMPETITION
We face competition both in attracting deposits and in making loans. Our
most direct competition for deposits has historically come from other savings
institutions and from commercial banks located in our principal market areas,
including many large financial institutions based in other parts of the country
or their subsidiaries. In addition, we face additional significant competition
for investors' funds from short-term money market securities and other corporate
and government securities. Our ability to attract and retain savings deposits
depends, generally, on our ability to provide a rate of return, liquidity and
risk comparable to that offered by competing investment opportunities and the
appropriate level of customer service.
We experience competition for real estate loans principally from other
savings institutions, commercial banks, mortgage banking companies and insurance
companies. We compete for loans principally through our interest rates and loan
fees we charge and our efficiency and quality of services we provide borrowers
and real estate brokers.
EMPLOYEES
At December 31, 2002, we had 2,352 full-time employees and 640 part-time
employees. We provide our employees with health and welfare benefits and a
retirement and savings plan. Additionally, we offer qualifying employees
participation in our stock purchase plan. Our employees are not represented by
any union or collective bargaining group, and we consider our employee relations
to be good.
REGULATION
GENERAL
Federal and state law extensively regulate savings and loan holding
companies and savings associations. This regulation is intended primarily to
protect our depositors and the SAIF and is not for the benefit of our
stockholders. Below we describe some of the regulations applicable to us and the
Bank. We do not claim this discussion is complete and qualify our discussion by
reference to applicable statutory or regulatory provisions.
REGULATION OF DOWNEY
General. We are a savings and loan holding company and are subject to
regulatory oversight by the OTS. We are required to register and file reports
with the OTS and are regulated and examined by the OTS. The OTS has enforcement
authority over us, which also permits the OTS to restrict or prohibit our
activities that it determines to be a serious risk to the Bank.
9
Activities Restrictions. As a savings and loan holding company with only
one savings and loan association subsidiary, we generally are not limited by OTS
activity restrictions, provided the Bank satisfies the qualified thrift lender
test or meets the definition of a domestic building and loan association in the
Internal Revenue Code. If we acquire control of another savings association as a
separate subsidiary of Downey, we would become a multiple savings and loan
holding company. As a multiple savings and loan holding company, our activities,
other than the activities of the Bank or any other SAIF-insured savings
association, would become subject to restrictions applicable to bank holding
companies unless these other savings associations were acquired in a supervisory
acquisition and each also satisfies the qualified thrift lender test or meets
the definition of a domestic building and loan association. Furthermore, if in
the future we sold control of the Bank to any other company, such company would
not succeed to our grandfathered status as a unitary thrift holding company and
would be subject to the same business activity restrictions as a bank holding
company. For more information, see Restrictions on Acquisitions below and
Regulation of the Bank--Qualified Thrift Lender Test on page 13.
Restrictions on Acquisitions. We must obtain approval from the appropriate
bank regulatory agencies before acquiring control of any insured depository
institution. The OTS generally prohibits these types of acquisitions if they
result in a multiple savings and loan holding company controlling savings
associations in more than one state. However, the OTS permits interstate
acquisitions if the acquisition is authorized by specific state authorization or
a supervisory acquisition of a failing savings association.
Federal law generally provides that no "person," acting directly or
indirectly or through or in concert with one or more other persons, may acquire
"control" of a federally insured savings association unless the person gives at
least 60 days written notice to the OTS. The OTS then has the opportunity to
disapprove the proposed acquisition. In addition, no company may acquire control
of this type of an institution without prior OTS approval. These provisions also
prohibit, among other things, any director or officer of a savings and loan
holding company, or any individual who owns or controls more than 25% of the
voting shares of a savings and loan holding company, from acquiring control of
any savings association not a subsidiary of the savings and loan holding
company, unless the acquisition is approved by the OTS.
Financial Holding Company Legislation. On November 12, 1999, the
Gramm-Leach-Bliley Act of 1999 ("GLBA") was signed into law. This law
established a comprehensive framework to permit affiliations among commercial
banks, insurance companies, securities firms and other financial service
providers by revising and expanding the Bank Holding Company Act framework to
permit a holding company to engage in a full range of financial activities
through a new entity known as a "Financial Holding Company." "Financial
activities" is broadly defined to include not only banking, insurance and
securities activities, but also merchant banking and additional activities that
the Federal Reserve Board, in consultation with the Secretary of the Treasury,
determines to be financial in nature, related or incidental to such financial
activities, or complementary activities that do not pose a substantial risk to
the safety and soundness of depository institutions or the financial system
generally.
GLBA provides that no company may acquire control of an insured savings
association, unless that company engages, and continues to engage, only in the
financial activities permissible for a Financial Holding Company, unless
grandfathered as a unitary savings and loan holding company. Downey is a
grandfathered unitary savings and loan holding company and we may continue to
operate under present law as long as we continue to control only the Bank and
the Bank continues to meet the qualified thrift lender test.
We do not believe that this law will have a material adverse effect on our
operations in the near-term. However, to the extent that GLBA permits banks,
securities firms and insurance companies to affiliate, the financial services
industry may experience further consolidation. GLBA is intended to grant to
community banks certain powers as a matter of right that larger institutions
have accumulated on an ad hoc basis and which unitary savings and loan holding
companies, such as Downey, already possess. Nevertheless, GLBA may increase the
competition that we face from larger institutions and other types of companies
offering financial products, many of which may have greater financial resources
than we do. In addition, GLBA may have an anti-takeover effect because it may
tend to limit the range of potential acquirers of Downey to other savings and
loan holding companies and Financial Holding Companies.
The Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act
was signed into law. This new legislation addresses accounting oversight and
corporate governance matters, including:
o the creation of a five-member oversight board appointed by the
Securities and Exchange Commission ("SEC") that will set standards for
accountants and have investigative and disciplinary powers;
o the prohibition of accounting firms from providing various types of
consulting services to public clients and requiring accounting firms
to rotate partners among public client assignments every five years;
10
o increased penalties for financial crimes;
o expanded disclosure of corporate operations and internal controls and
certification of financial statements;
o enhanced controls on and reporting of insider trading; and
o statutory separations between investment bankers and analysts.
Various aspects of the new legislation are dependent upon subsequent rulemaking
by the SEC. We are currently evaluating what impact the new legislation and its
implementing regulations will have upon our operations, including a potential
increase in certain outside professional costs.
REGULATION OF THE BANK
General. The OTS and the FDIC extensively regulate the Bank because the
Bank is a federally chartered, SAIF-insured savings association. The Bank must
ensure that its lending activities and its other investments comply with various
statutory and regulatory requirements. The Bank is also regulated by the Federal
Reserve.
The OTS, in conjunction with the FDIC, regularly examines the Bank and
prepares reports for the Bank's Board of Directors to consider with respect to
any deficiencies the OTS or the FDIC finds in the Bank's operations. Federal and
state laws also regulate the relationship between the Bank and its depositors
and borrowers, especially in matters regarding the ownership of savings accounts
and the documents used by the Bank.
The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition. In addition, the Bank must obtain regulatory
approvals before entering into some transactions like mergers with or
acquisitions of other financial institutions. This regulation and supervision
establishes a comprehensive framework of activities in which an institution may
engage and is intended primarily to protect the SAIF and our depositors. The
regulatory structure also gives the regulatory authorities extensive discretion
in connection with their supervisory and enforcement activities and examination
policies, including policies regarding the classification of assets and adequate
loan loss reserves for regulatory purposes. Any change in regulations, whether
by the OTS, the FDIC or the Congress, could have a material adverse impact on
us, the Bank and our operations.
Insurance of Deposit Accounts. The SAIF, as administered by the FDIC,
insures the Bank's deposit accounts up to the maximum amount permitted by law.
The FDIC may terminate insurance of deposits upon a finding that the
institution:
o has engaged in unsafe or unsound practices;
o is in an unsafe or unsound condition to continue operations; or
o has violated any applicable law, regulation, rule, order or condition
imposed by the FDIC or the institution's primary regulator.
The FDIC charges an annual assessment for the insurance of deposits based
on the risk a particular institution poses to its deposit insurance fund. Under
this system as of December 31, 2002, SAIF members paid within a range of 0% to
0.27% of insured domestic deposits, depending upon the institution's risk
classification. This risk classification is based on an institution's capital
group and supervisory subgroup assignment.
The Bank also pays, in addition to its normal deposit insurance premium as
a member of the SAIF, assessments towards the retirement of the Financing
Corporation Bonds (known as FICO Bonds) issued in the 1980s to assist in the
recovery of the savings and loan industry. These assessments will continue until
the FICO Bonds mature in 2017. For the last quarter of fiscal 2002, this
assessment was equal to approximately 0.017% of insured deposits.
Regulatory Capital Requirements. The Bank must meet regulatory capital
standards to be deemed in compliance with OTS capital requirements. OTS capital
regulations require savings associations to meet the following three capital
standards:
o tangible capital equal to 1.5% of total adjusted assets;
o leverage capital, or "core capital," equal to 3% of total adjusted
assets for institutions such as the Bank; and
11
o risk-based capital equal to 8.0% of total risk-based assets.
The OTS views its capital regulation requirements as minimum standards, and
it expects most institutions to maintain capital levels well above the minimum.
In addition, the OTS regulations provide that the OTS may establish minimum
capital levels higher than those provided in the regulations for individual
savings associations, upon a determination that the savings association's
capital is or may become inadequate in view of its circumstances. The OTS
regulations provide that higher individual minimum regulatory capital
requirements may be appropriate in circumstances where, among others, a savings
association:
o has a high degree of exposure to interest rate risk, prepayment risk,
credit risk, concentration of credit risk, other risks arising from
nontraditional activities, or similar risks or a high proportion of
off-balance sheet risk;
o is growing, either internally or through acquisitions, at a rate that
presents supervisory issues; or
o may be adversely affected by activities or the condition of its
holding company, affiliates, subsidiaries or other persons, or savings
associations with which it has significant business relationships.
The Bank is not required to meet any individual minimum regulatory capital
requirement. At December 31, 2002, the Bank's regulatory capital exceeded all
minimum regulatory capital requirements.
As a result of a number of federally insured financial institutions
extending their lending risk selection standards to attract lower credit quality
borrowers due to their loans having higher interest rates and fees, the federal
banking regulatory agencies jointly issued Interagency Guidelines on Subprime
Lending. Subprime lending involves extending credit to individuals with less
than perfect credit histories.
The guidelines consider subprime lending a high-risk activity that is
unsafe and unsound if the risks associated with subprime lending are not
properly controlled. Specifically, the 2002 guidelines direct examiners to
expect regulatory capital one and one-half to three times higher than that
typically set aside for prime assets for institutions that:
o have subprime assets equal to 25% or higher of Tier 1 capital, or
o have subprime portfolios experiencing rapid growth or adverse
performance trends, are administered by inexperienced management, or
have inadequate or weak controls.
Our subprime portfolio, pursuant to our definition, represented 168% of
Tier 1 capital as of year-end 2002. Subsequent to year end, the OTS notified us
that beginning March 31, 2003, we will need to risk weight our subprime
residential loans at 75% versus their current 50% risk weighting. This change
will increase the required regulatory capital associated with our subprime loans
by one and one-half times that of prime residential loans. For further
information regarding the impact of this change to our capital ratios, see
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Regulatory Capital Compliance on page 61.
The Home Owners' Loan Act permits savings associations not in compliance
with the OTS capital standards to seek an exemption from penalties or sanctions
for noncompliance. The OTS will grant an exemption only if the savings
association meets strict requirements. In addition, the OTS must deny the
exemption in some circumstances. If the OTS does grant an exemption, the savings
association still may be exposed to enforcement actions for other violations of
law or unsafe or unsound practices or conditions.
Prompt Corrective Action. The OTS's prompt corrective action regulation
requires the OTS to take mandatory actions and authorizes the OTS to take
discretionary actions against a savings association that falls within
undercapitalized capital categories specified in the regulation.
The regulation establishes five categories of capital classification:
o "well capitalized;"
o "adequately capitalized;"
o "undercapitalized;"
o "significantly undercapitalized;" and
12
o "critically undercapitalized."
The regulation uses an institution's risk-based capital, leverage capital
and tangible capital ratios to determine the institution's capital
classification. At December 31, 2002, the Bank exceeded the capital requirements
of a well capitalized institution under applicable OTS regulations.
Loans-to-One-Borrower. Savings associations generally are subject to the
lending limits applicable to national banks. With limited exceptions, the
maximum amount that a savings association or a national bank may lend to any
borrower, including some related entities of the borrower, at one time may not
exceed:
o 15% of the unimpaired capital and surplus of the institution, plus
o an additional 10% of unimpaired capital and surplus if the loans are
fully secured by readily marketable collateral.
Savings associations are additionally authorized to make loans to one
borrower, for any purpose:
o in an amount not to exceed $500,000; or
o by order of the Director of OTS, in an amount not to exceed the lesser
of $30,000,000 or 30% of unimpaired capital and surplus to develop
residential housing, provided:
o the purchase price of each single-family dwelling in the
development does not exceed $500,000;
o the savings association is in compliance with its capital
requirements;
o the loans comply with applicable loan-to-value requirements; and
o the aggregate amount of loans made under this authority does not
exceed 15% of unimpaired capital and surplus.
At December 31, 2002, the Bank's loans-to-one-borrower limit was $135
million based upon the 15% of unimpaired capital and surplus measurement.
Qualified Thrift Lender Test. The OTS requires savings associations to meet
a qualified thrift lender test. The test may be met either by maintaining a
specified level of assets in qualified thrift investments as specified in the
Home Owners' Loan Act or by meeting the definition of a "domestic building and
loan association." Qualified thrift investments are primarily residential
mortgages and related investments, including some mortgage-related securities.
The required percentage of investments under the Home Owners' Loan Act is 65% of
assets while the Internal Revenue Code requires investments of 60% of assets. An
association must be in compliance with the qualified thrift lender test or the
definition of domestic building and loan association on a monthly basis in nine
out of every 12 months. Associations failing to meet the qualified thrift lender
test are generally allowed only to engage in activities permitted for both
national banks and savings associations.
The FHLB also relies on the qualified thrift lender test. A savings
association will only enjoy full borrowing privileges from an FHLB if the
savings association is a qualified thrift lender. As of December 31, 2002, the
Bank was in compliance with its qualified thrift lender test requirement and met
the definition of a domestic building and loan association.
Affiliate Transactions. Transactions between a savings association and its
"affiliates" are quantitatively and qualitatively restricted under the Federal
Reserve Act and regulations. Affiliates of a savings association include, among
other entities, the savings association's holding company and companies that are
under common control with the savings association.
In general, a savings association and its subsidiaries are limited in their
ability to engage in "covered transactions" with affiliates:
o to an amount equal to 10% of the association's capital and surplus, in
the case of covered transactions with any one affiliate; and
o to an amount equal to 20% of the association's capital and surplus, in
the case of covered transactions with all affiliates.
13
In addition, a savings association and its subsidiaries may engage in covered
transactions and other specified transactions only on terms and under
circumstances that are substantially the same, or at least as favorable to the
savings association or its subsidiary, as those prevailing at the time for
comparable transactions with nonaffiliated companies. A "covered transaction"
includes:
o a loan or extension of credit to an affiliate;
o a purchase of investment securities issued by an affiliate;
o a purchase of assets from an affiliate, with some exceptions;
o the acceptance of securities issued by an affiliate as collateral for
a loan or extension of credit to any party; or
o the issuance of a guarantee, acceptance or letter of credit on behalf
of an affiliate.
In addition, under the OTS regulations:
o a savings association may not make a loan or extension of credit to an
affiliate unless the affiliate is engaged only in activities
permissible for bank holding companies;
o a savings association may not purchase or invest in securities of an
affiliate other than shares of a subsidiary;
o a savings association and its subsidiaries may not purchase a
low-quality asset from an affiliate;
o covered transactions and other specified transactions between a
savings association or its subsidiaries and an affiliate must be on
terms and conditions that are consistent with safe and sound banking
practices; and
o with some exceptions, each loan or extension of credit by a savings
association to an affiliate must be secured by collateral with a fair
value ranging from 100% to 130%, depending on the type of collateral,
of the amount of the loan or extension of credit.
Regulations generally exclude all non-bank and non-savings association
subsidiaries of savings associations from treatment as affiliates, except for:
o a financial subsidiary;
o a subsidiary controlled by one or more affiliates;
o an Employee Stock Option Plan ("ESOP"); or
o a subsidiary which the OTS or the Federal Reserve determines to be an
affiliate.
The regulations also require savings associations to make and retain
records that reflect affiliate transactions in reasonable detail and provide
that specified classes of savings associations may be required to give the OTS
prior notice of affiliate transactions.
Capital Distribution Limitations. A savings association that is a
subsidiary of a savings and loan holding company, such as the Bank, must file an
application or a notice with the OTS at least 30 days before making a capital
distribution. Savings associations are not required to file an application for
permission to make a capital distribution and need only file a notice if the
following conditions are met:
o they are eligible for expedited treatment under OTS regulations;
o they would remain adequately capitalized after the distribution;
o the annual amount of capital distribution does not exceed net income
for that year to date added to retained net income for the two
preceding years; and
o the capital distribution would not violate any agreements between the
OTS and the savings association or any OTS regulations.
14
Any other situation would require an application to the OTS. The OTS may
disapprove an application or notice if the proposed capital distribution would:
o make the savings association undercapitalized, significantly
undercapitalized or critically undercapitalized;
o raise safety or soundness concerns; or
o violate a statute, regulation or agreement with the OTS (or with the
FDIC), or a condition imposed in an OTS approved application or
notice.
Privacy. Under the Financial Services Modernization Act, federal banking
regulators adopted rules that will limit the ability of banks and other
financial institutions to disclose non-public information about consumers to
nonaffiliated third parties. Pursuant to those rules, financial institutions
must provide:
o initial notices to customers about their privacy policies, describing
the conditions under which they may disclose nonpublic personal
information to nonaffiliated third parties and affiliates;
o annual notices of their privacy policies to current customers; and
o a reasonable method for customers to "opt out" of disclosures to
nonaffiliated third parties.
These privacy provisions affect how consumer information is transmitted through
diversified financial companies and conveyed to outside vendors.
USA Patriot Act of 2001. On October 26, 2001, the USA Patriot Act was
signed into law. The Patriot Act is intended to strengthen U.S law enforcement
and the intelligence communities' ability to combat terrorism on a variety of
fronts. The potential impact of the Patriot Act on financial institutions is
significant and wide ranging. The Patriot Act contains sweeping anti-money
laundering and financial transparency laws in addition to current requirements
and requires various regulations, including:
o due diligence requirements for financial institutions that administer,
maintain, or manage private banks accounts or correspondent accounts
for non-US persons;
o standards for verifying customer identification at account opening;
o rules to promote cooperation among financial institutions, regulators,
and law enforcement entities in identifying parties that may be
involved in terrorism or money laundering;
o reports by non-financial businesses filed with the Treasury
Department's Financial Crimes Enforcement Network for cash
transactions exceeding $10,000; and
o the filing of suspicious activities reports by securities brokers and
dealers if they believe a customer may be violating U.S. laws and
regulations.
On July 23, 2002, the U.S. Treasury proposed regulations requiring
institutions to incorporate into their written money laundering plans a Board of
Director approved customer identification program implementing reasonable
procedures to:
o verify the identity of any person seeking to open an account, to the
extent reasonable and practicable;
o maintain records of the information used to verify the person's
identity; and
o determine whether the person appears on any list of known or suspected
terrorists or terrorist organizations.
"Account" is defined as a formal banking or business relationship established to
provide ongoing services, dealings, or other financial transactions. We do not
expect the proposed regulations will have a material impact on our operations.
Activities of Subsidiaries. A savings association seeking to establish a
new subsidiary, acquire control of an existing company or conduct a new activity
through a subsidiary must provide 30 days prior notice to the FDIC and the OTS
and conduct any activities of the subsidiary in compliance with regulations and
orders of the OTS. The OTS may require a savings association to divest any
subsidiary or terminate any activity conducted by a subsidiary that the OTS
determines to pose a serious threat to the financial safety, soundness or
stability of the savings
15
association or to be otherwise inconsistent with sound banking practices.
Community Reinvestment Act and the Fair Lending Laws. Savings associations
have a responsibility under the Community Reinvestment Act and related OTS
regulations to help meet the credit needs of their communities, including low-
and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act
and the Fair Housing Act prohibit lenders from discriminating in their lending
practices on the basis of characteristics specified in those statutes. An
institution's failure to comply with the provisions of the Community
Reinvestment Act could, at a minimum, result in regulatory restrictions on its
activities and the denial of applications. In addition, an institution's failure
to comply with the Equal Credit Opportunity Act and the Fair Housing Act could
result in the OTS, other federal regulatory agencies as well as the Department
of Justice taking enforcement actions.
Federal Home Loan Bank System. The Bank is a member of the FHLB system.
Among other benefits, each FHLB serves as a reserve or central bank for its
members within its assigned region. Each FHLB is financed primarily from the
sale of consolidated obligations of the FHLB system. Each FHLB makes available
loans or advances to its members in compliance with the policies and procedures
established by the Board of Directors of the individual FHLB.
As an FHLB member, the Bank is required to own capital stock in an FHLB in
an amount equal to the greater of:
o 1% of its aggregate outstanding principal amount of its residential
mortgage loans, home purchase contracts and similar obligations at the
beginning of each calendar year;
o 5% of its FHLB advances or borrowings; or
o $500.
At December 31, 2002, the Bank had $118 million of FHLB stock, an amount in
excess of our required investment of $108 million.
The GLBA made significant reforms to the FHLB system, including:
o Expanded Membership - (i) expands the uses for, and types of,
collateral for advances; (ii) eliminates bias toward qualified thrift
lenders; and (iii) removes capital limits on advances using real
estate related collateral (e.g., commercial real estate and home
equity loans).
o New Capital Structure - each FHLB is allowed to establish two classes
of stock: Class A is redeemable within six months of notice; and Class
B is redeemable within five years notice. Class B is valued at 1.5
times the value of Class A stock. Each FHLB will be required to
maintain minimum capital equal to 5% of equity. Each FHLB, including
our FHLB of San Francisco, submitted capital plans for review and
approval by the Federal Housing Finance Board.
o Voluntary Membership - federally chartered savings associations, such
as the Bank, are no longer required to be members of the system.
o REFCorp Payments - changes the amount paid by the system on debt
incurred in connection with the thrift crisis in the late 1980s from a
fixed amount to 20% of net earnings after deducting certain expenses.
The new capital plan for the FHLB of San Francisco was approved by the
Federal Housing Finance Board on June 12, 2002. The FHLB of San Francisco has
not yet established an implementation date for the new capital plan, with
implementation required by June 2005. The Bank will receive at least 240 days
written notice of the implementation date. The new capital plan incorporates a
single class of stock and requires each member to own stock in an amount equal
to the greater of:
o a membership stock requirement, or
o an activity based stock requirement.
The new capital stock is redeemable on five years written notice, subject
to certain conditions.
We do not believe that the initial implementation of the new capital plan
for the FHLB of San Francisco as approved will have a material impact upon our
financial condition, cash flows, or results of operations. However, to maintain
membership, the Bank could be required to purchase as much as 50% additional
capital stock or sell
16
as much as 50% of its proposed capital stock requirement at the discretion of
the FHLB of San Francisco.
Federal Reserve System. The Federal Reserve requires all depository
institutions to maintain non-interest-bearing reserves at specified levels
against their transaction accounts and non-personal time deposits. These
transaction accounts include checking, NOW and Super NOW checking accounts. The
balances a savings association maintains to meet the reserve requirements
imposed by the Federal Reserve may be used to satisfy the OTS's liquidity
requirements that are imposed by the OTS. At December 31, 2002, the Bank was in
compliance with these requirements.
Proposed Legislation. From time to time, new laws are proposed that could
have an effect on the financial institutions industry. For example, legislation
is currently being considered in the U.S. House of Representatives Financial
Institutions Subcommittee which would:
o merge the Bank Insurance Fund ("BIF") and the SAIF;
o increase the current deposit insurance coverage limit for insured
deposits to $130,000 and index future coverage limits to inflation;
o increase deposit insurance coverage limits for municipal deposits;
o double deposit insurance coverage limits for individual retirement
accounts; and
o smooth out bank deposit insurance premiums to avoid sharp increases
during times of recession.
While we cannot predict whether such proposals will eventually become law, they
could have an effect on our operations and the way we conduct business.
REGULATION OF DSL SERVICE COMPANY
DSL Service Company is licensed as a real estate broker under the
California Real Estate Law and as a contractor with the Contractors State
License Board. Thus, the real estate investment activities of DSL Service
Company, including development, construction and property management activities
relating to its portfolio of projects, are governed by a variety of laws and
regulations. Changes occur frequently in the laws and regulations or their
interpretation by agencies and the courts. DSL Service Company must comply with
various federal, state and local laws, ordinances, rules and regulations
concerning zoning, building design, construction, hazardous waste and similar
matters. Environmental laws and regulations also affect the operations of DSL
Service Company, including regulations pertaining to availability of water,
municipal sewage treatment capacity, land use, protection of endangered species,
population density and preservation of the natural terrain and coastlines. These
and other requirements could become more restrictive in the future, resulting in
additional time and expense in connection with DSL Service Company's real estate
activities.
With regard to environmental matters, the construction products industry is
regulated by federal, state and local laws and regulations pertaining to several
areas including human health and safety and environmental compliance. The
Comprehensive Environmental Response, Compensation and Liability Act of 1980, as
amended by the Superfund Amendments and Reauthorization Act of 1986, as well as
analogous laws in some states, create joint and several liability for the cost
of cleaning up or correcting releases to the environment of designated hazardous
substances. Among those who may be held jointly and severally liable are:
o those who generated the waste;
o those who arranged for disposal;
o those who owned or operated the disposal site or facility at the time
of disposal; and
o current owners.
In general, this liability is imposed in a series of governmental
proceedings initiated by the government's identification of a site for initial
listing as a "Superfund site" on the National Priorities List or a similar state
list and the government's identification of potentially responsible parties who
may be liable for cleanup costs. None of the DSL Service Company's project sites
is listed as a "Superfund site."
In addition, California courts have imposed warranty-like responsibility
upon developers of new housing for defects in structure and the housing site,
including soil conditions. This responsibility is not necessarily dependent upon
a finding that the developer was negligent.
17
As a licensed entity, DSL Service Company is also examined and supervised
by the California Department of Real Estate and the Contractors State License
Board.
TAXATION
Federal. Savings institutions are taxed like other corporations for federal
income tax purposes, and are required to comply with income tax statutes and
regulations similar to those applicable to large commercial banks. The Bank's
bad debt deduction is determined under the specific charge-off method, which
allows the Bank to take an income tax deduction for loans determined to be
wholly or partially worthless.
In addition to the regular income tax, corporations are also subject to an
alternative minimum tax. This tax is computed at 20% of the corporation's
regular taxable income, after taking certain adjustments into account. The
alternative minimum tax applies to the extent that it exceeds the regular income
tax liability.
A corporation that incurs alternative minimum tax generally is entitled to
take this tax as a credit against its regular tax liability in later years to
the extent that the regular tax liability in these later years exceeds the
alternative minimum tax.
State. The Bank uses California's financial corporation income tax rate to
compute its California franchise tax liability. This rate is higher than the
California non-financial corporation income tax rate because the financial
corporation rate reflects an amount "in lieu" of local personal property and
business license taxes that are paid by non-financial corporations, but not by
banks or other financial corporations. The financial corporation income tax rate
was 10.84% for both 2002 and 2001.
The Bank files a California franchise tax return on a combined reporting
basis. Other income and franchise tax returns are filed on a separate-entity
basis in various other states. The Bank anticipates that additional state income
and franchise tax returns will be required in future years as its lending
business expands nationwide.
The Internal Revenue Service and various state taxing authorities have
examined the Bank's tax returns for all tax years through 1997. Management
believes it has adequately provided for potential exposure to issues that may be
raised by tax auditors in the years subsequent to 1997, which remain open to
review.
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
In addition to the other information contained in this report, the
following risks may affect us. If any of these risks occur, our business,
financial condition or operating results could be adversely affected.
OUR CALIFORNIA BUSINESS FOCUS AND ECONOMIC CONDITIONS IN CALIFORNIA COULD
ADVERSELY AFFECT OUR OPERATIONS.
Downey is headquartered in and its operations are concentrated in
California. As a result of this geographic concentration, our results depend
largely upon economic and business conditions in this state. The economy in our
market areas has exhibited weakness. Deterioration of economic conditions in
California could have a material adverse impact on the quality of our loan and
real estate portfolios and the demand for our products and services.
SIGNIFICANT CHANGES IN INTEREST RATES COULD ADVERSELY AFFECT OUR
PERFORMANCE AND RESULTS OF OPERATIONS.
If interest rates vary substantially from present levels, our results may
differ materially from recent levels. Changes in interest rates will influence
the growth of loans, investments and deposits and affect the rates received on
loans and investment securities and paid on deposits. Changes in interest rates
also affect the value of our recorded mortgage servicing rights on loans we
service for others, generally increasing in value as interest rates rise and
declining as interest rates fall. If interest rates were to increase
significantly, the economic feasibility of real estate investment activities
also could be adversely affected.
WE ARE SUBJECT TO GOVERNMENT REGULATION AND FEDERAL MONETARY POLICY THAT
COULD LIMIT OR RESTRICT OUR ACTIVITIES, WHICH COULD ADVERSELY AFFECT OUR
OPERATIONS.
The financial services industry is subject to extensive federal and state
supervision and regulation. Significant new laws or changes in, or repeals of,
existing laws may cause our results to differ materially. Further,
18
federal monetary policy, particularly as implemented through the Federal Reserve
System, significantly affects credit conditions for Downey, primarily through
open market operations in United States government securities, the discount rate
for borrowings and reserve requirements. A material change in these conditions
would be likely to have a material impact on our results.
COMPETITION MAY ADVERSELY AFFECT OUR PERFORMANCE.
The banking and financial services business in our market areas is highly
competitive. The increasingly competitive environment is a result primarily of
changes in regulation, changes in technology and product delivery systems, and
the expectation of continued consolidation among financial services providers.
Increasing levels of competition in the banking and financial services
businesses may reduce our market share or cause the prices we charge for our
products to decline. Our results may differ in future periods depending on the
nature or level of competition.
IF A SIGNIFICANT NUMBER OF BORROWERS, GUARANTORS AND RELATED PARTIES FAIL
TO PERFORM AS REQUIRED BY THE TERMS OF THEIR LOANS, WE WILL SUSTAIN LOSSES.
A significant source of risk arises from the possibility that losses will
be sustained because borrowers, guarantors and related parties may fail to
perform in accordance with the terms of their loans. While we have adopted
underwriting and loan quality monitoring systems, procedures and credit
policies, including the establishment and review of the allowance for loan
losses, such policies and procedures, may not prevent unexpected losses that
could materially affect our results.
BECAUSE DOWNEY OPERATES AS A HOLDING COMPANY, CHANGES IN THE ABILITY OF THE
BANK TO PAY DIVIDENDS MAY ADVERSELY AFFECT DOWNEY'S ABILITY TO PAY DIVIDENDS.
Although we have been paying regular quarterly dividends, our ability to
pay dividends to our stockholders depends to a large extent upon the dividends
we receive from the Bank. Dividends paid by the Bank are subject to restrictions
under various federal and state banking laws. In addition, the Bank must
maintain certain capital levels, which may restrict the ability of the Bank to
pay dividends to us. The Bank's regulators have the authority to prohibit the
Bank or us from engaging in unsafe or unsound practices in conducting our
business. As a consequence, the Bank regulators could deem the payment of
dividends by the Bank to be an unsafe or unsound practice, depending on the
Bank's financial condition or otherwise, and prohibit such payments. If the Bank
were unable to pay dividends to us, we might cease paying or reduce the rate or
frequency at which we pay dividends to stockholders until such time that the
Bank could again pay us dividends.
TERRORIST ACTIVITIES COULD CAUSE REDUCTIONS IN INVESTOR CONFIDENCE AND
SUBSTANTIAL VOLATILITY IN REAL ESTATE AND SECURITIES MARKETS.
It is impossible to predict the extent to which terrorist activities may
occur in the United States or, if they occur, the extent of the effect on a
particular security issue. Moreover, it is uncertain what effects any past or
future terrorist activities and/or any consequent actions on the part of the
United States Government and others will have on the United States and world
financial markets; local, regional and national economies; real estate markets
across the United States; and/or particular business segments. Among other
things, reduced investor confidence could result in substantial volatility in
securities markets, a decline in real estate related investments and in increase
in defaults on loans. Such unexpected losses could materially affect our results
of operations.
19
ITEM 2. PROPERTIES
BRANCHES
The corporate offices of Downey, the Bank and DSL Service Company are
located at 3501 Jamboree Road, Newport Beach, California 92660. Part of that
corporate facility houses a branch office of the Bank. Certain departments
(warehousing, record retention, etc.) are located in other owned and leased
facilities in Orange County, California. The majority of our administrative
operations, however, are located in our corporate headquarters.
At December 31, 2002, we had 165 branches. We owned the building and land
occupied by 61 of our branches and we owned one branch building on leased land.
We operate branches in 103 locations (including 93 in-store locations) with
leases or licenses expiring at various dates through August 2011, with options
to extend the term.
The net book value of our owned branches, including the one on leased land,
totaled $84 million at December 31, 2002, and the net book value of our leased
branch offices totaled $4 million at December 31, 2002. The net book value of
our furniture and fixtures, including electronic data processing equipment, was
$26 million at December 31, 2002.
For additional information regarding our offices and equipment, see Note 1
on page 72 and Note 8 on page 88 of Notes to Consolidated Financial Statements.
ELECTRONIC DATA PROCESSING
We utilize a mainframe computer system and use various internally developed
and third-party vendors' software for retail deposit operations, loan servicing,
accounting and loan origination functions, including our operations conducted
over the Internet. The net book value of our electronic data processing
equipment, including personal computers and software, was $12 million at
December 31, 2002.
ITEM 3. LEGAL PROCEEDINGS
We have been named as a defendant in legal actions arising in the ordinary
course of business, none of which, in the opinion of management, is material.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to shareholders during the fourth quarter of
2002.
20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange ("NYSE") and the
Pacific Exchange ("PCX") under the trading symbol "DSL." At February 28, 2003,
we had approximately 725 stockholders of record (not including the number of
persons or entities holding stock in nominee or street name through various
brokerage firms) and 27,928,722 outstanding shares of common stock.
The following table sets forth for the quarters indicated the range of high
and low sale prices per share of our common stock as reported on the NYSE
Composite Tape.
2002 2001
-----------------------------------------------------------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
-------------------------------------------------------------------------------------------------------
High ........ $ 41.55 $ 49.25 $ 55.56 $ 48.83 $ 44.46 $ 58.81 $ 48.85 $ 54.31
Low ......... 31.32 33.34 46.70 41.84 32.98 40.61 41.44 39.45
End of period 39.00 34.25 47.30 45.60 41.25 44.13 47.26 45.30
=======================================================================================================
During 2002 and 2001, we paid quarterly cash dividends of $0.09 per share,
or $0.36 per share annually. Total cash dividends were $10.1 million in 2002 and
$10.2 million in 2001. On February 21, 2003, we paid a $0.09 per share quarterly
cash dividend, aggregating $2.5 million.
We may pay additional dividends out of funds legally available therefor at
such times as the Board of Directors determines that dividend payments are
appropriate. The Board of Directors' policy is to consider the declaration of
dividends on a quarterly basis.
The payment of dividends by the Bank to Downey is subject to OTS
regulations. For further information regarding these regulations, see
Business--Regulation--Regulation of the Bank--Capital Distribution Limitations
on page 14.
21
ITEM 6. SELECTED FINANCIAL DATA
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000 1999 1998
------------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT DATA
Total interest income .......................................... $ 633,038 $ 808,381 $ 784,360 $ 533,751 $ 440,404
Total interest expense ......................................... 317,640 502,811 521,885 326,273 266,057
------------------------------------------------------------------------------------------------------------------------------------
Net interest income ........................................ 315,398 305,570 262,475 207,478 174,347
Provision for loan losses ...................................... 939 2,564 3,251 11,270 3,899
------------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses ........ 314,459 303,006 259,224 196,208 170,448
------------------------------------------------------------------------------------------------------------------------------------
Other income, net:
Loan and deposit related fees .............................. 47,220 50,486 30,089 20,097 15,645
Real estate and joint ventures held for investment, net .... 10,250 3,885 8,798 19,302 22,363
Secondary marketing activities:
Loan servicing income (loss), net ........................ (39,629) (11,373) (3,628) 1,672 259
Net gains on sales of loans and mortgage-backed securities 45,860 22,432 3,297 14,806 6,462
Net gains on sales of mortgage servicing rights .......... 331 934 -- -- --
Net gains (losses) on sales of investment securities ....... 219 329 (106) 288 68
Gain on sale of subsidiary (1) ............................. -- -- 9,762 -- --
Other ...................................................... 2,431 1,843 2,342 3,113 2,556
------------------------------------------------------------------------------------------------------------------------------------
Total other income, net .................................. 66,682 68,536 50,554 59,278 47,353
------------------------------------------------------------------------------------------------------------------------------------
Operating expense:
General and administrative expense ......................... 186,644 162,496 136,189 144,382 115,890
Net operation of real estate acquired in settlement of loans 11 239 818 19 260
Amortization of excess cost over fair value of branch
acquisitions (2) ......................................... -- 457 462 474 510
------------------------------------------------------------------------------------------------------------------------------------
Total operating expense .................................. 186,655 163,192 137,469 144,875 116,660
------------------------------------------------------------------------------------------------------------------------------------
Net income (1) ................................................. $ 112,293 $ 120,181 $ 99,251 $ 63,804 $ 57,973
PER SHARE DATA
Earnings per share--Basic (1) .................................. $ 3.99 $ 4.26 $ 3.52 $ 2.27 $ 2.06
Earnings per share--Diluted (1) ................................ 3.99 4.25 3.51 2.26 2.05
Book value per share at end of period .......................... 29.47 26.01 22.15 18.91 17.08
Stock price at end of period ................................... 39.00 41.25 55.00 20.19 25.44
Cash dividends paid ............................................ 0.36 0.36 0.36 0.35 0.32
SELECTED FINANCIAL RATIOS
Effective interest rate spread ................................. 2.91% 2.91% 2.66% 2.88% 3.08%
Efficiency ratio (3) ........................................... 50.23 43.93 46.23 58.41 58.16
Return on average assets (1) ................................... 1.00 1.11 0.97 0.85 0.98
Return on average equity (1) ................................... 14.42 17.81 17.17 12.70 12.71
Dividend payout ratio .......................................... 9.02 8.45 10.22 15.44 15.33
LOAN ACTIVITY
Loans originated ............................................... $10,445,978 $ 8,128,285 $ 5,218,368 $ 7,132,486 $4,071,262
Loans and mortgage-backed securities purchased ................. 1,497,645 216,214 18,828 49,669 7,463
Loans and mortgage-backed securities sold ...................... 7,103,861 4,553,944 1,662,600 2,386,958 1,740,416
BALANCE SHEET SUMMARY (END OF PERIOD)
Total assets ................................................... $11,978,151 $11,105,030 $10,893,863 $ 9,407,540 $6,270,419
Loans and mortgage-backed securities ........................... 10,976,942 10,132,413 10,084,353 8,746,063 5,788,365
Investments, cash and cash equivalents ......................... 590,092 551,823 439,968 299,698 215,086
Deposits ....................................................... 9,238,350 8,619,566 8,082,689 6,562,761 5,039,733
Borrowings ..................................................... 1,624,084 1,522,712 1,978,572 2,122,780 703,720
Capital securities ............................................. 120,000 120,000 120,000 120,000 --
Stockholders' equity ........................................... 823,104 733,896 624,636 532,418 480,566
Loans serviced for others ...................................... 8,316,236 5,805,811 3,964,462 2,923,778 1,040,264
AVERAGE BALANCE SHEET DATA
Assets ......................................................... $11,230,354 $10,850,683 $10,217,371 $ 7,501,228 $5,918,507
Loans .......................................................... 10,336,951 10,033,155 9,514,978 6,937,342 5,345,380
Deposits ....................................................... 8,768,204 8,701,424 7,290,850 5,697,292 5,102,045
Stockholders' equity ........................................... 778,463 674,972 577,979 502,412 456,237
22
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000 1999 1998
------------------------------------------------------------------------------------------------------------------------------------
CAPITAL RATIOS
Average stockholders' equity to average assets ................. 6.93% 6.22% 5.66% 6.70% 7.71%
Bank only--end of period (4):
Core and tangible capital .................................. 6.92 7.10 6.42 6.27 6.83
Risk-based capital ......................................... 14.08 14.53 12.94 12.14 12.88
SELECTED ASSET QUALITY DATA (END OF PERIOD)
Total non-performing assets .................................... $79,814 $ 92,632 $ 54,974 $ 39,194 $ 27,419
Non-performing assets as a percentage of total assets .......... 0.67% 0.83% 0.50% 0.42% 0.44%
Allowance for loan losses:
Amount ..................................................... $34,999 $ 36,120 $ 34,452 $ 38,342 $ 31,517
As a percentage of non-performing loans .................... 51.89% 46.76% 76.63% 116.25% 140.86%
====================================================================================================================================
(1) In 2000, a $5.6 million after-tax gain was recognized from the sale of
Downey Auto Finance Corp. Excluding the gain, 2000 net income would have
been $93.6 million or $3.33 per share on a basic basis and $3.32 per share
on a diluted basis, the return on average assets would have been 0.92% and
the return on average equity would have been 16.20%.
(2) During the fourth quarter of 2002, we adopted SFAS 147, which required us
to cease the amortization of goodwill as of January 1, 2002.
(3) The amount of general and administrative expense incurred for each $1 of
net interest income plus other income, except for income associated with
real estate held for investment and securities gains or losses.
(4) For more information regarding these ratios, see Management's Discussion
and Analysis of Financial Condition and Results of Operations--Financial
Condition--Regulatory Capital Compliance on page 61.
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements under this caption constitute "forward-looking
statements" under the Private Securities Litigation Reform Act of 1995 which
involve risks and uncertainties. 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. For additional information concerning these factors, see
Business--Factors That May Affect Future Results Of Operations on page 18.
OVERVIEW
Our net income for 2002 totaled $112.3 million or $3.99 per share on a
diluted basis, down from last year's record of $120.2 million or $4.25 per
share, but second highest in Downey's history. During the year, we repurchased
306,300 shares of common stock at an average price per share of $39.73, leaving
$38 million of the $50 million authorization available for future share
repurchases.
The decline in our net income between years reflected lower net income from
our banking operations, as net income from our real estate operations increased
$5.5 million to $6.2 million due primarily to higher gains from sales and lower
operating expense. Net income from our banking operations totaled $106.1
million, down $13.4 million due to the following:
o a $28.3 million higher loss from loan servicing due primarily to
higher provisions to the valuation allowance for mortgage servicing
rights reflecting the continued decline in market interest rates that
increased the actual and expected rate of prepayments on loans we
service for others;
o a $26.3 million increase in operating expense due to higher costs
associated with the increased number of branch locations and higher
loan origination activity; and
o a $7.3 million decline in loan related fees due to lower prepayment
fees.
Those unfavorable items were partially offset by the following:
o a $23.4 million increase in net gains on sales of loans and
mortgage-backed securities due to a record volume of sales and the
favorable impact from the SFAS 133 valuation of derivatives associated
with the sale of loans;
o a $9.8 million increase in net interest income due to higher
interest-earning assets;
o a $4.1 million increase in deposit related fees; and
o a $1.6 million decline in provision for loan losses.
For 2002, our return on average assets was 1.00% and our return on average
equity was 14.42%. These compare to our 2001 returns of 1.11% on average assets
and 17.81% on average equity.
Our single family loan originations increased from $8.0 billion in 2001 to
a record $10.7 billion in 2002, of which $6.2 billion were originated for sale
in the secondary market. Of the 2002 total, $4.5 billion represented
originations of loans for portfolio, of which $520 million were subprime
credits. In addition to single family loans, we originated $269 million of other
loans during the year, including $181 million of construction and land loans.
Our assets increased $873 million or 7.9% during 2002 to $12.0 billion at
year end, following a 1.9% increase during 2001. We primarily funded our asset
growth with deposits that increased $619 million or 7.2% to a record year-end
level of $9.2 billion at December 31, 2002.
Non-performing assets totaled $80 million at December 31, 2002, down from
$93 million a year ago. The decrease was due primarily to a decline in our
residential non-performers. When measured as a percentage of total assets, our
non-performing assets dropped from 0.83% at year-end 2001 to 0.67% at year-end
2002.
24
At December 31, 2002, the Bank exceeded all regulatory capital tests, with
capital-to-asset ratios of 6.92% for both tangible and core capital and 14.08%
for risk-based capital. These capital levels are significantly above the "well
capitalized" standards defined by the federal banking regulators of 5% for core
and tangible capital and 10% for risk-based capital. For further information,
see Business--Regulation--Regulation of the Bank--Insurance of Deposit Accounts
on page 11, Financial Condition--Investments in Real Estate and Joint Ventures
on page 39 and Financial Condition--Regulatory Capital Compliance on page 61.
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 the Notes to the Consolidated Financial
Statements beginning on page 72. 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.
We believe the following are critical accounting policies that require the
most significant estimates and assumptions that are particularly susceptible to
significant change in the preparation of our financial statements:
o Allowance for losses on loans and real estate. For further
information, see Financial Condition--Problem Loans and Real
Estate--Allowance for Losses on Loans and Real Estate on page 53 and
Note 1 of Notes to the Consolidated Financial Statements on page 72.
o Valuation of mortgage servicing rights. For further information, see
Note 1 on page 72 and Note 10 on page 89 of Notes to the Consolidated
Financial Statements.
o Valuation of expected rate lock commitments. For further information,
see Note 1 on page 72 and Note 20 on page 101 of Notes to the
Consolidated Financial Statements.
25
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, borrowings and
capital securities ("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 $315.4 million in 2002, up $9.8 million or
3.2% from 2001 and $52.9 million or 20.2% greater than 2000. The improvement
during 2002 reflected higher interest-earning assets, as our effective interest
rate spread was unchanged. Our average interest-earning assets increased by $343
million or 3.3% to $10.8 billion. Our effective interest rate spread averaged
2.91% in both 2002 and 2001, up from 2.66% in 2000.
The following table presents for the years indicated the total dollar
amount of:
o interest income from average interest-earning assets and the resultant
yields; and
o interest expense on average interest-bearing liabilities and the
resultant costs, expressed as rates.
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:
o the difference between interest income on interest-earning assets and
interest expense on interest-bearing liabilities, divided by
o average interest-earning assets for the year.
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, borrowings and capital securities--for the years 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 to the extent we believe we will recover the remaining
principal balance of the loans. We computed average balances for the year using
the average of each month's daily average balance during the years indicated.
26
2002 2001 2000
---------------------------------------------------------------------------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
(Dollars in Thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate
------------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Loans ............................. $10,336,951 $612,762 5.93% $10,033,155 $782,784 7.80% $ 9,514,978 $760,538 7.99%
Mortgage-backed securities ........ 76,250 3,637 4.77 13,747 726 5.28 15,959 1,060 6.64
Investment securities ............. 420,142 16,639 3.96 443,386 24,871 5.61 346,192 22,762 6.57
------------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ... 10,833,343 633,038 5.84 10,490,288 808,381 7.71 9,877,129 784,360 7.94
Non-interest-earning assets .......... 397,011 360,395 340,242
------------------------------------------------------------------------------------------------------------------------------------
Total assets ...................... $11,230,354 $10,850,683 $10,217,371
====================================================================================================================================
Transaction accounts:
Non-interest-bearing checking ..... $ 306,890 $ -- -- % $ 302,628 $ -- -- % $ 209,221 $ -- -- %
Interest-bearing checking (1) ..... 421,590 1,391 0.33 406,666 2,057 0.51 381,269 3,520 0.92
Money market ...................... 113,862 1,929 1.69 93,964 2,436 2.59 89,495 2,544 2.84
Regular passbook .................. 3,042,839 69,113 2.27 1,118,287 34,553 3.09 796,212 27,841 3.50
------------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts ....... 3,885,181 72,433 1.86 1,921,545 39,046 2.03 1,476,197 33,905 2.30
Certificates of deposit .............. 4,883,023 172,108 3.52 6,779,879 385,809 5.69 5,814,653 345,398 5.94
------------------------------------------------------------------------------------------------------------------------------------
Total deposits .................... 8,768,204 244,541 2.79 8,701,424 424,855 4.88 7,290,850 379,303 5.20
Borrowings ........................... 1,410,762 60,936 4.32 1,219,484 65,793 5.40 2,118,497 130,419 6.16
Capital securities ................... 120,000 12,163 10.14 120,000 12,163 10.14 120,000 12,163 10.14
------------------------------------------------------------------------------------------------------------------------------------
Total deposits, borrowings and
capital securities ............... 10,298,966 317,640 3.08 10,040,908 502,811 5.01 9,529,347 521,885 5.48
Other liabilities .................... 152,925 134,803 110,045
Stockholders' equity ................. 778,463 674,972 577,979
------------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
stockholders' equity ............. $11,230,354 $10,850,683 $10,217,371
====================================================================================================================================
Net interest income/interest rate
spread ............................ $315,398 2.76% $305,570 2.70% $262,475 2.46%
Excess of interest-earning assets over
deposits, borrowings and capital
securities ........................ $ 534,377 $ 449,380 $ 347,782
Effective interest rate spread ....... 2.91 2.91 2.66
====================================================================================================================================
(1) Included amounts swept into money market deposit accounts.
27
Changes in our net interest income are a function of both changes in rates
and changes in 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 years indicated. For each category of
interest-earning assets and interest-bearing liabilities, we have provided
information on changes attributable to:
o changes in volume--changes in volume multiplied by comparative period
rate;
o changes in rate--changes in rate multiplied by comparative period
volume; and
o changes in rate/volume--changes in rate multiplied by changes in
volume.
Interest-earning asset and interest-bearing liability balances used in the
calculations represent annual average balances computed using the average of
each month's daily average balance during the years indicated.
2002 Versus 2001 2001 Versus 2000
Changes Due To Changes Due To
---------------------------------------------------------------------------------------------
Rate/ Rate/
(In Thousands) Volume Rate Volume Net Volume Rate Volume Net
---------------------------------------------------------------------------------------------------------------------------------
Interest income:
Loans ........................... $ 23,702 $(188,031) $ (5,693) $(170,022) $ 41,418 $(18,182) $ (990) $ 22,246
Mortgage-backed securities ...... 3,301 (70) (320) 2,911 (147) (217) 30 (334)
Investment securities ........... (1,304) (7,311) 383 (8,232) 6,393 (3,345) (939) 2,109
---------------------------------------------------------------------------------------------------------------------------------
Change in interest income ..... 25,699 (195,412) (5,630) (175,343) 47,664 (21,744) (1,899) 24,021
---------------------------------------------------------------------------------------------------------------------------------
Interest expense:
Transaction accounts:
Interest-bearing checking (1) . 75 (715) (26) (666) 234 (1,591) (106) (1,463)
Money market .................. 516 (844) (179) (507) 127 (224) (11) (108)
Regular passbook .............. 59,465 (9,153) (15,752) 34,560 11,262 (3,240) (1,310) 6,712
---------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts 60,056 (10,712) (15,957) 33,387 11,623 (5,055) (1,427) 5,141
Certificates of deposit ......... (107,941) (146,844) 41,084 (213,701) 57,336 (14,515) (2,410) 40,411
---------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits (47,885) (157,556) 25,127 (180,314) 68,959 (19,570) (3,837) 45,552
Borrowings ...................... 10,320 (13,119) (2,058) (4,857) (55,386) (15,373) 6,133 (64,626)
Capital securities .............. -- -- -- -- -- -- -- --
---------------------------------------------------------------------------------------------------------------------------------
Change in interest expense .... (37,565) (170,675) 23,069 (185,171) 13,573 (34,943) 2,296 (19,074)
---------------------------------------------------------------------------------------------------------------------------------
Change in net interest income ...... $ 63,264 $ (24,737) $(28,699) $ 9,828 $ 34,091 $ 13,199 $(4,195) $ 43,095
=================================================================================================================================
(1) Included amounts swept into money market deposit accounts.
PROVISION FOR LOAN LOSSES
Provision for loan losses was $0.9 million in 2002, down from $2.6 million
in 2001 and $3.3 million in 2000. The decrease is due primarily to an
improvement in asset quality from a year ago.
For further information, see Financial Condition--Problem Loans and Real
Estate--Allowance for Losses on Loans and Real Estate on page 53.
OTHER INCOME
Our total other income was $66.7 million in 2002, down from $68.5 million
in 2001, but up from $50.6 million in 2000. The decline in our other income in
2002 was primarily due to a larger addition to the valuation allowance for
mortgage servicing rights. The addition was reflected within the category of
loan servicing loss and was necessary due to the drop in long-term interest
rates, which resulted in an increase in the actual and projected rate at which
loans serviced for others are expected to prepay, thereby shortening their
expected average life. In addition, the decline in long-term interest rates
reduced the expected value of associated custodial accounts. The pre-tax
addition was $36.6 million, up from $10.6 million during 2001 and $6.1 million
during 2000. Excluding the valuation allowances additions, our total other
income would have been $103.3 million in 2002, up $24.2 million or
28
30.5% from the adjusted 2001 level and up $46.7 million or 82.4% from the
adjusted 2000 level. This adjusted increase was primarily due to the following:
o a $23.4 million increase in net gains on sales of loans and
mortgage-backed securities;
o a $6.4 million increase in income from real estate held for investment
due to higher gains from sales; and
o a $4.1 million increase in deposit related fees.
Those favorable items were partially offset by a $7.3 million decline in loan
related fees and a $2.2 million increase in the adjusted loss associated with
our loan servicing activity.
Total other income increased $18.0 million during 2001 due primarily to a
$20.4 million increase in loan and deposit related fees and a $20.1 million
increase in net gains on sales of loans, mortgage-backed securities and mortgage
servicing rights. Those favorable items were partially offset by the absence of
a $9.8 million pre-tax gain associated with our sale of the indirect automobile
finance subsidiary in 2000, an increase of $7.7 million in loan servicing losses
as well as a decline of $4.9 million in income from real estate held for
investment. Below is a further discussion of the major other income categories.
LOAN AND DEPOSIT RELATED FEES
Loan and deposit related fees totaled $47.2 million in 2002, down from
$50.5 million in 2001, but up from $30.1 million in 2000. Our current year loan
related fees declined $7.3 million from 2001, due to a decline in loan
prepayment fees. This decline was partially offset by a $4.1 million or 22.8%
increase in our deposit related fees, primarily due to higher fees from our
checking accounts.
The following table presents a breakdown of loan and deposit related fees
during the years indicated.
(In Thousands) 2002 2001 2000
-------------------------------------------------------------------------
Loan related fees:
Prepayment fees ..................... $15,999 $23,839 $11,195
Other fees .......................... 9,258 8,764 5,527
Deposit related fees:
Automated teller machine fees ....... 7,328 6,524 5,792
Other fees .......................... 14,635 11,359 7,575
-------------------------------------------------------------------------
Total loan and deposit related fees $47,220 $50,486 $30,089
=========================================================================
REAL ESTATE AND JOINT VENTURES HELD FOR INVESTMENT
Income from our real estate and joint ventures held for investment totaled
$10.3 million in 2002, up from $3.9 million in 2001 and $8.8 million in 2000.
The current year increase of $6.4 million over 2001 reflected two factors.
First, our net gains from sales increased by $5.9 million to $6.4 million. Of
the increase, $4.8 million was related to joint venture projects reported in the
category equity in net income from joint ventures. Second, our interest from
joint venture advances increased by $0.6 million.
The table below sets forth the key components comprising our income from
real estate and joint venture operations during the years indicated.
(In Thousands) 2002 2001 2000
-------------------------------------------------------------------------------------------------------------
Rental operations, net of expenses .......................................... $ 2,102 $ 2,245 $ 2,572
Equity in net income from joint ventures .................................... 5,476 736 3,224
Interest from joint venture advances ........................................ 1,024 468 887
Net gains on sales of wholly owned real estate .............................. 1,200 129 2,981
(Provision for) reduction of losses on real estate and joint ventures ....... 448 307 (866)
-------------------------------------------------------------------------------------------------------------
Total income from real estate and joint ventures held for investment, net $10,250 $ 3,885 $ 8,798
=============================================================================================================
For additional information, see Financial Condition--Investments in Real
Estate and Joint Ventures on page 39, Financial Condition--Problem Loans and
Real Estate--Allowance for Losses on Loans and Real Estate on page 53 and Note 6
of Notes to Consolidated Financial Statements on page 83.
29
SECONDARY MARKETING ACTIVITIES
A loss of $39.6 million was recorded in loan servicing from our portfolio
of loans serviced for others during 2002, compared to a loss of $11.4 million in
2001 and $3.6 million in 2000. The higher loss in 2002 primarily reflected a
$36.6 million provision to the valuation allowance for mortgage servicing
rights, up from $10.6 million in 2001. The current year valuation addition was
associated with the decline in the fair value of our mortgage servicing rights
due to the drop in long-term interest rates, which resulted in an increase in
the actual and projected rate at which loans serviced for others are expected to
prepay, thereby shortening their expected average life. Excluding the valuation
additions, we incurred a loss of $3.0 million in 2002 in the loan servicing
category, compared to a loss of $0.8 million in 2001. When a loan we service for
others prepays, 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 a reduction of our borrowing costs within net interest income. Most
of our loan servicing agreements, however, require us to pay interest to the
investor up to the date we remit funds to them. Therefore, when the loan
prepays, we remit to the investor more interest than we collect from the
borrower. That additional interest cost, which we call pay-off and curtailment
interest losses, appears as a reduction to income from servicing activities and
totaled $5.1 million in 2002, up from $2.7 million in 2001 and $0.5 million in
2000. At December 31, 2002, we serviced $8.3 billion of loans for others,
compared to $5.8 billion at December 31, 2001, and $4.0 billion at December 31,
2000.
The following table presents a breakdown of the components of our loan
servicing loss for the years indicated.
(In Thousands) 2002 2001 2000
------------------------------------------------------------------------
Income from servicing operations . $ 11,419 $ 9,028 $ 8,414
Amortization of MSRs ............. (14,435) (9,813) (5,968)
Provision for impairment ......... (36,613) (10,588) (6,074)
------------------------------------------------------------------------
Total loan servicing loss, net $(39,629) $(11,373) $ (3,628)
========================================================================
Sales of loans and mortgage-backed securities we originated increased in
2002 to a record $6.0 billion from $4.6 billion in 2001 and $1.7 billion in
2000. Net gains associated with these sales totaled $45.6 million in 2002, up
from $22.4 million in 2001 and $3.3 million in 2000. Included in the current
year was a $6.1 million gain associated with the SFAS 133 impact of valuing
derivatives associated with the sale of loans compared to a $6.0 million loss in
2001. Excluding the SFAS 133 gain, a gain of $39.5 million or 0.66% of loans
sold was realized, up slightly from 0.62% in 2001. Net gains included the
capitalization of mortgage servicing rights of $53.2 million in 2002, $44.4
million in 2001 and $18.5 million in 2000.
The following table presents a breakdown of the components of our net gains
(losses) on sales of loans and mortgage-backed securities for the periods
indicated.
(In Thousands) 2002 2001 2000
------------------------------------------------------------------------------------------------------------
Mortgage servicing rights .......................................... $ 53,236 $ 44,391 $ 18,510
All other components excluding SFAS 133 (1) ........................ (13,474) (15,995) (15,213)
SFAS 133 (2) ....................................................... 6,098 (5,964) --
------------------------------------------------------------------------------------------------------------
Total net gains on sales of loans and mortgage-backed securities $ 45,860 $ 22,432 $ 3,297
============================================================================================================
Secondary marketing gain excluding SFAS 133 as percent of
associated sales ............................................... 0.66% 0.62% 0.20%
============================================================================================================
(1) Included a $0.3 million gain associated with the sale of $1.0 billion of
mortgage-backed securities purchased during 2002.
(2) On January 1, 2001, SFAS 133 was adopted.
In addition to sales of loans and mortgage-backed securities, we also sold
mortgage servicing rights related to $172 million of loans serviced for others
during 2002 at an incremental gain of $0.3 million above the carrying value of
the associated mortgage servicing rights. This compares to sales of $602 million
in 2001 for a gain of $0.9 million.
For additional information concerning mortgage servicing rights, see Note
10 of Notes to Consolidated Financial Statements on page 89.
30
OTHER CATEGORY
The all other category of other income totaled $2.4 million in 2002, up
from $1.8 million in 2001 and $2.3 million in 2000.
OPERATING EXPENSE
Our operating expense totaled $186.7 million in 2002, up from $163.2
million in 2001 and $137.5 million in 2000. The current year increase was due to
higher general and administrative expense, which increased by $24.1 million or
14.9%. That increase was primarily due to higher costs associated with an
increased number of branch locations and higher loan origination activity.
The following table presents a breakdown of key components comprising
operating expense during the years indicated.
(In Thousands) 2002 2001 2000
---------------------------------------------------------------------------------------------------------
Salaries and related costs ........................................... $119,514 $ 99,935 $ 82,522
Premises and equipment costs ......................................... 30,694 26,016 23,220
Advertising expense .................................................. 4,418 4,410 4,786
SAIF insurance premiums and regulatory assessments ................... 3,078 3,051 2,626
Professional fees .................................................... 1,435 5,452 3,319
Other general and administrative expense ............................. 27,505 23,632 19,716
---------------------------------------------------------------------------------------------------------
Total general and administrative expense ......................... 186,644 162,496 136,189
Net operation of real estate acquired in settlement of loans ......... 11 239 818
Amortization of excess cost over fair value of branch acquisitions (1) -- 457 462
---------------------------------------------------------------------------------------------------------
Total operating expense .......................................... $186,655 $163,192 $137,469
=========================================================================================================
(1) During the fourth quarter of 2002, Downey adopted SFAS 147, which required
us to cease the amortization of goodwill as of January 1, 2002 and to
subject this asset to annual impairment testing.
PROVISION FOR INCOME TAXES
Downey's effective tax rate was 42.3% for both 2002 and 2001, and 42.4% in
2000. See Note 1 on page 72 and Note 15 on page 95 of Notes to the Consolidated
Financial Statements for a further discussion of income taxes and an explanation
of the factors which impact Downey's effective tax rate.
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
a description of these business segments and the accounting policies used, see
Business on page 1 and Note 1 on page 72 and Note 22 on page 106 of Notes to
Consolidated Financial Statements.
The following table presents by business segment our net income for the
years indicated.
(In Thousands) 2002 2001 2000 (1)
--------------------------------------------------------------------
Banking net income .............. $106,074 $119,454 $ 94,822
Real estate investment net income 6,219 727 4,429
--------------------------------------------------------------------
Total net income .......... $112,293 $120,181 $ 99,251
====================================================================
(1) Banking included a $5.6 million after-tax gain related to the sale of
subsidiary.
31
BANKING
Net income from our banking operations totaled $106.1 million in 2002, down
from $119.5 million in 2001, but up from $94.8 million in 2000. The decrease was
primarily due to the following:
o a $28.3 million higher loss from loan servicing due primarily to
higher provisions to the valuation allowance for mortgage servicing
rights reflecting the continued decline in market interest rates that
increased the actual and expected rate of prepayments on loans we
service for others;
o a $26.3 million increase in operating expense due to higher costs
associated with the increased number of branch locations and higher
loan origination activity; and
o a $7.3 million decline in loan related fees due to lower prepayment
fees.
Those unfavorable items were partially offset by the following:
o a $23.4 million increase in net gains on sales of loans and
mortgage-backed securities due to a record volume of sales and the
favorable impact from the SFAS 133 valuation of derivatives associated
with the sale of loans;
o a $9.8 million increase in net interest income due to higher
interest-earning assets;
o a $4.1 million or increase in deposit related fees; and
o a $1.6 million decline in provision for loan losses.
During 2001, net income from our banking operations increased $30.3
million, excluding the after-tax gain of $5.6 million from the sale of our
indirect automobile finance subsidiary during 2000. The adjusted increase was
primarily due to a $43.3 million increase in net interest income, a $20.1
million increase in net gains from sales of loans, mortgage-backed securities
and mortgage servicing rights, a $19.7 million increase in loan and deposit
related fees, and a $0.7 million decline in provision for loan losses. These
favorable items were partially offset by a $23.6 million increase in operating
expenses and a $7.7 million increase in loan servicing losses.
The table below sets forth banking operational results and selected
financial data for the years indicated.
(In Thousands) 2002 2001 2000 (1)
-----------------------------------------------------------------------------------
Net interest income ................... $ 315,353 $ 305,573 $ 262,232
Provision for loan losses ............. 939 2,564 3,251
Other income:
Gain on sale of subsidiary ........ -- -- 9,762
All other ......................... 55,051 63,340 31,644
Operating expense ..................... 185,859 159,604 135,996
Net intercompany income ............... 343 369 397
-----------------------------------------------------------------------------------
Income before income taxes ............ 183,949 207,114 164,788
Income taxes .......................... 77,875 87,660 69,966
-----------------------------------------------------------------------------------
Net income ......................... $ 106,074 $ 119,454 $ 94,822
===================================================================================
AT DECEMBER 31,
Assets:
Loans and mortgage-backed securities $10,976,942 $10,132,413 $10,084,353
Other .............................. 995,470 966,942 806,201
-----------------------------------------------------------------------------------
Total assets ..................... 11,972,412 11,099,355 10,890,554
-----------------------------------------------------------------------------------
Equity ................................ $ 823,104 $ 733,896 $ 624,636
===================================================================================
(1) Included a $5.6 million after-tax gain related to the sale of subsidiary.
32
REAL ESTATE INVESTMENT
Net income from our real estate investment operations totaled $6.2 million
in 2002, up from $0.7 million in 2001 and $4.4 million in 2000. The increase was
primarily attributed to higher gains from sales and lower operating expenses, as
2001 included expense pertaining to litigation matters associated with certain
joint venture partners.
During 2001, net income from our real estate investment operations declined
$3.7 million primarily due to lower gains from sales, lower recapture of
valuation allowances, and higher operating expenses.
The table below sets forth real estate investment operational results and
selected financial data for the years indicated.
(In Thousands) 2002 2001 2000
------------------------------------------------------------------------------------
Net interest income (loss) ..................... $ 45 $ (3) $ 243
Other income ................................... 11,631 5,196 9,148
Operating expense .............................. 796 3,588 1,473
Net intercompany expense ....................... 343 369 397
------------------------------------------------------------------------------------
Income before income taxes ..................... 10,537 1,236 7,521
Income taxes ................................... 4,318 509 3,092
------------------------------------------------------------------------------------
Net income .................................. $ 6,219 $ 727 $ 4,429
====================================================================================
AT DECEMBER 31,
Assets:
Investments in real estate and joint ventures $ 33,890 $ 38,185 $ 17,641
Other ....................................... 14,174 2,003 3,584
------------------------------------------------------------------------------------
Total assets .............................. 48,064 40,188 21,225
------------------------------------------------------------------------------------
Equity ......................................... $ 42,325 $ 34,513 $ 17,916
====================================================================================
For a further discussion regarding income from real estate investment, see
Other Income--Real Estate and Joint Ventures Held For Investment on page 29, and
for information regarding related assets, see Financial Condition--Investments
in Real Estate and Joint Ventures on page 39.
33
FINANCIAL CONDITION
LOANS AND MORTGAGE-BACKED SECURITIES
Total loans and mortgage-backed securities, including those we hold for
sale, increased $845 million or 8.3% from year-end 2001 to a total of $11.0
billion or 91.6% of assets at December 31, 2002. The increase primarily
represents a higher level of single family loans held for investment despite
continued high loan prepayments as a result of the low interest rate environment
and borrower preference for fixed rate loans. Our prepayment speed during the
year was 39%, compared to 37% during 2001 and 18% during 2000.
Our loan originations, including loans purchased, totaled a record $10.9
billion in 2002, up from $8.2 billion in 2001 and $5.2 billion in 2000. This
current year increase primarily reflects record originations of one-to-four unit
residential loans of $10.6 billion, of which approximately $4.5 billion or 42%
were for portfolio, with the balance for sale in the secondary market. Our
origination of subprime loans totaled $520 million in 2002, up from $428 million
in 2001.
The table below presents information regarding interest rates and loan
origination costs, net of fees collected on loans originated during the years
indicated.
(Dollars in Thousands) 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------------------------
Average interest rate on new loans .................... 5.43% 6.18% 6.10% 5.92% 6.45%
Total loan origination costs (net of fees) and premiums
(net of discounts) deferred during the year (1) ... $ 75,420 $ 36,497 $ 34,797 $ 53,181 $ 30,621
=================================================================================================================================
(1) The increase in 2002 reflects a borrower preference for low out-of-pocket
cost loans resulting in both higher loan yields and higher net costs to
Downey.
We originate one-to-four unit residential adjustable rate mortgages both
with and without loan origination fees. In adjustable rate mortgage transactions
for which we charge no origination fees, we receive a larger margin over the
index to which the loan pricing is tied than in those in which we charge fees.
In addition, a prepayment fee on these loans is generally required if prepaid
within the first three years. This trend towards loans with no origination fees
has generally resulted in deferrable loan origination costs exceeding loan
origination fees.
Residential one-to-four unit adjustable rate mortgage originations,
including loans purchased, were $4.8 billion during 2002, up from $3.2 billion
in 2001 and $3.5 billion in 2000. Refinancing activities related to residential
one-to-four unit loans, including new loans to refinance existing loans which we
or other lenders originated, constituted 78% of originations during the year
compared to 75% during 2001 and 42% during 2000. Refinancing activities
increased from $6.0 billion in 2001 to $8.3 billion in 2002, as a lower interest
rate environment existed throughout most of the year. During 2002, loan
originations for investment consisted primarily of adjustable rate mortgages
which provide for negative amortization and are tied to COFI or the 12-month
moving average of the annual yields on actively traded U.S. Treasury securities
adjusted to a constant maturity of one year ("MTA"), indexes which lag behind
the movement in market interest rates. During 2002, 49% of portfolio
originations represented monthly adjusting COFI rate mortgages, 20% represented
monthly adjusting MTA rate mortgages, while 29% represented adjustable rate
loans where the initial rate is fixed for the first three or five years. At
December 31, 2002, $7.3 billion of our one-to-four unit adjustable rate
mortgages were subject to negative amortization, of which $112 million
represented the amount of negative amortization included in the loan balance.
For further information, see Business--Banking Activities--Lending
Activities--Residential Real Estate Lending on page 3.
Our origination of commercial real estate loans, including loans purchased,
totaled $1 million in 2002, compared to $7 million in 2001 and $24 million in
2000. Originations of loans secured by multi-family properties, including loans
purchased, totaled $3 million in 2002, compared to less than $1 million in both
2001 and 2000.
During 2002, we originated $124 million of construction loans, principally
for entry level and first time move-up residential tracts. This compares to $102
million in 2001 and $99 million in 2000. Our origination of land development
loans totaled $56 million in 2002, compared to $16 million in 2001 and $17
million in 2000.
Origination of non-mortgage commercial loans totaled $14 million in 2002,
down from $18 million in 2001 and $19 million in 2000. A substantial majority of
these originations represented secured loans.
34
Origination of automobile loans totaled $1 million in 2002, compared to $5
million in 2001 and $57 million in 2000. The majority of these originations
during 2000 represented our indirect lending program that was conducted by
Downey Auto Finance Corp., a former subsidiary sold in February 2000, whereby
loans to finance the purchase of new or used automobiles were obtained through
preapproved automobile dealers. For further information regarding Downey Auto
Finance Corp., see Sale of Subsidiary on page 63.
During 2002, we purchased $1.0 billion of 30-year fixed rate
mortgage-backed securities due to a net interest spread of over 3% given the
steepness in the yield curve. These securities were sold in the fourth quarter
of 2002 due to interest rate volatility and the potential adverse impact market
interest rate changes could have on the carrying value of the investment.
Approximately $1.0 million was earned on the securities while owned.
At December 31, 2002, our unfunded loan application pipeline totaled $2.3
billion. Within that pipeline, we had commitments to borrowers for short-term
interest rate locks of $996 million, of which $790 million were related to
residential one-to-four unit loans being originated for sale in the secondary
market. Furthermore, we had commitments for undrawn lines and letters of credit
of $102 million and loans in process of $88 million. We believe our current
sources of funds will enable us to meet these obligations.
35
The following table sets forth the origination, purchase and sale activity
relating to our loans and mortgage-backed securities during the years indicated.
(In Thousands) 2002 2001 2000 1999 1998
-------------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO
Loans originated:
Loans secured by real estate:
Residential one-to-four units:
Adjustable ......................................... $ 2,648,302 $ 1,800,777 $ 2,798,592 $ 3,100,154 $ 943,736
Adjustable - subprime ............................. 466,086 423,777 392,794 1,105,384 367,179
Adjustable - fixed for 3-5 years .................. 818,417 890,704 33,004 2,656 --
Adjustable - fixed for 3-5 years - subprime ....... 47,794 -- 3,117 77,168 5,107
-------------------------------------------------------------------------------------------------------------------------------
Total adjustable residential one-to-four units ... 3,980,599 3,115,258 3,227,507 4,285,362 1,316,022
Fixed .............................................. 40,245 16,443 9,167 262,923 192,436
Fixed - subprime ................................... -- 4,708 -- 12,238 6,020
Residential five or more units:
Adjustable ......................................... 2,806 -- -- 247 875
Fixed .............................................. -- 125 678 -- 13,229
-------------------------------------------------------------------------------------------------------------------------------
Total residential ................................ 4,023,650 3,136,534 3,237,352 4,560,770 1,528,582
Commercial real estate .............................. 1,157 133 23,720 10,063 10,363
Construction ........................................ 124,168 101,716 98,330 149,143 111,534
Land ................................................ 56,362 16,242 16,530 56,851 48,357
Non-mortgage:
Commercial .......................................... 13,671 17,581 18,504 24,948 6,376
Automobile .......................................... 855 4,825 56,576 233,948 175,193
Other consumer ...................................... 70,388 32,953 38,136 54,489 28,274
-------------------------------------------------------------------------------------------------------------------------------
Total loans originated ............................. 4,290,251 3,309,984 3,489,148 5,090,212 1,908,679
Real estate loans purchased:
One-to-four units ..................................... 460,263 88,057 9,178 36,317 4,343
One-to-four units - subprime .......................... 6,439 -- 8,595 12,912 1,833
Other (1) ............................................. -- 6,923 1,055 440 1,287
-------------------------------------------------------------------------------------------------------------------------------
Total real estate loans purchased ................... 466,702 94,980 18,828 49,669 7,463
-------------------------------------------------------------------------------------------------------------------------------
Total loans originated and purchased .............. 4,756,953 3,404,964 3,507,976 5,139,881 1,916,142
Loan repayments .......................................... (3,911,209) (3,715,163) (1,981,802) (1,823,585) (1,855,157)
Other net changes (2) .................................... (37,515) 2,029 (291,935) (36,794) (34,145)
-------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for investment .. 808,229 (308,170) 1,234,239 3,279,502 26,840
-------------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO
Residential one-to-four units:
Originated whole loans ................................ 6,155,727 4,818,301 1,641,099 2,028,402 2,162,583
Originated whole loans - subprime ..................... -- -- 87,174 13,872 --
Loans purchased ....................................... 16,845 5,637 947 -- --
Loans transferred from (to) the investment portfolio .. (2,928) (7,454) 54,993 42,570 (3,056)
Originated whole loans sold ........................... (919,211) (737,773) (687,512) (999,594) (1,130,303)
Loans exchanged for mortgage-backed securities ........ (5,104,433) (3,816,171) (970,319) (1,387,364) (608,831)
Other net changes ..................................... (5,386) (4,762) (10,815) (9,263) (8,111)
Capitalized basis adjustment (3) ...................... 12,414 (10,326) -- -- --
-------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for sale ...... 153,028 247,452 115,567 (311,377) 412,282
-------------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities, net:
Received in exchange for loans ........................ 5,104,433 3,816,171 970,319 1,387,364 608,831
Sold .................................................. (6,184,650) (3,816,171) (975,088) (1,387,364) (610,113)
Purchased ............................................. 1,014,098 115,597 -- -- --
Repayments ............................................ (51,956) (6,523) (7,031) (9,936) (15,129)
Other net changes ..................................... 1,347 (296) 284 (491) (742)
-------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in mortgage-backed securities
available for sale ................................. (116,728) 108,778 (11,516) (10,427) (17,153)
-------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in loans held for sale and
mortgage-backed securities available for sale ...... 36,300 356,230 104,051 (321,804) 395,129
-------------------------------------------------------------------------------------------------------------------------------
Total net increase in loans
and mortgage-backed securities ..................... $ 844,529 $ 48,060 $ 1,338,290 $ 2,957,698 $ 421,969
===============================================================================================================================
(1) Primarily five or more unit residential loans except for $6.7 million of
commercial real estate loans in 2001, $1.1 million of construction loans in
2000 and $0.6 million of commercial real estate loans in 1998.
(2) 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). Also included in 2000 was $367 million of net automobile
loans sold as part of the sale of subsidiary.
(3) Reflected the change in fair value of the rate lock derivative from the
date of commitment to the date of funding.
36
The following table sets forth the composition of our loan and
mortgage-backed securities portfolio at the dates indicated. At December 31,
2002, approximately 95% of our real estate loans were secured by real estate
located in California, principally in Los Angeles, Santa Clara, Orange, San
Diego and Alameda counties.
December 31,
--------------------------------------------------------------------
(In Thousands) 2002 2001 2000 1999 1998
----------------------------------------------------------------------------------------------------------------------------
INVESTMENT PORTFOLIO
Loans secured by real estate:
Residential one-to-four units:
Adjustable .................................. $ 6,739,243 $ 6,365,149 $ 7,098,689 $5,554,332 $3,614,053
Adjustable - subprime ....................... 1,297,280 1,424,656 1,633,917 1,532,780 574,720
Adjustable - fixed for 3-5 years ............ 1,697,953 999,528 101,711 90,551 107,675
Adjustable - fixed for 3-5 years - subprime . 81,421 66,760 92,609 87,844 5,512
Fixed ....................................... 210,001 334,384 454,838 510,516 325,454
Fixed - subprime ............................ 7,412 15,303 17,388 18,777 8,719
----------------------------------------------------------------------------------------------------------------------------
Total residential one-to-four units ........ 10,033,310 9,205,780 9,399,152 7,794,800 4,636,133
Residential five or more units:
Adjustable .................................. 6,964 6,055 14,203 15,889 18,617
Fixed ....................................... 3,676 5,124 5,257 5,166 21,412
Commercial real estate:
Adjustable .................................. 40,373 40,900 37,374 37,419 39,360
Fixed ....................................... 31,042 71,609 127,230 110,908 101,430
Construction ................................... 103,547 84,942 118,165 176,487 127,761
Land ........................................... 53,538 22,028 26,880 67,631 44,859
Non-mortgage:
Commercial ..................................... 15,021 22,017 21,721 26,667 28,293
Automobile (1) ................................. 11,641 24,529 39,614 399,789 357,988
Other consumer ................................. 56,782 50,908 60,653 49,344 41,894
----------------------------------------------------------------------------------------------------------------------------
Total loans held for investment ............. 10,355,894 9,533,892 9,850,249 8,684,100 5,417,747
Increase (decrease) for:
Undisbursed loan funds ......................... (95,002) (61,280) (72,328) (125,159) (108,414)
Net deferred costs and premiums ................ 96,744 77,916 79,109 67,740 31,021
Allowance for losses ........................... (34,999) (36,120) (34,452) (38,342) (31,517)
----------------------------------------------------------------------------------------------------------------------------
Total loans held for investment, net ........ 10,322,637 9,514,408 9,822,578 8,588,339 5,308,837
----------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO, NET
Loans held for sale:
Residential one-to-four units .................. 649,964 509,350 251,572 136,005 447,382
Capitalized basis adjustment (2) ............... 2,088 (10,326) -- -- --
----------------------------------------------------------------------------------------------------------------------------
Total loans held for sale ................... 652,052 499,024 251,572 136,005 447,382
Mortgage-backed securities available for sale:
Adjustable ..................................... 2,253 101,562 6,050 7,700 10,996
Fixed .......................................... -- 17,419 4,153 14,019 21,150
----------------------------------------------------------------------------------------------------------------------------
Total mortgage-backed securities
available for sale ....................... 2,253 118,981 10,203 21,719 32,146
----------------------------------------------------------------------------------------------------------------------------
Total loans held for sale and mortgage-backed
securities available for sale ............ 654,305 618,005 261,775 157,724 479,528
----------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities .. $10,976,942 $10,132,413 $10,084,353 $8,746,063 $5,788,365
============================================================================================================================
(1) The decline during 2000 primarily reflected the sale of subsidiary.
(2) 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 December 31,
2002, no valuation allowance was required as the fair value exceeded book value
on an aggregate basis.
At December 31, 2002, our residential one-to-four units subprime portfolio
consisted of approximately 87% "A-" credit, 11% "B" credit and 2% "C" credit
loans. At year end, the average loan-to-value ratio at origination for these
loans was approximately 75%.
37
We carry mortgage-backed securities available for sale at fair value which,
at December 31, 2002, reflected an unrealized gain of less than $0.1 million.
The 2002 year-end unrealized gain, less the associated tax effect, is reflected
within a separate component of other comprehensive income (loss) until realized.
The table below sets forth the scheduled contractual maturities of our loan
and mortgage-backed securities portfolio at December 31, 2002.
Within 1-2 2-3 3-5 5-10 10-15 Beyond
(In Thousands) 1 Year Years Years Years Years Years 15 Years Total
---------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units:
Adjustable by index: (1)
COFI ............... $ 81,793 $ 86,708 $ 91,918 $200,736 $ 617,374 $ 826,513 $4,881,828 $ 6,786,870
MTA ................ 15,479 16,223 17,004 36,500 107,766 136,299 756,824 1,086,095
6-Month LIBOR ...... 16,457 17,485 18,578 40,710 126,229 170,909 912,560 1,302,928
Other, primarily CMT 10,137 10,741 11,382 24,842 76,295 101,938 451,481 686,816
Fixed (1) ............. 13,620 14,514 15,471 34,061 121,893 144,623 478,471 822,653
Five or more units:
Adjustable ............ 199 213 2,956 440 1,377 1,779 -- 6,964
Fixed ................. 152 158 166 931 1,027 1,219 23 3,676
Commercial real estate:
Adjustable ............ 1,220 1,308 1,401 3,112 33,332 -- -- 40,373
Fixed ................. 1,209 1,311 5,173 3,895 19,454 -- -- 31,042
Construction ............ 103,547 -- -- -- -- -- -- 103,547
Land .................... 31,069 21,954 93 213 209 -- -- 53,538
Non-mortgage:
Commercial ................ 13,231 155 166 365 1,104 -- -- 15,021
Automobile ................ 4,780 5,242 678 941 - -- -- 11,641
Other consumer (2) ........ 2,920 3,151 3,399 2,724 44,588 -- -- 56,782
---------------------------------------------------------------------------------------------------------------------------------
Total loans 295,813 179,163 168,385 349,470 1,150,648 1,383,280 7,481,187 11,007,946
Mortgage-backed securities, net 83 85 88 187 532 640 638 2,253
---------------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-
backed securities ....... $295,896 $179,248 $168,473 $349,657 $1,151,180 $1,383,920 $7,481,825 $11,010,199
=================================================================================================================================
(1) Included loans held for sale.
(2) Included home equity line of credit loans, which are interest only, with
balances due at the end of the term. All or part of the outstanding
balances may be paid off at any time during the term without penalty.
At December 31, 2002, the maximum amount the Bank could have loaned to any
one borrower, and related entities, under regulatory limits was $135 million, or
$225 million for loans secured by readily marketable collateral, compared to
$128 million or $214 million for loans secured by readily marketable collateral
at year-end 2001. We do not expect that these regulatory limitations will
adversely impact our proposed lending activities during 2003.
INVESTMENT SECURITIES
The following table sets forth the composition of our investment securities
portfolio at the dates indicated.
December 31,
-------------------------------------------------------
(In Thousands) 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------
Federal funds ........................................ $ 2,555 $ 37,001 $ 19,601 $ 1 $ 33,751
U.S. Treasury and agency securities available for sale 457,797 356,910 284,102 171,823 116,061
Corporate bonds available for sale ................... -- 45,445 21,513 -- --
Municipal bonds held to maturity ..................... 6,216 6,388 6,550 6,728 6,764
---------------------------------------------------------------------------------------------------------------
Total investment securities ...................... $466,568 $445,744 $331,766 $178,552 $156,576
===============================================================================================================
38
The following table sets forth the maturities of our investment securities
and the weighted average yield of those securities at December 31, 2002.
After 1 Year
1 Year or Less Through 5 Years After 5 Years Total
------------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
(Dollars in Thousands) Amount Yield Amount Yield Amount Yield Amount Yield
-----------------------------------------------------------------------------------------------------------------------------
Federal funds ...................... $2,555 0.75% $ -- -- % $ -- -- % $ 2,555 0.75%
U.S. Treasury and agency securities
available for sale ............. -- -- 456,790 3.08 1,007 (2) 2.40 457,797 3.08
Municipal bonds held to maturity (1) -- -- -- -- 6,216 3.68 6,216 3.68
-----------------------------------------------------------------------------------------------------------------------------
Total ........................ $2,555 0.75% $456,790 3.08% $7,223 3.50% $466,568 3.07%
=============================================================================================================================
(1) Yield on a fully tax-equivalent basis is 6.39%.
(2) These securities were called on January 22, 2003.
INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
DSL Service Company participates as an owner of, or a partner in, a variety
of real estate development projects, principally retail neighborhood shopping
centers and residential developments, most of which are located in California.
For additional information regarding these real estate investments, see Note 6
of Notes to the Consolidated Financial Statements on page 83. We have
substantially completed and leased most of the neighborhood shopping center
projects--with a weighted average occupancy rate of 80% at December 31, 2002. At
December 31, 2002, the Bank had loan commitments of $38 million to the joint
ventures, of which $21 million were outstanding.
DSL Service Company is entitled to interest on its equity invested in its
joint venture projects on a priority basis after third-party debt and shares
profits and losses with the developer partner, generally on an equal basis. DSL
Service Company has obtained guarantees from the principals of the developer
partners. Partnership equity or deficit accounts are affected by current period
results of operations, additional partner advances, partnership distributions
and partnership liquidations.
As of December 31, 2002, DSL Service Company was involved with two joint
venture partners. One of these partners was the operator of two residential
housing development projects, and the other partnership involves vacant land
that was sold, but the partnership remains until a receivable related to that
sale is collected. DSL Service Company had seven wholly owned retail
neighborhood shopping centers located in California and Arizona.
Our investment in real estate and joint ventures amounted to $34 million at
December 31, 2002, compared to $38 million at December 31, 2001 and $18 million
at December 31, 2000. During 2002, we sold wholly owned projects with a carrying
value of $22 million. That decline was partially offset by a $17 million
investment in a residential joint venture and a $1 million investment in a
shopping center development. During 2001, our investment increased by $20
million due primarily to a $16 million settlement of litigation with former
joint venture partners wherein we became the sole owner of two shopping centers.
39
The following table sets forth the condensed balance sheets of DSL Service
Company's joint ventures by property type at December 31, 2002, on a historical
cost basis. For further information regarding the establishment of loss
allowances, see Problem Loans and Real Estate--Allowance for Losses on Loans and
Real Estate on page 53. It is possible that certain of our real estate joint
venture partnerships may require consolidation as a result of applying the
provisions of Financial Accounting Standards Board Interpretation 46. For
further information regarding this interpretation, see Current Accounting Issues
on page 62. For further information on our real estate joint venture
partnerships, see Note 6 on page 83 of Notes to Consolidated Financial
Statements.
Note
Receivable-
(Dollars in Thousands) Residential Sold Land Total
---------------------------------------------------------------------------------------------------
ASSETS
Cash ....................................................... $ 4,060 $ 11 $ 4,071
Projects under development ................................. 44,170 -- 44,170
Other assets ............................................... 214 360 574
---------------------------------------------------------------------------------------------------
$48,444 $ 371 $48,815
===================================================================================================
LIABILITIES AND EQUITY
Liabilities:
Notes payable to the Bank .............................. $20,742 $ -- $20,742
Other .................................................. 9,836 145 9,981
Equity:
DSL Service Company (1) ................................ 16,703 125 16,828
Allowance for losses recorded by DSL Service Company (2) -- -- --
Other partners (2) ..................................... 1,163 101 1,264
---------------------------------------------------------------------------------------------------
Net equity .......................................... 17,866 226 18,092
---------------------------------------------------------------------------------------------------
$48,444 $ 371 $48,815
===================================================================================================
Number of joint venture projects ........................... 2 1 3
===================================================================================================
(1) We included in these amounts interest-bearing joint venture advances with
priority interest payments from joint ventures to DSL Service Company.
(2) The aggregate other partners' equity of $1 million represents their equity
interest in the accumulated retained earnings of the respective joint
ventures. Those results include the net profit on sales and the operating
results of the real estate assets, net of depreciation and funding costs.
Except for any secured financing which has been obtained, DSL Service
Company has provided all other financing. As part of our internal asset
review process, we compare the fair value of the joint venture real estate
assets to the secured notes payable to the Bank and others and DSL Service
Company's equity investment. To the extent the fair value of the real
estate assets is less than the aggregate of those amounts, we make a
provision to create a valuation allowance. No valuation allowance was
required at December 31, 2002.
The following table sets forth by property type our investments in real
estate and related allowances for losses at December 31, 2002.
Retail
Neighborhood
(Dollars in Thousands) Residential Shopping Centers Land Total
----------------------------------------------------------------------------------------------------
Investment in wholly owned projects ....... $ -- $ 16,828 (1) $ 291 $ 17,119
Investment in Affordable Housing Funds .... 851 -- -- 851
Allowance for losses ...................... -- (805) (103) (908)
----------------------------------------------------------------------------------------------------
Net investment in real estate projects $ 851 $ 16,023 $ 188 $ 17,062
====================================================================================================
Number of projects ........................ 1 7 3 11
====================================================================================================
(1) Included five free-standing stores that are part of neighborhood shopping
centers totaling less than $1 million, which we counted as one project.
40
Real estate investments entail risks similar to those our construction and
commercial lending activities present. In addition, California courts have
imposed warranty-like responsibility upon developers of new housing for defects
in structure and the housing site, including soil conditions. This
responsibility is not necessarily dependent upon a finding that the developer
was negligent. Owners of real property also may incur liabilities with respect
to environmental matters, including financial responsibility for clean-up of
hazardous waste or other conditions, under various federal and state laws.
DEPOSITS
Our deposits increased $619 million or 7.2% in 2002 and totaled a year-end
record of $9.2 billion at December 31, 2002. Compared to the year-ago period,
our lower-rate transaction accounts--i.e., checking, money market and regular
passbook--increased $1.6 billion or 56.2%, which was partially offset by a
decrease in our certificates of deposit of $1.0 billion or 18.0%. As depositors
seemed more interested in liquidity given the relatively low level of interest
rates, they moved monies from certificates of deposit to transaction accounts,
primarily regular passbook accounts. When interest rates begin to rise, we
expect the reverse to occur. Of the total increase in our deposits, $227 million
was associated with 25 in-store branches and 3 traditional branches we opened
during 2002. At December 31, 2002, the average deposit size of our traditional
branches was $105 million, while the average size of our in-store branches was
$18 million, or $22 million excluding the 25 new in-store branches opened within
the past 12 months.
The following table sets forth information concerning our deposits and
weighted average rates paid at the dates indicated.
December 31,
--------------------------------------------------------------
2002 2001 2000
--------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
(Dollars in Thousands) Rate Amount Rate Amount Rate Amount
---------------------------------------------------------------------------------------------------
Transaction accounts:
Non-interest-bearing checking . -- % $ 388,376 -- % $ 263,165 -- % $ 244,311
Interest-bearing checking (1) . 0.25 422,417 0.35 423,776 0.78 395,640
Money market .................. 1.37 120,105 2.01 108,747 2.88 89,408
Regular passbook .............. 1.70 3,639,798 2.46 2,131,048 3.41 754,127
---------------------------------------------------------------------------------------------------
Total transaction accounts .. 1.41 4,570,696 1.92 2,926,736 2.12 1,483,486
Certificates of deposit:
Less than 2.00% ............... 1.57 919,864 1.94 99,654 1.51 1,366
2.00-2.49 ..................... 2.28 401,657 2.30 556,075 2.01 406
2.50-2.99 ..................... 2.79 528,557 2.74 315,125 2.63 4,585
3.00-3.49 ..................... 3.38 1,188,078 3.20 458,511 3.45 25
3.50-3.99 ..................... 3.89 700,250 3.84 532,634 3.97 384
4.00-4.49 ..................... 4.25 374,424 4.22 892,517 4.19 26,916
4.50-4.99 ..................... 4.80 473,399 4.76 555,885 4.82 80,844
5.00 and greater .............. 5.63 81,425 5.94 2,282,429 6.36 6,484,677
---------------------------------------------------------------------------------------------------
Total certificates of deposit 3.19 4,667,654 4.54 5,692,830 6.33 6,599,203
---------------------------------------------------------------------------------------------------
Total deposits ............ 2.31% $9,238,350 3.65% $8,619,566 5.56% $8,082,689
===================================================================================================
(1) Included amounts swept into money market deposit accounts.
41
The following table shows at December 31, 2002 our certificates of deposit
maturities by interest rate category.
Less
Than 2.50% - 3.00% - 3.50% - 4.00% - 5.00% Percent
(Dollars in Thousands) 2.50% 2.99% 3.49% 3.99% 4.99% and Greater Total (1) of Total
-------------------------------------------------------------------------------------------------------------------------------
Within 3 months .......... $ 481,561 $163,783 $ 564,433 $165,296 $ 16,459 $30,310 $1,421,842 30.46%
3 to 6 months ............ 292,336 258,177 135,748 291,760 17,776 5,737 1,001,534 21.46
6 to 12 months ........... 442,977 68,844 281,233 139,917 168,719 9,108 1,110,798 23.80
12 to 24 months .......... 104,057 33,554 161,085 55,026 17,428 6,740 377,890 8.09
24 to 36 months .......... 580 3,426 30,472 26,885 174,822 13,895 250,080 5.36
36 to 60 months .......... 10 773 15,107 21,366 452,619 15,635 505,510 10.83
Over 60 months ........... -- -- -- -- -- -- -- --
-------------------------------------------------------------------------------------------------------------------------------
Total ................ $1,321,521 $528,557 $1,188,078 $700,250 $847,823 $81,425 $4,667,654 100.00%
===============================================================================================================================
(1) Includes jumbo ($100,000 and over) certificates of deposit of $511 million
with maturities of 3 months or less, $331 million with maturities of 3 to 6
months, $362 million with maturities of 6 to 12 months and $392 million
with a remaining term of over 12 months.
BORROWINGS
At December 31, 2002, borrowings totaled $1.6 billion, up from $1.5 billion
at year-end 2001, but down from $2.0 billion at year-end 2000. The increase
during 2002 occurred in advances from the FHLB.
The following table sets forth information concerning our FHLB advances and
other borrowings at the dates indicated.
December 31,
-----------------------------------------------------------------
(Dollars in Thousands) 2002 2001 2000 1999 1998
---------------------------------------------------------------------------------------------------------------------
Federal Home Loan Bank advances ................... $1,624,084 $1,522,705 $1,978,348 $2,122,407 $695,012
Real estate notes ................................. -- 7 224 373 8,708
---------------------------------------------------------------------------------------------------------------------
Total borrowings ............................ $1,624,084 $1,522,712 $1,978,572 $2,122,780 $703,720
=====================================================================================================================
Weighted average rate on borrowings during the year 4.32% 5.40% 6.16% 5.46% 6.07%
Total borrowings as a percentage of total assets .. 13.56 13.71 18.16 22.56 11.22
=====================================================================================================================
The following table sets forth certain information with respect to our
short-term borrowings.
(Dollars in Thousands) 2002 2001 2000
-------------------------------------------------------------------------------------------------------------------
FHLB advances with original maturities less than one year:
Balance at end of year ............................................. $ 341,234 $ 671,300 $1,475,000
Average balance outstanding during the year ........................ 218,404 581,868 1,601,732
Maximum amount outstanding at any month-end during the year ........ 497,081 1,260,000 1,942,000
Weighted average interest rate during the year ..................... 2.12% 5.63% 6.38%
Weighted average interest rate at end of year ...................... 1.38 2.16 6.55
Securities sold under agreement to repurchase:
Balance at end of year ............................................. $ -- $ -- $ --
Average balance outstanding during the year ........................ 7,494 -- 753
Maximum amount outstanding at any month-end during the year ........ 182,358 -- 39,250
Weighted average interest rate during the year ..................... 1.86% -- % 6.10%
Weighted average interest rate at end of year ...................... -- -- --
Total short-term borrowings:
Total average short-term borrowings outstanding during the year .... $ 225,898 $ 581,868 $1,602,485
Total weighted average rate on short-term borrowings during the year 2.11% 5.63% 6.38%
===================================================================================================================
42
At year-end 2002, total intermediate and long-term advances totaled $1.3
billion, up from $851 million at December 31, 2001. The weighted average rate on
our intermediate and long-term FHLB advances at year-end 2002 was 4.54%.
The following table sets forth the associated maturities at December 31,
2002.
(In Thousands)
-----------------------------------------------------------------
2003 .............................................. $ 72,700
2004 .............................................. 194,100
2005 .............................................. 415,750
2006 .............................................. 76,300
2007 .............................................. 65,000
Thereafter ........................................ 459,000
-----------------------------------------------------------------
Total intermediate and long-term FHLB advances $1,282,850
=================================================================
CAPITAL SECURITIES
On July 23, 1999, we issued $120 million in capital securities through
Downey Financial Capital Trust I. The capital securities pay quarterly
cumulative cash distributions at an annual rate of 10.00% of the liquidation
value of $25 per share. Interest expense on our capital securities, including
the amortization of deferred issuance costs, was $12.2 million for 2002. For
further information regarding our capital securities, see Note 16 on page 96 of
Notes to Consolidated Financial Statements.
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 there is less than 20% ownership,
we generally carry them at cost. In the course of our business, we participate
as a partner in real estate joint venture relationships through our wholly-owned
subsidiary, DSL Service Company. It is possible that certain of our real estate
joint venture partnerships may require consolidation as a result of applying the
provisions of the recently issued Financial Accounting Standards Board
Interpretation 46. The expected financial impact of this interpretation is
deemed to be immaterial. For further information regarding this interpretation,
see Current Accounting Issues on page 62. For further information regarding our
real estate joint venture partnerships, see Note 6 of Notes to the Consolidated
Financial Statements on page 83.
We enter into derivative financial instruments as part of our interest rate
risk management process, primarily related to our sale of loans in the secondary
market. The associated fair value changes to the notional amount of the
derivative instrument are recorded on-balance sheet. For further information
regarding our derivative instruments, see Asset/Liability Management and Market
Risk on page 44, Capital Resources and Liquidity--Contractual Obligations and
Other Commitments on page 60 and Note 20 of Notes to the Consolidated Financial
Statements on page 101.
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, commitments to purchase loans and
mortgage-backed securities for our portfolio, letters of credit, lines of credit
and loans in process. The contract or notional amounts of these instruments
reflect the extent of involvement we have in particular classes of financial
instruments. For further information regarding these commitments, see
Asset/Liability Management and Market Risk on page 44, Capital Resources and
Liquidity--Contractual Obligations and Other Commitments on page 60 and Note 20
of Notes to the Consolidated Financial Statements on page 101.
We use the same credit policies in making commitments to originate 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. Downey controls the credit risk of its 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.
43
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 were made on substantially the same terms as comparable transactions.
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. This interest rate risk primarily occurs
to the degree that our interest-bearing liabilities reprice or mature on a
different basis--generally more rapidly--than our interest-earning assets. Since
our earnings depend primarily on our net interest income, which is the
difference between the interest and dividends earned on interest-earning assets
and the interest paid on interest-bearing liabilities, our principal objectives
are to actively monitor and manage the effects of adverse changes in interest
rates on net interest income while maintaining asset quality. Our primary
strategy to manage interest rate risk is to emphasize the origination of
adjustable rate mortgages or loans with relatively short maturities. Interest
rates on adjustable rate mortgages are primarily tied to COFI and MTA.
In addition to the market 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. 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. Although we
continue to hedge as previously done, SFAS 133, as applied to our risk
management strategies, may increase or decrease reported net income and
stockholders' equity, depending on levels of 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. We generally do not
enter into hedging contracts for speculative purposes.
Changes in mortgage interest rates also impact the value of our mortgage
servicing rights. Rising interest rates typically result in slower prepayment
speeds on the loans being serviced for others which increase the value of
mortgage servicing rights. Declining interest rates typically result in faster
prepayment speeds which decrease the value of mortgage servicing rights.
Currently, we do not hedge our mortgage servicing rights against that risk.
Our Asset/Liability Management Committee is responsible for implementing
the interest rate risk management policy which sets forth limits established by
the Board of Directors of acceptable changes in net interest income and net
portfolio value from specified changes in interest rates. The OTS defines net
portfolio value as the present value of expected net cash flows from existing
assets minus the present value of expected net cash flows from existing
liabilities plus the present value of expected cash flows from existing
off-balance sheet contracts. Our Asset/Liability Management Committee reviews,
among other items, economic conditions, the interest rate outlook, the demand
for loans, the availability of deposits and borrowings, and our current
operating results, liquidity, capital and interest rate exposure. In addition,
our Asset/Liability Management Committee monitors asset and liability maturities
and repricing characteristics on a regular basis and performs various
simulations and other analyses to determine the potential impact of various
business strategies in controlling interest rate risk and the potential impact
of those strategies upon future earnings under various interest rate scenarios.
Based on these reviews, our Asset/Liability Management Committee formulates a
strategy that is intended to implement the objectives set forth in our business
plan without exceeding the net interest income and net portfolio value limits
set forth in our interest rate risk policy.
44
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
December 31, 2002, as well as other information regarding the repricing and
maturity differences between our interest-earning assets and total deposits,
borrowings and capital securities 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.
December 31, 2002
------------------------------------------------------------------------------
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 FHLB stock .........(1) $ 292,464 $ 286,310 $ 5,290 $ 67 $ -- $ 584,131
Loans and mortgage-backed securities: ........(2)
Loans secured by real estate:
Residential:
Adjustable .............................. 8,286,115 281,198 1,368,315 -- -- 9,935,628
Fixed ................................... 659,182 38,477 113,702 15,234 2,270 828,865
Commercial real estate .................... 35,676 4,008 7,696 19,300 2,230 68,910
Construction .............................. 43,980 -- -- -- -- 43,980
Land ...................................... 22,273 7 52 613 -- 22,945
Non-mortgage loans:
Commercial ................................ 7,063 -- -- -- -- 7,063
Consumer .................................. 58,784 2,673 5,841 -- -- 67,298
Mortgage-backed securities .................. 2,253 -- -- -- -- 2,253
---------------------------------------------------------------------------------------------------------------------------------
Total loans and mortgage-backed securities ... 9,115,326 326,363 1,495,606 35,147 4,500 10,976,942
---------------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets ............... $9,407,790 $ 612,673 $1,500,896 $ 35,214 $ 4,500 $11,561,073
=================================================================================================================================
Transaction accounts:
Non-interest-bearing checking ................ $ 388,376 $ -- $ -- $ -- $ -- $ 388,376
Interest-bearing checking ....................(3) 422,417 -- -- -- -- 422,417
Money market .................................(4) 120,105 -- -- -- -- 120,105
Regular passbook .............................(4) 3,639,798 -- -- -- -- 3,639,798
---------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts .................. 4,570,696 -- -- -- -- 4,570,696
Certificates of deposit ..........................(1) 2,423,376 1,110,798 1,133,480 -- -- 4,667,654
---------------------------------------------------------------------------------------------------------------------------------
Total deposits ............................... 6,994,072 1,110,798 1,133,480 -- -- 9,238,350
Borrowings ....................................... 401,234 12,700 751,150 459,000 -- 1,624,084
Capital securities ............................... -- -- -- -- 120,000 120,000
---------------------------------------------------------------------------------------------------------------------------------
Total deposits, borrowings and
capital securities .......................... $7,395,306 $1,123,498 $1,884,630 $ 459,000 $ 120,000 $10,982,434
=================================================================================================================================
Excess (shortfall) of interest-earning assets over
deposits, borrowings and capital securities .. $2,012,484 $ (510,825) $ (383,734) $(423,786) $ (115,500) $ 578,639
Cumulative gap ................................... 2,012,484 1,501,659 1,117,925 694,139 578,639
Cumulative gap - as a % of total assets:
December 31, 2002 ............................ 16.80% 12.54% 9.33% 5.80% 4.83%
December 31, 2001 ............................ 12.01 4.76 7.91 4.71 3.86
December 31, 2000 ............................ 28.66 7.13 5.94 3.13 3.13
=================================================================================================================================
(1) Based upon contractual maturity and repricing date.
(2) Based upon contractual maturity, repricing date and projected repayment and
prepayments of principal.
(3) Included amounts swept into money market deposit accounts and is subject to
immediate repricing.
(4) Subject to immediate repricing.
45
Our six-month gap at December 31, 2002 was a positive 16.80%. This means
that more interest-earning assets mature or reprice within six months than total
deposits, borrowings and capital securities. This compares to a positive
six-month gap of 12.01% at December 31, 2001 and 28.66% at December 31, 2000. We
originated and purchased approximately $4.7 billion during 2002 and $3.4 billion
during both 2001 and 2000 of loans and mortgage-backed securities with
adjustable interest rates or maturities of five years or less. These loans
represented approximately 99% during both 2002 and 2001, and 97% during 2000 of
all loans and mortgage-backed securities originated and purchased for investment
during these periods.
At December 31, 2002, essentially all of our interest-earning assets
mature, reprice or are estimated to prepay within five years, compared to 99% at
December 31, 2001 and 98% at December 31, 2000. At December 31, 2002, loans held
for investment and mortgage-backed securities with adjustable interest rates
represented 92% of those portfolios. During 2003, we will continue to offer
residential fixed rate loan products to our customers to meet customer demand.
We primarily originate fixed rate loans for sale in the secondary market and
price them accordingly to create loan servicing income and to increase
opportunities for originating adjustable rate mortgages. However, we may
originate fixed rate loans for investment when funded with long-term funds to
mitigate interest rate risk and small volumes to facilitate the sale of real
estate acquired through foreclosure or that meet required yield and other
approved guidelines. For further information, see Business--Banking
Activities--Lending Activities--Secondary Marketing and Loan Servicing
Activities on page 5.
We are better protected against rising interest rates with a positive
six-month gap. However, we remain subject to possible interest rate spread
compression, which would adversely impact our net interest income if interest
rates rise. This is primarily due to the lag in repricing of the indices to
which our adjustable rate loans and mortgage-backed securities are tied, as well
as the repricing frequencies and periodic interest rate caps on these adjustable
rate loans and mortgage-backed securities. The amount of such interest rate
spread compression would depend upon the frequency and severity of such interest
rate fluctuations.
In addition to measuring interest rate risk via a gap analysis, we
establish limits on, and measure the sensitivity of, our net interest income and
net portfolio value to changes in interest rates. Changes in interest rates are
defined as instantaneous and sustained movements in interest rates in 100 basis
point increments. We utilize an internally maintained asset/liability management
simulation model to make the calculations which, for net portfolio value, are
calculated on a discounted cash flow basis. First, we estimate our net interest
income for the next twelve months and the current net portfolio value assuming
no change in interest rates from those at period end. Once the base case has
been estimated, we make calculations for each of the defined changes in interest
rates, to include any associated differences in the anticipated prepayment speed
of loans. We then compare those results against the base case to determine the
estimated change to net interest income and net portfolio value due to the
changes in interest rates. The following are the estimated impacts to net
interest income and net portfolio value from various instantaneous, parallel
shifts in interest rates based upon our asset and liability structure as of
year-ends 2002 and 2001. Since we base these estimates upon numerous
assumptions, like the expected maturities of our interest-bearing assets and
liabilities and the shape of the period-end interest rate yield curve, our
actual sensitivity to interest rate changes could vary significantly if actual
experience differs from those assumptions used in making the calculations.
2002 2001
----------------------------------------------------------------------
Percentage Change in Percentage Change in
------------------------------------------------------------------------
Change in Interest Rates Net Interest Net Portfolio Net Interest Net Portfolio
(In Basis Points) Income(1) Value (2) Income (1) Value (2)
-----------------------------------------------------------------------------------------------------------------
+200 ...................... (4.8)% 21.0% (11.3)% 6.0%
+100 ...................... (2.4) 10.7 (5.9) 4.6
(100) ..................... 1.6 (13.4) 4.9 (5.4)
(200) .....................(3) N/A N/A 8.8 (5.2)
=================================================================================================================
(1) The percentage change in this column represents net interest income for 12
months in a stable interest rate environment versus the net interest income
in the various rate scenarios.
(2) The percentage change in this column represents the net portfolio value of
the Bank in a stable interest rate environment versus the net portfolio
value in the various rate scenarios.
(3) The change in interest rates for 2002 is not applicable due to the low
level of interest rates at December 31, 2002.
46
The following table shows our financial instruments that are sensitive to
changes in interest rates, categorized by expected maturity, and the
instruments' fair values at December 31, 2002. This data differs from that in
the gap table as it does not incorporate the repricing characteristics of assets
and liabilities. Rather, it only reflects contractual maturities adjusted for
anticipated prepayments. Market risk sensitive instruments are generally defined
as on and off balance sheet derivatives and other financial instruments. Our
assets and liabilities that do not have a stated maturity date, such as certain
deposits, are considered to be long term in nature and are reported in the
"thereafter" column. We do not consider these financial instruments to be
materially sensitive to interest rate fluctuations, and historically, the
balances have remained fairly constant over various economic conditions. The
weighted average interest rates for the various fixed-rate and variable-rate
assets and liabilities presented are based on the actual rates that existed at
December 31, 2002. The fair value of our financial instruments is determined as
follows:
o Fed funds and FHLB Stock equal their book values due to their short
maturities.
o Investment securities and mortgage-backed securities are based on the
closing market price quotations from financial market monitoring
firms.
o Loans held for sale are based on bid quotations from financial market
monitoring firms.
o Loans held for investment takes into consideration discounted cash
flows through the estimated maturity or repricing dates using
estimated market discount rates.
o Demand deposits, money market and savings accounts are equal to their
book values.
o Time deposits and borrowings are based on the discounted value of
contractual cash flows, which is estimated using wholesale borrowing
rates offered for similar terms.
The degree of market risk inherent in loans with prepayment features may not be
completely reflected in the disclosures. Although we have taken into
consideration our historical prepayment trends to determine expected maturity
categories, prepayment features are triggered by changes in the market rates of
interest. Unexpected changes may increase the rate of prepayments above those
anticipated. As such, the potential loss from such market rate changes may be
significantly larger.
47
Expected Maturity Date at December 31, 2002 (1)
--------------------------------------------------------------------------------------------------
Total Fair
(Dollars in Thousands) 2003 2004 2005 2006 2007 Thereafter Balance Value
------------------------------------------------------------------------------------------------------------------------------------
Investment securities
and FHLB stock ................ $ 572,625 $ -- $ 5,290 $ -- $ -- $ 6,216 $ 584,131 $ 584,117
Average interest rate ......... 3.52% -- % 2.59% -- % -- % 3.68% 3.51%
Loans held for sale (2) .......... 652,052 -- -- -- -- -- 652,052 668,336
Average interest rate ......... 5.88% -- % -- % -- % -- % -- % 5.88%
Mortgage-backed securities
available for sale ............ 310 278 266 290 275 834 2,253 2,253
Average interest rate ......... 3.66% 3.66% 3.66% 3.68% 3.72% 3.75% 3.70%
Loans held for investment:
Loans secured by real estate:
Residential:
Adjustable ................. 2,314,864 1,491,518 1,201,246 962,894 773,238 3,145,056 9,888,816 10,040,990
Average interest rate .... 5.70% 5.69% 5.67% 5.65% 5.63% 5.61% 5.66%
Fixed ...................... 89,436 53,075 31,501 18,710 11,720 19,183 223,625 227,344
Average interest rate .... 7.55% 7.48% 7.38% 7.21% 6.96% 6.76% 7.38%
Other ....................... 48,208 4,190 25,171 3,887 3,963 50,416 135,835 143,978
Average interest rate ...... 7.52% 7.60% 7.73% 7.93% 7.95% 7.96% 7.75%
Non-mortgage:
Commercial .................. 5,418 142 153 163 173 1,014 7,063 7,780
Average interest rate ...... 5.84% 6.28% 6.28% 6.28% 6.28% 6.28% 5.94%
Consumer .................... 5,701 4,142 1,607 55,848 -- -- 67,298 68,882
Average interest rate ...... 6.48% 6.25% 6.09% 6.05% -- % -- % 6.10%
Interest-bearing advances to
joint ventures ................ 17,734 -- -- -- -- -- 17,734 17,734
Average interest rate ......... 10.00% -- % -- % -- % -- % -- % 10.00%
Expected rate lock commitments (3) 5,386 -- -- -- -- -- 5,386 17,423
MSR's and loan servicing ......... 14,114 11,494 8,559 6,220 4,546 12,796 57,729 58,168
portfolio (4)
------------------------------------------------------------------------------------------------------------------------------------
Total interest-sensitive assets .. $3,725,848 $1,564,839 $1,273,793 $1,048,012 $793,915 $3,235,515 $11,641,922 $11,837,005
====================================================================================================================================
Transaction accounts:
Non-interest-bearing checking . $ 70,936 $ 57,980 $ 47,390 $ 38,734 $ 31,659 $ 141,677 $ 388,376 $ 388,376
Interest-bearing checking (5) . 77,154 63,062 51,544 42,129 34,434 154,094 422,417 422,417
Money market .................. 21,937 17,930 14,655 11,979 9,791 43,813 120,105 120,105
Regular passbook .............. 664,801 543,377 444,130 363,011 296,707 1,327,772 3,639,798 3,639,798
------------------------------------------------------------------------------------------------------------------------------------
Total transaction accounts .. 834,828 682,349 557,719 455,853 372,591 1,667,356 4,570,696 4,570,696
Average interest rate ...... 1.41% 1.41% 1.41% 1.41% 1.41% 1.41% 1.41%
Certificates of deposit .......... 3,534,174 377,890 250,080 134,257 371,253 -- 4,667,654 4,705,950
Average interest rate ......... 2.92% 3.04% 4.18% 4.72% 4.68% -- % 3.19%
Undesignated loan forward sale
and purchase contracts, net ... 4,173 -- -- -- -- -- 4,173 4,173
Designated forward sale contracts 7,711 -- -- -- -- -- 7,711 7,711
Borrowings ....................... 413,934 194,100 415,750 76,300 65,000 459,000 1,624,084 1,681,488
Average interest rate ......... 1.92% 4.17% 3.75% 4.72% 5.01% 5.33% 3.88%
Capital securities ............... -- -- -- -- -- 120,000 120,000 128,640
Average interest rate ......... -- % -- % -- % -- % -- % 10.00% 10.00%
------------------------------------------------------------------------------------------------------------------------------------
Total deposits, borrowings and
capital securities ............ $4,794,820 $1,254,339 $1,223,549 $ 666,410 $808,844 $2,246,356 $10,994,318 $11,098,658
====================================================================================================================================
(1) Expected maturities are contractual maturities adjusted for prepayments of
principal. We use a number of assumptions to estimate fair values and
expected maturities. For assets, we base expected maturities upon
contractual maturity, projected repayments and prepayments of principal.
The prepayment experience reflected herein is based on our historical
experience. Our average projected constant prepayment rate ("CPR") is 48.8%
on our fixed-rate and 29.3% on our adjustable rate mortgage portfolio for
interest-earning assets, excluding investment securities which are not
subject to prepayment except for call provisions, if any. For deposits, in
accordance with standard industry practice and our own historical
experience, we have applied "decay factors," used to estimate deposit
runoff, of 20.0% per year. The actual maturities of these instruments could
vary substantially if future prepayments differ from our historical
experience.
(2) Included capitalized basis adjustment reflecting the change in fair value
of the rate lock derivative from the date of commitment to the date of
funding.
(3) At December 31, 2002, the estimated fair value included mortgage servicing
rights totaling $6.9 million not to be recognized in the financial
statements until the expected loans are sold.
(4) The estimated fair value included mortgage servicing rights acquired prior
to January 1, 1996 when Downey began capitalizing the asset.
(5) Included amounts swept into money market deposit accounts.
48
For further information regarding the sensitivity of our mortgage servicing
rights to changes in interest rates, see Note 10 of Notes to Consolidated
Financial Statements on page 89. For further information regarding commitments,
contingencies and hedging activities, see Note 20 of Notes to Consolidated
Financial Statements on page 101.
The following table sets forth the interest rate spread between our
interest-earning assets and interest-bearing liabilities at the dates indicated.
December 31,
---------------------------------------------
2002 2001 2000 1999 1998
-----------------------------------------------------------------------------------------
Weighted average yield:
Loans and mortgage-backed securities 5.83% 7.15% 8.45% 7.67% 7.72%
Federal Home Loan Bank stock ....... 5.24 5.31 5.52 5.60 5.44
Investment securities .............. 3.07 3.54 6.45 6.12 5.40
-----------------------------------------------------------------------------------------
Interest-earning assets yield .... 5.72 6.98 8.36 7.62 7.65
-----------------------------------------------------------------------------------------
Weighted average cost:
Deposits ........................... 2.31 3.65 5.56 4.72 4.53
Borrowings:
Federal Home Loan Bank advances .. 3.88 3.73 6.26 5.77 5.47
Other borrowings ................. -- 7.88 8.12 7.88 8.69
-----------------------------------------------------------------------------------------
Total borrowings ............. 3.88 3.73 6.26 5.99 5.51
Capital securities ................. 10.00 10.00 10.00 10.00 --
-----------------------------------------------------------------------------------------
Combined funds cost .............. 2.63 3.74 5.75 5.05 4.66
-----------------------------------------------------------------------------------------
Interest rate spread ......... 3.09% 3.24% 2.61% 2.57% 2.99%
=========================================================================================
The year-end weighted average yield on our loan portfolio decreased to
5.83% at December 31, 2002, from 7.15% at year-end 2001. The weighted average
rate on new loans originated during 2002 was 5.43%, compared to 6.18% during
2001 and 6.10% during 2000. At December 31, 2002, our adjustable rate mortgage
portfolio of single family residential loans, including mortgage-backed
securities, totaled $9.9 billion with a weighted average rate of 5.75%, compared
to $9.0 billion with a weighted average rate of 7.11% at December 31, 2001 and
$9.0 billion with a weighted average rate of 8.47% at December 31, 2000.
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 totaled $80 million at December 31, 2002,
compared to $93 million at December 31, 2001 and $55 million at December 31,
2000. The decrease in our non-performing assets during 2002 was primarily
attributed to declines in our residential one-to-four unit prime category of $7
million and subprime category of $3 million. Other non-accrual loans declined by
$2 million during the current year primarily due to a decline in commercial real
estate non-performers as a result of a short-pay that was accepted in full
consideration of the loan. Of the total, real estate acquired in settlement of
loans represented $12 million at December 31, 2002, down from $15 million at
December 31, 2001, but up from $10 million at December 31, 2000. Our
non-performing assets as a percentage of total assets was 0.67% at year-end
2002, compared to 0.83% at year-end 2001 and 0.50% at year-end 2000.
49
The following table summarizes our non-performing assets at the dates
indicated.
December 31,
-------------------------------------------------------
(Dollars in Thousands) 2002 2001 2000 1999 1998
-------------------------------------------------------------------------------------------------------------
Non-accrual loans:
Residential one-to-four units ................... $34,504 $43,210 $20,746 $15,590 $15,571
Residential one-to-four units - subprime ........ 32,263 31,166 22,296 13,914 1,975
Other ........................................... 681 2,668 1,708 3,477 4,829
-------------------------------------------------------------------------------------------------------------
Total non-accrual loans ....................... 67,448 77,044 44,750 32,981 22,375
Troubled debt restructure - below market rate (1) ... -- 203 206 -- --
Real estate acquired in settlement of loans ......... 12,360 15,366 9,942 5,899 4,475
Repossessed automobiles ............................. 6 19 76 314 569
-------------------------------------------------------------------------------------------------------------
Total non-performing assets ...................... $79,814 $92,632 $54,974 $39,194 $27,419
=============================================================================================================
Allowance for loan losses:
Amount .......................................... $34,999 $36,120 $34,452 $38,342 $31,517
As a percentage of non-performing loans ......... 51.89% 46.76% 76.63% 116.25% 140.86%
Non-performing assets as a percentage of total assets 0.67 0.83 0.50 0.42 0.44
=============================================================================================================
(1) Represented one residential one-to-four unit loan.
It is our policy to take appropriate, timely and aggressive action when
necessary to resolve non-performing assets. When resolving problem loans, it is
our policy to determine collectibility under various circumstances which are
intended to result in our maximum financial benefit. We accomplish this by
either working with the borrower to bring the loan current or by foreclosing and
selling the asset. We perform ongoing reviews of loans that display weaknesses
and maintain adequate loss allowances on the loans. For a discussion on our
internal asset review policy, refer to Allowance for Losses on Loans and Real
Estate on page 53.
All but $23 million of our non-performing assets at December 31, 2002 were
located in California, compared to $20 million outside of California a year ago.
We evaluate the need for appraisals of non-performing assets on a periodic
basis. We will generally obtain a new appraisal when we believe that there may
have been an adverse change in the property operations or in the economic
conditions of the geographic market of the property securing our loans. Our
policy is to obtain new appraisals at least annually for all real estate
acquired in settlement of loans.
Non-Accrual Loans. It is our general policy to account for a loan as
non-accrual when the loan becomes 90 days delinquent or when collection of
interest appears doubtful. In a number of cases, loans may remain on accrual
status past 90 days when we determine that continued accrual is warranted
because the loan is well-secured and in process of collection. As of December
31, 2002, we had no loans 90 days or more delinquent which remained on accrual
status. We reverse and charge against interest income any interest previously
accrued with respect to non-accrual loans. We recognize interest income on
non-accrual loans to the extent that we receive payments and to the extent that
we believe we will recover the remaining principal balance of the loan. We
restore these loans to an accrual status only if all past due payments are made
by the borrower and the borrower has demonstrated the ability to make future
payments of principal and interest. At December 31, 2002, non-accrual loans
aggregating $16 million were less than 90 days delinquent relative to their
contractual terms.
Troubled Debt Restructurings. We consider a restructuring of a debt a
troubled debt restructuring when we, for economic or legal reasons related to
the borrower's financial difficulties, grant a concession to the borrower that
we would not otherwise grant. Troubled debt restructurings may include changing
repayment terms, reducing the stated interest rate or reducing the amounts of
principal and/or interest due or extending the maturity date. The restructuring
of a loan is intended to recover as much of our investment as possible and to
achieve the highest yield possible. At December 31, 2002, we had no troubled
debt restructurings on accrual status.
Real Estate Acquired in Settlement of Loans. Real estate acquired in
settlement of loans consists of real estate acquired through foreclosure or
deeds in lieu of foreclosure and totaled $12 million at December 31, 2002.
50
DELINQUENT LOANS
When a borrower fails to make required payments on a loan and does not cure
the delinquency within 60 days, we normally record a notice of default to
commence foreclosure proceedings, so long as we have given any required prior
notice to the borrower. If the loan is not reinstated within the time permitted
by law for reinstatement, which is normally five business days prior to the date
set for the non-judicial trustee's sale, we may then sell the property at a
foreclosure sale. In general, if we have elected to pursue a non-judicial
foreclosure, we are not permitted under applicable law to obtain a deficiency
judgment against the borrower, even if the security property is insufficient to
cover the balance owed. At these foreclosure sales, we generally acquire title
to the property.
At December 31, 2002, loans delinquent 30 days or more as a percentage of
total loans was 0.86%, down from 1.10% at year-end 2001 but up from 0.66% at
year-end 2000. The decrease from prior year occurred in every one of the
delinquent categories, most notably within our residential one-to-four unit
categories. As a percentage of its loan category, residential one-to-four units
decreased from 0.80% at year-end 2001 to 0.59% at year-end 2002, while subprime
residential one-to-four units decreased from 2.87% at year-end 2001 to 2.80% at
year-end 2002. A higher incidence of delinquency is expected on subprime loans
as these borrowers have a history of delinquencies for which we charge higher
interest rates to compensate for that risk. In addition, the loan-to-value ratio
on these loans is generally lower thereby providing more equity protection
against loss.
51
The following table indicates the amounts of our past due loans at the
dates indicated.
December 31,
-------------------------------------------------------------------------------------
2002 2001
-------------------------------------------------------------------------------------
30-59 60-89 90+ 30-59 60-89 90+
(Dollars in Thousands) Days Days Days (1) Total Days Days Days (1) Total
------------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $ 19,881 $ 8,066 $ 27,333 $ 55,280 $ 19,170 $ 12,797 $ 33,449 $ 65,416
One-to-four units - subprime ......... 8,971 5,944 23,831 38,746 13,159 9,104 20,958 43,221
Five or more units ................... -- -- -- -- -- -- -- --
Commercial real estate ................. -- -- -- -- -- -- -- --
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- -- -- -- -- -- --
------------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 28,852 14,010 51,164 94,026 32,329 21,901 54,407 108,637
Non-mortgage:
Commercial ............................. -- -- 466 466 -- -- 1,163 1,163
Automobile ............................. 98 13 4 115 174 85 46 305
Other consumer ......................... 48 47 211 306 356 62 173 591
------------------------------------------------------------------------------------------------------------------------------------
Total delinquent loans ............... $ 28,998 $ 14,070 $ 51,845 $ 94,913 $ 32,859 $ 22,048 $ 55,789 $110,696
====================================================================================================================================
Delinquencies as a percentage of total loans 0.26% 0.13% 0.47% 0.86% 0.33% 0.22% 0.55% 1.10%
====================================================================================================================================
2000 1999
-------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $ 12,400 $ 8,611 $ 15,246 $ 36,257 $ 8,630 $ 3,889 $ 12,793 $ 25,312
One-to-four units - subprime ......... 7,300 7,658 14,427 29,385 7,867 3,069 7,935 18,871
Five or more units ................... -- -- -- -- -- -- -- --
Commercial real estate ................. -- -- -- -- -- -- -- --
Construction ........................... -- -- -- -- -- -- -- --
Land ................................... -- -- -- -- -- -- -- --
------------------------------------------------------------------------------------------------------------------------------------
Total real estate loans .............. 19,700 16,269 29,673 65,642 16,497 6,958 20,728 44,183
Non-mortgage:
Commercial ............................. -- -- -- -- -- -- -- --
Automobile ............................. 393 26 151 570 4,758 674 717 6,149
Other consumer ......................... 98 29 246 373 679 42 114 835
------------------------------------------------------------------------------------------------------------------------------------
Total delinquent loans ............... $ 20,191 $ 16,324 $ 30,070 $ 66,585 $ 21,934 $ 7,674 $ 21,559 $ 51,167
====================================================================================================================================
Delinquencies as a percentage of total loans 0.20% 0.16% 0.30% 0.66% 0.25% 0.09% 0.24% 0.58%
====================================================================================================================================
1998
-------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .................... $ 9,841 $ 6,014 $ 12,832 $ 28,687
One-to-four units - subprime ......... 244 784 947 1,975
Five or more units ................... -- -- 155 155
Commercial real estate ................. -- -- -- --
Construction ........................... -- -- -- --
Land ................................... -- -- -- --
-----------------------------------------------------------------------------------------
Total real estate loans .............. 10,085 6,798 13,934 30,817
Non-mortgage:
Commercial ............................. -- -- -- --
Automobile ............................. 4,650 888 1,048 6,586
Other consumer ......................... 334 45 344 723
-----------------------------------------------------------------------------------------
Total delinquent loans ............... $ 15,069 $ 7,731 $ 15,326 $ 38,126
=========================================================================================
Delinquencies as a percentage of total loans 0.26% 0.13% 0.26% 0.65%
=========================================================================================
(1) All 90 day or greater delinquencies are on non-accrual status and reported
as part of non-performing assets.
52
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. The adequacy of the allowance
is evaluated quarterly by management to maintain the allowance at levels
sufficient to provide for inherent losses. A key component to our evaluation is
our internal asset review process.
Our Internal Asset Review Department conducts independent reviews to
evaluate the risk and quality of all our assets. Our Internal Asset Review
Committee is responsible for the review and classification of assets. The
Internal Asset Review Committee members include the Chief Internal Asset Review
Officer, Chief Executive Officer, Chief Financial Officer, Chief Administrative
Officer, Chief Lending Officer, General Counsel and Director of Compliance/Risk
Management. The Internal Asset Review Committee meets quarterly to review and to
determine asset classifications and to recommend any changes to asset valuation
allowances. With the exception of payoffs or asset sales, the classification of
an asset, once established, can be removed or upgraded only upon approval of the
Internal Asset Review Committee. The Chief Internal Asset Review Officer reports
quarterly to the Audit Committee of the Board of Directors regarding overall
asset quality, the adequacy of valuation allowances on classified assets and our
adherence to policies and procedures regarding asset classification and
valuation.
We adhere to an internal asset review system and loss allowance methodology
designed to provide for timely recognition of problem assets and adequate
general valuation allowances to cover asset losses. Our current asset monitoring
process includes the use of asset classifications to segregate the assets,
largely loans and real estate, into various risk categories. We use the various
asset classifications as a means of measuring risk for determining the valuation
allowance at a point in time. We currently use a six grade system to classify
our assets. The current grades are:
o pass;
o watch;
o special mention;
o substandard;
o doubtful; and
o loss.
We consider substandard, doubtful and loss assets "classified assets" for
regulatory purposes. A brief description of these classifications follows:
o The pass classification represents a level of credit quality which
contains no well-defined deficiency or weakness.
o The watch classification is used to identify an asset that currently
contains no well-defined deficiency or weakness, but it is determined
to be desirable to closely monitor the asset--e.g., loans to
facilitate the sale of real estate acquired in settlement of loans.
This category may also be used for assets upgraded from lower
classifications where continuing monitoring is deemed appropriate.
o A special mention asset does not currently expose us to a sufficient
degree of risk to warrant an adverse classification, but does possess
a correctable deficiency or potential weakness deserving management's
close attention.
o Substandard assets have a well-defined weakness or weaknesses. They
are characterized by the distinct possibility that we will sustain
some loss if the deficiencies are not corrected.
o An asset classified doubtful has all the weaknesses inherent in those
classified substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of
currently existing facts, conditions and values, highly questionable
and improbable. We consider doubtful to be a temporary classification
until resolution of pending weakness issues enables us to more clearly
define the potential for loss.
o That portion of an asset classified as loss is considered
uncollectible and of so little value that its continuance as an asset,
without establishment of a specific valuation allowance, is not
warranted. A loss classification does not mean that an asset has
absolutely no recovery or salvage value, but rather it is not
reasonable to defer writing off or providing for all or a portion of
an impaired asset even though
53
partial recovery may be effected in the future. We will generally
classify as loss the balance of the asset that is greater than the net
fair value of the asset unless we can expect payment from another
source. Therefore, the amount of an asset classified as loss reflects
the total of specific valuation allowances established for the
particular asset. Specific valuation allowances are not includable in
determining the Bank's total regulatory capital.
The OTS has the authority to require us to change our asset
classifications. If the change results in an asset being classified in whole or
in part as loss, a specific allowance must be established against the amount so
classified or that amount must be charged off. OTS guidelines set forth
quantitative benchmarks as a starting point for the determination of appropriate
levels of general valuation allowances. The OTS directs its examiners to rely on
management's estimates of adequate general valuation allowances if the Bank's
process for determining adequate allowances is deemed to be sound.
The allowances for losses on loans and real estate are maintained at an
amount management deems adequate to cover inherent losses. We have implemented
and adhere to an internal asset review system and loan loss allowance
methodology designed to provide for the detection of problem assets and an
adequate allowance to cover loan losses. In determining the allowance for loan
losses related to specific large loans (loans over $5 million), we evaluate the
allowance on an individual loan basis, including an analysis of the
creditworthiness, cash flows and financial status of the borrower, and the
condition and the estimated value of the collateral. We review all loans under
$5 million by analyzing their performance and composition of their collateral as
a whole because of the relatively homogeneous nature of the portfolios. Given
the above evaluations, the amount of the allowance is based upon the summation
of general valuation allowances, allocated allowances and an unallocated
allowance.
We utilize the asset classifications from our internal asset review process
in the following manner to determine the amount of our allowances:
o General valuation allowances: This element relates to assets with no
well-defined deficiency or weakness (i.e., assets classified pass or
watch) and takes into consideration loss that is imbedded within the
portfolio but has not yet been realized. Generally, we believe that
borrowers are impacted by events well in advance of a lender's
knowledge that may ultimately result in loan default and eventual
loss. Examples of such loss-causing events would be borrower job loss,
divorce or medical crisis in the case of single family residential and
consumer loans, or loss of a major tenant in the case of commercial
real estate loans. General valuation allowances are determined by
applying factors that take into consideration past loss experience and
asset duration for each major asset type to the associated asset
balance.
o Allocated allowances: This element relates to assets with well-defined
deficiencies or weaknesses (i.e., assets classified special mention,
substandard, doubtful or loss). We calculate on an ongoing basis loss
by credit classification for each major asset type. Factors based upon
those loss statistics are applied against current classified asset
balances to determine the amount of allocated allowances. Included in
these allowances are those amounts associated with assets where it is
probable that the value of the asset has been impaired and the loss
can be reasonably estimated. If we determine our carrying value of the
asset exceeds the net fair value and no alternative payment source
exists, then a specific allowance is recorded for the amount of that
difference.
o Unallocated allowance: This element 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.
Our provision for loan losses was $0.9 million in 2002, down $1.6 million
from 2001. Our net loan charge-offs exceeded the provision for loan losses by
$1.1 million resulting in a decrease in the allowance for loan losses to $35.0
million at December 31, 2002. The decrease in the allowance reflected a decrease
of $1.1 million in general valuation allowances to $26.7 million. Allocated
allowances increased by $0.1 million in our single-family portfolio and $0.1
million in our commercial non-mortgage portfolio, which was partially offset by
a $0.2 million decrease in the commercial real estate mortgage portfolio. There
was no change in the unallocated allowance of $2.8 million. During 2001, our
provision for loan losses exceeded net loan charge-offs by $1.7 million
resulting in an increase in the allowance for loan losses to $36.1 million at
December 31, 2001. The increase in the allowance reflected an increase of $0.8
million in general valuation allowances to $27.8 million. Allocated allowances
increased by $1.8 million in our single-family portfolio and $0.2 million in our
commercial non-mortgage portfolio, which was partially offset by a $1.0 million
decrease in the commercial real estate mortgage portfolio. There was no change
in the unallocated allowance.
54
The following table summarizes the activity in our allowance for loan
losses during the years indicated.
(In Thousands) 2002 2001 2000 1999 1998
--------------------------------------------------------------------------------------------
Balance at beginning of period $ 36,120 $ 34,452 $ 38,342 $ 31,517 $ 32,092
Provision .................... 939 2,564 3,251 11,270 3,899
Charge-offs .................. (2,231) (1,348) (1,749) (5,535) (7,372)
Recoveries ................... 171 452 419 1,090 2,898
Transfers (1) ................ -- -- (5,811) -- --
--------------------------------------------------------------------------------------------
Balance at end of period ..... $ 34,999 $ 36,120 $ 34,452 $ 38,342 $ 31,517
============================================================================================
(1) Reduction in 2000 was due to the sale of subsidiary.
Net loan charge-offs were $2.1 million in 2002, up from $0.9 million in
2001 and $1.3 million in 2000. The increase from a year ago primarily reflected
a $1.2 million charge-off in the current year of a commercial real estate loan
for which a short-pay was accepted in full consideration of the loan.
55
The following table presents by category of loan gross charge-offs, gross
recoveries and net charge-offs during the years indicated.
(Dollars in Thousands) 2002 2001 2000 1999 1998
----------------------------------------------------------------------------------------------------------------
GROSS LOAN CHARGE-OFFS
Loans secured by real estate:
Residential:
One-to-four units ........................... $ 435 $ 530 $ 352 $ 393 $ 1,035
One-to-four units - subprime ................ 166 344 383 187 --
Five or more units .......................... -- -- -- -- 68
Commercial real estate ........................ 1,188 -- -- -- --
Construction .................................. -- -- -- -- --
Land .......................................... -- -- -- -- --
Non-mortgage:
Commercial .................................... -- -- -- -- --
Automobile .................................... 104 197 832 4,795 6,118
Other consumer ................................ 338 277 182 160 151
----------------------------------------------------------------------------------------------------------------
Total gross loan charge-offs ................ 2,231 1,348 1,749 5,535 7,372
----------------------------------------------------------------------------------------------------------------
GROSS LOAN RECOVERIES
Loans secured by real estate:
Residential:
One-to-four units ........................... 111 267 19 -- 125
One-to-four units - subprime ................ -- 166 -- -- --
Five or more units .......................... -- -- -- -- --
Commercial real estate ........................ -- 1 250 250 1,610
Construction .................................. -- -- -- -- --
Land .......................................... -- -- -- -- --
Non-mortgage:
Commercial .................................... -- -- -- -- --
Automobile .................................... 47 4 136 831 1,159
Other consumer ................................ 13 14 14 9 4
----------------------------------------------------------------------------------------------------------------
Total gross loan recoveries ................. 171 452 419 1,090 2,898
----------------------------------------------------------------------------------------------------------------
NET LOAN CHARGE-OFFS
Loans secured by real estate:
Residential:
One-to-four units ........................... 324 263 333 393 910
One-to-four units - subprime ................ 166 178 383 187 --
Five or more units .......................... -- -- -- -- 68
Commercial real estate ........................ 1,188 (1) (250) (250) (1,610)
Construction .................................. -- -- -- -- --
Land .......................................... -- -- -- -- --
Non-mortgage:
Commercial .................................... -- -- -- -- --
Automobile .................................... 57 193 696 3,964 4,959
Other consumer ................................ 325 263 168 151 147
----------------------------------------------------------------------------------------------------------------
Total net loan charge-offs .................. $ 2,060 $ 896 $ 1,330 $ 4,445 $ 4,474
================================================================================================================
Net loan charge-offs as a percentage of average loans 0.02% 0.01% 0.01% 0.06% 0.08%
================================================================================================================
56
The following table indicates our allocation of the allowance for loan
losses to the various categories of loans at the dates indicated.
December 31,
---------------------------------------------------------------------------------------------
2002 2001 2000
-----------------------------------------------------------------------------------------------
Gross Allowance Gross Allowance Gross Allowance
Loan Percentage Loan Percentage Loan Percentage
Portfolio to Loan Portfolio to Loan Portfolio to Loan
(Dollars in Thousands) Allowance Balance Balance Allowance Balance Balance Allowance Balance Balance
-------------------------------------------------------------------------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .......... $18,562 $8,647,197 0.21% $19,033 $7,699,061 0.25% $15,254 $7,655,238 0.20%
One-to-four units - subprime 8,642 1,386,113 0.62 9,633 1,506,719 0.64 10,157 1,743,914 0.58
Five or more units ......... 80 10,640 0.75 84 11,179 0.75 146 19,460 0.75
Commercial real estate ....... 1,364 71,415 1.91 1,848 112,509 1.64 2,935 164,604 1.78
Construction ................. 1,223 103,547 1.18 1,005 84,942 1.18 1,390 118,165 1.18
Land ......................... 636 53,538 1.19 274 22,028 1.24 332 26,880 1.24
Non-mortgage:
Commercial ................... 586 15,021 3.90 573 22,017 2.60 442 21,721 2.03
Automobile (1) ............... 100 11,641 0.86 277 24,529 1.13 269 39,614 0.68
Other consumer ............... 1,006 56,782 1.77 593 50,908 1.16 727 60,653 1.20
Not specifically allocated ...... 2,800 -- -- 2,800 -- -- 2,800 -- --
-------------------------------------------------------------------------------------------------------------------------------
Total loans held for
investment .............. $34,999 $10,355,894 0.34% $36,120 $9,533,892 0.38% $34,452 $9,850,249 0.35%
===============================================================================================================================
1999 1998
----------------------------------------------------------------
Loans secured by real estate:
Residential:
One-to-four units .......... $12,913 $6,155,399 0.21% $11,244 $4,047,182 0.28%
One-to-four units - subprime 9,876 1,639,401 0.60 3,055 588,951 0.52
Five or more units ......... 184 21,055 0.87 401 40,029 1.00
Commercial real estate ....... 2,439 148,327 1.64 2,632 140,790 1.87
Construction ................. 2,075 176,487 1.18 1,508 127,761 1.18
Land ......................... 843 67,631 1.25 568 44,859 1.27
Non-mortgage:
Commercial ................... 334 26,667 1.25 218 28,293 0.77
Automobile ................... 6,259 399,789 1.57 8,344 357,988 2.33
Other consumer ............... 619 49,344 1.25 747 41,894 1.78
Not specifically allocated ...... 2,800 -- -- 2,800 -- --
------------------------------------------------------------------------------------------------
Total loans held for
investment .............. $38,342 $8,684,100 0.44% $31,517 $5,417,747 0.58%
================================================================================================
(1) The decline during 2000 primarily reflects the sale of subsidiary.
Impaired Loans. We consider a loan to be impaired when, based upon current
information and events, we believe it is probable that we will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. We carry impaired loans at either the present value of expected
future cash flows discounted at the loan's effective interest rate or at the
loan's observable market price or the net fair value of the collateral securing
the loan. Impaired loans exclude large groups of smaller balance homogeneous
loans that we collectively evaluate for impairment. For us, loans we
collectively review for impairment include all single family loans and
performing multi-family and non-residential loans having principal balances of
less than $5 million.
In determining impairment, we consider large non-homogeneous loans with the
following characteristics: non-accrual loans, debt restructurings and performing
loans which exhibit, among other characteristics, high loan-to-value ratios or
delinquent taxes. We base the measurement of collateral dependent impaired loans
on the fair value of the loan's collateral. We value non-collateral dependent
loans based on a present value calculation of expected future cash flows,
discounted at the loan's effective rate. We generally use cash receipts on
impaired loans not performing according to contractual terms to reduce the
carrying value of the loan, unless we believe we will recover the remaining
principal balance of the loan. We include impairment losses in the allowance for
loan losses through a charge to provision for loan losses. We include
adjustments to impairment losses due to changes in the fair value of the
collateral of impaired loans in provision for loan losses. Upon disposition of
an impaired loan, we record loss of principal through a charge-off to the
allowance for loan losses. The recorded investment in loans for which we have
recognized impairment totaled $13 million at December 31, 2001. During 2002,
that amount increased but by year end had declined back to $13 million as a
short-pay was accepted in full
57
consideration of a commercial real estate loan. The total allowance for losses
related to these loans was $1 million for both December 31, 2002 and 2001.
During 2002, the total interest recognized on the impaired portfolio was $1.3
million, compared to $1.7 million in 2001. For further information regarding
impaired loans, see Note 5 of the Notes to Consolidated Financial Statements on
page 81.
The following table summarizes the activity in our allowance for loan
losses associated with impaired loans during the years indicated.
(In Thousands) 2002 2001 2000 1999 1998
------------------------------------------------------------------------------------
Balance at beginning of period $ 759 $ 800 $ 797 $ 810 $ 1,301
Provision (reduction) ........ 1,154 (41) 3 (13) (491)
Charge-offs .................. (1,188) -- -- -- --
Recoveries ................... -- -- -- -- --
------------------------------------------------------------------------------------
Balance at end of period ..... $ 725 $ 759 $ 800 $ 797 $ 810
====================================================================================
The provision of $1.2 million during 2002 and resultant $1.2 million
charge-off relates to the previously mentioned commercial real estate loan for
which a short-pay was accepted in full consideration.
In addition to losses charged against the allowance for loan losses, we
have maintained a valuation allowance for losses on real estate and joint
ventures held for investment. The provision reductions in all years were, in
general, due to a continuing improvement in the real estate market which
favorably impacted the valuation of certain neighborhood shopping center
investments and to a reduction in the investment in certain joint venture
investments.
The following table summarizes the activity in our allowance for real
estate and joint ventures held for investment during the years indicated.
(In Thousands) 2002 2001 2000 1999 1998
-------------------------------------------------------------------------------------------
Balance at beginning of period $ 2,690 $ 2,997 $ 2,131 $ 7,717 $ 21,244
Provision (reduction) ........ (448) (307) 866 (3,666) (5,296)
Charge-offs .................. (1,334) -- -- (1,920) (8,231)
Recoveries ................... -- -- -- -- --
-------------------------------------------------------------------------------------------
Balance at end of period ..... $ 908 $ 2,690 $ 2,997 $ 2,131 $ 7,717
===========================================================================================
We have recorded losses on real estate acquired in settlement of loans by
direct write-off to net operations of real estate acquired in settlement of
loans and against an allowance for losses specifically established for these
assets. As of September 30, 1999, we ceased maintaining an allowance for real
estate acquired in settlement of loans as we record the related individual
assets at the lower of cost or fair value.
The following table summarizes the activity of our allowance for real
estate acquired in settlement of loans during the years indicated.
(In Thousands) 2002 2001 2000 1999 1998
-----------------------------------------------------------------------------
Balance at beginning of period $-- $-- $-- $ 533 $ 839
Provision (reduction) ........ 608 517 412 (45) 455
Charge-offs .................. (612) (583) (442) (488) (761)
Recoveries ................... 4 66 30 -- --
-----------------------------------------------------------------------------
Balance at end of period ..... $-- $-- $-- $-- $ 533
=============================================================================
58
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 during 2002 were from:
o principal repayments--including prepayments, but excluding our
refinances of our existing loans--on loans and mortgage-backed
securities of $2.9 billion;
o sales of mortgage-backed securities available for sale of $1.0
billion;
o an increase in deposits of $619 million;
o maturities and sales of U.S. Treasury securities, agency obligations
and other investment securities available for sale of $618 million;
and
o a net increase in FHLB advances and other borrowings of $101 million.
We used these funds for the following purposes:
o to originate and purchase loans held for investment, excluding
refinances of our existing loans, of $3.7 billion;
o to purchase mortgage-backed securities available for sale of $1.0
billion;
o to purchase U.S. Treasury securities, agency obligations and other
investment securities available for sale of $675 million; and
o to increase our loans held for sale a net $153 million.
Our principal source of liquidity is our ability to utilize borrowings, as
needed. Our primary source of borrowings is the FHLB. At December 31, 2002, our
FHLB borrowings totaled $1.6 billion, representing 13.6% of total assets. We
currently are approved by the FHLB to borrow up to 40% of total assets to the
extent we provide qualifying collateral and hold sufficient FHLB stock. That
approved limit would have permitted us, as of year end, to borrow an additional
$3.2 billion. To the extent 2003 deposit growth 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 will utilize our FHLB borrowing arrangement or
possibly other sources. As of December 31, 2002, we had commitments to borrowers
for short-term rate locks of $996 million, undisbursed loan funds and unused
lines and letters of credit of $190 million, and other contingent liabilities of
$2 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.
Another measure of liquidity in the savings and loan industry is the ratio
of cash and eligible investments to the sum of withdrawable savings and
borrowings due within one year. At December 31, 2002, the Bank's ratio was 5.4%,
compared to 4.3% at both December 31, 2001 and 2000.
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 December 31, 2002, the holding company's liquid assets, including due
from Bank--interest bearing balances, totaled $65 million.
On July 24, 2002, the Board of Directors of Downey authorized a share
repurchase program of up to $50 million of Downey's common stock. To fund this
program, the Bank paid a special $50 million dividend during the year to the
holding company. The shares are being repurchased from time-to-time in open
market transactions. The timing, volume and price of purchases will be made at
the discretion of Downey, and will also be contingent upon Downey's overall
financial condition, as well as market conditions in general. During the current
year, 306,300 shares were repurchased at an average price of $39.73 and, at year
end, $38 million of the original authorization remains available for future
purchases.
Stockholders' equity totaled $823 million at December 31, 2002, up from
$734 million at December 31, 2001 and $625 million at December 31, 2000.
59
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 enter into derivative financial instruments as part of our interest rate
risk management process, primarily related to our sale of loans in the secondary
market. For further information regarding our derivative instruments, see
Asset/Liability Management and Market Risk on page 44 and Note 20 of Notes to
the Consolidated Financial Statements on page 101.
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 of the commitments may 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. Downey evaluates each customer's creditworthiness on a case-by-case
basis. Undisbursed loan funds and unused lines of credit include home equity
lines of credit and funds not disbursed, but committed to construction and
commercial lending by the Bank.
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.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party.
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.
At December 31, 2002, scheduled maturities of certificates of deposit and
FHLB advances, secondary marketing activities, loans held for investment and
future operating minimum lease commitments, and other contractual obligations
are as follows:
Within 1 - 3 4 - 5 Over Total
(In Thousands) 1 Year Years Years 5 Years Balance
----------------------------------------------------------------------------------------------------------------------------
Certificates of deposit .................................. $3,534,174 $ 627,970 $ 505,510 $ -- $4,667,654
FHLB advances ............................................ 413,934 609,850 141,300 459,000 1,624,084
Secondary marketing activities:
Non-qualifying hedge transactions:
Expected rate lock commitments ..................... 614,592 -- -- -- 614,592
Associated forward sale contracts .................. 624,062 -- -- -- 624,062
Associated forward purchase contracts .............. 50,000 -- -- -- 50,000
Qualifying cash flow hedge transactions:
Loans held for sale, at lower of cost or fair value 652,052 -- -- -- 652,052
Associated forward sale contracts .................. 623,975 -- -- -- 623,975
Commitments to originate loans held for investment:
Adjustable ........................................... 249,121 -- -- -- 249,121
Fixed ................................................ 716 -- -- -- 716
Undisbursed loan funds and unused lines of credit ........ 82,671 12,331 -- 94,281 189,283
Operating leases ......................................... 4,347 7,158 4,541 2,482 18,528
Standby letters of credit and other contingent liabilities -- -- -- 2,662 2,662
----------------------------------------------------------------------------------------------------------------------------
Total obligations and commitments .................... $6,849,644 $1,257,309 $ 651,351 $ 558,425 $9,316,729
============================================================================================================================
60
REGULATORY CAPITAL COMPLIANCE
Our core and tangible capital ratios were both 6.92% and our risk-based
capital ratio was 14.08% at December 31, 2002. These levels are down from
comparable ratios of 7.10% for both core and tangible capital and 14.53% for
risk-based capital at December 31, 2001, and continue to exceed the "well
capitalized" standards of 5.00% for core capital and 10.00% for risk-based
capital, as defined by regulation.
The following table is a reconciliation of the Bank's stockholder's equity
to federal regulatory capital as of December 31, 2002.
Tangible Capital Core Capital Risk-Based Capital
--------------------- --------------------- -------------------------
(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio
---------------------------------------------------------------------------------------------------------------------------------
Stockholder's equity ................................. $873,851 $873,851 $873,851
Adjustments:
Deductions:
Investment in subsidiary, primarily real estate .. (41,587) (41,587) (41,587)
Excess cost over fair value of branch acquisitions (3,150) (3,150) (3,150)
Non-permitted mortgage servicing rights .......... (5,773) (5,773) (5,773)
Additions:
Unrealized losses on securities available for sale 1,422 1,422 1,422
General loss allowance - investment in DSL
Service Company ............................... 202 202 202
Allowance for loan losses,
net of specific allowances (1) ................. -- -- 34,480
---------------------------------------------------------------------------------------------------------------------------------
Regulatory capital ................................... 824,965 6.92% 824,965 6.92% 859,445 14.08%
Well capitalized requirement ......................... 178,739 1.50 (2) 595,797 5.00 610,398 10.00 (3)
---------------------------------------------------------------------------------------------------------------------------------
Excess ............................................... $646,226 5.42% $229,168 1.92% $249,047 4.08%
=================================================================================================================================
(1) Limited to 1.25% of risk-weighted assets.
(2) Represents the minimum requirement for tangible capital, as no "well
capitalized" requirement has been established for this category.
(3) A third requirement is Tier 1 capital to risk-weighted assets of 6.00%,
which the Bank met and exceeded with a ratio of 13.52%.
Subsequent to December 31, 2002, the OTS notified us that beginning March
31, 2003, we will need to make the following changes to our regulatory capital
calculations:
o Deduct from capital, loans the Bank has made to certain joint ventures
in which DSL Service Company is a partner. At December 31, 2002, these
loans totaled $37 million.
o Risk weight our subprime residential loans at 75% instead of 50%. For
further information regarding this change, see
Business-Regulation-Regulation of the Bank on page 11.
While these changes will reduce our regulatory capital ratios, our ratios
will remain above the well capitalized requirement. The pro forma impact of
these changes to our year-end 2002 regulatory capital ratios are:
o Tangible capital ratio declines from 6.92% to 6.63% - the well
capitalized requirement is 1.50%.
o Core capital ratio declines from 6.92% to 6.63% - the well capitalized
requirement is 5.00%.
o Risk-based capital ratio declines from 14.08% to 12.82% - the well
capitalized requirement is 10.00%.
NEWLY ADOPTED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards No. 144. Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" ("SFAS 144"), addresses financial accounting and reporting
for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," and the accounting and reporting provisions of APB
Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions," for the disposal of a business segment. SFAS
144 also eliminates the exception to consolidation for a subsidiary for which
control is likely to be temporary. The provisions of SFAS 144 are effective
61
for financial statements issued for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years. The provisions of SFAS 144
generally are to be applied prospectively.
Statement of Financial Accounting Standards No. 147. Statement of Financial
Accounting Standards No. 147, "Acquisitions of Certain Financial Institutions,
an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9"
("SFAS 147"), addresses the financial accounting and reporting for the
acquisition of all or part of a financial institution, except for a transaction
between two or more mutual enterprises. SFAS 147 removes acquisitions of
financial institutions, other than transactions between two or more mutual
enterprises, from the scope of Statement of Financial Accounting Standards No.
72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions,"
("SFAS 72"), and Financial Accounting Standards Board Interpretation No. 9,
"Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a
Similar Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method," and requires that those transactions be accounted for in
accordance with Statement of Financial Accounting Standards No. 141, "Business
Combinations," and Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142"). Thus, the requirement in
SFAS 72 to recognize, and subsequently amortize, any excess of the fair value of
liabilities assumed over the fair value of tangible and identifiable intangible
assets acquired as an unidentifiable intangible asset no longer applies to
acquisitions within the scope of SFAS 147. Consequently, Downey ceased
amortizing the remaining excess cost over fair value of branch acquisitions and
will subject this asset to annual impairment testing. Downey also restated
previously issued financial statements during the fourth quarter of 2002 back to
January 1, 2002, when SFAS 142 was applied. As of December 31, 2002, this asset
totaled $3 million.
CURRENT ACCOUNTING ISSUES
Statement of Financial Accounting Standards No. 143. Statement of Financial
Accounting Standards No. 143, "Accounting for Asset Retirement Obligations"
("SFAS 143"), addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. SFAS 143 is effective for financial statements issued
for fiscal years beginning after June 15, 2002. It is anticipated that the
financial impact of SFAS 143 will not have a material effect on Downey.
Statement of Financial Accounting Standards No. 145. Statement of Financial
Accounting Standards No. 145, "Rescission of SFAS Statements No. 4, 44, and 64,
Amendment of SFAS Statement No. 13, and Technical Corrections" ("SFAS 145"),
updates, clarifies and simplifies existing accounting pronouncements. SFAS 145
rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt."
SFAS 145 amends SFAS No. 13, "Accounting for Leases," to eliminate an
inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. The provisions of SFAS
145 related to SFAS No. 4 and SFAS No. 13 are effective for fiscal years
beginning and transactions occurring after May 15, 2002, respectively. It is
anticipated that the financial impact of SFAS 145 will not have a material
effect on Downey.
Statement of Financial Accounting Standards No. 146. Statement of Financial
Accounting Standards No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities" ("SFAS 146"), requires Downey to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of a commitment to an exit or disposal plan. SFAS 146 replaces Emerging Issues
Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The provisions of SFAS 146 are to be
applied prospectively to exit or disposal activities initiated after December
31, 2002.
Statement of Financial Accounting Standards No. 148. Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure" ("SFAS 148"), amends Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), to provide alternative methods of transition for an entity that
voluntarily changes to the fair value method of accounting for stock-based
employee compensation. SFAS 148 also amends the disclosure provisions of SFAS
123 to require prominent disclosure about the effects on reported net income of
Downey's accounting policy decisions with respect to stock-based employee
compensation. Finally, SFAS 148 amends APB Opinion No. 28, "Interim Financial
Reporting", to require disclosure about those effects in interim financial
information. Presently, Downey does not intend to adopt the fair value method.
For further information regarding our accounting for stock options, see Note 17
of Notes to Consolidated Financial Statements on page 97.
62
Financial Accounting Standards Board Interpretation 46. Financial
Accounting Standards Board Interpretation 46, "Provides Guidance to Improve
Financial Reporting for SPEs, Off-Balance Sheet Structures and Similar Entities"
("FIN 46"), requires a variable interest entity to be consolidated by a company
if that company is subject to a majority of the risk of loss from the variable
interest entity's activities or is entitled to receive a majority of the
entity's residual returns or both. Prior to FIN 46, a company included another
entity in its consolidated financial statements only if it controlled the entity
through voting interests. FIN 46 also requires disclosures about variable
interest entities that the company is not required to consolidate but in which
it has a significant variable interest. The consolidated requirements of FIN 46
apply immediately to variable interest entities created after January 31, 2003.
The consolidated requirements apply to older entities in the first fiscal year
or interim period after June 15, 2003. Certain disclosure requirements apply in
all financial statements issued after January 31, 2003, regardless of when the
variable interest entity was established. It is possible that certain of our
real estate joint venture partnerships may require consolidation as a result of
applying the provisions of FIN 46. The financial impact will likely be
immaterial. For further information regarding Downey's real estate joint venture
partnerships, see Financial Condition--Investments in Real Estate and Joint
Ventures on page 39 and Note 6 on page 83 of Notes to Consolidated Financial
Statements
SALE OF SUBSIDIARY
On February 29, 2000, the Bank sold its indirect automobile finance
subsidiary, Downey Auto Finance Corp., to Auto One Acceptance Corp., a
subsidiary of California Federal Bank and recognized a pre-tax gain from the
sale of $9.8 million. At December 31, 1999, Downey Auto Finance Corp. had loans
totaling $366 million and total assets of $373 million. The proceeds from the
sale have provided additional capital to further the growth of our residential
lending business.
63
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding quantitative and qualitative disclosures about
market risk, see Financial Condition--Asset/Liability Management and Market Risk
on page 44.
64
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Independent Auditors' Report ................................. 66
Consolidated Balance Sheets .................................. 67
Consolidated Statements of Income ............................ 68
Consolidated Statements of Comprehensive Income .............. 69
Consolidated Statements of Stockholders' Equity .............. 69
Consolidated Statements of Cash Flows ........................ 70
Notes to Consolidated Financial Statements ................... 72
65
KPMG
355 South Grand Avenue
Los Angeles, CA 90071
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
Downey Financial Corp.:
We have audited the accompanying consolidated balance sheets of Downey Financial
Corp. and subsidiaries ("Downey") as of December 31, 2002 and 2001, and the
related consolidated statements of income, comprehensive income, stockholders'
equity and cash flows for each of the years in the three-year period ended
December 31, 2002. These consolidated financial statements are the
responsibility of Downey's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Downey Financial
Corp. and subsidiaries as of December 31, 2002 and 2001, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States of America.
/s/ KPMG LLP
Los Angeles, California
January 16, 2003
66
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
-------------------------------
(Dollars in Thousands, Except Per Share Data) 2002 2001
---------------------------------------------------------------------------------------------------------------
ASSETS
Cash ......................................................................... $ 123,524 $ 106,079
Federal funds ................................................................ 2,555 37,001
---------------------------------------------------------------------------------------------------------------
Cash and cash equivalents ................................................ 126,079 143,080
U.S. Treasury securities, agency obligations and other investment securities
available for sale, at fair value ........................................ 457,797 402,355
Municipal securities held to maturity, at amortized cost (estimated fair value
of $6,202 at December 31, 2002 and $6,373 at December 31, 2001) .......... 6,216 6,388
Loans held for sale, at lower of cost or fair value .......................... 652,052 499,024
Mortgage-backed securities available for sale, at fair value ................. 2,253 118,981
Loans receivable held for investment ......................................... 10,322,637 9,514,408
Investments in real estate and joint ventures ................................ 33,890 38,185
Real estate acquired in settlement of loans .................................. 12,360 15,366
Premises and equipment ....................................................... 113,536 111,762
Federal Home Loan Bank stock, at cost ........................................ 117,563 113,139
Mortgage servicing rights, net ............................................... 57,729 56,895
Other assets ................................................................. 76,039 85,447
---------------------------------------------------------------------------------------------------------------
$ 11,978,151 $ 11,105,030
===============================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ..................................................................... $ 9,238,350 $ 8,619,566
Federal Home Loan Bank advances and other borrowings ......................... 1,624,084 1,522,712
Accounts payable and accrued liabilities ..................................... 102,533 67,431
Deferred income taxes ........................................................ 70,080 41,425
---------------------------------------------------------------------------------------------------------------
Total liabilities ........................................................ 11,035,047 10,251,134
---------------------------------------------------------------------------------------------------------------
Company obligated mandatorily redeemable capital securities of subsidiary
trust holding solely junior subordinated debentures of the Company
("Capital Securities") ................................................... 120,000 120,000
STOCKHOLDERS' EQUITY
Preferred stock, par value of $0.01 per share; authorized 5,000,000 shares;
outstanding none ......................................................... -- --
Common stock, par value of $0.01 per share; authorized 50,000,000 shares;
issued 28,235,022 shares at December 31, 2002 and 28,213,048
shares at December 31, 2001 .............................................. 282 282
Additional paid-in capital ................................................... 93,792 93,400
Accumulated other comprehensive loss ......................................... (1,422) (239)
Retained earnings ............................................................ 742,622 640,453
Treasury stock, at cost, 306,300 shares at December 31, 2002 ................. (12,170) --
---------------------------------------------------------------------------------------------------------------
Total stockholders' equity ............................................... 823,104 733,896
---------------------------------------------------------------------------------------------------------------
$ 11,978,151 $ 11,105,030
===============================================================================================================
See accompanying notes to consolidated financial statements.
67
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
----------------------------------------------
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000
-------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans receivable ................................................. $ 612,762 $ 782,784 $ 760,538
U.S. Treasury securities and agency obligations .................. 9,682 15,392 13,387
Mortgage-backed securities ....................................... 3,637 726 1,060
Other investments ................................................ 6,957 9,479 9,375
-------------------------------------------------------------------------------------------------------------------
Total interest income ........................................ 633,038 808,381 784,360
-------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits ......................................................... 244,541 424,855 379,303
Borrowings ....................................................... 60,936 65,793 130,419
Capital securities ............................................... 12,163 12,163 12,163
-------------------------------------------------------------------------------------------------------------------
Total interest expense ....................................... 317,640 502,811 521,885
-------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME .............................................. 315,398 305,570 262,475
PROVISION FOR LOAN LOSSES ........................................ 939 2,564 3,251
-------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses .......... 314,459 303,006 259,224
-------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET
Loan and deposit related fees .................................... 47,220 50,486 30,089
Real estate and joint ventures held for investment, net .......... 10,250 3,885 8,798
Secondary marketing activities:
Loan servicing loss, net ..................................... (39,629) (11,373) (3,628)
Net gains on sales of loans and mortgage-backed securities ... 45,860 22,432 3,297
Net gains on sales of mortgage servicing rights .............. 331 934 --
Net gains (losses) on sales of investment securities ............. 219 329 (106)
Gain on sale of subsidiary ....................................... -- -- 9,762
Other ............................................................ 2,431 1,843 2,342
-------------------------------------------------------------------------------------------------------------------
Total other income, net ...................................... 66,682 68,536 50,554
-------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE
Salaries and related costs ....................................... 119,514 99,935 82,522
Premises and equipment costs ..................................... 30,694 26,016 23,220
Advertising expense .............................................. 4,418 4,410 4,786
SAIF insurance premiums and regulatory assessments ............... 3,078 3,051 2,626
Professional fees ................................................ 1,435 5,452 3,319
Other general and administrative expense ......................... 27,505 23,632 19,716
-------------------------------------------------------------------------------------------------------------------
Total general and administrative expense ..................... 186,644 162,496 136,189
-------------------------------------------------------------------------------------------------------------------
Net operation of real estate acquired in settlement of loans ..... 11 239 818
Amortization of excess cost over fair value of branch acquisitions -- 457 462
-------------------------------------------------------------------------------------------------------------------
Total operating expense ...................................... 186,655 163,192 137,469
-------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES ....................................... 194,486 208,350 172,309
Income taxes ..................................................... 82,193 88,169 73,058
-------------------------------------------------------------------------------------------------------------------
NET INCOME ................................................... $ 112,293 $ 120,181 $ 99,251
===================================================================================================================
PER SHARE INFORMATION
BASIC ............................................................ $ 3.99 $ 4.26 $ 3.52
===================================================================================================================
DILUTED .......................................................... $ 3.99 $ 4.25 $ 3.51
===================================================================================================================
CASH DIVIDENDS DECLARED AND PAID ................................. $ 0.36 $ 0.36 $ 0.36
===================================================================================================================
Weighted average diluted shares outstanding ...................... 28,173,659 28,271,103 28,225,551
===================================================================================================================
See accompanying notes to consolidated financial statements.
68
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31,
--------------------------------------
(In Thousands) 2002 2001 2000
-------------------------------------------------------------------------------------------------------------------
NET INCOME ................................................................ $ 112,293 $ 120,181 $ 99,251
-------------------------------------------------------------------------------------------------------------------
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 ....................... 61 705 2,032
Mortgage-backed securities available for sale, at fair value .......... 935 (714) 173
Less reclassification of realized (gains) losses included in net income (284) (190) 50
Unrealized losses on cash flow hedges:
Net derivative instruments ............................................ (11,434) (5,981) --
Less reclassification of realized losses included in net income ....... 9,539 5,254 --
-------------------------------------------------------------------------------------------------------------------
Total other comprehensive income (loss), net of income taxes (benefits) ... (1,183) (926) 2,255
-------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME ...................................................... $ 111,110 $ 119,255 $ 101,506
===================================================================================================================
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated
Additional Other
Common Paid-in Comprehensive Retained Treasury
(Dollars in Thousands, Except Per Share Data) Stock Capital Income (Loss) Earnings Stock Total
-------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1999 .................... $ 281 $ 92,385 $ (1,568) $ 441,320 $ -- $ 532,418
Cash dividends, $0.36 per share .................. -- -- -- (10,143) -- (10,143)
Exercise of stock options ........................ 1 854 -- -- -- 855
Unrealized gains on securities available for sale -- -- 2,255 -- -- 2,255
Net income ....................................... -- -- -- 99,251 -- 99,251
-------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2000 .................... 282 93,239 687 530,428 -- 624,636
Cash dividends, $0.36 per share .................. -- -- -- (10,156) -- (10,156)
Exercise of stock options ........................ -- 161 -- -- -- 161
Unrealized losses on securities available for sale -- -- (199) -- -- (199)
Unrealized losses on cash flow hedges ............ -- -- (727) -- -- (727)
Net income ....................................... -- -- -- 120,181 -- 120,181
-------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2001 .................... 282 93,400 (239) 640,453 -- 733,896
Cash dividends, $0.36 per share .................. -- -- -- (10,124) -- (10,124)
Exercise of stock options ........................ -- 392 -- -- -- 392
Unrealized gains on securities available for sale -- -- 712 -- -- 712
Unrealized losses on cash flow hedges ............ -- -- (1,895) -- -- (1,895)
Purchase of treasury stock ....................... -- -- -- -- (12,170) (12,170)
Net income ....................................... -- -- -- 112,293 -- 112,293
-------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2002 .................... $ 282 $ 93,792 $ (1,422) $ 742,622 $ (12,170) $ 823,104
===============================================================================================================================
See accompanying notes to consolidated financial statements.
69
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
--------------------------------------------
(In Thousands) 2002 2001 2000
------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income .................................................................... $ 112,293 $ 120,181 $ 99,251
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization ............................................ 61,840 49,009 32,957
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 ..................................... 37,712 13,366 10,605
Net gains on sales of loans and mortgage-backed securities, mortgage
servicing rights, investment securities, real estate and other assets .. (55,046) (26,019) (10,111)
Gain on sale of subsidiary ............................................... -- -- (9,762)
Interest capitalized on loans (negative amortization) .................... (25,615) (31,576) (72,641)
Federal Home Loan Bank stock dividends ................................... (4,424) (6,783) (7,522)
Loans originated for sale ..................................................... (6,172,572) (4,823,938) (1,729,220)
Proceeds from sales of loans held for sale, including those sold
as mortgage-backed securities ............................................ 6,036,671 4,539,068 1,547,187
(Increase) decrease in other, net ............................................. (4,687) 18,509 (33,238)
------------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities ........................................ (13,828) (148,183) (172,494)
------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of:
Subsidiary, net .......................................................... -- -- 379,234
U.S. Treasury securities, agency obligations and other
investment securities available for sale ............................... 92,137 29,139 29,645
Mortgage-backed securities available for sale ............................ 1,080,491 -- 3,253
Loans held for investment ................................................ -- -- 99,751
Wholly owned real estate and real estate acquired in settlement of loans . 41,811 11,141 38,707
Federal Home Loan Bank stock ............................................. -- -- 17,516
Proceeds from maturities of U.S. Treasury securities, agency obligations
and other investment securities available for sale ....................... 525,440 462,545 22,000
Purchase of:
U.S. Treasury securities, agency obligations and other investment
securities available for sale .......................................... (674,740) (584,244) (181,905)
Mortgage-backed securities available for sale ............................ (1,014,098) (115,597) --
Loans receivable held for investment ..................................... (466,702) (94,980) (18,828)
Premises and equipment ................................................... (20,369) (25,548) (8,984)
Federal Home Loan Bank stock ............................................. -- -- (13,958)
Originations of loans receivable held for investment (net of refinances of
$1,039,283 for the year ended December 31, 2002, $794,823 for the year
ended December 31, 2001 and $165,148 for the year ended December 31, 2000) (3,235,805) (2,505,098) (3,317,104)
Principal payments on loans receivable held for investment and
mortgage-backed securities available for sale ............................ 2,923,882 2,926,863 1,823,685
Net change in undisbursed loan funds .......................................... 60,342 (9,930) (59,588)
Investments in real estate held for investment ................................ (18,134) (5,860) (1,356)
Other, net .................................................................... 4,318 4,007 650
------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities .......................... (701,427) 92,438 (1,187,282)
------------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
70
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
Years Ended December 31,
---------------------------------------------
(In Thousands) 2002 2001 2000
-----------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits ...................................................... $ 618,784 $ 536,877 $ 1,519,928
Proceeds from Federal Home Loan Bank advances and other borrowings ............ 7,220,550 3,914,900 6,059,445
Repayments of Federal Home Loan Bank advances and other borrowings ............ (7,119,178) (4,370,760) (6,203,653)
Purchase of treasury stock .................................................... (12,170) -- --
Proceeds from exercise of stock options ....................................... 392 161 855
Cash dividends ................................................................ (10,124) (10,156) (10,143)
----------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities ..................................... 698,254 71,022 1,366,432
----------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents .......................... (17,001) 15,277 6,656
Cash and cash equivalents at beginning of period .............................. 143,080 127,803 121,147
----------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD .................................... $ 126,079 $ 143,080 $ 127,803
============================================================================================================================
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest ................................................................. $ 318,665 $ 512,657 $ 511,943
Income taxes ............................................................. 73,459 77,995 73,744
Supplemental disclosure of non-cash investing:
Loans transferred to held for investment from held for sale ............... 2,928 7,454 42,054
Loans transferred from held for investment to held for sale ............... -- -- 97,047
Loans transferred from held for investment to wholly owned real estate .... -- 15,688 --
Loans exchanged for mortgage-backed securities ............................ 5,104,433 3,816,171 970,319
Real estate acquired in settlement of loans ............................... 25,208 25,743 18,389
Loans to facilitate the sale of real estate acquired in settlement of loans 15,163 10,063 6,896
============================================================================================================================
See accompanying notes to consolidated financial statements.
71
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2002, 2001 and 2000
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of Downey Financial Corp. and
subsidiaries ("Downey") include all accounts of Downey Financial Corp. and
the consolidated accounts of all subsidiaries, including Downey Savings and
Loan Association, F.A. (the "Bank"). All significant intercompany balances
and transactions have been eliminated.
BUSINESS
Downey provides a full range of financial services to individual and
corporate customers. Downey is subject to competition from other financial
institutions. Downey is subject to the regulations of certain governmental
agencies and undergoes periodic examinations by those regulatory
authorities.
BASIS OF FINANCIAL STATEMENT PRESENTATION
The accompanying consolidated financial statements have been prepared in
conformity with generally accepted accounting principles accepted in the
United States of America. In preparing the consolidated financial
statements, management is required to make estimates and assumptions that
affect the reported amounts of assets and liabilities as of the dates of
the balance sheets and the results of operations for the reporting periods.
Actual results could differ significantly from those estimates.
Material estimates that are particularly susceptible to significant change
in the near term relate to the determination of the allowances for losses
on loans, real estate and mortgage servicing rights ("MSRs") and the
valuation of expected rate lock commitments. Management believes that the
allowances established for losses on loans, real estate and MSRs are
adequate and that the valuation of expected rate lock commitments are
reasonable. While management uses available information to recognize losses
on loans, real estate and MSRs and to value expected rate lock commitments,
future changes to the allowances or valuations may be necessary based on
changes in economic conditions. In addition, various regulatory agencies,
as an integral part of their examination process, periodically review
Downey's allowances for losses on loans, real estate and MSRs and
valuations of expected rate lock commitments. Such agencies may require
Downey to recognize changes to the allowances or valuations based on their
judgments about information available to them at the time of their
examination.
Downey is required to carry its loans held for sale portfolio,
mortgage-backed and investment securities available for sale portfolios,
real estate acquired in settlement of loans, real estate held for
investment or under development, derivatives and MSRs at the lower of cost
or fair value or in certain cases, at fair value. Fair value estimates are
made at a specific point in time based upon relevant market information and
other information about the asset or liability. Such estimates related to
loans held for sale is estimated based upon market prices obtained from
readily available market quote systems. Fair value for the mortgage-backed
and investment securities portfolios and derivatives include published bid
prices or bid quotations received from securities dealers. Fair value
estimates for real estate acquired in settlement of loans and real estate
held for investment or under development is determined by current
appraisals and, where no active market exists for a particular property,
discounting a forecast of expected cash flows at a rate commensurate with
the risk involved. Fair value for MSRs is determined by computing the
present value of the expected net servicing income from the portfolio.
NEWLY ADOPTED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards No. 144. Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" ("SFAS 144"), addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. SFAS 144
supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of," and the accounting and
reporting provisions of APB Opinion No. 30, "Reporting the Results of
72
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Operations--Reporting the Effects of Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a business segment. SFAS 144 also
eliminates the exception to consolidation for a subsidiary for which
control is likely to be temporary. The provisions of SFAS 144 are effective
for financial statements issued for fiscal years beginning after December
15, 2001, and interim periods within those fiscal years. The provisions of
SFAS 144 generally are to be applied prospectively.
Statement of Financial Accounting Standards No. 147. Statement of Financial
Accounting Standards No. 147, "Acquisitions of Certain Financial
Institutions, an amendment of FASB Statements No. 72 and 144 and FASB
Interpretation No. 9" ("SFAS 147"), addresses the financial accounting and
reporting for the acquisition of all or part of a financial institution,
except for a transaction between two or more mutual enterprises. SFAS 147
removes acquisitions of financial institutions, other than transactions
between two or more mutual enterprises, from the scope of Statement of
Financial Accounting Standards No. 72, "Accounting for Certain Acquisitions
of Banking or Thrift Institutions," ("SFAS 72"), and Financial Accounting
Standards Board Interpretation No. 9, "Applying APB Opinions No. 16 and 17
When a Savings and Loan Association or a Similar Institution Is Acquired in
a Business Combination Accounted for by the Purchase Method," and requires
that those transactions be accounted for in accordance with Statement of
Financial Accounting Standards No. 141, "Business Combinations," and
Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"). Thus, the requirement in SFAS 72 to
recognize, and subsequently amortize, any excess of the fair value of
liabilities assumed over the fair value of tangible and identifiable
intangible assets acquired as an unidentifiable intangible asset no longer
applies to acquisitions within the scope of SFAS 147. Consequently, Downey
ceased amortizing the remaining excess cost over fair value of branch
acquisitions and will subject this asset to annual impairment testing.
Downey also restated previously issued financial statements during the
fourth quarter of 2002 back to January 1, 2002, when SFAS 142 was applied.
As of December 31, 2002, this asset totaled $3 million.
CASH AND CASH EQUIVALENTS
For purposes of the statements of cash flows, cash and cash equivalents
include cash on hand, amounts due from banks, certificates of deposit with
maturities three months or less and federal funds sold. Generally, federal
funds are purchased and sold for one-day periods.
MORTGAGE-BACKED SECURITIES PURCHASED UNDER RESALE AGREEMENTS, U.S. TREASURY
SECURITIES AND AGENCY OBLIGATIONS, OTHER INVESTMENT SECURITIES, MUNICIPAL
SECURITIES AND MORTGAGE-BACKED SECURITIES
Downey has established written guidelines and objectives for its investing
activities. At the time of purchase of a mortgage-backed security purchased
under resale agreement, U.S. Treasury security and agency obligation, other
investment security, municipal security or a mortgage-backed security,
management of Downey designates the security as either held to maturity,
available for sale or held for trading based on Downey's investment
objectives, operational needs and intent. Downey then monitors its
investment activities to ensure that those activities are consistent with
the established guidelines and objectives.
Held to Maturity. Securities held to maturity are carried at cost, adjusted
for amortization of premiums and accretion of discounts which are
recognized in interest income using the interest method. Mortgage-backed
securities represent participating interests in pools of long-term first
mortgage loans originated and serviced by the issuers of the securities.
Mortgage-backed securities held to maturity are carried at unpaid principal
balances, adjusted for unamortized premiums and unearned discounts.
Premiums and discounts on mortgage-backed securities are amortized using
the interest method over the remaining period to the call date or
contractual maturity, adjusted for anticipated prepayments. It is the
positive intent of Downey, and Downey has the ability, to hold these
securities until maturity as part of its portfolio of long-term,
interest-earning assets. If the cost basis of these securities is
determined to be other than temporarily impaired, the amount of the
impairment is charged to operations.
73
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Available for Sale. Securities available for sale are carried at fair
value. Premiums and discounts are amortized using the interest method over
the remaining period to the call date or contractual maturity and, in the
case of mortgage-backed securities, adjusted for anticipated prepayments.
Unrealized holding gains and losses, or valuation allowances established
for net unrealized losses, are excluded from earnings and reported as a
separate component of stockholders' equity as accumulated other
comprehensive income, net of income taxes, unless the security is deemed
other than temporarily impaired. If the security is determined to be other
than temporarily impaired, the amount of the impairment is charged to
operations.
Realized gains and losses on the sale of securities available for sale,
determined using the specific identification method and recorded on a trade
date basis, are reflected in earnings.
Held for Trading. Securities held for trading are carried at fair value.
Realized and unrealized gains and losses are reflected in earnings.
DERIVATIVES AND HEDGES
Derivative financial instruments are recorded at fair value and reported as
either assets or liabilities on the balance sheet. The accounting for gains
and losses associated with changes in the fair value of derivatives are
reported in current earnings or other comprehensive income, net of tax,
depending on whether they qualify for hedge accounting and whether the
hedge is highly effective in achieving offsetting changes in the fair value
or cash flows of the asset or liability being hedged. Derivative
instruments designated in a hedge relationship to mitigate exposure to the
variability in fair values or expected future cash flows are considered
fair value hedges or cash flow hedges, respectively. 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.
LOANS HELD FOR SALE
Downey identifies those loans which foreseeably may be sold prior to
maturity. These loans have been classified as held for sale in the
Consolidated Balance Sheets and are recorded at the lower of amortized cost
or fair value. Effective with the adoption of SFAS 133, the carrying amount
includes a basis adjustment to the loan at funding resulting from the
change in the fair value of the interest rate lock derivative from the date
of commitment to the date of funding. In response to unforeseen events such
as changes in regulatory capital requirements, liquidity shortfalls,
changes in the availability of sources of funds and excess loan demand by
borrowers that could not be controlled immediately by loan price changes,
Downey may sell loans which had been held for investment. In such
occurrences, the loans are transferred at amortized cost and the lower of
cost or fair value method is then applied.
GAINS OR LOSSES ON SALES OF LOANS AND MORTGAGE SERVICING ASSETS
Gains or losses on sales of loans are recognized at the time of sale and
are determined by the difference between the net sales proceeds and the
allocated basis of the loans sold. Downey capitalizes MSRs acquired through
purchase or when mortgage loans are sold or securitized with servicing
rights retained. The total cost of the mortgage loans designated for sale
is allocated to the MSRs and the mortgage loans without the MSRs based on
their relative fair values. The MSRs are included as a component of gain on
sale of loans. The MSRs are amortized in proportion to and over the
estimated period of net servicing income. Such amortization is reflected as
a component of loan servicing income (loss).
The MSRs are periodically reviewed for impairment based on their fair
value. The fair value of the MSRs, for the purposes of impairment, is
measured using a discounted cash flow analysis based on available market
quotes, market-adjusted discount rates and anticipated prepayment speeds.
Market sources are used to determine prepayment speeds, the net cost of
servicing per loan, and inflation, default and interest rates for
mortgages.
The Company capitalizes and measures MSR impairment on a disaggregated
basis based on the following predominant risk characteristics of the
underlying mortgage loans: fixed-rate mortgage loans by loan term and
coupon rate (less than 7%, 150 basis point increments between 7% and 10%,
and greater than 10%), and loan term for adjustable rate mortgages.
Impairment losses are recognized through a valuation
74
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
allowance for each impaired stratum, with any associated provision recorded
as a component of loan servicing income (loss).
LOANS RECEIVABLE HELD FOR INVESTMENT
Loans receivable are recorded at cost, net of discounts and premiums,
undisbursed loan proceeds, net deferred fees and costs and the allowance
for loan losses.
Interest income on loans is accrued based on the outstanding principal
amount of loans using the interest method. Discounts and premiums on loans
are amortized to income using the interest method over the remaining period
to contractual maturity. The amortization of discounts into income is
discontinued on loans that are contractually ninety days past due or when
collection of interest appears doubtful.
Loan origination fees and related incremental direct loan origination costs
are deferred and amortized to income using the interest method over the
contractual life of the loans, adjusted for actual prepayments. Fees
received for a commitment to originate or purchase a loan or group of loans
are deferred and, if the commitment is exercised, recognized over the life
of the loan as an adjustment of yield or, if the commitment expires
unexercised, recognized as income upon expiration of the commitment. The
amortization of deferred fees and costs is discontinued on loans that are
contractually ninety days past due or when collection of interest appears
doubtful.
Accrued interest on loans that are contractually ninety days or more past
due or when collection of interest appears doubtful is generally reversed
and charged against interest income. Income is subsequently recognized only
to the extent cash payments are received and the principal balance is
expected to be recovered. Such loans are restored to an accrual status only
if the loan is brought contractually current and the borrower has
demonstrated the ability to make future payments of principal and interest.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at an amount management deems
adequate to cover inherent losses. Downey has implemented and adheres to an
internal asset review system and loan loss allowance methodology designed
to provide for the detection of problem assets and an adequate allowance to
cover loan losses. In determining the allowance for loan losses related to
specific large loans (loans over $5 million), management evaluates its
allowance on an individual loan basis, including an analysis of the
creditworthiness, cash flows and financial status of the borrower, and the
condition and the estimated value of the collateral. Downey reviews all
loans under $5 million by analyzing their performance and composition of
their collateral as a whole because of the relatively homogeneous nature of
the portfolios. Given the above evaluations, the amount of the allowance is
based upon the summation of general valuation allowances, allocated
allowances and an unallocated allowance. General valuation allowances
relate to loans with no well-defined deficiency or weakness and are
determined by applying against such loans factors for each major loan
category that consider past loss experience and loan duration. Allocated
allowances relate to loans with well-defined deficiencies or weaknesses and
are generally determined by loss factors that consider past loss experience
for such loans or are determined by the excess of the recorded investment
in the loan over the fair value of the collateral, where appropriate. The
unallocated allowance is more subjective and is reviewed quarterly to take
into consideration estimation errors and other factors such as prevailing
and forecasted economic conditions.
Downey considers a loan to be impaired when, based upon current information
and events, it believes it is probable that Downey will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. In determining impairment, Downey considers large
non-homogeneous loans with the following characteristics: non-accrual
loans, debt restructurings and performing loans which exhibit, among other
characteristics, high loan-to-value ratios or delinquent taxes. Downey
bases the measurement of collateral dependent impaired loans on the fair
value of the loan's collateral. Non-collateral dependent loans are valued
based on a present value calculation of expected future cash flows,
discounted at the loan's effective rate. Cash receipts on impaired loans
not performing according to contractual terms are generally used to reduce
the carrying value of the loan, unless Downey believes it will recover the
remaining principal balance of the loan. Impairment losses are included in
the allowance for loan losses through a charge to provision for loan
losses. Adjustments to impairment losses due to changes in the fair
75
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
value of collateral of impaired loans are included in provision for loan
losses. Upon disposition of an impaired loan, loss of principal, if any, is
recorded through a charge-off to the allowance for loan losses.
In the opinion of management, and in accordance with the loan loss
allowance methodology, the present allowance is considered adequate to
absorb estimable and probable loan losses. Additions to the allowances are
reflected in current operations. Charge-offs to the allowance are made when
the loan is considered uncollectible or is transferred to real estate
owned. Recoveries are credited to the allowance.
For regulatory capital purposes, the Bank's general allowance for loan
losses is included to a limit of 1.25% of regulatory risk-weighted assets.
LOAN SERVICING
Downey services mortgage loans for investors. Fees earned for servicing
loans owned by investors are reported as income when the related mortgage
loan payments are collected. Loan servicing costs are charged to expense as
incurred.
INVESTMENT IN REAL ESTATE AND JOINT VENTURES
Real estate held for investment or under development is held at the lower
of cost (less accumulated depreciation) or fair value. Costs, including
interest, of holding real estate in the process of development or
improvement are capitalized, whereas costs relating to holding completed
property are expensed. An allowance for losses is established by a charge
to operations if the carrying value of a property exceeds its fair value,
including the consideration of disposition costs.
Downey utilizes the equity method of accounting for investments in
non-controlled joint ventures. All intercompany profits are eliminated.
Income from the sale of real estate is recognized principally when title to
the property has passed to the buyer, minimum down payment requirements are
met and the terms of any notes received by Downey satisfy continuing
investment requirements. At the time of sale, costs are relieved from real
estate projects on a relative sales value basis and charged to operations.
REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS
Real estate acquired through foreclosure is initially recorded at the lower
of cost or fair value, net of an allowance for estimated selling costs, on
the date of foreclosure and a loan charge-off is recorded, if necessary.
After that the individual assets are recorded at the lower of cost or fair
value. All legal fees and direct costs, including foreclosure and other
related costs, are expensed as incurred.
PREMISES AND EQUIPMENT
Buildings, leasehold improvements and furniture, fixtures and equipment are
carried at cost, less accumulated depreciation and amortization. Buildings
and furniture, fixtures and equipment are depreciated using the
straight-line method over the estimated useful lives of the assets. The
cost of leasehold improvements is being amortized using the straight-line
method over the shorter of the estimated useful life of the asset or the
terms of the related leases.
IMPAIRMENT OF LONG-LIVED ASSETS
Downey reviews long-lived assets and certain identifiable intangibles for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying
amount of an asset to future net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the
assets exceed the fair value of the assets. Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs to
sell.
76
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Downey enters into sales of securities under agreements to repurchase
("reverse repurchase agreements"). Reverse repurchase agreements are
treated as financing arrangements and, accordingly, the obligations to
repurchase the securities sold are reflected as liabilities in Downey's
consolidated financial statements. The securities collateralizing reverse
repurchase agreements are delivered to several major national brokerage
firms who arranged the transactions. These securities are reflected as
assets in Downey's consolidated financial statements. The brokerage firms
may loan such securities to other parties in the normal course of their
operations and agree to return the identical securities to Downey at the
maturity of the agreements.
INCOME TAXES
Downey applies the asset and liability method of accounting for income
taxes. The asset and liability method recognizes deferred income taxes for
the tax consequences of "temporary differences" by applying enacted
statutory tax rates applicable to future years to differences between the
financial statement carrying amounts and the tax bases of existing assets
and liabilities. The effect on deferred taxes of a change in tax rates is
recognized in income in the period that includes the enactment date.
Deferred tax assets are to be recognized for temporary differences that
will result in deductible amounts in future years and for tax carryforwards
if, in the opinion of management, it is more likely than not that the
deferred tax assets will be realized.
TREASURY STOCK
Downey applies the cost method of accounting for treasury stock. The cost
method requires Downey to record the reacquisition cost of treasury stock
as a deduction from the total paid-in capital and retained earnings on the
balance sheet. The treasury stock account is debited for the cost of the
shares acquired and is credited upon reissuance at cost on a
first-in-first-out basis. If the treasury shares are reissued at a price in
excess of the acquisition cost, the excess is credited to paid-in capital
from treasury stock. If the treasury shares are reissued at less than
acquisition cost, the deficiency is treated first as a reduction of any
paid-in capital related to previous reissuances or retirements. If the
balance in paid-in capital from treasury stock is insufficient to absorb
the deficiency, the remainder is recorded as a reduction of retained
earnings.
STOCK OPTION PLAN
Downey records compensation expense on the date of grant only if the
current market price of the underlying stock exceeded the exercise price
rather than recognizing as expense over the vesting period the fair value
of all stock-based awards on the date of grant. However, Downey provides
pro forma net income and pro forma net income per share disclosures for
employee stock option grants made since 1995 as if the fair-value of all
stock-based awards as of the grant date are recognized as expense over the
vesting period.
PER SHARE INFORMATION
Two earnings per share ("EPS") measures are presented. Basic EPS excludes
dilution and is computed by dividing income available to common
stockholders by the weighted average number of common shares outstanding
for the period, excluding common shares in treasury. Diluted EPS 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 issuance of common stock that then shared in earnings.
CURRENT ACCOUNTING PRONOUNCEMENTS
Statement of Financial Accounting Standards No. 143. Statement of Financial
Accounting Standards No. 143, "Accounting for Asset Retirement Obligations"
("SFAS 143"), addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the
associated
77
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
asset retirement costs. SFAS 143 is effective for financial statements
issued for fiscal years beginning after June 15, 2002. It is anticipated
that the financial impact of SFAS 143 will not have a material effect on
Downey.
Statement of Financial Accounting Standards No. 145. Statement of Financial
Accounting Standards No. 145, "Rescission of SFAS Statements No. 4, 44, and
64, Amendment of SFAS Statement No. 13, and Technical Corrections" ("SFAS
145"), updates, clarifies and simplifies existing accounting
pronouncements. SFAS 145 rescinds SFAS No. 4, "Reporting Gains and Losses
from Extinguishment of Debt." SFAS 145 amends SFAS No. 13, "Accounting for
Leases," to eliminate an inconsistency between the required accounting for
sale-leaseback transactions and the required accounting for certain lease
modifications that have economic effects that are similar to sale-leaseback
transactions. The provisions of SFAS 145 related to SFAS No. 4 and SFAS No.
13 are effective for fiscal years beginning and transactions occurring
after May 15, 2002, respectively. It is anticipated that the financial
impact of SFAS 145 will not have a material effect on Downey.
Statement of Financial Accounting Standards No. 146. Statement of Financial
Accounting Standards No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities" ("SFAS 146"), requires Downey to recognize costs
associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. SFAS 146
replaces Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a Restructuring)."
The provisions of SFAS 146 are to be applied prospectively to exit or
disposal activities initiated after December 31, 2002.
Statement of Financial Accounting Standards No. 148. Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure" ("SFAS 148"), amends Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation"
("SFAS 123"), to provide alternative methods of transition for an entity
that voluntarily changes to the fair value method of accounting for
stock-based employee compensation. SFAS 148 also amends the disclosure
provisions of SFAS 123 to require prominent disclosure about the effects on
reported net income of Downey's accounting policy decisions with respect to
stock-based employee compensation. Finally, SFAS 148 amends APB Opinion No.
28, "Interim Financial Reporting", to require disclosure about those
effects in interim financial information. Presently, Downey does not intend
to adopt the fair value method. For further information regarding our
accounting for stock options, see Note 17 on page 97.
Financial Accounting Standards Board Interpretation 46. Financial
Accounting Standards Board Interpretation 46, "Provides Guidance to Improve
Financial Reporting for SPEs, Off-Balance Sheet Structures and Similar
Entities" ("FIN 46"), requires a variable interest entity to be
consolidated by a company if that company is subject to a majority of the
risk of loss from the variable interest entity's activities or is entitled
to receive a majority of the entity's residual returns or both. Prior to
FIN 46, a company included another entity in its consolidated financial
statements only if it controlled the entity through voting interests. FIN
46 also requires disclosures about variable interest entities that the
company is not required to consolidate but in which it has a significant
variable interest. The consolidated requirements of FIN 46 apply
immediately to variable interest entities created after January 31, 2003.
The consolidated requirements apply to older entities in the first fiscal
year or interim period after June 15, 2003. Certain disclosure requirements
apply in all financial statements issued after January 31, 2003, regardless
of when the variable interest entity was established. It is possible that
certain of our real estate joint venture partnerships may require
consolidation as a result of applying the provisions of FIN 46. The
financial impact will likely be immaterial. For further information
regarding Downey's real estate joint venture partnerships, see Note 6 on
page 83.
78
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(2) U.S. TREASURY SECURITIES, AGENCY OBLIGATIONS AND OTHER INVESTMENT
SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of U.S. Treasury securities,
agency obligations and other investment securities available for sale are
summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
(In Thousands) Cost Gains Losses Value
-------------------------------------------------------------------------------------
U.S. Treasury and agency securities $455,761 $ 2,036 $ -- $457,797
Corporate securities .............. -- -- -- --
-------------------------------------------------------------------------------------
December 31, 2002 ................. $455,761 $ 2,036 $ -- $457,797
=====================================================================================
U.S. Treasury and agency securities $355,947 $ 1,214 $ 251 $356,910
Corporate securities .............. 44,259 1,203 17 45,445
-------------------------------------------------------------------------------------
December 31, 2001 ................. $400,206 $ 2,417 $ 268 $402,355
=====================================================================================
At December 31, 2002, all of these investment securities contained call
provisions ranging from January 22, 2003 until maturity.
The amortized cost and estimated fair value of U.S. Treasury securities,
agency obligations and other investment securities available for sale at
December 31, 2002, by contractual maturity, are shown below.
Amortized Fair
(In Thousands) Cost Value
-------------------------------------------------------------
Due in one year or less ............. $ -- $ --
Due after one year through five years 454,759 456,790
Due after five years ................ 1,002 1,007
-------------------------------------------------------------
Total ............................ $455,761 $457,797
=============================================================
Proceeds, gross realized gains and losses on the sales of U.S. Treasury
securities, agency obligations and other investment securities available
for sale are summarized as follows:
(In Thousands) 2002 2001 2000
-----------------------------------------------------
Proceeds ............ $65,993 $29,139 $29,645
=====================================================
Gross realized gains $ 675 $ 329 $ 4
=====================================================
Gross realized losses $ 456 $ -- $ 110
=====================================================
Net unrealized gains on investment securities available for sale were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $2.0 million, or $1.2 million net of income taxes,
at December 31, 2002, compared to net unrealized gains of $2.1 million, or
$1.2 million net of income taxes, at December 31, 2001.
79
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(3) LOANS AND MORTGAGE-BACKED SECURITIES PURCHASED UNDER RESALE AGREEMENTS AND
OTHER INVESTMENT SECURITIES HELD TO MATURITY
LOANS AND MORTGAGE-BACKED SECURITIES PURCHASED UNDER RESALE AGREEMENTS
There were no outstanding loans or mortgage-backed securities purchased
under resale agreements at December 31, 2002 or 2001. The average interest
rate and balance of such transactions was 1.80% and $4 million,
respectively, during 2002 and 4.35% and $34 million, respectively, during
2001. The maximum amount outstanding at any month-end during 2002 was $10
million and $60 million during 2001.
MUNICIPAL SECURITIES HELD TO MATURITY
The amortized cost and estimated fair value of municipal securities held to
maturity are summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
(In Thousands) Cost Gains Losses Value
-----------------------------------------------------------------------------
December 31, 2002 ..... $6,216 $ -- $ 14 $6,202
=============================================================================
December 31, 2001 ..... $6,388 $ -- $ 15 $6,373
=============================================================================
All of the investment at December 31, 2002 and 2001 represents an
industrial revenue bond on which the interest income is not subject to
federal income taxes and matures in 2015.
(4) MORTGAGE-BACKED SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of the mortgage-backed
securities available for sale are summarized as follows:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
(In Thousands) Cost Gains Losses Value
---------------------------------------------------------------------------------
December 31, 2002:
Non-agency certificates $ 2,210 $ 43 $ -- $ 2,253
---------------------------------------------------------------------------------
Total .............. $ 2,210 $ 43 $ -- $ 2,253
=================================================================================
December 31, 2001:
Agency certificates ... $ 17,805 $ -- $ 387 $ 17,418
Non-agency certificates 102,480 15 932 101,563
---------------------------------------------------------------------------------
Total .............. $120,285 $ 15 $ 1,319 $118,981
=================================================================================
Net unrealized gains on mortgage-backed securities available for sale were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $43,000, or $25,000 net of income taxes, at
December 31, 2002. At December 31, 2001, net unrealized losses were
recognized in stockholders' equity as accumulated other comprehensive
income in the amount of $1.3 million, or $0.8 million net of income taxes.
80
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Proceeds, gross realized gains and losses on the sales of mortgage-backed
securities available for sale are summarized as follows:
(In Thousands) 2002 2001 2000
--------------------------------------------------------------
Proceeds ............ $6,187,799 $3,798,775 $ 963,712
==============================================================
Gross realized gains $ 39,951 $ 24,507 $ 4,788
==============================================================
Gross realized losses $ 6,974 $ 5,030 $ 5,690
==============================================================
(5) LOANS RECEIVABLE
Loans receivable are summarized as follows:
December 31,
-------------------------------
(In Thousands) 2002 2001
-----------------------------------------------------------------------------------
Held for investment:
Loans secured by real estate:
Residential:
One-to-four units ........................ $ 8,647,197 $ 7,699,061
One-to-four units - subprime ............. 1,386,113 1,506,719
Five or more units ....................... 10,640 11,179
Commercial real estate ..................... 71,415 112,509
Construction ............................... 103,547 84,942
Land ....................................... 53,538 22,028
Non-mortgage:
Commercial ................................. 15,021 22,017
Automobile ................................. 11,641 24,529
Other consumer ............................. 56,782 50,908
-----------------------------------------------------------------------------------
Total loans receivable held for investment 10,355,894 9,533,892
Increase (decrease) for:
Undisbursed loan funds ..................... (95,002) (61,280)
Net deferred costs and premiums ............ 96,744 77,916
Allowance for losses ....................... (34,999) (36,120)
-----------------------------------------------------------------------------------
Total loans held for investment, net ..... $ 10,322,637 $ 9,514,408
===================================================================================
Held for sale:
Loans secured by real estate:
Residential one-to-four units .............. $ 649,964 $ 509,350
Capitalized basis adjustment (1) ........... 2,088 (10,326)
-----------------------------------------------------------------------------------
Total loans held for sale, net ........... $ 652,052 $ 499,024
===================================================================================
(1) Reflected the change in fair value of the rate lock derivative from the
date commitment to the date of funding.
At December 31, 2002, over 95% of the real estate securing Downey's loans
was located in California.
The combined weighted average interest yield on loans receivable held for
investment and sale was 5.83% and 7.16% at December 31, 2002 and 2001,
respectively, and averaged 5.93%, 7.80% and 7.99% during 2002, 2001 and
2000, respectively.
Most of our 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
81
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
principal of accrued interest that exceeds the required monthly loan
payments. At December 31, 2002, loans with negative amortization
represented 75% of Downey's adjustable rate one-to-four unit residential
portfolio, of which $112 million represented the amount of negative
amortization included in the loan balance. This compares to 76% and $180
million, respectively, at December 31, 2001.
A summary of activity in the allowance for loan losses for loans receivable
held for investment during 2002, 2001 and 2000 follows:
Not
Real Other Specifically
(In Thousands) Estate Commercial Automobile Consumer Allocated Total
--------------------------------------------------------------------------------------------------------
Balance at December 31, 1999 $ 28,330 $ 334 $ 6,259 $ 619 $ 2,800 $ 38,342
Provision for loan losses .. 2,350 108 517 276 -- 3,251
Charge-offs ................ (735) -- (832) (182) -- (1,749)
Recoveries ................. 269 -- 136 14 -- 419
Transfers (1) .............. -- -- (5,811) -- -- (5,811)
--------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 30,214 442 269 727 2,800 34,452
Provision for loan losses .. 2,103 131 201 129 -- 2,564
Charge-offs ................ (874) -- (197) (277) -- (1,348)
Recoveries ................. 434 -- 4 14 -- 452
--------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 31,877 573 277 593 2,800 36,120
Provision for loan losses .. 308 13 (120) 738 -- 939
Charge-offs ................ (1,789) -- (104) (338) -- (2,231)
Recoveries ................. 111 -- 47 13 -- 171
--------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 $ 30,507 $ 586 $ 100 $ 1,006 $ 2,800 $ 34,999
========================================================================================================
(1) Reduction in 2000 was due to the sale of subsidiary.
Net charge-offs represented 0.02%, 0.01% and 0.01% of average loans for
2002, 2001 and 2000, respectively.
All impaired loans at December 31, 2002, 2001 and 2000 were secured by
commercial real estate. The following table presents impaired loans with
specific allowances and the amount of such allowances and impaired loans
without specific allowances.
Specific Net
(In Thousands) Carrying Value Allowance Balance
------------------------------------------------------------------------------
December 31, 2002:
Loans with specific allowances .. $ -- $ -- $ --
Loans without specific allowances 12,714 -- 12,714
------------------------------------------------------------------------------
Total impaired loans ............ $12,714 $ -- $12,714
==============================================================================
December 31, 2001:
Loans with specific allowances .. $ -- $ -- $ --
Loans without specific allowances 13,201 -- 13,201
------------------------------------------------------------------------------
Total impaired loans ............ $13,201 $ -- $13,201
==============================================================================
December 31, 2000:
Loans with specific allowances .. $ -- $ -- $ --
Loans without specific allowances 13,841 -- 13,841
------------------------------------------------------------------------------
Total impaired loans ............ $13,841 $ -- $13,841
==============================================================================
82
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
The average recorded investment in impaired loans totaled $15 million in
2002 and $14 million in 2001. During 2002, total interest recognized on the
impaired loan portfolio was $1.3 million, compared to $1.7 million in 2001
and $2.9 million in 2000.
The aggregate amount of non-accrual loans receivable that are contractually
past due 90 days or more as to principal or interest, in the foreclosure
process, restructured, or upon which interest collection is doubtful were
$67 million and $77 million at December 31, 2002 and 2001, respectively. At
December 31, 2002 we had no troubled debt restructurings on accrual status,
compared to less than $1 million at December 31, 2001, representing one
residential one-to-four unit loan.
Interest due on non-accrual loans, but excluded from interest income, was
approximately $0.9 million for 2002, $3.2 million for 2001 and $1.8 million
for 2000.
Downey has had, and expects in the future to have, transactions in the
ordinary course of business with executive officers, directors and their
associates on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions
with other non-related parties. In the opinion of management, those
transactions neither involve more than the normal risk of collectibility
nor present any unfavorable features. At December 31, 2002, the Bank had
extended loans to two of its directors and their associates totaling $20
million. At December 31, 2001, the Bank had extended loans to two directors
and their associates totaling $21 million. All such loans are performing in
accordance with their loan terms. Presented below is a summary of activity
with respect to such loans for the years ending December 31, 2002 and 2001:
(In Thousands) 2002 2001
--------------------------------------------------------
Balance at beginning of period $ 21,479 $ 23,067
Additions .................... 445 508
Repayments ................... (1,760) (2,096)
--------------------------------------------------------
Balance at end of period ..... $ 20,164 $ 21,479
========================================================
(6) INVESTMENTS IN REAL ESTATE AND JOINT VENTURES
Investments in real estate and joint ventures are summarized as follows:
December 31,
------------------------
(In Thousands) 2002 2001
----------------------------------------------------------------------------------------
Gross investments in real estate (1) ......................... $ 23,643 $ 44,429
Accumulated depreciation ..................................... (5,673) (7,495)
Allowance for losses ......................................... (908) (2,690)
----------------------------------------------------------------------------------------
Investments in real estate ................................ 17,062 34,244
----------------------------------------------------------------------------------------
Investments in and interest bearing advances to joint ventures 16,703 3,806
Note receivable from sale of land ............................ 125 135
----------------------------------------------------------------------------------------
Investments in joint ventures ............................. 16,828 3,941
----------------------------------------------------------------------------------------
Total investments in real estate and joint ventures ....... $ 33,890 $ 38,185
========================================================================================
(1) Included $0.9 million invested in low income housing.
83
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
The table set forth below describes the type, location and amount invested
in real estate and joint ventures, net of specific valuation allowances of
$1 million and general valuation allowances of less than $1 million, at
December 31, 2002:
(In Thousands) California Arizona Total
-------------------------------------------------------------------------------------------
Shopping centers ...................................... $ 13,342 $ 2,883 $ 16,225
Residential (1) ....................................... 17,554 -- 17,554
Land .................................................. 188 -- 188
Note receivable from sale of land ..................... 125 -- 125
-------------------------------------------------------------------------------------------
Total real estate before general valuation allowance $ 31,209 $ 2,883 34,092
General valuation allowance ........................... (202)
-------------------------------------------------------------------------------------------
Net investment in real estate and joint ventures ...... $ 33,890
===========================================================================================
(1) Included $0.9 million invested in low income housing.
A summary of real estate and joint venture operations included in Downey's
results of operations follows:
(In Thousands) 2002 2001 2000
---------------------------------------------------------------------------------------------
Wholly owned operations:
Rental operations:
Rental income ................................... $ 3,624 $ 3,235 $ 3,617
Costs and expenses .............................. (1,522) (990) (1,045)
---------------------------------------------------------------------------------------------
Net rental operations ......................... 2,102 2,245 2,572
Net gains on sales of real estate .................. 1,200 129 2,981
Reduction of losses on real estate ................. 448 307 639
---------------------------------------------------------------------------------------------
Total wholly owned operations ................... 3,750 2,681 6,192
---------------------------------------------------------------------------------------------
Joint venture operations:
Equity in net income from joint ventures ........... 5,476 736 3,224
Provision for losses provided by DSL Service Company -- -- (1,505)
---------------------------------------------------------------------------------------------
Net joint venture operations .................... 5,476 736 1,719
Interest from joint venture advances .................. 1,024 468 887
---------------------------------------------------------------------------------------------
Total joint venture operations ..................... 6,500 1,204 2,606
---------------------------------------------------------------------------------------------
Total ........................................... $ 10,250 $ 3,885 $ 8,798
=============================================================================================
84
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Activity in the allowance for losses on investments in real estate and
joint ventures for 2002, 2001 and 2000 is as follows:
Real Estate Shopping
Held for Centers Investments
or Under Held for In Joint
(In Thousands) Development Investment Ventures Total
-----------------------------------------------------------------------------------------------------
Balance at December 31, 1999 ................ $ 1,062 $ 1,069 $ -- $ 2,131
Provision for (reduction of) estimated losses -- (639) 1,505 866
Charge-offs ................................. -- -- -- --
Recoveries .................................. -- -- -- --
-----------------------------------------------------------------------------------------------------
Balance at December 31, 2000 ................ 1,062 430 1,505 2,997
Reduction of estimated losses ............... (29) (278) -- (307)
Charge-offs ................................. -- -- -- --
Recoveries .................................. -- -- -- --
Transfers (1) ............................... -- 1,505 (1,505) --
-----------------------------------------------------------------------------------------------------
Balance at December 31, 2001 ................ 1,033 1,657 -- 2,690
Reduction of estimated losses ............... (90) (358) -- (448)
Charge-offs ................................. (840) (494) -- (1,334)
Recoveries .................................. -- -- -- --
Transfers ................................... -- -- -- --
-----------------------------------------------------------------------------------------------------
Balance at December 31, 2002 ................ $ 103 $ 805 $ -- $ 908
=====================================================================================================
(1) Transfer due to a settlement of litigation with former joint venture
partners wherein we became the sole owner of two shopping centers.
85
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Condensed financial information of joint ventures reported on the equity
method is as follows:
CONDENSED COMBINED BALANCE SHEETS - JOINT VENTURES
December 31,
--------------------
(In Thousands) 2002 2001
---------------------------------------------------------------------------------
ASSETS
Cash ...................................................... $ 4,071 $ 725
Projects under development ................................ 44,170 10,817
Completed projects ........................................ -- 4,989
Other assets .............................................. 574 592
---------------------------------------------------------------------------------
$48,815 $17,123
=================================================================================
LIABILITIES AND EQUITY
Liabilities:
Notes payable to the Bank .............................. $20,742 $ 6,642
Notes payable to others ................................ -- 3,407
Other .................................................. 9,981 1,418
Equity:
DSL Service Company (1) ................................ 16,828 3,941
Allowance for losses recorded by DSL Service Company (2) -- --
Other partners (2) ..................................... 1,264 1,715
---------------------------------------------------------------------------------
Net equity ........................................... 18,092 5,656
---------------------------------------------------------------------------------
$48,815 $17,123
=================================================================================
(1) Included in these amounts are interest-bearing joint venture advances
with priority interest payments from joint ventures to DSL Service
Company.
(2) The aggregate other partners' equity of $1 million and $2 million at
December 31, 2002 and 2001, respectively, represents their equity
interest in the accumulated retained earnings of the respective joint
ventures. Those results include the net profit on sales and the
operating results of the real estate assets, net of depreciation and
funding costs. Except for any secured financing which has been
obtained, DSL Service Company has provided all other financing. As
part of Downey's internal asset review process, the fair value of the
joint venture real estate assets is compared to the secured notes
payable to the Bank and others and DSL Service Company's investment.
To the extent the fair value of the real estate assets is less than
the aggregate of those amounts, a provision is made to create a
valuation allowance. No valuation allowances were required at both
December 31, 2002 and 2001.
86
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
CONDENSED COMBINED STATEMENTS OF OPERATIONS - JOINT VENTURES
(In Thousands) 2002 2001 2000
------------------------------------------------------------------------------------------
Real estate sales:
Sales .......................................... $ 38,520 $ 1,009 $ 32,237
Cost of sales .................................. (26,758) (333) (26,021)
------------------------------------------------------------------------------------------
Net gains on sales ............................ 11,762 676 6,216
------------------------------------------------------------------------------------------
Rental operations:
Rental income .................................. 182 2,741 3,849
Operating expenses ............................. (239) (363) (901)
Interest, depreciation and other expenses ...... (2,056) (2,165) (3,131)
------------------------------------------------------------------------------------------
Net income (loss) on rental operations ........ (2,113) 213 (183)
------------------------------------------------------------------------------------------
Net income ......................................... 9,649 889 6,033
Less other partners' share of net income ........... 4,173 153 2,809
------------------------------------------------------------------------------------------
DSL Service Company's share of net income .......... 5,476 736 3,224
Provision for losses provided by DSL Service Company -- -- (1,505)
------------------------------------------------------------------------------------------
DSL Service Company's share of net income .......... $ 5,476 $ 736 $ 1,719
==========================================================================================
(7) REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS
The type and amount of real estate acquired in settlement of loans is
summarized as follows:
December 31,
--------------------
(In Thousands) 2002 2001
--------------------------------------------------------------------------
Residential one-to-four units ...................... $ 9,681 $ 8,450
Residential one-to-four units - subprime ........... 2,679 6,916
--------------------------------------------------------------------------
Total real estate acquired in settlement of loans $12,360 $15,366
==========================================================================
A summary of net operation of real estate acquired in settlement of loans
included in Downey's results of operations follows:
(In Thousands) 2002 2001 2000
---------------------------------------------------------------------------------------------------
Net gains on sales ............................................. $(2,231) $(1,811) $ (669)
Net operating expense .......................................... 1,634 1,533 1,075
Provision for estimated losses ................................. 608 517 412
---------------------------------------------------------------------------------------------------
Net operations of real estate acquired in settlement of loans $ 11 $ 239 $ 818
===================================================================================================
87
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(8) PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
December 31,
--------------------------
(In Thousands) 2002 2001
---------------------------------------------------------------------
Land .................................... $ 25,808 $ 25,282
Building and improvements ............... 99,236 95,521
Furniture, fixtures and equipment ....... 88,602 78,444
Construction in progress ................ 1,119 662
Other ................................... 62 62
---------------------------------------------------------------------
Total premises and equipment ......... 214,827 199,971
Accumulated depreciation and amortization (101,291) (88,209)
---------------------------------------------------------------------
Total premises and equipment, net .... $ 113,536 $ 111,762
=====================================================================
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. Rental expense was $3.8 million in 2002, $2.8
million in 2001 and $2.3 million in 2000. The following table summarizes
future minimum rental commitments under noncancelable leases.
(In Thousands)
---------------------------------------------
2003 ............................ $ 4,347
2004 ............................ 3,766
2005 ............................ 3,392
2006 ............................ 2,786
2007 ............................ 1,755
Thereafter (1) .................. 2,482
---------------------------------------------
Total future lease commitments $18,528
=============================================
(1) There are no lease commitments beyond the year 2011, though options to
renew at that time are available.
(9) FEDERAL HOME LOAN BANK STOCK
The Bank's required investment in FHLB stock, based on December 31, 2002
financial data, was $108 million. The investment in FHLB stock amounted to
$118 million and $113 million at December 31, 2002 and 2001, respectively.
88
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(10) MORTGAGE SERVICING RIGHTS
The following table summarizes the activity in mortgage servicing rights
and its related allowance for the years indicated and other related
financial data:
(Dollars in Thousands) 2002 2001 2000
---------------------------------------------------------------------------------------------------
Gross balance at beginning of period ............. $ 65,630 $ 46,214 $ 34,266
Additions ........................................ 53,236 44,391 18,510
Amortization ..................................... (14,435) (9,813) (5,968)
Sales of mortgage servicing rights ............... (1,354) (7,826) --
Impairment write-down ............................ (12,493) (7,336) (594)
---------------------------------------------------------------------------------------------------
Gross balance at end of period ................ 90,584 65,630 46,214
---------------------------------------------------------------------------------------------------
Allowance balance at beginning of period ......... 8,735 5,483 3
Provision for impairment ......................... 36,613 10,588 6,074
Impairment write-down ............................ (12,493) (7,336) (594)
---------------------------------------------------------------------------------------------------
Allowance balance at end of period ............ 32,855 8,735 5,483
---------------------------------------------------------------------------------------------------
Total mortgage servicing rights, net .......... $ 57,729 $ 56,895 $ 40,731
===================================================================================================
Estimated fair value (1) ......................... $ 57,736 $ 58,047 $ 41,826
Weighted average expected life (in months) ....... 43 82 82
Custodial account earnings rate .................. 1.61% 4.36% 6.35%
Weighted average discount rate ................... 8.35 9.16 9.78
===================================================================================================
AT PERIOD END
Mortgage loans serviced for others:
Total ......................................... $ 8,316,236 $ 5,805,811 $ 3,964,462
With capitalized mortgage servicing rights (1):
Amount ..................................... 8,036,393 5,379,513 3,779,562
Weighted average interest rate ............. 6.51% 6.97% 7.56%
===================================================================================================
Custodial escrow balances ........................ $ 15,243 $ 10,596 $ 8,207
===================================================================================================
(1) The estimated fair value may exceed book value for certain asset
strata and excluded loans sold or securitized prior to 1996 and loans
temporarily sub-serviced without capitalized mortgage servicing
rights.
Key assumptions, which vary due to changes in market interest rates and are
used to determine the fair value of mortgage servicing rights, include:
expected prepayment speeds, which impact the average life of the portfolio;
the earnings rate on custodial accounts, which impact the value of
custodial accounts; and the discount rate used in valuing future cash
flows. The following table summarizes the estimated changes in the fair
value of mortgage servicing rights for changes in those assumptions
individually and in combination associated with an immediate 100 basis
point increase or decrease in market rates. Also summarized is the earnings
impact associated with provisions for or reductions of the valuation
allowance for mortgage servicing rights. Impairment is measured on a
disaggregated basis based upon the predominant risk characteristics of the
underlying mortgage loans such as term and coupon. 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.
89
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
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 Value of
Prepayment Custodial Discount
(Dollars in Thousands) Speeds Accounts Rate Combination
-------------------------------------------------------------------------------------------------------------
Increase rates 100 basis points:
Increase (decrease) in fair value (1) ............... $ 38,696 $ 2,590 $ (4,770) $ 38,025
Reduction of (increase in) valuation allowance ...... 31,504 2,584 (4,770) 31,667
Decrease rates 100 basis points:
Increase (decrease) in fair value (2) ............... (20,693) (3,232) 4,468 (23,191)
Reduction of (increase in) valuation allowance ...... (20,693) (3,232) 4,346 (23,191)
=============================================================================================================
(1) The weighted-average expected life is 85 months.
(2) The weighted-average expected life is 26 months.
The components of loan servicing loss included in Downey's results of
operations are summarized as follows:
(In Thousands) 2002 2001 2000
----------------------------------------------------------------------
Income from servicing operations $ 11,419 $ 9,028 $ 8,414
Amortization of MSRs ........... (14,435) (9,813) (5,968)
Provision for impairment ....... (36,613) (10,588) (6,074)
----------------------------------------------------------------------
Total loan servicing loss, net $(39,629) $(11,373) $ (3,628)
======================================================================
(11) OTHER ASSETS
Other assets are summarized as follows:
December 31,
--------------------
(In Thousands) 2002 2001
-------------------------------------------------------------------------
Accounts receivable ............................... $ 3,819 $ 4,908
Accrued interest receivable:
Loans .......................................... 42,273 48,658
Mortgage-backed securities ..................... 9 601
Investment securities .......................... 4,612 8,174
Prepaid expenses .................................. 12,572 10,479
Expected rate lock commitments .................... 5,386 --
Designated forward sale contracts ................. -- 4,332
Excess of purchase price over fair value of
assets acquired and liabilities assumed, net (1) 3,150 3,150
Repossessed automobiles, net ...................... 6 19
Other ............................................. 4,212 5,126
-------------------------------------------------------------------------
Total other assets ............................. $76,039 $85,447
=========================================================================
(1) During the fourth quarter of 2002, Downey adopted SFAS 147, which
required Downey to cease the amortization of goodwill as of January 1,
2002 and to subject this asset to annual impairment testing. No
impairment existed at December 31, 2002.
90
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Upon the adoption of SFAS 147 on January 1, 2002, Downey ceased amortizing
its goodwill, which decreased noninterest expense and increased net income
in 2002 as compared to 2001 and 2000. The following table shows the impact
to net income on both an absolute and per share basis for 2002 and the pro
forma effects of applying SFAS 142 to years 2001 and 2000.
(In Thousands, Except Per Share Data) 2002 2001 2000
--------------------------------------------------------------------------------------------------------------
Amortization of excess cost over fair value of net assets acquired:
Pretax ......................................................... $ -- $ 457 $ 462
After-tax ...................................................... -- 264 266
Net income:
As reported .................................................... 112,293 120,181 99,251
Add back after-tax goodwill amortization ....................... -- 264 266
--------------------------------------------------------------------------------------------------------------
Pro forma ......................................................... $ 112,293 $ 120,455 $ 99,517
==============================================================================================================
Earnings per share - Basic:
As reported .................................................... $ 3.99 $ 4.26 $ 3.52
Add back after-tax goodwill amortization ....................... -- 0.01 0.01
--------------------------------------------------------------------------------------------------------------
Pro forma ......................................................... $ 3.99$ 4.27 $ 3.53
==============================================================================================================
Earnings per share - Diluted:
As reported .................................................... $ 3.99 $ 4.25 $ 3.51
Add back after-tax goodwill amortization ....................... -- 0.01 0.01
--------------------------------------------------------------------------------------------------------------
Pro forma ......................................................... $ 3.99 $ 4.26 $ 3.52
==============================================================================================================
91
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(12) DEPOSITS
Deposits are summarized as follows:
December 31,
-----------------------------------------------
2002 2001
-----------------------------------------------
Weighted Weighted
Average Average
(Dollars in Thousands) Rate Amount Rate Amount
-----------------------------------------------------------------------------------
Transaction accounts:
Non-interest-bearing checking . -- % $ 388,376 -- % $ 263,165
Interest-bearing checking (1) . 0.25 422,417 0.35 423,776
Money market .................. 1.37 120,105 2.01 108,747
Regular passbook .............. 1.70 3,639,798 2.46 2,131,048
-----------------------------------------------------------------------------------
Total transaction accounts . 1.41 4,570,696 1.92 2,926,736
Certificates of deposit:
Less than 2.00% ............... 1.57 919,864 1.94 99,654
2.00-2.49 ..................... 2.28 401,657 2.30 556,075
2.50-2.99 ..................... 2.79 528,557 2.74 315,125
3.00-3.49 ..................... 3.38 1,188,078 3.20 458,511
3.50-3.99 ..................... 3.89 700,250 3.84 532,634
4.00-4.49 ..................... 4.25 374,424 4.22 892,517
4.50-4.99 ..................... 4.80 473,399 4.76 555,885
5.00 and greater .............. 5.63 81,425 5.94 2,282,429
-----------------------------------------------------------------------------------
Total certificates of deposit 3.19 4,667,654 4.54 5,692,830
-----------------------------------------------------------------------------------
Total deposits ............ 2.31% $9,238,350 3.65% $8,619,566
===================================================================================
(1) Included amounts swept into money market accounts.
The aggregate amount of jumbo certificates of deposit with a minimum
denomination of $100,000 was $1.6 billion and $2.4 billion at December 31,
2002 and 2001, respectively.
At December 31, 2002, scheduled maturities of certificates of deposit are
as follows:
Weighted
(Dollars in Thousands) Average Rate Amount
-------------------------------------------------------
2003 ................. 2.92% $3,534,174
2004 ................. 3.04 377,890
2005 ................. 4.18 250,080
2006 ................. 4.72 134,257
2007 ................. 4.68 371,253
Thereafter ........... -- --
-------------------------------------------------------
Total ............. 3.19% $4,667,654
-------------------------------------------------------
The weighted average cost of deposits averaged 2.79%, 4.88% and 5.20%
during 2002, 2001 and 2000, respectively.
92
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
At December 31, 2002 and 2001 public funds of approximately $1 million and
$3 million, respectively, are secured by mortgage loans with a carrying
value of approximately $2 million and $4 million, respectively.
Interest expense on deposits by type is summarized as follows:
(In Thousands) 2002 2001 2000
--------------------------------------------------------------------
Interest-bearing checking (1) ... $ 1,391 $ 2,057 $ 3,520
Money market .................... 1,929 2,436 2,544
Regular passbook ................ 69,113 34,553 27,841
Certificate accounts ............ 172,108 385,809 345,398
--------------------------------------------------------------------
Total deposit interest expense $244,541 $424,855 $379,303
====================================================================
(1) Included amounts swept into money market deposit accounts.
Accrued interest on deposits, which is included in accounts payable and
accrued liabilities, was $1 million at December 31, 2002 and $2 million at
December 31, 2001.
(13) SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase are summarized as follows:
(Dollars in Thousands) 2002 2001 2000
------------------------------------------------------------------------------------------------------
Balance at year end ....................................... $ -- $ -- $ --
Average balance outstanding during the year ............... 7,494 -- 753
Maximum amount outstanding at any month-end during the year 182,358 -- 39,250
Weighted average interest rate during the year ............ 1.86% -- % 6.10%
Weighted average interest rate at year end ................ -- -- --
======================================================================================================
The securities collateralizing these transactions were delivered to major
national brokerage firms who arranged the transactions. Securities sold
under agreements to repurchase generally mature within 30 days of the
various dates of sale.
(14) FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS
FHLB advances are summarized as follows:
(Dollars in Thousands) 2002 2001 2000
-------------------------------------------------------------------------------------------------------
Balance at year end ....................................... $1,624,084 $1,522,705 $1,978,348
Average balance outstanding during the year ............... 1,403,268 1,216,495 2,117,787
Maximum amount outstanding at any month-end during the year 1,687,431 1,763,677 2,460,276
Weighted average interest rate during the year ............ 4.33% 5.40% 6.15%
Weighted average interest rate at year end ................ 3.88 3.73 6.26
As of year end secured by:
Loans receivable ....................................... $1,860,292 $1,791,068 $2,222,863
=======================================================================================================
In addition to the collateral securing existing advances, Downey had an
additional $2.4 billion in loans available at the FHLB as collateral for
any future advances as of December 31, 2002.
93
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
FHLB advances have the following maturities at December 31, 2002:
(In Thousands)
-------------------------------------
2003 .............. $ 413,934
2004 .............. 194,100
2005 .............. 415,750
2006 .............. 76,300
2007 .............. 65,000
Thereafter ........ 459,000
-------------------------------------
Total .......... $1,624,084
=====================================
Other borrowings are summarized as follows:
December 31,
---------------------------
(Dollars in Thousands) 2002 2001
---------------------------------------------------------------------------------------------------------
Long-term notes payable to banks, secured by real estate and mortgage loans
with a carrying value of $239 at December 31, 2001, bearing an interest
rate of 7.88% .......................................................... $ -- $ 7
=========================================================================================================
94
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(15) INCOME TAXES
Current income taxes payable were $9 million and $5 million at December 31,
2002 and 2001, respectively.
Deferred tax liabilities (assets) are comprised of the following temporary
differences between the financial statement carrying amounts and the tax
basis of assets:
December 31,
-------------------------
(In Thousands) 2002 2001
-------------------------------------------------------------------------------------
Deferred tax liabilities:
Mortgage servicing rights, net of allowances ......... $ 25,595 $ 25,193
Deferred loan costs .................................. 25,546 --
Tax reserves in excess of base year .................. 20,067 22,115
FHLB stock dividends ................................. 15,739 12,900
Deferred loan fees ................................... 9,102 7,720
Depreciation on premises and equipment ............... 2,775 2,290
Equity in joint ventures ............................. 2,613 2,424
Unrealized gains on investment securities ............ 880 357
Fair value adjustment on loans held for sale ......... -- 533
-------------------------------------------------------------------------------------
Total deferred tax liabilities .................... 102,317 73,532
-------------------------------------------------------------------------------------
Deferred tax assets:
Loan valuation allowances, net of bad debt charge-offs (16,136) (18,396)
California franchise tax ............................. (6,777) (7,173)
Deferred compensation ................................ (2,073) (2,126)
Derivative instrument adjustment ..................... (1,924) (533)
Fair value adjustment on loans held for sale ......... (1,606) --
Real estate and joint venture valuation allowances ... (332) (1,100)
Other deferred income items .......................... (3,389) (2,779)
-------------------------------------------------------------------------------------
Total deferred tax assets ......................... (32,237) (32,107)
Deferred tax assets valuation allowance .................. -- --
-------------------------------------------------------------------------------------
Net deferred tax liability ............................... $ 70,080 $ 41,425
=====================================================================================
Deferred loan costs include refund claims of $23 million filed by the Bank
related to loan origination costs that were originally capitalized in prior
years, and would be deductible under the claims. After initially allowing
the refunds, the Internal Revenue Service has stated its intent to
challenge the deductibility of these costs. The Bank has not recorded these
amounts as a reduction to income taxes, and has provided deferred taxes to
cover the potential disallowance of the claims.
95
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Income taxes are summarized as follows:
(In Thousands) 2002 2001 2000
------------------------------------------------------------------
Federal:
Current ..................... $33,290 $59,288 $48,714
Deferred .................... 27,785 6,071 5,567
------------------------------------------------------------------
Total federal income taxes $61,075 $65,359 $54,281
==================================================================
State:
Current ..................... $19,380 $20,493 $16,214
Deferred .................... 1,738 2,317 2,563
------------------------------------------------------------------
Total state income taxes . $21,118 $22,810 $18,777
==================================================================
Total:
Current ..................... $52,670 $79,781 $64,928
Deferred .................... 29,523 8,388 8,130
------------------------------------------------------------------
Total income taxes ....... $82,193 $88,169 $73,058
==================================================================
A reconciliation of income taxes to the expected statutory federal
corporate income taxes follows:
2002 2001 2000
----------------------------------------------------------------
(Dollars in Thousands) Amount Percent Amount Percent Amount Percent
------------------------------------------------------------------------------------------------------------------
Expected statutory income taxes ............... $68,070 35.0% $72,922 35.0% $60,308 35.0%
California franchise tax, net of federal income
tax benefit ................................ 13,727 7.1 14,827 7.1 12,206 7.1
Increase resulting from other items ........... 396 0.2 420 0.2 544 0.3
------------------------------------------------------------------------------------------------------------------
Income taxes .................................. $82,193 42.3% $88,169 42.3% $73,058 42.4%
==================================================================================================================
Downey made income and franchise tax payments, net of refunds, amounting to
$73.5 million, $78.0 million and $73.7 million in 2002, 2001 and 2000,
respectively.
Downey and its wholly owned subsidiaries file a consolidated federal income
tax return and various state income and franchise tax returns on a calendar
year basis. The Internal Revenue Service and state taxing authorities have
examined Downey's tax returns for all tax years through 1997. Management
believes it has adequately provided for potential exposure to issues that
may be raised by tax auditors in the years subsequent to 1997, which remain
open to review.
(16) CAPITAL SECURITIES
On July 23, 1999, Downey, through Downey Financial Capital Trust I (the
"Trust"), issued $120 million in 10.00% capital securities. The capital
securities, which were sold in a public underwritten offering, pay
quarterly cumulative cash distributions at an annual rate of 10.00% of the
liquidation value of $25 per share and are recorded as interest expense by
Downey. The capital securities represent undivided beneficial interests in
the Trust, which was established by Downey for the purpose of issuing the
capital securities. Downey owns all of the issued and outstanding common
securities of the Trust. Proceeds from the offering and from the issuance
of common securities were invested by the Trust in 10.00% Junior
Subordinated Deferrable Interest Debentures due September 15, 2029 issued
by Downey (the "Junior Subordinated Debentures"), with an aggregate
principal amount of $124 million. The sole asset of the Trust is the Junior
Subordinated Debentures. The obligations of the Trust with respect to the
securities are fully and unconditionally guaranteed by Downey. The payment
of distributions on the capital securities may be deferred if Downey defers
payments of interest on the junior subordinated debentures. Downey will
have the right, on one or more occasions, to defer payments of interest on
the junior subordinated debentures for up to 20 consecutive quarterly
periods. During the time Downey defers interest payments, interest on the
96
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
junior subordinated debentures will continue to accrue and distributions on
the capital securities will continue to accumulate and the deferred
interest and deferred distributions will themselves accrue interest at an
annual rate of 10.00%, compounded quarterly, to the extent permitted by
applicable law. Downey may redeem, in whole or in part, the junior
subordinated debentures before their maturity at a redemption price of 100%
of their principal amount plus accrued and unpaid interest on or after July
23, 2004.
Downey invested $108 million of the $115 million of net proceeds from the
sale of the Junior Subordinated Debentures (net of underwriting discounts
and commissions and other offering expenses) as additional common stock of
the Bank thereby increasing the Bank's regulatory core / tangible capital
by that amount. The balance of the net proceeds have been used for general
corporate purposes.
(17) STOCKHOLDERS' EQUITY
REGULATORY CAPITAL
Downey is not subject to any regulatory capital requirements. However, the
Bank is subject to regulation by the Office of Thrift Supervision ("OTS")
which has adopted regulations ("Capital Regulations") that contain a
capital standard for savings institutions. The Bank is in compliance with
the Capital Regulations at December 31, 2002 and 2001.
Under Prompt Corrective Action Provisions
------------------------------------------------------
To Be Adequately To Be Well
Actual Capitalized Capitalized
---------------------- ----------------------- ---------------------------
(Dollars in Thousands) Amount Ratio Amount Ratio Amount Ratio
-------------------------------------------------------------------------------------------------------------------
2002
Risk-based capital
(to risk-weighted assets) .. $859,445 14.08% $488,318 8.00% $610,398 10.00%
Core capital
(to adjusted assets) ....... 824,965 6.92 357,478 3.00 595,797 5.00
Tangible capital
(to adjusted assets) ....... 824,965 6.92 178,739 1.50 -- -- (1)
Tier I capital
(to risk-weighted assets) .. 824,965 13.52 -- -- (1) 366,239 6.00
===================================================================================================================
2001
Risk-based capital
(to risk-weighted assets) .. $819,875 14.53% $451,295 8.00% $564,119 10.00%
Core capital
(to adjusted assets) ....... 784,267 7.10 331,544 3.00 552,574 5.00
Tangible capital
(to adjusted assets) ....... 784,267 7.10 165,772 1.50 -- -- (1)
Tier I capital
(to risk-weighted assets) .. 784,267 13.90 -- -- (1) 338,471 6.00
===================================================================================================================
(1) Ratio is not specified under capital regulations.
CAPITAL DISTRIBUTIONS
The OTS rules impose certain limitations regarding stock repurchases and
redemptions, cash-out mergers and any other distributions charged against
an institution's capital accounts. The payment of dividends by the Bank is
subject to OTS regulations. Inasmuch as the Bank is owned by a holding
company, the Bank is required to provide the OTS with a notice before
payment of any dividend. Prior OTS approval is required to the extent the
Bank would not be considered adequately capitalized under the prompt
corrective action regulations of the OTS following the distribution or the
amount of the dividend exceeds the Bank's retained net income for that year
to date plus retained net income for the preceding two years.
97
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
As of December 31, 2002, the Bank had the capacity to declare a dividend
totaling $237 million without obtaining prior OTS approval.
TREASURY STOCK
On July 24, 2002, the Board of Directors of Downey authorized a share
repurchase program of up to $50 million of Downey's common stock. To fund
this program, the Bank paid a special $50 million dividend during the third
quarter to the holding company. The shares are being repurchased from
time-to-time in open market transactions. The timing, volume and price of
purchases will be made at the discretion of Downey, and will also be
contingent upon Downey's overall financial condition, as well as market
conditions in general. Since July 25, 2002, 306,300 shares of Downey's
common stock have been repurchased at an aggregate cost of $39.73 per
share. No shares were reissued during the year, leaving $38 million
available for future purchases.
EMPLOYEE STOCK OPTION PLANS
During 1994, the Bank adopted and the stockholders approved the Downey
Savings and Loan Association 1994 Long Term Incentive Plan (the "LTIP").
The LTIP 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 the Bank's common stock available for issuance under the LTIP. Effective
January 23, 1995, Downey Financial Corp. and the Bank executed an amendment
to the LTIP by which Downey Financial Corp. adopted and ratified the LTIP
such that shares of Downey Financial Corp. shall be issued upon exercise of
options or payment of other awards, for which payment is to be made in
stock, in lieu of the Bank's common stock. At December 31, 2002, the Bank
had 306,300 shares of treasury stock that may be used to satisfy the
exercise of options or for payment of other awards. No other stock based
plan exists.
No shares were granted under the LTIP since 1998.
Options outstanding under the LTIP at December 31, 2002 and 2001 are
summarized as follows:
Outstanding Options
---------------------------
Number Average
of Option
Shares Price
----------------------------------------------------
December 31, 1999 ..... 200,750 $ 20.66
Options granted ....... -- --
Options exercised ..... (57,332) 14.91
Options canceled ...... -- --
----------------------------------------------------
December 31, 2000 ..... 143,418 22.96
Options granted ....... -- --
Options exercised ..... (7,307) 22.01
Options canceled ...... (15,922) 25.44
----------------------------------------------------
December 31, 2001 ..... 120,189 22.69
Options granted ....... -- --
Options exercised ..... (21,974) 17.83
Options canceled ...... (5,740) 25.44
----------------------------------------------------
December 31, 2002 ..... 92,475 $ 23.67
====================================================
Under the LTIP, options are exercisable over vesting periods specified in
each grant and, unless exercised, the options terminate between 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.
98
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
At December 31, 2002, options for 92,475 shares were outstanding at a
weighted average remaining contractual life of five years, of which 76,583
options were exercisable at a weighted average option price per share of
$23.31 and 131,851 shares were available for future grants under the LTIP.
At December 31, 2001 and 2000, options of 82,667 and 71,214, respectively,
were exercisable at a weighted average option price per share of $21.44 and
$20.45, respectively.
Downey measures its employee stock-based compensation arrangements under
the provisions of APB 25. Accordingly, no compensation expense has been
recognized for the stock option plan. Had compensation expense for Downey's
stock option plan been determined based on the fair value estimated using
the Black-Scholes model at the grant date for previous awards, Downey's net
income and income per share would have been reduced to the pro forma
amounts indicated below:
(In Thousands, Except Per Share Data) 2002 2001 2000
-----------------------------------------------------------------------------------------------
Net income:
As reported ................................ $ 112,293 $ 120,181 $ 99,251
Stock based compensation expense, net of tax (13) (36) (79)
-----------------------------------------------------------------------------------------------
Pro forma .................................. 112,280 120,145 99,172
Earnings per share - Basic:
As reported ................................ $ 3.99 $ 4.26 $ 3.52
Pro forma .................................. 3.99 4.26 3.52
Earnings per share - Diluted:
As reported ................................ 3.99 4.25 3.51
Pro forma .................................. 3.99 4.25 3.51
===============================================================================================
(18) EARNINGS PER SHARE
Earnings per share of common stock is based on the weighted average number
of common and common equivalent shares outstanding, excluding common shares
in treasury. A reconciliation of the components used to derive basic and
diluted earnings per share for 2002, 2001 and 2000 follows:
Net Weighted Average Per Share
(Dollars in Thousands, Except Per Share Data) Income Shares Outstanding Amount
---------------------------------------------------------------------------------------------
2002:
Basic earnings per share ....... $ 112,293 28,128,013 $ 3.99
Effect of dilutive stock options -- 45,646 --
---------------------------------------------------------------------------------------------
Diluted earnings per share . $ 112,293 28,173,659 $ 3.99
=============================================================================================
2001:
Basic earnings per share ....... $ 120,181 28,211,587 $ 4.26
Effect of dilutive stock options -- 59,516 0.01
---------------------------------------------------------------------------------------------
Diluted earnings per share . $ 120,181 28,271,103 $ 4.25
=============================================================================================
2000:
Basic earnings per share ....... $ 99,251 28,177,152 $ 3.52
Effect of dilutive stock options -- 48,399 0.01
---------------------------------------------------------------------------------------------
Diluted earnings per share . $ 99,251 28,225,551 $ 3.51
=============================================================================================
There were no options excluded from the computation of earnings per share
due to anti-dilution.
99
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(19) EMPLOYEE BENEFIT PLANS
RETIREMENT AND SAVINGS PLAN
Downey amended its profit sharing plan (the "Plan") and restated it in its
entirety as of October 1, 1997. The Plan continues to qualify as both a
profit sharing plan and a qualified cash or deferred arrangement under
Internal Revenue Code Sections 401 (a) and 401 (k). Under the Plan, all
employees of Downey are eligible to participate provided they are 18 years
of age and have completed one year of service. Participants may contribute
up to 15% of their compensation each year, subject to limitations and
provisions in the Plan. Downey makes a matching contribution equal to 50%
of the participant's pretax contributions which do not exceed 6% of the
participant's annual compensation.
Prior to January 1, 2002, all employees of Downey were eligible to
participate provided they were 21 years of age and had completed one year
of service. Participants could contribute up to 15% of their compensation
each year, subject to limitations and provisions in the Plan. Downey made a
matching contribution equal to 25% of the participant's pretax
contributions which did not exceed 4% of the participant's annual
compensation. In addition, Downey made an annual discretionary profit
sharing contribution to the Plan based on Downey's net income. Allocation
of the discretionary contribution was based on points credited to each
eligible participant and salary. Points were credited based on the
employee's age and vested years of service.
Downey's contributions to the Plan totaled $1.6 million for 2002, compared
to $2.4 million in 2001 and $2.0 million in 2000.
Downey has a Deferred Compensation Plan for key management employees and
directors. The Deferred Compensation Plan is considered to be an essential
element in a comprehensive competitive benefits package designed to attract
and retain individuals who contribute to the success of Downey.
Participants are eligible to defer compensation on a pre-tax basis,
including director fees, and earn a competitive interest rate on the
amounts deferred. As of December 31, 2002, 93 management employees and
eight directors are eligible to participate in the program. During 2002, 16
management employees and one director elected to defer compensation
pursuant to the plan. Downey's expense related to the Deferred Compensation
Plan has been less than $0.1 million each year since inception. At December
31, 2002, the associated liability was $2.1 million.
GROUP BENEFIT PLAN
Downey provides certain health and welfare benefits for active employees
under a cafeteria plan (the "Benefit Plan") as defined by section 125 of
the Internal Revenue Code. Under the Benefit Plan, employees make
appropriate selections as to the type of benefits and the amount of
coverage desired. The benefits are provided through insurance companies and
other health organizations and are funded by contributions from Downey,
employees and retirees and include deductibles, co-insurance provisions and
other limitations. Downey's expense for health and welfare benefits was
$5.8 million, $4.3 million and $3.9 million in 2002, 2001 and 2000,
respectively.
100
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(20) COMMITMENTS, CONTINGENCIES AND HEDGING ACTIVITIES (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, a certain number of
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 December
31, 2002, Downey had a notional amount of expected rate lock commitments
identified to sell as part of its secondary marketing activities of $615
million, with an estimated fair value gain of $12.3 million, of which $6.9
million was associated with mortgage servicing rights not recognized in the
financial statements until the expected loans are sold.
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. Downey does not generally enter into derivative
transactions for purely speculative purposes. Contracts designated to loans
held for sale 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 to loans held for sale 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
December 31, 2002, the notional amount of forward sale contracts amounted
to $1.2 billion, with an estimated fair value loss of $12.5 million, of
which $624 million were designated as cash flow hedges. The notional amount
of forward purchase contracts amounted to $50 million, with an estimated
fair value gain of $0.6 million that partially offsets the loss on our
forward sale contracts not designated to loans held for sale.
Downey has not discontinued any designated derivative instruments
associated with loans held for sale due to a change in the probability of
settling a forecasted transaction.
101
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
The following table shows the impact from non-qualifying hedges and the
ineffectiveness of cash flow hedges on net gains (losses) on sales of loans
and mortgage-backed securities (i.e., SFAS 133 effect as adopted on January
1, 2001), as well as the impact to other comprehensive income (loss) from
qualifying cash flow transactions for the years indicated. Also shown is
the notional amount of expected rate lock commitment derivatives for loans
originated for sale, loans held for sale and the notional amounts for their
associated hedging derivatives (i.e., forward sale contracts).
December 31,
---------------------------
(In Thousands) 2002 2001
-------------------------------------------------------------------------------------------
Net gains (losses) on non-qualifying hedge transactions ....... $ 6,098 $ (5,964)
Net losses on qualifying cash flow hedge transactions:
Unrealized hedge ineffectiveness ........................... -- (467)
Less reclassification of realized hedge ineffectiveness .... -- 467
-------------------------------------------------------------------------------------------
Total net gains (losses) recognized in sales of loans and
mortgage-backed securities (SFAS 133 effect) .......... 6,098 (5,964)
Other comprehensive loss ...................................... (1,895) (727)
===========================================================================================
NOTIONAL AMOUNT AT PERIOD END
Non-qualifying hedge transactions:
Expected rate lock commitments ............................. $ 614,592 $ 269,315
Associated forward sale contracts .......................... 624,062 278,319
Associated forward purchase contracts ...................... 50,000 --
Qualifying cash flow hedge transactions:
Loans held for sale, at lower of cost or fair value ........ 652,052 499,024
Associated forward sale contracts .......................... 623,975 508,706
===========================================================================================
These forward 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--to such
agreements. 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, commitments to sell or purchase loans and
mortgage-backed securities, letters of credit, lines of credit and loans in
process. The contract or notional amounts of those instruments reflect the
extent of involvement Downey has in particular classes of financial
instruments.
Downey uses the same credit policies in making commitments to originate
loans, 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.
102
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
The following is a summary of commitments and contingent liabilities with
off-balance sheet risk:
December 31,
----------------------
(In Thousands) 2002 2001
----------------------------------------------------------------------------------
Commitments to originate loans held for investment:
Adjustable ........................................... $249,121 $322,209
Fixed ................................................ 716 --
Undisbursed loan funds and unused lines of credit ........ 189,283 137,151
Standby letters of credit and other contingent liabilities 2,662 2,640
==================================================================================
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 of the commitments may 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. Downey evaluates each customer's
creditworthiness on a case-by-case basis. Undisbursed loan funds and unused
lines of credit include home equity lines of credit and funds not
disbursed, but committed to construction and commercial lending by the
Bank.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party.
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.
In connection with its interest rate risk management, Downey may enter into
interest rate exchange agreements ("swap contracts") with certain national
investment banking firms under terms that provide mutual payment of
interest on the outstanding notional amount of the swap. The effect of
these swaps serve to reduce Downey's interest rate risk between repricing
assets and liabilities. At December 31, 2002, no swap contracts were
outstanding.
LITIGATION
Downey has been named as a defendant in legal actions arising in the
ordinary course of business, none of which, in the opinion of management,
is material.
(21) FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value estimates are made at a specific point in time based upon
relevant market information and other information about the financial
instrument. The estimates do not necessarily reflect the price Downey might
receive if it were to sell at one time its entire holding of a particular
financial instrument. Because no active market exists for a significant
portion of Downey's financial instruments, fair value estimates are based
upon the following methods and assumptions, some of which are subjective in
nature. Changes in assumptions could significantly affect the estimates.
CASH, FEDERAL FUNDS SOLD AND SECURITIES PURCHASED UNDER RESALE AGREEMENTS
The carrying amounts reported in the balance sheet for these items
approximate fair value.
INVESTMENT SECURITIES INCLUDING U.S. TREASURIES AND MORTGAGE-BACKED
SECURITIES
Fair value is based upon bid prices published in financial newspapers, or
bid quotations received from securities dealers or readily available market
quote systems.
103
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
LOANS RECEIVABLE
For residential mortgage loans, fair value is estimated based upon market
prices obtained from readily available market quote systems. The remaining
portfolio was segregated into those loans with variable rates of interest
and those with fixed rates of interest. For non-residential loans, fair
values are based on discounting future contractual cash flows using
discount rates offered for such loans with similar remaining maturities and
credit risk. The amounts so determined for each category of loan are
reduced by the associated allowance for loan losses which thereby takes
into consideration changes in credit risk.
INTEREST-BEARING ADVANCES TO JOINT VENTURES
The carrying amounts approximate fair value as the interest earned is based
upon a variable rate.
FEDERAL HOME LOAN BANK STOCK
The carrying amounts approximate fair value.
MORTGAGE SERVICING RIGHTS
The fair value of MSRs related to loans serviced for others is determined
by computing the present value of the expected net servicing income from
the portfolio.
DERIVATIVE ASSETS AND LIABILITIES
Fair values for expected rate lock commitments and loan forward sale and
purchase contracts are based on observable market prices acquired from
third parties.
DEPOSITS
The fair value of deposits with no stated maturity such as regular passbook
accounts, money market accounts and checking accounts, is the carrying
amount reported in the balance sheet. The fair value of deposits with a
stated maturity such as certificates of deposit is based on discounting
future contractual cash flows by discount rates offered for such deposits
with similar remaining maturities.
BORROWINGS
For short-term borrowings, fair value approximates carrying value. The fair
value of long-term borrowings is based on their interest rate
characteristics. For variable rate borrowings, fair values approximate
carrying values. For fixed rate borrowings, fair value is based on
discounting future contractual cash flows by discount rates paid on such
borrowings with similar remaining maturities.
CAPITAL SECURITIES
Fair value is based upon the closing stock price published in financial
information services or newspapers.
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS
Outstanding commitments to originate loans and mortgage-backed securities
held for investment, unused lines of credit, standby letters of credit and
other contingent liabilities are essentially carried at zero with a fair
value of approximately $7 million. See Note 20 on page 101, for information
concerning the notional amount of such financial instruments.
104
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
Based on the above methods and assumptions, the following table presents
the estimated fair value of Downey's financial instruments:
December 31, 2002 December 31, 2001
---------------------------------------------------------
Carrying Estimated Carrying Estimated
(In Thousands) Amount (1) Fair Value Amount (1) Fair Value
------------------------------------------------------------------------------------------------------------
ASSETS:
Cash ........................................... $ 123,524 $ 123,524 $ 106,079 $ 106,079
Federal funds .................................. 2,555 2,555 37,001 37,001
U.S. Government and agency obligations and other
investment securities available for sale ... 457,797 457,797 402,355 402,355
Municipal securities held to maturity .......... 6,216 6,202 6,388 6,373
Loans held for sale (2) ........................ 652,052 668,336 499,024 506,989
Mortgage-backed securities available for sale .. 2,253 2,253 118,981 118,981
Loans receivable held for investment:
Loans secured by real estate:
Residential:
Adjustable ............................. 9,888,816 10,040,990 8,913,248 9,113,797
Fixed .................................. 223,625 227,344 353,107 359,627
Other .................................... 135,835 143,978 160,557 171,726
Non-mortgage loans:
Commercial ............................... 7,063 7,780 12,951 13,547
Consumer ................................. 67,298 68,882 74,545 76,313
Interest-bearing advances to joint ventures .... 17,734 17,734 3,186 3,186
Federal Home Loan Bank stock ................... 117,563 117,563 113,139 113,139
Expected rate lock commitments (3) ............. 5,386 17,423 -- --
Designated forward sale contracts .............. -- -- 4,332 4,332
MSRs and loan servicing portfolio (4) .......... 57,729 58,168 56,895 58,880
LIABILITIES:
Deposits:
Transaction accounts ....................... 4,570,696 4,570,696 2,926,736 2,926,736
Certificates of deposit .................... 4,667,654 4,705,950 5,692,830 5,700,465
Expected rate lock commitments (3) ............. -- -- 600 (1,888)
Undesignated loan forward sale and purchase
contracts, net ............................. 4,173 4,173 630 630
Designated forward sale contracts .............. 7,711 7,711 -- --
Borrowings ..................................... 1,624,084 1,681,488 1,522,712 1,483,749
Capital securities ............................. 120,000 128,640 120,000 123,840
============================================================================================================
(1) The carrying amount of loans is stated net of undisbursed loan funds,
unearned fees and discounts and allowances for losses.
(2) Included capitalized basis adjustment reflecting the change in fair
value of the rate lock derivative from the date of commitment to the
date of funding.
(3) The estimated fair value included mortgage servicing rights totaling
$6.9 million at December 31, 2002 and $3.1 million at December 31,
2001 not to be recognized in the financial statements until the
expected loans are sold.
(4) The estimated fair value included mortgage servicing rights acquired
prior to January 1, 1996 when Downey began capitalizing the asset.
105
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(22) BUSINESS SEGMENT REPORTING
Downey views its business as consisting of two reportable business
segments--banking and real estate investment. The accounting policies of
the segments are the same as those described in Note 1, Summary of
Significant Accounting Policies on page 72. Downey evaluates performance
based on the net income generated by each segment. Internal expense
allocations between segments are independently negotiated and, where
possible, service and price is measured against comparable services
available in the external marketplace.
The following describes the two business segments.
BANKING
The principal business activities of this segment are attracting funds from
the general public and institutions and originating and investing in loans,
primarily residential real estate mortgage loans, mortgage-backed
securities and investment securities.
This segment's primary sources of revenue are interest earned on mortgage
loans and mortgage-backed securities, income from investment securities,
gains on sales of loans and mortgage-backed securities, fees earned in
connection with loans and deposits and income earned on its portfolio of
loans and mortgage-backed securities serviced for investors.
This segment's principal expenses are interest incurred on interest-bearing
liabilities, including deposits and borrowings, and general and
administrative costs.
REAL ESTATE INVESTMENT
Real estate development and joint venture operations are conducted
principally through the Bank's wholly owned service corporation subsidiary,
DSL Service Company.
DSL Service Company participates as an owner of, or a partner in, a variety
of real estate development projects, principally retail neighborhood
shopping center and residential developments, most of which are located in
California.
In its joint ventures, DSL Service Company is entitled to interest on its
equity invested in the project on a priority basis after third-party debt
and shares profits and losses with the developer partner, generally on an
equal basis. Partnership equity (deficit) accounts are affected by current
period results of operations, additional partner advances, partnership
distributions and partnership liquidations.
This segment's primary sources of revenue are net rental income and gains
from the sale of real estate investment assets. This segment's principal
expenses are interest expense and general and administrative expense.
106
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
OPERATING RESULTS AND ASSETS
The following table presents the operating results and selected financial
data by major business segments for 2002, 2001 and 2000:
Real Estate
(In Thousands) Banking Investment Elimination Totals
-------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2002
Net interest income ............................. $ 315,353 $ 45 $ -- $ 315,398
Provision for loan losses ....................... 939 -- -- 939
Other income .................................... 55,051 11,631 -- 66,682
Operating expense ............................... 185,859 796 -- 186,655
Net intercompany income (expense) ............... 343 (343) -- --
-------------------------------------------------------------------------------------------------------------
Income before income taxes ...................... 183,949 10,537 -- 194,486
Income taxes .................................... 77,875 4,318 -- 82,193
-------------------------------------------------------------------------------------------------------------
Net income ................................... $ 106,074 $ 6,219 $ -- $ 112,293
=============================================================================================================
AT DECEMBER 31, 2002
Assets:
Loans and mortgage-backed securities ........ $10,976,942 $ -- $ -- $10,976,942
Investments in real estate and joint ventures -- 33,890 -- 33,890
Other ....................................... 995,470 14,174 (42,325) 967,319
-------------------------------------------------------------------------------------------------------------
Total assets ............................. 11,972,412 48,064 (42,325) 11,978,151
-------------------------------------------------------------------------------------------------------------
Equity .......................................... $ 823,104 $ 42,325 $ (42,325) $ 823,104
=============================================================================================================
YEAR ENDED DECEMBER 31, 2001
Net interest income (expense) ................... $ 305,573 $ (3) $ -- $ 305,570
Provision for loan losses ....................... 2,564 -- -- 2,564
Other income .................................... 63,340 5,196 -- 68,536
Operating expense ............................... 159,604 3,588 -- 163,192
Net intercompany income (expense) ............... 369 (369) -- --
-------------------------------------------------------------------------------------------------------------
Income before income taxes ...................... 207,114 1,236 -- 208,350
Income taxes .................................... 87,660 509 -- 88,169
-------------------------------------------------------------------------------------------------------------
Net income .................................. $ 119,454 $ 727 $ -- $ 120,181
=============================================================================================================
AT DECEMBER 31, 2001
Assets:
Loans and mortgage-backed securities ........ $10,132,413 $ -- $ -- $10,132,413
Investments in real estate and joint ventures -- 38,185 -- 38,185
Other ....................................... 966,942 2,003 (34,513) 934,432
-------------------------------------------------------------------------------------------------------------
Total assets ............................. 11,099,355 40,188 (34,513) 11,105,030
-------------------------------------------------------------------------------------------------------------
Equity .......................................... $ 733,896 $ 34,513 $ (34,513) $ 733,896
=============================================================================================================
YEAR ENDED DECEMBER 31, 2000
Net interest income ............................. $ 262,232 $ 243 $ -- $ 262,475
Provision for loan losses ....................... 3,251 -- -- 3,251
Other income .................................... 41,406 9,148 -- 50,554
Operating expense ............................... 135,996 1,473 -- 137,469
Net intercompany income (expense) ............... 397 (397) -- --
-------------------------------------------------------------------------------------------------------------
Income before income taxes ...................... 164,788 7,521 -- 172,309
Income taxes .................................... 69,966 3,092 -- 73,058
-------------------------------------------------------------------------------------------------------------
Net income .................................. $ 94,822 $ 4,429 $ -- $ 99,251
=============================================================================================================
AT DECEMBER 31, 2000
Assets:
Loans and mortgage-backed securities ........ $10,084,353 $ -- $ -- $10,084,353
Investments in real estate and joint ventures -- 17,641 -- 17,641
Other ....................................... 806,201 3,584 (17,916) 791,869
-------------------------------------------------------------------------------------------------------------
Total assets ............................. 10,890,554 21,225 (17,916) 10,893,863
-------------------------------------------------------------------------------------------------------------
Equity .......................................... $ 624,636 $ 17,916 $ (17,916) $ 624,636
=============================================================================================================
107
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(23) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected unaudited quarterly financial data are presented below by quarter
for the years ended December 31, 2002 and 2001:
December 31, September 30, June 30, March 31,
(In Thousands, Except Per Share Data) 2002 2002 2002 2002
----------------------------------------------------------------------------------------------------------
Total interest income ................................ $ 158,291 $ 154,924 $ 153,425 $ 166,398
Total interest expense ............................... 74,938 77,952 78,297 86,453
----------------------------------------------------------------------------------------------------------
Net interest income ............................... 83,353 76,972 75,128 79,945
Provision for (reduction of) loan losses ............. 127 471 (1,106) 1,447
----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 83,226 76,501 76,234 78,498
Total other income (loss), net ....................... 35,993 (4,766) 4,102 31,353
Total operating expense .............................. 50,026 46,489 45,023 45,117
----------------------------------------------------------------------------------------------------------
Income before income taxes ........................... 69,193 25,246 35,313 64,734
Income taxes ......................................... 29,221 10,678 14,938 27,356
----------------------------------------------------------------------------------------------------------
Net income ........................................... $ 39,972 $ 14,568 $ 20,375 $ 37,378
==========================================================================================================
Net income per share:
Basic ............................................. $ 1.43 $ 0.52 $ 0.72 $ 1.32
Diluted ........................................... 1.43 0.52 0.72 1.32
==========================================================================================================
Market range:
High bid .......................................... $ 41.55 $ 49.25 $ 55.56 $ 48.83
Low bid ........................................... 31.32 33.34 46.70 41.84
End of period ..................................... 39.00 34.25 47.30 45.60
==========================================================================================================
December 31, September 30, June 30, March 31,
2001 2001 2001 2001
----------------------------------------------------------------------------------------------------------
Total interest income ................................ $ 183,484 $ 193,696 $ 211,235 $ 219,966
Total interest expense ............................... 103,769 120,249 134,989 143,804
----------------------------------------------------------------------------------------------------------
Net interest income ............................... 79,715 73,447 76,246 76,162
Provision for loan losses ............................ 1,290 791 431 52
----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 78,425 72,656 75,815 76,110
Total other income, net .............................. 33,170 7,070 22,283 6,013
Total operating expense .............................. 43,866 41,935 40,141 37,250
----------------------------------------------------------------------------------------------------------
Income before income taxes ........................... 67,729 37,791 57,957 44,873
Income taxes ......................................... 28,633 16,025 24,502 19,009
----------------------------------------------------------------------------------------------------------
Net income ........................................... $ 39,096 $ 21,766 $ 33,455 $ 25,864
==========================================================================================================
Net income per share:
Basic ............................................. $ 1.39 $ 0.77 $ 1.18 $ 0.92
Diluted ........................................... 1.39 0.77 1.18 0.91
==========================================================================================================
Market range:
High bid .......................................... $ 44.46 $ 58.81 $ 48.85 $ 54.31
Low bid ........................................... 32.98 40.61 41.44 39.45
End of period ..................................... 41.25 44.13 47.26 45.30
==========================================================================================================
Variation in total other income (loss) was primarily due to changes in the
valuation allowance for mortgage servicing rights and net gains on sales of
loans and mortgage-backed securities.
108
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
(24) PARENT COMPANY FINANCIAL INFORMATION
Downey Financial Corp. was incorporated in Delaware on October 21, 1994. On
January 23, 1995, after obtaining necessary stockholder and regulatory
approvals, Downey Financial Corp. acquired 100% of the issued and
outstanding capital stock of the Bank, and the Bank's stockholders became
stockholders of Downey Financial Corp. The transaction was accounted for in
a manner similar to a pooling-of-interests. Downey Financial Corp. was
thereafter funded by a $15 million dividend from the Bank. Condensed
financial statements of Downey Financial Corp. only are as follows:
CONDENSED BALANCE SHEETS
December 31,
-----------------------
(In Thousands) 2002 2001
-------------------------------------------------------------
ASSETS
Cash ................................ $ 11 $ 12
Due from Bank - interest bearing .... 65,360 22,215
Investment in subsidiaries:
Bank ............................. 873,851 827,381
Downey Financial Capital Trust I . 3,711 3,711
Downey Affiliated Insurance Agency 207 204
Other assets ........................ 4,859 5,183
-------------------------------------------------------------
$947,999 $858,706
=============================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Junior subordinated debentures ...... $123,711 $123,711
Accounts payable and accrued expenses 1,184 1,099
-------------------------------------------------------------
Total liabilities ................ 124,895 124,810
Stockholders' equity ................ 823,104 733,896
-------------------------------------------------------------
$947,999 $858,706
=============================================================
109
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
CONDENSED STATEMENTS OF INCOME
AND OTHER COMPREHENSIVE INCOME
Years Ended December 31,
-------------------------------------
(In Thousands) 2002 2001 2000
-------------------------------------------------------------------------------------------------------
INCOME
Dividends from the Bank ....................................... $ 71,984 $ 21,984 $ 21,985
Interest income ............................................... 634 700 933
Other income .................................................. 59 59 59
-------------------------------------------------------------------------------------------------------
Total income ............................................... 72,677 22,743 22,977
-------------------------------------------------------------------------------------------------------
EXPENSE
Interest expense .............................................. 12,163 12,163 12,163
General and administrative expense ............................ 981 940 816
-------------------------------------------------------------------------------------------------------
Total expense .............................................. 13,144 13,103 12,979
-------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED
NET INCOME OF SUBSIDIARIES ................................. 59,533 9,640 9,998
Income tax benefit ............................................ 5,104 5,061 4,895
-------------------------------------------------------------------------------------------------------
INCOME BEFORE EQUITY IN UNDISTRIBUTED NET INCOME
OF SUBSIDIARIES ............................................ 64,637 14,701 14,893
Equity in undistributed net income of subsidiaries ............ 47,656 105,480 84,358
-------------------------------------------------------------------------------------------------------
NET INCOME ................................................. 112,293 120,181 99,251
-------------------------------------------------------------------------------------------------------
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 . 61 705 2,032
Mortgage-backed securities available for sale, at fair value 935 (714) 173
Less reclassification of realized (gains) losses
included in net income .................................. (284) (190) 50
Unrealized losses on cash flow hedges:
Net derivative instruments ................................. (11,434) (5,981) --
Less reclassification of realized losses
included in net income .................................. 9,539 5,254 --
-------------------------------------------------------------------------------------------------------
Total other comprehensive income (loss), net of
income taxes (benefits) .................................... (1,183) (926) 2,255
-------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME .......................................... $ 111,110 $ 119,255 $ 101,506
=======================================================================================================
110
DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)
CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31,
--------------------------------------
(In Thousands) 2002 2001 2000
---------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income ......................................... $ 112,293 $ 120,181 $ 99,251
Equity in undistributed net income of subsidiaries . (47,656) (105,480) (84,358)
Increase (decrease) in liabilities ................. 85 30 (639)
(Increase) decrease in other, net .................. 324 (155) (13)
---------------------------------------------------------------------------------------------
Net cash provided by operating activities ....... 65,046 14,576 14,241
---------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Increase in due from Bank - interest bearing ....... (43,145) (4,580) (4,949)
---------------------------------------------------------------------------------------------
Net cash used for investing activities .......... (43,145) (4,580) (4,949)
---------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Exercise of stock options .......................... 392 161 855
Dividends on common stock .......................... (10,124) (10,156) (10,143)
Purchase of treasury stock ......................... (12,170) -- --
---------------------------------------------------------------------------------------------
Net cash used for financing activities .......... (21,902) (9,995) (9,288)
---------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (1) 1 4
Cash and cash equivalents at beginning of period ... 12 11 7
---------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ......... $ 11 $ 12 $ 11
=============================================================================================
(25) SALE OF SUBSIDIARY
On February 29, 2000, Downey Savings and Loan Association, F.A. sold its
indirect automobile finance subsidiary, Downey Auto Finance Corp., to Auto
One Acceptance Corp., a subsidiary of California Federal Bank and
recognized a pre-tax gain from the sale of $9.8 million. As of December 31,
1999, Downey Auto Finance Corp. had loans totaling $366 million and total
assets of $373 million. The proceeds of the sale provided additional
capital to further the growth of our residential lending business.
111
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Downey Financial Corp. intends to file with the Securities and Exchange
Commission a definitive proxy statement (the "Proxy Statement") pursuant to
Regulation 14A, which will involve the election of directors, within 120 days of
the end of the year covered by this Form 10-K. Information regarding directors
of Downey Financial Corp. will appear under the caption "Proposal 1. Election of
Directors" in the Proxy Statement for the Annual Meeting of Stockholders to be
held on April 23, 2003, and is incorporated herein by this reference.
Information regarding executive officers of Downey Financial Corp. will appear
under the caption "Executive Officers" in the Proxy Statement and is
incorporated herein by this reference.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation will appear under the caption
"Executive Compensation" in the Proxy Statement and is incorporated herein by
this reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Information included under the captions "Security Ownership of Certain
Beneficial Owners" and "Equity Compensation Plan Information" in the Proxy
Statement is incorporated herein by this reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information included under the caption "Certain Relationships and Related
Transactions" in the Proxy Statement is incorporated herein by this reference.
ITEM 14. CONTROLS AND PROCEDURES
Within the 90 days prior to the date of this report, 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 Exchange Act Rule 13a-14. 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 required to be included
in Downey's periodic Securities and Exchange Commission filings. There has been
no significant changes in Downey's internal controls or in other factors that
could significantly affect these controls subsequent to the evaluation date.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements. These documents are listed in the Index to
Consolidated Financial Statements under Item 8.
2. Financial Statement Schedules. Financial Statement Schedules have been
omitted because they are not applicable or the required information is
shown in the Consolidated Financial Statements or Notes thereto.
112
(b) Reports on Form 8-K during the last quarter of 2002.
1. Form 8-K filed October 16, 2002, with respect to a press release
reporting results of operations for the three and nine months ended
September 30, 2002.
2. Form 8-K filed November 18, 2002, with respect to a press release
reporting monthly selected financial data for the thirteen months
ended October 31, 2002.
3. Form 8-K filed December 17, 2002, with respect to a press release
reporting monthly selected financial data for the thirteen months
ended November 30, 2002.
(c) Exhibits.
EXHIBIT
NUMBER DESCRIPTION
3.1 (2) Certificate of Incorporation of Downey Financial Corp.
3.2 (1) Bylaws of Downey Financial Corp.
4.1 (4) Junior Subordinated Indenture dated as of July 23, 1999 between
Downey Financial Corp. and Wilmington Trust Company as Indenture
Trustee.
4.2 (4) 10% Junior Subordinated Debenture due September 15, 2029,
Principal Amount $123,711,350.
4.3 (4) Certificate of Trust of Downey Financial Capital Trust I, dated as
of May 25, 1999.
4.4 (4) Trust Agreement of Downey Financial Capital Trust I, dated May 25,
1999.
4.5 (4) Amended and Restated Trust Agreement of Downey Financial Capital
Trust I, between Downey Financial Corp., Wilmington Trust Company and
the Administrative Trustees named therein, dated as of July 23, 1999.
4.6 (4) Certificate Evidencing Common Securities of Downey Financial
Capital Trust I, 10% Common Securities.
4.7 (4) Certificate Evidencing Capital Securities of Downey Financial
Capital Trust I, 10% Capital Securities (Global Certificate).
4.8 (4) Common Securities Guarantee Agreement of Downey Financial Corp.
(Guarantor), dated July 23, 1999.
4.9 (4) Capital Securities Guarantee Agreement of Downey Financial Corp.
and Wilmington Trust Company, dated as of July 23, 1999.
10.1 (3) Downey Savings and Loan Association, F.A. Employee Stock Purchase
Plan (Amended and Restated as of January 1, 1996).
10.2 (3) Amendment No. 1, Downey Savings and Loan Association, F.A.
Employee Stock Purchase Plan. Amendment No. 1, Effective and Adopted
January 22, 1997.
10.3 (3) Downey Savings and Loan Association, F.A. Employees' Retirement
and Savings Plan (October 1, 1997 Restatement).
10.4 (3) Amendment No. 1, Downey Savings and Loan Association, F.A.
Employees' Retirement and Savings Plan (October 1, 1997 Restatement)
Amendment No. 1, Effective and Adopted January 28, 1998.
10.5 (3) Trust Agreement for Downey Savings and Loan Association, F.A.
Employees' Retirement and Savings Plan, Effective October 1, 1997
between Downey Savings and Loan Association, F.A. and Fidelity
Management Trust Company.
113
(c) Exhibits (Continued)
EXHIBIT
NUMBER DESCRIPTION
10.6 (2) Downey Savings and Loan Association 1994 Long-Term Incentive Plan
(as amended).
10.10(1) Founder Retirement Agreement of Maurice L. McAlister, dated
December 21, 1989.
10.11(5) Amendment No. 1, Founders Retirement Agreement of Maurice L.
McAlister, dated December 21, 1989. Amendment No. 1, Effective and
Adopted July 26, 2000.
10.13 (6) Deferred Compensation Program.
10.14 (6) Director Retirement Benefits.
10.15 Director Retirement Benefits Agreement of Sam Yellen, dated
January 15, 2003.
21 Subsidiaries.
23 Consent of Independent Auditors.
99.1 Certification of Chief Executive Officer pursuant to Section 906 of
Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer pursuant to Section 906 of
Sarbanes-Oxley Act of 2002.
(1) Filed as part of Downey's Registration Statement on Form 8-B/A filed January
17, 1995.
(2) Filed as part of Downey's Registration Statement on Form S-8 filed February
3, 1995.
(3) Filed as part of Downey's report on Form 10-K filed March 16, 1998.
(4) Filed as part of Downey's report on Form 10-Q filed November 2, 1999.
(5) Filed as part of Downey's report on Form 10-Q filed August 2, 2000.
(6) Filed as part of Downey's report on Form 10-K filed March 7, 2001.
AVAILABILITY OF REPORTS
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 available free of charge from
our internet site, www.downeysavings.com, by clicking on "Investor Relations"
located on our home page and proceeding to "Corporate Filings."
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
114
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.
By: /s/ DANIEL D. ROSENTHAL
-----------------------------------
Daniel D. Rosenthal
President and Chief Executive Officer
Director
DATED: March 6, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ MAURICE L. MCALISTER Chairman of the Board March 6, 2003
------------------------
Maurice L. McAlister Director
/s/ CHERYL E. OLSON Vice Chairman of the Board March 6, 2003
------------------------
Cheryl E. Olson Director
/s/ DANIEL D. ROSENTHAL President and March 6, 2003
------------------------ Chief Executive Officer
Daniel D. Rosenthal Director
/s/ THOMAS E. PRINCE Executive Vice President March 6, 2003
------------------------ Chief Financial Officer
Thomas E. Prince (Principal Financial and
Accounting Officer)
/s/ MICHAEL ABRAHAMS Director March 6, 2003
------------------------
Michael Abrahams
/s/ JAMES H. HUNTER Director March 6, 2003
------------------------
James H. Hunter
/s/ DR. PAUL KOURI Director March 6, 2003
------------------------
Dr. Paul Kouri
/s/ BRENT MCQUARRIE Director March 6, 2003
------------------------
Brent McQuarrie
/s/ LESTER C. SMULL Director March 6, 2003
------------------------
Lester C. Smull
------------------------ Director March 6, 2003
Gerald E. Finnell
115
CERTIFICATION PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Daniel D. Rosenthal, certify that:
1. I have reviewed this annual report on Form 10-K of Downey Financial Corp.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 6, 2003 /s/ Daniel D. Rosenthal
-------------------------------------
Daniel D. Rosenthal
President and Chief Executive Officer
116
CERTIFICATION PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Thomas E. Prince, certify that:
1. I have reviewed this annual report on Form 10-K of Downey Financial Corp.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 6, 2003 /s/ Thomas E. Prince
----------------------------------------------------
Thomas E. Prince
Executive Vice President and Chief Financial Officer
117