Earnings Decline 23% at Downey

A slowing housing market and more cautious lending practices depressed second-quarter earnings by 23% at Downey Financial Corp., whose low-start-rate mortgages helped keep the housing boom going as prices went stratospheric. The Newport Beach-based parent of Downey Savings said Wednesday it earned $49.5 million, or $1.77 a share, in the quarter, down from $64.1 million, or $2.30, a year earlier.

Revenue fell 10%, from $169.8 million to $153.4 million.

Most of Downey’s home loans have rates that are adjustable, with a twist: Borrowers get a low rate for a few years and during that time are given a choice of monthly payment arrangements, including paying less than the full interest due.

If the borrowers make the lowest payment, the balance of these “pay option” adjustable-rate mortgages rises. But after a few years, or if the loan balance rises 10%, full payments are triggered -- potentially at far higher interest rates.

Under some scenarios loan payments can double, banking regulators have warned. Critics of the loans say they could lead many borrowers to financial ruin.

In the last few months, Downey has raised the lowest start rates on its pay-option ARMs from 1% to 1.37%. But with some lenders still promoting start rates at 1%, demand for Downey’s loans has dwindled, Chief Executive Daniel Rosenthal said Wednesday.

Downey keeps many of its loans but sells others on Wall Street. That business has shrunk drastically. In the second quarter, Downey sold only a third as many loans as it did a year earlier, and it recorded $40.2 million less in earnings on the sales. Downey also set aside $6.7 million to cover future loan losses, 11 times as much as a year earlier, even though most of its borrowers have considerable equity in their homes and only 0.23% of its loans are nonpaying -- a negligible amount by traditional measures.

Because home prices are no longer rocketing, Downey wanted more protection against losses because there presumably will be less equity if foreclosures increase, said Chief Operating Officer Thomas Prince.

“When you get into a market in which housing values are relatively flat or going down, there’s greater risk than if housing values are rising,” Prince said.

Paul Miller, an analyst at Friedman Billings Ramsey & Co., said Downey exceeded his earnings expectation despite weak mortgage production in the quarter.

He noted that Downey’s net interest margin -- a key gauge of basic lending profitability -- jumped from a year earlier, in part because customers kept significant volumes of cash in checking accounts that don’t pay interest.

Downey shares rose 48 cents to $69.88 on Wednesday, before the earnings report. The stock is up 2% this year.

Separately, Los Angeles County’s two largest commercial banks reported higher second-quarter profit.

* City National Corp. earned $58.7 million, or $1.16 a share, up 2% from $57.7 million, or $1.13, a year earlier, as the Beverly Hills-based bank recorded double-digit growth in loans and income from fees. Credit quality was “excellent,” President Russell Goldsmith said.

City National stock plunged in June, after the company warned that earnings would be squeezed by rising short-term interest rates. The shares rose $1.11 to $65 on Wednesday before the report. They are down 10% year to date.

* Pasadena-based East West Bancorp Inc. said quarterly profit was $36.6 million, or 59 cents a share, up 44% from $25.5 million, or 47 cents, a year earlier.

Dominic Ng, East West’s chairman, said loans grew rapidly, deposits grew steadily and total assets topped $10 billion for the first time. Shares of East West rose 87 cents to $38.16 before the report. They are up 5% year to date.