NEWPORT BEACH, Calif., Oct. 22 /PRNewswire-FirstCall/ -- Downey Financial Corp. (NYSE: DSL) reported a net loss for third quarter 2008 of $81.1 million or $2.89 per share on a diluted basis, compared to a net loss of $23.4 million or $0.84 per share on a diluted basis in the year-ago third quarter.

The $45.5 million unfavorable change in pre-tax loss between third quarters was due primarily to:

    -- A $48.7 million or 59.7% increase in provision for credit losses
       primarily due to a higher level of delinquent loans and an increase in
       loss severity from the continuing decline in housing values that
       provide the underlying collateral for our loans;
    -- A $40.0 million or 63.8% increase in operating expense, of which
       approximately 69% was due to higher costs related to the operation of
       real estate acquired in settlement of loans, with the balance of the
       increase primarily associated with higher deposit insurance premiums,
       and professional fees and consulting fees; and
    -- A $21.9 million or 22.4% decline in net interest income due to both a
       lower level of interest-earning assets and a lower effective interest
       rate spread.

These unfavorable items were partially offset by an increase in other income of $65.2 million primarily due to the sale of non-core real estate related contracts.

For the first nine months of 2008, the net loss totaled $547.7 million or $19.64 per share on a diluted basis, compared with net income of $52.2 million or $1.87 per share on a diluted basis for the first nine months of 2007.

Charles Rinehart, CEO, commented, 'At quarter end, our core capital ratio was 7.48% and our risk-based capital ratio was 14.50%, in each case exceeding the minimum regulatory capital ratio required to be maintained by the Bank. We continue to work with our financial advisor towards raising additional external capital and we are reviewing the recently announced governmental programs to determine which programs, if any, might be available and appropriate for us. Finally, given depositor and marketplace concerns as various banks failed during the third quarter, we increased our cash-related assets as a cautionary measure relative to Downey's liquidity despite the additional costs associated with doing so.'

NET INTEREST INCOME

Net interest income totaled $76.0 million in the third quarter of 2008, down $21.9 million or 22.4% from a year ago, reflecting a $1.828 billion or 13.0% decline in average interest-earning assets to $12.214 billion and a decline in the effective interest rate spread. The average effective interest rate spread was 2.49% in the current quarter, down 0.30% from a year ago and 0.24% from the second quarter of 2008. The decline in the current quarter effective interest spread from a year ago primarily reflected the negative impact of a higher proportion of non-performing assets. The decline in the effective interest spread from the second quarter of 2008 reflected both a higher level of non-performing assets as well as an increase in non-interest bearing cash related assets for liquidity purposes funded with interest-bearing liabilities.

For the first nine months of 2008, net interest income totaled $242.7 million, down $91.9 million or 27.5% from the year-ago period.

PROVISION FOR CREDIT LOSSES

During the current quarter, the provision for credit losses totaled $130.3 million, up $48.7 million from a year ago.

At September 30, 2008, the allowance for credit losses was $763 million, comprised of $762 million for loan losses and $1 million for unfunded loan commitments which is reported within accounts payable and accrued liabilities. The allowance for credit losses increased $29.3 million this quarter, of which $24.3 million was related to specific allowances associated with certain troubled debt restructurings pursuant to our borrower retention program which is discussed more fully below in the section entitled 'Non-Performing Assets.' These specific allowances will be accreted into interest income over the remaining life of the modified loans as long as they remain on accrual status. The balance of the increase in the allowance for credit losses was primarily due to loan workout modifications.

Downey's allowance methodology incorporates assumptions related to default probabilities, loss severities and loss horizons based on historical experience, current market conditions, and the unique characteristics of each borrower, loan and underlying collateral. On a comparative basis, these factors individually increase or decrease the amount of the allowance for loan losses from prior periods. In the current quarter, loss severities continued to increase and loss horizons continued to shorten. Further, as a result of deteriorating conditions facing the residential housing market, borrower equity continues to decline. Partially offsetting this unfavorable trend was a small decrease in default probabilities due to lower mortgage interest rates and a lower proportion of option ARM loans in our portfolio that have a higher loss experience.

Net loan charge-offs totaled $97.6 million in the current quarter, compared with $8.3 million a year ago. Net charge-offs in the current quarter are primarily related to residential one-to-four unit loans compared with the year-ago quarter which included a $4.0 million net charge-off associated with a land loan that was foreclosed upon. The annualized net charge-off ratio in the current quarter grew to 3.62% from 0.28% a year ago.

For the first nine months of 2008, the provision for credit losses totaled $626.0 million and net charge-offs were $204.9 million. This compares with a $91.7 million provision for credit losses and net charge-offs of $10.0 million a year ago.

OTHER INCOME

Other income totaled $68.2 million in the current quarter, up $65.2 million from a year ago primarily due to a $70.0 million gain from the previously reported sale of certain non-core real estate contracts to a third party. Offsetting contributors to this increase between third quarters was:

    -- A $2.9 million unfavorable change in income from investments in real
       estate and joint ventures primarily due to losses from sales in the
       current quarter of $2.4 million, compared with a gain of $0.7 million
       a year ago.  Writedowns in the value of single family home lots in
       which the company is a joint venture partner totaled $8.1 million in
       the current quarter, down from $9.0 million a year ago; and
    -- A $1.8 million decline in net gains on sale of loans and
       mortgage-backed securities, reflecting a decline in loans sold,
       partially offset by a higher gain per dollar of loan sold. Net gains in
       the current quarter totaled $0.7 million, including a $1.6 million loss
       due to the impact of valuing derivatives associated with the sale of
       loans. Excluding the impact of the SFAS 133 derivative valuation, a
       gain was realized equal to 1.03% on secondary market sales of $221
       million, compared with the year-ago gain of 0.91% on secondary market
       sales of $337 million.

For the first nine months of 2008, other income totaled $89.2 million, up $51.0 million or 133.3% from a year ago.

OPERATING EXPENSE

Operating expense totaled $102.7 million in the current quarter, up $40.0 million or 63.8% from a year ago. The increase primarily reflected an increase of $27.8 million in net operations of real estate acquired in the settlement of loans due to a higher number of foreclosed properties and general and administrative expense of $12.2 million or 20.7%. The increase in general and administrative expense between third quarters was primarily a result of increases of:

    -- $5.7 million in deposit insurance premiums and regulatory assessments
       due, in part, to a special credit received in the year-ago period and
       higher premium rates in the current quarter;
    -- $6.0 million in professional, consulting, and executive search fees;
       and
    -- $0.9 million in salaries and related costs due, in part, to the
       year-ago reversal of certain management incentive plan accruals.

For the first nine months of 2008, operating expense totaled $280.2 million, up $89.5 million or 46.9% from a year ago.

INCOME TAXES

A tax benefit of $7.6 million was recorded in the current quarter, reflecting an effective tax rate benefit of 8.6%, compared with the year-ago effective tax rate benefit of 46.0%. For the first nine months of 2008, an effective tax rate benefit of 4.6% was recorded, compared with effective tax rate of 42.2% a year ago.

The decline in the effective tax rate benefit between third quarters relates to the valuation allowance established against the deferred tax asset.

The deferred tax asset resulted from a significant increase in the loan loss allowance due, in part, to the factors discussed above in 'Provision for Credit Losses.' To the extent the loan loss allowance is not allocable to specific loans, it represents future tax benefits which would be realized when actual charge-offs are made against the allowance. To the extent available sources of taxable income, including prior years' tax returns, are deemed per generally accepted accounting principles to be insufficient to absorb tax losses, the establishment of a valuation allowance against the tax asset is necessary. The valuation allowance increased by $33 million in the current quarter to $216 million against tax assets of $235 million.

Since generally accepted accounting principles require Downey to spread its expected annual tax benefit across the entire year through an effective tax rate, we expect to continue realizing a tax benefit for the remainder of the current year.

ASSETS, LOAN ORIGINATIONS AND DEPOSITS

At September 30, 2008, assets totaled $12.781 billion, down $1.637 billion or 11.4% from a year ago. During the current quarter, assets increased $149 million primarily due to increases of $460 million in cash and cash equivalents, $118 million in loans held for investment, $54 million in Federal Home Loan Bank stock, and $33 million in other assets. Those asset increases were partially offset by declines of $406 million in investment securities, $78 million in loans held for sale and $48 million in investments in real estate and joint ventures. Included within loans held for investment at quarter end were $5.715 billion of single family adjustable rate mortgages subject to negative amortization, down $527 million from June 30, 2008. These loans comprised 52% of the single family residential loan portfolio held for investment at quarter end, compared with 74% a year ago. The amount of negative amortization included in loan balances declined $27 million during the current quarter to $318 million or 5.6% of loans subject to negative amortization. During the current quarter, approximately 10% of loan interest income represented negative amortization, down from 15% in the second quarter 2008 and 26% in the year-ago third quarter.

Loan originations (including purchases) totaled $804 million in the current quarter, up $110 million or 15.8% from $694 million originated a year ago but down from $1.027 billion originated in the second quarter of 2008. Single family residential loans originated for portfolio increased $128 million or 29.6% from a year ago to $560 million, while other loans originated for portfolio increased $79 million to $96 million in the current quarter. Those increases were partially offset by a decline in loans originated for sale, which declined $98 million or 39.8% to $147 million.

Not included in the above originations are loans for which we modify the terms of a borrower's loan. During the current quarter, we modified $157 million of loans associated with our borrower retention program, wherein the borrower was current with their loan payments and the new interest rate was no less than that afforded new borrowers, and an additional $149 million of loans at below market interest rates in loan workout situations. All of the portfolio retention modifications were adjustable rate loans, which permitted negative amortization, that were modified into five-year interest-only adjustable rate loans with interest rates that adjust semi-annually but do not permit negative amortization. Most of the other modifications were modified for a two year period into a fixed rate interest-only product.

Deposits totaled $9.618 billion at quarter end, down $1.044 billion or 9.8% from a year ago. At quarter end, the number of branches totaled 175 (170 in California and five in Arizona). At quarter end, the average deposit size of our 85 traditional branches was $89 million, while the average deposit size of our 90 in-store branches was $23 million. During the current quarter, borrowings increased by $487 million and represented 18% of total assets at quarter end.

NON-PERFORMING ASSETS

Non-performing assets increased during the quarter by $44 million to $2.002 billion and represented 15.66% of total assets, compared with 7.77% at year-end 2007 and 2.94% a year ago.

A borrower retention program was initiated at the beginning of the third quarter of 2007 to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loan that permits negative amortization to a less costly financing alternative. Those loans are considered troubled debt restructurings and have been placed on non-accrual status even though the interest rate following modification was no less than that afforded new borrowers. The reason for this is because the modified interest rate was lower than the interest rate on the original loan and the loan was not re-underwritten to prove that the new interest rate was, in fact, a market interest rate for a borrower with similar credit quality. Interest income is recorded as these borrowers make their loan payments and in the current quarter $8.7 million of interest income was recognized, including $1.1 million of amortization of the associated impairment allowance. If these borrowers perform pursuant to the modified terms for six consecutive months, the loans will be placed back on accrual status and, while still reported as troubled debt restructurings, they will no longer be classified as non-performing assets because the borrower will have demonstrated an ability to perform in accordance with the loan modification and the interest rate was no less than those afforded new borrowers at the time of modification.

To the extent borrowers whose loans were modified pursuant to the borrower retention program are current with their loan payments and included in non-performing assets, it is relevant to distinguish those loans from total non-performing assets because, unlike other loans classified as non-performing assets, these loans are paying interest at interest rates no less than those afforded new borrowers. At September 30, 2008, $409 million or 72% of the borrowers whose loans were modified subject to the program had made all loan payments due. Accordingly, the 15.66% ratio of non-performing assets to total assets includes 3.20% related to performing troubled debt restructurings, resulting in an adjusted ratio of 12.46%.

At September 30, 2008, $578 million of loans modified pursuant to our borrower retention program have been removed from non-performing status because they met the six-month payment performance threshold and have continued to perform. Of all loans modified pursuant to the borrower retention program, including those classified as non-performing as well as those removed from non-performing status, 82% have made all payments due.

At September 30, 2008, real estate acquired in settlement of loans totaled $278 million.