Downey Financial Corp.’s third-quarter net income surged 143.7% from a year earlier, to $59.7 million, but negative amortization of its option ARMs accelerated.
The Newport Beach, Calif., thrift company, a longtime player in the now red-hot option ARM product, held $12.6 billion of such mortgages on Sept. 30, up 5% from June 30 and up 23% from a year earlier. Analysts say that in recent months about three-quarters of all option ARM borrowers have been making minimum payments that do not cover interest owed.
Downey’s outstanding deferred interest, or total negative amortization, grew $27 million during the third quarter, compared with a $35 million rise in the first six months of this year. Deferred interest rose to 0.78% of option ARM balances on Sept. 30 from 0.36% at yearend.
Scott Carmel, a Moors & Cabot Inc. analyst, said the growth of deferred interest indicates that many of the borrowers simply cannot afford their loans as rates rise. “We worry that could foreshadow credit problems,” said Mr. Carmel, who rates Downey a “sell” because of its option ARM focus and his expectation that industry originations will decline.
In an interview, Thomas E. Prince, Downey’s chief operating officer and CFO, disagreed with Mr. Carmel’s analysis. He stressed that the average loan-to-value ratio on its option ARMs at origination was 69%. “There’s a lot of equity in these loans at origination” and “since origination, some of these properties have [even] higher values,” he said.
Mr. Prince also said that negative amortization “is not at high levels at this point compared to history,” referring to past periods of rising short-term rates.
Downey’s earnings release Tuesday was the first in which it disclosed extensive data on the ARMs. It previously waited until quarterly securities filings to do so.
Per-share earnings of $2.14 handily topped the average analyst estimate of $1.75. They got a boost from a $1.9 million rise in the value of servicing rights (versus a $16.7 million loss a year earlier) due to higher interest rates. Also, gains on loans and securities sales nearly doubled, to $29.5 million, as Downey sold more loans, and at better margins, than a year earlier. And prepayments boosted loan fees.
Downey reduced loan-loss provisions by $800,000 after adding $1.1 million to them in the year-earlier period. It cited the recovery of $400,000 from a charged-off asset and a decline in loans that are not one-to-four-family mortgages.
Mr. Carmel said the drop was consistent with what is happening at many banks — given “still very benign” credit trends — but that a need to add provisions should create “earnings headwind” next year.
Mr. Prince said: “Who knows what the future is? But if you look at it, our annualized chargeoffs for the last couple of years have been less than 1 basis point.” He noted that Downey’s loss allowance rose slightly both from a year earlier and from yearend, to $36 million.
