| DOWNEY FINANCIAL CORP ITEM 1A RISK FACTORS In addition to the other information contained in this annual report, the following risks may affect us |
| If any of these risks occur, our business, financial condition, results of operations, cash flows and prospects could be adversely affected |
| Changes in economic conditions could adversely affect our business |
| Our business is directly affected by factors such as economic, political and market conditions; broad trends in the industry and finance; legislative and regulatory changes; changes in government monetary and fiscal policies; and inflation, all of which are beyond our control |
| We are principally affected by economic conditions in the state of California where our business is concentrated |
| Deterioration in economic conditions could result in the following consequences, any of which could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects: * problem assets and foreclosures may increase; * demand for our products and services may decline; * low cost or non-interest bearing deposits may decrease; * collateral for potential loans, especially real estate, may decline in value, in turn reducing customers’ borrowing power; and * the value of assets and collateral associated with our existing loans may decline |
| In view of the concentration of our operations and the collateral securing our loan portfolio in California, we may be particularly susceptible to the adverse effects from any of these consequences, which could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance |
| A substantial portion of our income is derived from the differential or "e spread "e between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities |
| Because of differences in the maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities |
| Changes in interest rates also affect the value of our recorded MSRs on loans we service for others, generally increasing in value as interest rates rise and declining as interest rates fall |
| Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and other income and, in turn, our profitability |
| At December 31, 2005, our balance sheet was asset sensitive and, as a result, our net interest margin will tend to expand in a rising interest rate environment and contract in a declining interest rate environment |
| For additional information, see Asset/Liability Management and Market Risk on page 51 |
| In addition, loan origination volumes and loan repayment rates are affected by market interest rates |
| Rising interest rates, generally, are associated with a lower volume of loan originations and declining repayment rates, while falling interest rates are usually associated with higher loan originations and increasing repayment rates |
| In addition, in a rising interest rate environment, we may need to accelerate the pace of rate increases on our deposit accounts as compared to the pace of increases in loan rates |
| Accordingly, changes in levels of market interest rates could adversely affect our net interest spread, other income, loan origination volume, business, financial condition, results of operations, cash flows and prospects |
| The types of loans in our portfolio have a higher degree of risk and a downturn in our real estate markets could adversely affect our business |
| A downturn in our real estate markets could adversely affect our business |
| As of December 31, 2005, approximately 98prca of the book value of our loan portfolio consisted of loans collateralized by various types of real estate, of which 90prca were subject to negative amortization |
| A negative amortization loan is one in which accrued interest exceeding the required monthly loan payment is added to loan principal |
| If a loan incurs significant negative amortization, the loan-to-value ratio could rise, which increases the Bank’s credit risk exposure and its susceptibility to a downturn in our real estate market |
| For further information regarding loans subject to negative amortization and their contractual terms, see Residential Real Estate Lending on page 3 |
| Page 20 ____________________________ [24]Navigation Links Real estate values and real estate markets are generally affected by changes in national, regional and local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies and acts of nature |
| Most of our real estate collateral is located in California |
| If California real estate prices decline significantly, the value of real estate collateral securing our loans will be reduced and provide less security |
| Our ability to recover our investment on defaulted loans by foreclosing and selling the real estate collateral would then be diminished, and we would be more likely to suffer losses on defaulted loans |
| Real estate values could also be affected by, among other things, earthquakes and natural disasters particular to California |
| Any such downturn could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| We are exposed to credit risk with respect to underwriting guidelines related to income and asset verifications that could adversely affect our business |
| Our business could be hurt by a downturn in real estate markets from a concentration of loan products offered associated with particular underwriting guidelines related to income and asset verifications |
| At December 31, 2005, approximately 76prca of our residential one-to-four unit loans held for investment were originated based on income as stated by the borrower and asset verification, while an additional 11prca were underwritten with no verification of either borrower income or assets |
| To the extent the borrower overstated their income and/or assets, the ability of the borrower to repay their loan may be impaired, which could adversely affect the quality of our loan portfolio and financial condition, results of operations, cash flows and prospects |
| For further information regarding credit risk in our residential one-to-four unit investment loan portfolio, see Loans and Mortgage-Backed Securities on page 40 |
| We are subject to extensive government regulation |
| These regulations may hamper our ability to increase our assets and earnings |
| Our operations and those of the Bank are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations |
| The laws, rules and regulations applicable to us are subject to regular modification and change |
| There are currently proposed various laws, rules and regulations that, if adopted, would impact our operations |
| We cannot assure you that these proposed laws, rules and regulations or any other laws, rules or regulations will not be adopted in the future, which could make compliance much more difficult or expensive, restrict our ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by us or otherwise adversely affect our business, financial condition, results of operations or cash flows and prospects |
| We are exposed to risk of environmental liabilities with respect to properties to which we take title |
| In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties |
| We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean-up hazardous or toxic substances, or chemical releases at a property |
| The costs associated with investigation or remediation activities could be substantial |
| In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property |
| Becoming subject to significant environmental liabilities could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| If we cannot attract deposits or obtain borrowings, our growth may be inhibited |
| Our ability to increase our asset base depends in large part on our ability to attract additional deposits and obtain borrowings at favorable rates |
| We intend to seek additional deposits by offering deposit products that are competitive with those offered by other financial institutions in our markets and by establishing personal relationships with our customers |
| We cannot assure you that these efforts will be successful |
| Although we are not aware of any trends, events or uncertainties, our ability to obtain borrowings could be diminished |
| Our inability to attract additional deposits or obtain borrowings at competitive rates could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| Page 21 ____________________________ [25]Navigation Links Our allowance for loan losses or loan sale indemnification reserve may not be adequate to cover actual losses |
| A significant source of risk arises from the possibility that we could sustain losses because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans |
| The underwriting and credit monitoring policies and procedures that we have adopted to address this risk may not prevent unexpected losses that could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| Unexpected losses may arise from a wide variety of specific or systemic factors, many of which are beyond our ability to predict, influence or control |
| As all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance |
| Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could adversely affect our business, financial condition, results of operations, cash flows and prospects |
| The allowance for loan losses reflects our estimate of the probable losses in our loan portfolio at the relevant balance sheet date |
| Our allowance for loan losses is based on prior experience, as well as an evaluation of the known risks in the current portfolio, composition and growth of the loan portfolio and economic factors |
| The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions |
| The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control and these losses may exceed current estimates |
| Federal and state regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses |
| While we believe that our allowance for loan losses is adequate to cover current losses, we cannot assure you that we will not increase the allowance for loan losses further or that regulators will not require us to increase this allowance |
| Either of these occurrences could have a material adverse affect on our business, financial condition, results of operations, cash flows and prospects |
| We sell loans to outside investors that are subject to repurchase risk in the event of breaches of representations or warranties we make in connection with the sales |
| While we establish secondary marketing reserves in connection with such sales, we cannot assure that the amount reserved is sufficient to cover all potential losses that may result from such repurchases |
| Significant loan sale repurchases could have a material adverse affect on our business, financial condition, results of operations, cash flows and prospects |
| We are dependent on key personnel and the loss of one or more of those key personnel may adversely affect our business |
| Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the California community banking industry |
| The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy |
| Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel |
| The loss of the services of any one of our key personnel could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| We rely on communications, information, operating and financial control systems technology from third-party service providers, and we may suffer an interruption in those systems that may result in lost business and we may not be able to obtain substitute providers on terms that are as favorable if our relationships with our existing service providers are interrupted |
| We rely on third-party service providers for much of our communications, information, operating and financial control systems technology |
| Any failure or interruption or breach in security of these systems could result in failures or interruptions in our customer relationship management, general ledger, deposit, loan servicing and/or loan origination systems |
| We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely |
| If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all |
| Any of these circumstances could have an adverse effect on our business, financial condition, results of operations, cash flows and prospects |
| Page 22 ____________________________ [26]Navigation Links We face strong competition from financial services companies and other companies that offer banking services which could adversely affect our business |
| We conduct most of our operations in California |
| Increased competition in our markets may result in reduced loans and deposits |
| Ultimately, we may not be able to compete successfully against current and future competitors |
| Many competitors offer the banking services that we offer in our service areas |
| These competitors include a variety of financial institutions such as banks, savings and loan associations, mortgage banks, finance companies, brokerage firms, insurance companies, credit unions and other financial intermediaries |
| In particular, our competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns |
| Areas of competition include interest rates offered on loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services |
| Technological innovation continues to contribute to greater competition in financial services markets as technological advances enable more companies to provide financial services |
| We also face competition from out-of-state financial intermediaries that have opened loan production offices or that solicit deposits in our market areas |
| If we are unable to attract and retain banking customers, we may be unable to continue our loan growth and level of deposits and our business, financial condition, results of operations, cash flows and prospects may be adversely affected |
| Negative public opinion could adversely affect our business |
| Negative public opinion, inherent in business, can adversely affect our earnings and capital |
| Negative public opinion can result from the actual or perceived manner in which we conduct our business activities, including practices in our loan origination, loan servicing and retail banking operations; our management of conflicts of interest and ethical issues; and our protection of confidential customer information |
| Our ability to keep and attract customers can be affected by negative public opinion and expose us to litigation and regulatory action |
| If we are unable to attract and retain banking customers, we may be unable to maintain loan and deposit levels and our business, financial condition, results of operations, cash flows and prospects may be adversely affected |
| Our growth and expansion may strain our ability to manage our operations and our financial resources |
| Our financial performance and profitability depend on our ability to execute our corporate growth strategy |
| In addition to seeking deposit and loan growth in our existing markets, we intend to pursue expansion opportunities through strategically placed new branches and by acquiring branch locations that we find attractive |
| In addition, acquisitions of other financial institutions might be considered |
| Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition, results of operations, cash flows and prospects |
| Accordingly, there can be no assurance that we will be able to execute our growth strategy |
| Our growth may place a strain on our administrative, operational and financial resources and increase demands on our systems and controls |
| We plan to pursue opportunities to expand our business primarily through internally generated growth |
| This business growth may require continued enhancements to and expansion of our operating and financial systems and controls and may strain or significantly challenge them |
| In addition, our existing operating and financial control systems and infrastructure may not be adequate to maintain and effectively monitor future growth |
| Our continued growth may also increase our need for qualified personnel |
| We cannot assure you that we will be successful in attracting, integrating and retaining such personnel |
| The following risks, associated with our growth, could have a material adverse effect on our business, financial condition, results of operations, cash flows and prospects: * our inability to continue to upgrade or maintain effective operating and financial control systems; * our inability to recruit and hire necessary personnel or to integrate successfully new personnel into our operations; and * our inability to respond promptly or adequately to the emergence of unexpected expansion difficulties |
| Page 23 ____________________________ [27]Navigation Links Changes in the ability of the Bank to pay dividends to the holding company may adversely affect Downey’s ability to pay dividends and service its debt |
| Although we have been paying regular quarterly dividends to our stockholders and paying interest on our debt, our ability to do so 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 debt service and dividends to stockholders until such time that the Bank could again pay us dividends |