Week of Horror for Doral - TheStreet

Puerto Rico-based mortgage lender

Doral Financial


has had a week to forget.

Heading into the close of trading Friday, shares of the bank were getting crushed, falling $6.34, or 24%, to $20.05. For the week, the bank, which is one of Puerto Rico's biggest mortgage originators, has plummeted 48%.

The selling in Doral has accelerated throughout the week, following a series of analyst downgrades because of concern about the bank's aggressive use of derivatives to hedge its mortgage portfolio against interest rate fluctuations. The downgrades were prompted by a series of disclosures in the bank's 2004 annual report, which revealed that Doral has been making more aggressive valuation assumptions than previously believed.

Another nail in Doral's coffin came Friday when the credit rating agency Standard & Poor's lowered its outlook for the bank's long-term debt to negative from stable. S&P revised its outlook, which is often the precursor to a credit downgrade, after expressing "concern over the sustainability of the company's business model'' and noting the potential "for lower quality earnings.''

The Friday crushing of Doral stock got so bad that the bank even put out a statement saying it "knows of no relevant events or material information causing the unusual activity'' in its shares other than the S&P warning.

It appears the selling in Doral is simply a case of institutional investors losing faith in a stock that had been one of the top performers in the financial sector for nearly two years.

The stock, which was trading around $49 a share at the beginning of the year, had risen 172% since the beginning of 2003, a period that coincided with the mortgage refinancing boom and an era of historically low interest rates. Early in the bank's run in February 2003,


spotlighted the stock as a potential mortgage play.

But it's been downhill for shares of Doral this year.

Early on in 2005, investors began selling shares of Doral and taking profits, fearing that rising interest rates would crimp earnings. But the real selling pressure came on Jan. 19, when the bank reported fourth-quarter earnings. At that time, it gave the first warning of potential trouble with its hedging strategy and reliance on so-called interest-only strips as a hedge against interest rate changes.

In the fourth quarter, Doral recorded a $97.5 million pretax impairment charge on the securities, commonly referred to as IO strips. The company denied the bank had suffered any problem with its hedging strategy, but many on Wall Street didn't buy it and feared the bank was sitting on a potential derivatives mess.

Derivatives are sophisticated investment contracts used to hedge against the change in value of a stock, bond, commodity or other investment.

In the annual report, analysts applauded Doral for giving more information about its use of derivatives and IO strips. But the disclosure only led to more worry. After reading the annual report, analysts and investors concluded that Doral has been using overly aggressive assumptions in valuing its derivatives portfolio of IO strips.

"We question the aggressive assumptions the company is using'' to value the IO strips, said Gimme Credit financial analyst Kathleen Bochman, in a research report. Additionally, Bochman said she is wary about the "effectiveness'' of the hedges the bank is using.

From this past week's action, it would seem she isn't alone.