Downey Seized, Sold to U.S. Bancorp as Mortgage Fallout Spreads

By Ari Levy and Finbarr Flynn

Nov. 22 (Bloomberg) -- Seizure and sale of Downey Financial Corp. and two smaller lenders may cost the FDIC more than $2 billion as foreclosures rise and home prices extend declines in the worst housing slump since the Great Depression.

U.S. Bancorp acquired Downey and smaller PFF Bank & Trust, California thrifts crippled by bad mortgages, yesterday in a deal brokered by the Federal Deposit Insurance Corp. Community Bank of Loganville, Georgia, was also closed and its $611.4 million of deposits taken over by Bank of Essex in Tappahannock, Virginia.

Regulators this year have closed the most banks since 1993 as mortgage defaults and tightening credit froze markets. The collapse of IndyMac Bancorp Inc. was among the biggest in history, costing the FDIC $8.9 billion. The agency expects Downey’s demise to deplete its Deposit Insurance Fund by $1.4 billion, with PFF costing $700 million and Community $240 million.

“The restructuring or consolidation of the U.S. banking industry has probably just begun,” said Neil Katkov, senior vice president of Celent, a Boston-based financial research firm. “There’s a whole world of potential mergers and acquisitions that will continue to emerge like these one.”

Downey Financial, based in Newport Beach, California, lost about $680 million on mortgages in the past five quarters. The lender is the last of the five biggest sellers of option adjustable-rate mortgages to fail or be sold.

Those loans, which let borrowers defer part of the monthly payment and add it to the principal, leave banks vulnerable to defaults when housing prices fall because the size of the mortgage can rise beyond the value of the property.

‘More Trouble’

“We’ll probably see more regional and community banks get into trouble,” Katkov said.

Loans no longer collecting interest surged to 15.7 percent of assets from 2.9 percent a year ago, Downey said Oct. 22, in reporting an $81.1 million third-quarter loss. At the end of the previous period, Downey held $6.9 billion in option ARMs.

Housing prices in California declined by 41 percent in September, the 12th straight monthly fall, the California Association of Realtors said in October. In its annual housing forecast, the group said home prices in the state will drop another 6 percent next year.

“With the deterioration in the economy and especially the California economy, it suggests even more losses are coming” in Downey’s portfolio, James Barth, former chief economist at the Office of Thrift Supervision and professor of finance at Auburn University in Alabama, said in an interview before the takeover was announced.

California

For Minneapolis-based U.S. Bancorp, the takeovers add approximately $12.8 billion of assets and $11.3 billion of liabilities, the bank said in a statement. The lender’s share of deposits and network in southern California markets more than doubles, with 170 Downey branches in California and five in Arizona, along with 38 PFF Bank California outlets.

Bank of Essex will buy about $84.4 million of failed Community Bank’s $681 million in assets, with the FDIC retaining the rest for later disposition. It paid a premium of $3.2 million to assume the deposits, the FDIC said. Community Bank’s four offices will open Nov. 24 as Bank of Essex branches.

The FDIC oversees 8,451 institutions with $13.3 trillion in assets, and insures deposits of as much as $250,000 per depositor per bank and the same amount for retirement accounts. The agency has proposed doubling premiums charged to banks for coverage to replenish its reserves amid agency forecasts that bank failures through 2013 will cost almost $40 billion.

‘Problem’ Banks

The FDIC in August said 117 banks were classified as “problem” in the second quarter, a 30 percent jump from the first quarter. The agency, which doesn’t name “problem” lenders, will update its assessment on Nov. 25 while reporting on the industry’s third-quarter financial results.

“Earnings will again be substantially below the prior year,” FDIC Chairman Sheila Bair said yesterday in a Baltimore speech. “But despite the problems facing our economy, the vast majority of banks remain well-capitalized, profitable, and in sound condition.”

Washington Mutual, the biggest savings and loan, sold its assets to JPMorgan Chase & Co. Sept. 25 after customers drained $16.7 billion in deposits in less than two weeks. Wachovia Corp., the sixth-biggest bank, was pushed by regulators to sell itself to Wells Fargo & Co. for $11.7 billion or face collapse.

The Treasury bought preferred shares in nine banks: Wells Fargo, JPMorgan, Citigroup Inc., Bank of America Corp., Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group Inc., Bank of New York Mellon Corp. and State Street Corp.

Option-ARMs

Separately, Hartford Financial Services Group Inc. and Genworth Financial Inc., two of the world’s biggest life insurers, are planning to acquire savings and loans. Lincoln National Corp. and Aegon NV, owner of Transamerica Corp., are seeking status as saving-and-loan holding companies. The insurers are taking the step to improve their chances of tapping the U.S. rescue package.

Downey was fourth biggest seller of option-ARMs, ahead of IndyMac and behind Wachovia, Washington Mutual and Countrywide Financial Corp., now part of Bank of America Corp.

Downey named Charles Rinehart chief executive officer on Sept. 22 to help orchestrate a rebound. Rinehart, 61, assumed the duties of Thomas Prince, who was interim CEO since July when Daniel Rosenthal stepped down.

Co-founder Maurice L. McAlister quit as chairman the same day Rosenthal -- his son-in-law -- lost his job. His daughter Cheryl E. Olson retired as vice chairman in December 2007. McAlister had helped run the bank for 50 years after establishing the business with Gerald H. McQuarrie, who died in 1992, according to the company.

Downey Savings and Loan opened its doors in 1957 with an office in Downey, California, in Los Angeles County.

To contact the reporter on this story: Ari Levy in San Francisco at alevy5@bloomberg.net; Finbarr Flynn in Tokyo at fflynn3@bloomberg.net