Downey Financial

(DSL) - Get Report

may soon join the growing list of financial institutions seeking an additional capital cushion against souring loans.

Downey, the holding company for Downey Savings & Loan, on Monday reported a $247.7 million first-quarter loss fueled by another huge increase in bad loans. Moody's on Tuesday downgraded the holding company's senior debt from Baa2 to Ba1, with a negative outlook.

In

another recent piece

, I noted Downey's loan quality wasn't quite as bad as it appeared on the surface, since performing loans that were restructured to benefit borrowers were required by accounting rules to be reported as problem loans.

I also pointed out that Downey's capital ratios were quite high, probably enabling it to ride out the storm, and avoid joining the list of banks raising capital and diluting shareholders, including

National City

( NCC),

Wachovia

(WB) - Get Report

and

Washington Mutual

(WM) - Get Report

, as well as ongoing capital raises by

Citigroup

(C) - Get Report

and Wednesday's $24.9 billion bomb from

Royal Bank of Scotland

(RBS) - Get Report

.

Based on the partial set of first quarter numbers for the holding company available at this point, Downey's loan quality and capital ratios paint a more grim picture compared to last quarter. Once again, we are excluding restructured performing loans:

Downey's nonperforming assets shot up to 7.41% as of March 31. The net loss of $247.7 million mainly resulted from a $236.9 million provision for loan loss reserves. The loss also reflected a significant decline in interest income because of a high level of problem loans.

Loan loss reserves covered 69.7% of nonperforming loans, again excluding restructured performing mortgages. That's a stronger coverage ratio than the previous quarter, despite the 49% increase in nonperforming loans.

Even with such terrible loan quality, Downey's relatively high level of capital has enabled it to maintain adequate loan loss reserves. The company's risk-based capital ratio was 15.04% as of March 31, while it needs to maintain a ratio of 10% to be considered well capitalized under regulatory guidelines.

Still, the question is, how long can this go on? If Downey's nonperforming loans were to stabilize at this level, it would have sufficient reserves to avoid taking significant further net losses and preserve its capital. So far, its additions to loan loss reserves over the past few quarters have greatly outweighed the company's net loan charge-offs.

Even Downey's strong capital position could be threatened if the company reports similar large increases in problem loans over the next two quarters. Just in the first quarter of 2008, the company's risk-based capital ratio dropped from 18.70% to 15.04%. While it's still a high level of capital, Downey's annualized return on equity of negative 76.96%, shows that several quarters of similar performance will force the company to raise capital, diluting current shareholders.

Downey also announced that while it would pay its usual 12-cent dividend for the first quarter, future dividends would be suspended in order to preserve capital.

Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.