by Calculated Risk on 6/17/2009 08:21:00 PM

Note: Downey Savings & Loan was seized by regulators on Nov 21, 2008, at an estimated cost to the Deposit Insurance Fund (DIF) of $1.4 billion.

From E. Scott Reckard at the LA Times Money & Co blog: Report: Lax oversight allowed Downey Savings' loan binge

Federal regulators responded inadequately from 2005 on as billions of dollars in high-risk mortgages piled up at weakly managed Downey Savings and Loan, the U.S. Treasury Department inspector general said in a report on last year’s failure of the Newport Beach thrift.

The Office of Thrift Supervision ... began warning Downey management in 2002 about its heavy issuance of pay-option adjustable-rate mortgages but failed to rein in the practice, the report said.
...
Yet despite the warnings, "OTS examiners did not require Downey to limit concentrations in higher-risk loan products," said the 71-page inspector general report, posted Tuesday on the Treasury Department’s website.

Here is a Downey ad from the loose lending period (not in report):



Click on Ad for larger image in new window.
Not sure of the exact date of this advertisement, but thanks for the memories! (hat tip Elroy).

From the report:

The primary causes of Downey’s failure were the thrift’s high concentrations in single-family residential loans which included concentrations in option adjustable rate mortgage (ARM) loans, reduced documentation loans, subprime loans, and loans with layered risk; inadequate risk-monitoring systems; the thrift’s unresponsiveness to OTS recommendations; and high turnover in the thrift’s management. These conditions were exacerbated by the drop in real estate values in Downey’s markets.

And oversight from the OTS was insufficient:

OTS examiners did not require Downey to limit concentrations in higher-risk loan products. We believe that in light of the OTS’s repeated expressions of concern and management’s unresponsiveness to those concerns, OTS should have been more forceful, at least by 2005, to limit such concentrations. In interviews, OTS examiners commented that this would have been difficult since there was no history of losses in Downey’s option ARM, low documentation, and layered-risk loans from 2002 to 2006. However, both ND Bulletin 02-17 and the successor ND Bulletin 06-14 provide that examiners can direct thrifts to discontinue activities that lead to a specific high-risk concentration when proper oversight and controls are not in place. We believe that if there is one lesson to be learned from Downey’s failure it is that a lack of losses in the short term should not negate the need to address risk exposure such as high concentrations.

This graph from the Inspector General's report (with color added) shows the shift over time to reduced documentation loans. This add risk to already risky products and should have been a huge red flag.

"Reduced documentation" is code word for borrower underwritten, as opposed to lender unwritten loans. Not surprisingly, reduced documentation loans perform worse than full documentation loans.



At the same time Downey was shifting to more and more reduced doc loans, they were also increasing the percentage of Option ARMs.

(See the ad above)

This was a toxic combination of risk layering.