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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

(Mark One)

[X]  ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE
     ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 1997

                                       OR

[_]  TRANSITION  REPORT  PURSUANT  TO  SECTION  13 OR  15(d)  OF THE  SECURITIES
     EXCHANGE  ACT OF 1934 [NO FEE  REQUIRED]  For the  transition  period  from
     _______________ to _______________.

                         Commission File Number 1-13578

                             DOWNEY FINANCIAL CORP.
             (Exact name of registrant as specified in its charter)

                Delaware                                 95-1953342
      (State or other jurisdiction          (I.R.S. Employer Identification No.)
    of incorporation or organization)
           3501 Jamboree Road                               92660
        Newport Beach, California                        (Zip Code)
(Address of principal executive offices)

       Registrant's telephone number, including area code: (714) 854-0300

          Securities registered pursuant to Section 12(b) of the Act:

                                                       Name of each exchange
      Title of each class                               on which registered
 Common Stock, $0.01 par value                        New York Stock Exchange
                                                         Pacific Exchange

           Securities registered pursuant to Section 12(g) of the Act:

                                      None

     Indicate  by check mark  whether the  registrant  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days. Yes  X  No 
                                              ---    ---

     Indicate by a check mark if  disclosure of  delinquent  filers  pursuant to
Item 405 of Regulation S-K is not contained  herein,  and will not be contained,
to the best of  Registrant's  knowledge,  in  definitive  proxy  or  information
statements  incorporated  by  reference  in Part  III of this  Form  10-K or any
amendment to this Form 10-K.

         The aggregate  market value of the voting stock held by  non-affiliates
of the  registrant,  based upon the  closing  sale price of its Common  Stock on
February 27, 1998, on the New York Stock Exchange was $594,033,102.

     At February 27, 1998,  26,755,938 shares of the Registrant's  Common Stock,
$0.01 par value were outstanding.

                       Documents Incorporated by Reference

     Portions  of  the  Registrant's  Proxy  Statement  to  be  filed  with  the
Securities  and Exchange  Commission  in connection  with the Annual  Meeting of
Stockholders to be held April 22, 1998 are incorporated by reference in Part III
hereof.
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                             DOWNEY FINANCIAL CORP.

                         1997 ANNUAL REPORT ON FORM 10-K

                                TABLE OF CONTENTS



                                     PART I

ITEM 1.   BUSINESS.......................................................    1
           General.......................................................    1
           Lending Activities............................................    2
            Loan and Mortgage-Backed Securities Portfolio................    2
            Residential Real Estate Lending..............................    3
            Secondary Marketing and Loan Servicing Activities............    4
            Commercial Real Estate and Multi-Family Lending..............    5
            Construction Lending.........................................    5
            Commercial Lending...........................................    5
            Consumer Lending.............................................    5
           Investment Activities.........................................    6
           Real Estate Investments.......................................    6
           Sources of Funds..............................................    6
            Deposits.....................................................    6
            Borrowings...................................................    7
           Asset/Liability Management....................................    7
           Earnings Spread...............................................    7
           Competition...................................................    8
           Employees.....................................................    8
           Regulation....................................................    9
            General......................................................    9
            Regulation of Downey.........................................    9
            Regulation of the Bank.......................................    9
           Taxation......................................................   13
           Factors That May Affect Future Results........................   14
ITEM 2.   PROPERTIES.....................................................   16
           Branches......................................................   16
           Electronic Data Processing....................................   16
ITEM 3.   LEGAL PROCEEDINGS..............................................   16
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS................   16



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                                     PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
           STOCKHOLDER MATTERS...........................................   17
ITEM 6.   SELECTED FINANCIAL DATA........................................   18
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
           AND RESULTS OF OPERATIONS.....................................   19
           Overview......................................................   19
           Results of Operations.........................................   20
            Net Interest Income..........................................   20
            Provision for Loan Losses....................................   21
            Other Income.................................................   21
             Loan and Deposit Related Fees...............................   21
             Real Estate and Joint Venture Operations Held for Investment   22
             Secondary Marketing Activities .............................   22
             Net Gains (Losses) on Sales of Investment Securities........   22
             Provision for Loss on Investment in Lease Residual..........   22
             Other Category..............................................   22
            Operating Expenses...........................................   23
            Provision for Income Taxes...................................   23
           Financial Condition...........................................   24
            Loans and Mortgage-Backed Securities.........................   24
            Investment Securities........................................   27
            Investments in Real Estate and Joint Ventures................   28
            Deposits.....................................................   30
            Borrowings...................................................   31
            Asset/Liability Management and Market Risk...................   31
            Problem Loans and Real Estate................................   36
             Non-Performing Assets.......................................   36
             Delinquent Loans............................................   38
             Allowance for Losses on Loans and Real Estate...............   40
            Capital Resources and Liquidity..............................   43
            Regulatory Capital Compliance................................   44
            Current Accounting Issue.....................................   44
            Year 2000....................................................   45
ITEM 8.   FINANCIAL STATEMENTS...........................................   46
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
           AND FINANCIAL DISCLOSURES.....................................   88

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............   88
ITEM 11.  EXECUTIVE COMPENSATION.........................................   88
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT....................................................   88
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................   88

                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
           ON FORM 8-K...................................................   88
SIGNATURES...............................................................   90


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                                     PART I

     Certain   matters   discussed   in  this  Annual   Report  may   constitute
forward-looking   statements  within  the  meaning  of  the  Private  Securities
Litigation Reform Act of 1995 (the "Reform Act") and, as such, may involve risks
and  uncertainties.  These  forward-looking  statements  relate to,  among other
things, expectations of the business environment in which Downey Financial Corp.
("Downey") operates, projections of future performance,  perceived opportunities
in the market and statements  regarding  Downey's  mission and vision.  Downey's
actual results,  performance,  or achievements may differ significantly from the
results,   performance,   or   achievements   expressed   or   implied  in  such
forward-looking  statements. For discussion of the factors that might cause such
a difference, see "Item 1. Business - Factors That May Affect Future Results" on
page 14.

ITEM 1.       BUSINESS

GENERAL

         Downey was incorporated in Delaware on October 21, 1994. On January 23,
1995, after obtaining  necessary  stockholder and regulatory  approvals,  Downey
acquired 100% of the issued and outstanding  capital stock of Downey Savings and
Loan  Association  (the  "Bank"),   and  the  Bank's   stockholders  became  the
stockholders  of  Downey.  Downey  was  thereafter  capitalized  by the Bank and
presently operates as the Bank's holding company.

     The Bank  was  formed  in 1957 as a  California-licensed  savings  and loan
association and conducts its business  through 86 retail deposit branches (26 of
which are full-service  in-store branches).  Residential loans are originated by
retail loan  officers who are located in 20 retail  deposit  branches  providing
loan origination services to all the Bank's branches.  Wholesale loans submitted
by  mortgage  brokers  are  originated  from five loan  origination  centers  in
California,  three of which are  located in or adjacent  to a Bank  office.  The
executive  offices of Downey are located at 3501  Jamboree  Road,  North  Tower,
Newport Beach,  California,  92660,  and the telephone number is (714) 854-0300.
Downey's  stock is traded on the New York Stock  Exchange  and Pacific  Exchange
under trading symbol "DSL." Unless otherwise stated or indicated,  references to
"Downey" or the "Bank" include their respective subsidiaries.

     On  March   9,   1995,   the  Bank   completed   its   conversion   from  a
California-licensed  to a federally  chartered savings association and currently
operates  under  the  name  "Downey  Savings  and Loan  Association,  F.A." As a
federally chartered savings  association,  the Bank's activities and investments
are generally  governed by the Home Owners' Loan Act, as amended  ("HOLA"),  and
implementing  regulations and policies of the Office of Thrift  Supervision (the
"OTS").  The  Bank  and  Downey  are  subject  to  the  primary  regulatory  and
supervisory   jurisdiction  of  the  OTS.  As  a  federally  insured  depository
institution,  the Bank is also  subject to  regulation  and  supervision  by the
Federal  Deposit  Insurance   Corporation   ("FDIC")  with  respect  to  certain
activities and  investments.  The Bank is a member of the Federal Home Loan Bank
("FHLB") of San  Francisco,  which is one of the 12 regional banks for federally
insured  depository  institutions  comprising the Federal Home Loan Bank System.
The  Bank's  savings  deposits  are  insured  through  the  Savings  Association
Insurance  Fund  ("SAIF") of the FDIC, an  instrumentality  of the United States
government. The Bank is further subject to regulations of the Board of Governors
of the Federal Reserve System ("Federal Reserve Board") with respect to reserves
required to be maintained against deposits and certain other matters.

     On January 25, 1995, Downey Affiliated Insurance Agency was incorporated as
a wholly owned  subsidiary of Downey and was  capitalized  on February 24, 1995,
with $400,000.  Operations commenced in the second quarter of 1995 at which time
representatives of Downey Affiliated Insurance Agency were available in Downey's
branches to offer annuity products.  During 1996,  Downey  Affiliated  Insurance
Agency began  offering  forced-placed  casualty  insurance  policies on mortgage
loans and ceased offering annuity products.

     Downey's principal business is attracting funds from the general public and
institutions, and originating and investing in loans, primarily residential real
estate  mortgage  loans,  mortgage-backed  securities  ("MBSs"),  and investment
securities. MBSs include securities issued or guaranteed by government-sponsored
enterprises  ("Agency MBSs"), such as the Federal National Mortgage  Association
("FNMA"),   the  Federal  Home  Loan  Mortgage  Corporation  ("FHLMC")  and  the
Government National Mortgage  Association  ("GNMA"),  and mortgage  pass-through
securities  issued by other  entities.  Downey's  primary sources of revenue are
interest earned on mortgage loans and MBSs,  income from investment  securities,
gains on sales of loans  and MBSs,  fees  earned in  connection  with  loans and
deposits  and income  earned on its  portfolio  of loans and MBSs  serviced  for
investors. Downey's principal expenses are interest incurred on interest-bearing
liabilities,




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including  deposits  and  borrowings,  and  general  and  administrative  costs.
Downey's primary sources of funds are deposits,  principal and interest payments
on loans and MBSs,  proceeds  from  sales of loans  and  MBSs,  and  borrowings.
Scheduled  payments on loans and MBSs are a relatively  stable  source of funds,
while prepayments of loans and MBSs and flows in deposits vary widely.

     Prior to 1989, the Bank conducted  substantial  commercial and  residential
real estate development and investment activities, primarily retail neighborhood
shopping centers located in California,  principally through its subsidiary, DSL
Service  Company,  an active  wholly owned real estate  subsidiary  of the Bank.
Since the passage in August 1989 of the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 ("FIRREA"), the Bank's ability to engage in new real
estate  development  activities and retain existing real estate  investments has
been curtailed dramatically,  and such activities may be economically unfeasible
for the Bank  because of the capital  requirements  for such  activities.  Since
FIRREA,  the Bank has been  engaged  in  significant  efforts to reduce its real
estate  investments and is now within allowable limits for its investment in DSL
Service Company and other equity investments.

     Downey's  operations  are  significantly  influenced  by  general  economic
conditions,  the monetary and fiscal policies of the federal  government and the
regulatory policies of governmental  authorities.  Deposit flows and the cost of
interest-bearing  liabilities  ("cost of  funds") to Downey  are  influenced  by
interest  rates on competing  investments  and general  market  interest  rates.
Similarly,  Downey's loan volume and yields on loans and MBSs,  and the level of
prepayments on such loans and MBSs, are affected by market  interest  rates,  as
well as  additional  factors  affecting the supply of and demand for housing and
the availability of funds.

LENDING ACTIVITIES

     Historically,  Downey's lending  activities have emphasized the origination
of first mortgage loans secured by residential  property and retail neighborhood
shopping  centers,  and,  to a lesser  extent,  real  estate  loans  secured  by
multi-family  and  commercial  and  industrial   properties,   including  office
buildings,  land and other  properties with income  producing  capabilities.  In
addition,  Downey has provided construction loan financing for residential (both
single family and  multi-family)  and commercial  retail  neighborhood  shopping
center projects,  including loans to joint ventures where DSL Service Company or
the Bank was a participant.  Downey also originates loans to businesses  through
its commercial banking operations and loans on new and used automobiles  through
the purchase of motor  vehicle sales  contracts  from auto dealers in California
and other western  states.  The indirect auto lending  program is in addition to
automobile loans originated directly through Downey's branch network.

     During 1998,  Downey's primary focus will continue to be the origination of
adjustable rate single family mortgage loans,  particularly subprime loans which
carry higher  interest  rates,  and  consumer  loans.  In addition,  Downey will
continue its secondary marketing activities of selling its production of certain
fixed rate  single  family  loans as well as certain  adjustable  rate  mortgage
("ARM") loan products.  See "Lending  Activities - Secondary  Marketing and Loan
Servicing Activities" on page 4.

     For  additional  information  on the  composition  of Downey's loan and MBS
portfolio,  see "Management's Discussion and Analysis of Financial Condition and
Results  of  Operations  -  Financial  Condition  -  Loans  and  Mortgage-Backed
Securities" on page 24.

Loan and Mortgage-Backed Securities Portfolio

     Loans  receivable  held for  investment  are carried at cost,  adjusted for
amortization  of premiums and  accretion of discounts  which are  recognized  in
interest  income  using  the  interest  method.  MBSs  represent   participating
interests  in pools of first  mortgage  loans  originated  and  serviced  by the
issuers of the securities. MBSs held to maturity are carried at unpaid principal
balances, adjusted for unamortized premiums and unearned discounts. Premiums and
discounts on MBSs are  amortized  using the interest  method over the  remaining
period to contractual maturity, adjusted for anticipated prepayments.

         Downey  identifies  those loans which  foreseeably may be sold prior to
maturity.  These loans have been classified as held for sale in the Consolidated
Balance  Sheets and are recorded at the lower of amortized cost or market value.
Net  unrealized  losses,  if any,  are  recognized  in a valuation  allowance by
charges to income.

         MBSs  available  for sale are carried at market value.  Net  unrealized
gains or losses are  excluded  from income and reported net of income taxes as a
component of stockholders' equity until realized.




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<PAGE>



     Residential  mortgage loans originated by Downey typically have contractual
maturities  at  origination  of 15 to 40 years.  To limit the interest rate risk
associated  with  such  maturities,  Downey,  among  other  things,  principally
originates  ARMs for its own loan  portfolio.  Fixed  rate  loans are  primarily
originated for sale in the secondary  market on a  non-recourse  basis for cash.
However,  Downey occasionally  originates for its own portfolio fixed rate loans
to facilitate the sale of real estate  acquired in settlement of loans and which
meet  certain  yield  and  other  approved   guidelines.   See  "Asset/Liability
Management"  on page 7. In  addition,  the average term of such  mortgage  loans
historically has been significantly  shorter than their contractual maturity due
to loan payoffs as a result of home sales or refinancings and prepayments.

Residential Real Estate Lending

     Downey's  primary  lending  activity is the  origination  of mortgage loans
secured by single family residential  properties consisting of one-to-four units
located in  California.  Such loans are primarily for the purchase of residences
or for the  refinancing  of existing  mortgages at lower rates or upon different
terms.  At present,  Downey is primarily  originating  ARMs for its portfolio of
loans held for investment.  See  "Asset/Liability  Management" on page 7. Downey
also originates  residential fixed interest rate mortgage loans to meet consumer
demand,  but  intends to sell the  majority  of all such loans in the  secondary
market,  rather  than hold such loans in its  portfolio.  In  addition,  a small
volume of  residential  one-to-four  unit fixed rate  loans are  originated  for
investment to facilitate the sale of real estate acquired in settlement of loans
and which  meet  certain  yield  and other  approved  guidelines.  See  "Lending
Activities - Secondary Marketing and Loan Servicing Activities" on page 4.

     Downey's  ARMs  generally  begin with an  interest  rate below the  current
market rate ("incentive rate") and adjust to the applicable index plus a defined
spread,  subject to periodic and lifetime caps,  after one, three or six months.
Downey's ARMs generally provide that the maximum rate that can be charged cannot
exceed the incentive rate by more than six to nine percentage points,  depending
on the type of loan and the initial rate offered.  The interest rate  adjustment
on  Downey's  ARMs which  adjust  semi-annually  generally  is limited to 1% per
adjustment period. With respect to ARMs that adjust monthly, there is a lifetime
interest  rate cap, but no specified  periodic  interest  rate  adjustment  cap.
Instead,  monthly  adjustment  ARMs have a periodic  cap on changes in  required
monthly  payments,  which adjust  annually.  Monthly  adjustment  ARMs allow for
negative  amortization  (the addition to loan principal of accrued interest that
exceeds the  required  monthly loan  payments).  In the event that a loan incurs
significant  negative  amortization,  there is an increased risk that the market
value of the underlying  collateral on the loan would be insufficient to satisfy
fully the outstanding principal and interest.  There is a limit on the amount of
negative  amortization,  such that the  principal  plus the added amount  cannot
exceed 125% of the original loan amount for loans  originated prior to July 1994
and 110% of the original  loan amount for loans  originated  thereafter.  Downey
permits ARMs to be assumed by qualified borrowers.

     During 1997,  approximately  21% of Downey's  one-to-four  unit residential
real estate  loans were  originated  by retail loan  representatives  of Downey.
Retail loan  representatives  typically  receive loan referrals from real estate
agents, builders,  depositors and customers obtained from retail advertising and
other sources.  Prior to the fourth quarter of 1997, retail loan representatives
were  compensated on a commission  basis.  Beginning in the 1997 fourth quarter,
the  compensation  program was changed to a salary plus a fixed  amount per loan
originated.  The remainder of Downey's  one-to-four unit residential real estate
loans were obtained by Downey's  wholesale loan  representatives  but originated
through outside mortgage brokers.  Wholesale loan  representatives are paid on a
commission basis. Compensation for the services performed by the mortgage broker
is considered in the overall  pricing of mortgage loan products.  These mortgage
brokers do not operate from Downey's offices and are not employees of Downey.

     Downey requires that  residential  real estate loans be approved at various
levels of management,  depending upon the amount of the loan. On a single family
residential  loan originated for portfolio,  the maximum amount Downey generally
will lend is $1 million. The average loan size, however, is much lower. In 1997,
the  average  loan  size  was  $237,000.   Downey  generally  makes  loans  with
loan-to-value  ratios  (the  ratio of the  principal  amount  of the loan to the
appraised value at origination of the property  securing the loan) not exceeding
80% (up to 95% for certain  loans made  pursuant to  Downey's  low and  moderate
income lending  program under the Community  Reinvestment  Act ("CRA")).  Downey
will make loans with loan-to-value  ratios of over 80%, but not exceeding 97% of
the value of the property,  if private mortgage  insurance is obtained to reduce
the  effective  loan-to-value  ratio  to  between  70% to 78%,  consistent  with
secondary marketing requirements.  In addition, Downey requires hazard insurance
for all  residential  real estate loans covering the lower of the loan amount or
the replacement value of the structure.

     In the approval  process for the loans it originates  or purchases,  Downey
assesses  both the value of the property  securing the loan and the  applicant's
ability to repay the loan. Loan  underwriters  analyze the loan  application and
the



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property involved,  and qualified staff appraisers or outside appraisers inspect
and  appraise  the  property.  All  appraisers  are  approved by Downey's  Chief
Appraiser or, with respect to Federal  Housing  Administration  ("FHA")  insured
loans, by the FHA.  Appraisals  performed by approved appraisers are selectively
reviewed by senior staff  appraisers or approved fee review  appraisers.  Downey
also obtains information concerning the income, financial condition,  employment
and credit  history of the  applicant.  Typically,  Downey  will  verify  credit
information for loans originated by retail loan  representatives or other Downey
employees.  For loans from mortgage brokers, Downey requires the mortgage broker
to review and verify  credit  information  and  employment  pursuant to Downey's
origination  procedures.  In addition,  Downey  obtains credit  information  and
performs  certain other  underwriting  tests of such mortgage broker  originated
loans. On its ARMs offered with incentive rates, Downey qualifies applicants for
loan  programs  with no  negative  amortization  at the  higher  of the  initial
incentive rate plus 2% or the fully indexed rate, with a minimum qualifying rate
of 7% for  loans  having a  loan-to-value  ratio of 80% or less;  and  qualifies
applicants at a minimum  qualifying  rate of 7% for loans having a loan-to-value
ratio of greater than 80%. For loan programs that include negative amortization,
Downey qualifies  applicants at the lesser of the initial incentive rate plus 2%
or the fully indexed rate, with a minimum qualifying rate of 6% for loans having
a  loan-to-value  ratio of 80% or less;  and  qualifies  applicants at a minimum
qualifying  rate of 7% for loans  having a  loan-to-value  ratio of greater than
80%.

     Late in 1996,  Downey began offering  one-to-four unit residential loans to
borrowers who have or, in the case of purchases, will have equity in their homes
but whose credit rating  contains  certain  exceptions  which preclude them from
qualifying  for the best market terms.  These lower grade credits ("A-," "B" and
"C" loans),  commonly  referred to as subprime loans, are characterized by lower
loan-to-value  ratios and higher average interest rates than higher credit grade
loans ("A" loans).  Downey believes these lower credit grade borrowers represent
an opportunity  to earn a higher net return for the risks assumed.  Underwriting
guidelines have been developed for each classification of credit.

Secondary Marketing and Loan Servicing Activities

     As part of its secondary  marketing  activities,  Downey originates certain
residential  real  estate  ARMs and loans  with  fixed  rates  with an intent of
selling such loans. Accordingly,  such loans are classified as held for sale and
are  carried at the lower of cost or market.  These  loans are  secured by first
liens on  one-to-four  unit  residential  properties  and  have  15- to  30-year
maturities or 30-year  amortization periods with balloon payments in five years,
seven years or other maturities. For additional information regarding loans held
for  investment  and for sale,  see  Notes 1 and 6 of Notes to the  Consolidated
Financial Statements on pages 53 and 62,  respectively.  Downey utilizes various
hedging  programs to manage the  interest  rate risk of its fixed rate  mortgage
origination process. See "Asset/Liability Management" on page 7.

     Management  of Downey  believes that  servicing  loans for others can be an
important asset/liability  management tool because it produces operating results
which, in response to changes in market  interest rates,  tend to move inversely
to changes in net interest  income.  Because ARMs lag market interest rates, net
interest income associated with these loans is expected to decline in periods of
rising interest rates and increase in periods of falling rates. In contrast, the
value of the loan servicing  portfolio normally increases as interest rates rise
(and loan  prepayments  decrease) and declines as interest  rates fall (and loan
prepayments increase). In addition, increased levels of servicing activities can
provide additional income with minimal additional overhead costs.

     Depending  upon  market  pricing  for  servicing,  loans  are  sold  either
servicing retained or servicing released.  When sold servicing retained,  Downey
records  gains or losses  from the sale of loans at the time of sale,  which are
determined by the  difference  between the net sales  proceeds and the allocated
basis of the loans sold. Downey adopted, effective January 1, 1997, Statement of
Financial  Accounting Standards No. 125, "Accounting for Transfers and Servicing
of Financial  Assets and  Extinguishments  of  Liabilities,"  ("SFAS  125").  In
accordance with SFAS 125, Downey capitalizes  mortgage servicing rights ("MSRs")
acquired  through  either the purchase or origination of mortgage loans for sale
or securitization with servicing rights retained. The total cost of the mortgage
loans  designated  for sale is  allocated  to the MSRs  and the  mortgage  loans
without the MSRs based on their  relative fair values.  MSRs are included in the
financial  statements in the category of "other assets."  Impairment  losses are
recognized through a valuation allowance, with any associated provision recorded
as a component of loan servicing  fees. At December 31, 1997,  MSRs totaled $2.0
million.

     Loans  originated  for sale may be exchanged with  government  agencies for
MBSs collateralized by such loans. Downey's cost for the exchange is the payment
of a monthly  guaranty  fee,  which is expressed  as a percentage  of the unpaid
principal  balance and which is deducted from interest  income.  The  securities
received can be used by Downey to  collateralize  various types of borrowings at
rates  which  frequently  are  more  favorable  than  rates  on  other  types of
liabilities and also carry a lower  risk-based  capital  requirement  than whole
loans. Such MBSs available for sale are carried at fair



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value.  However, no gain or loss on the exchange is recorded in the statement of
income until the securities are sold to a third party. All changes in fair value
prior  to the  sale to third  parties  are  shown  as a  separate  component  of
stockholders' equity, net of income taxes.

Commercial Real Estate and Multi-Family Lending

     Downey has provided permanent loans secured by retail neighborhood shopping
centers and multi-family properties. Downey's commercial real estate lending and
multi-family  activities are conducted by Downey's  major loan account  officers
who are compensated on a salary basis.

     Commercial real estate and multi-family  loans generally entail  additional
risks as compared to  single-family  residential  mortgage  lending.  Each loan,
including  loans to  facilitate  the sale of real  estate  owned,  is subject to
Downey's  underwriting  standards,  which generally include an evaluation of the
creditworthiness  and  reputation of the borrower,  the amount of the borrower's
equity in the project as determined on the basis of appraisal, sales and leasing
information on the property and cash flow  projections.  To protect the value of
the security for Downey's loan, Downey requires casualty  insurance for the loan
amount or replacement cost. In addition,  for non-residential loans in excess of
$500,000, Downey requires the borrower to obtain comprehensive general liability
insurance.  All  commercial  real estate loans  originated by Downey require the
approval  of at least two  officers,  one of whom must be the  originating  loan
account  officer  and the  other a  designated  officer  with  appropriate  loan
approval authority.

Construction Lending

     Downey has provided  construction  loan  financing  for  residential  (both
single family and  multi-family)  and  commercial  real estate  projects  (e.g.,
retail neighborhood shopping centers).  Downey originates such loans principally
through  its major  loan  officers.  Construction  loans  generally  are made at
floating  rates  based upon the prime or  reference  rate of a major  commercial
bank.  Generally,  Downey  requires  a  loan-to-value  ratio  of 75% or  less on
construction lending and subjects each loan to Downey's underwriting standards.

     Construction  loans involve risks different from completed  project lending
because  loan  funds  are  advanced  upon  the  security  of the  project  under
construction, and if the loan goes into default, additional funds may have to be
advanced to complete the project before it can be sold.  Moreover,  construction
projects are subject to uncertainties inherent in estimating construction costs,
potential  delays in  construction  time,  market demand and the accuracy of the
estimate of value upon  completion.  Downey requires the general  contractor to,
among other things,  carry  contractor's  liability  insurance  equal to certain
prescribed  minimum  amounts,  carry builder's risk insurance and have a blanket
bond against employee misappropriation.

Commercial Lending

     Downey  originates  commercial  loans and  revolving  lines of credit,  and
issues standby letters of credit for its middle market commercial customers. The
various credit  products are offered on both a secured and unsecured  basis with
interest rates being either fixed or variable.  The portfolio emphasis is toward
secured,  floating rate credit  facilities.  The activities are directed through
the  Commercial  Banking  Group  with the focus on  long-term-relationship-based
customers.  The retail branch network is also utilized as a source of commercial
customers,   typically  managed  by  the  branch  manager.  The  smaller  branch
originated  business  borrowers  are  desirable  due to their lower cost deposit
accounts which usually accompany the relationship.

Consumer Lending

     Downey originates fixed rate automobile loans primarily through an indirect
lending  program  of  Downey  Auto  Finance  Corp.  which  utilizes  preapproved
automobile  dealers to finance consumer  purchases of new and used  automobiles.
This operation is centralized at Downey's  headquarters and utilizes  technology
to process and evaluate  loan  applications,  including  credit  scoring and the
automated  retrieval of consumer  credit bureau  files.  In addition to indirect
automobile lending through Downey Auto Finance Corp., the Bank originates direct
automobile loans, home equity loans and lines of credit, and other consumer loan
products. Before making a consumer loan, Downey assesses the applicant's ability
to repay the loan and, if applicable,  the value of the collateral  securing the
loan. The risk involved with home equity loans and lines of credit is similar to
the risk involved with residential real estate loans.  Downey offers customers a
credit card  through a third  party,  which  extends the credit and services the
loans made to Downey's customers.



                                       5
<PAGE>



INVESTMENT ACTIVITIES

     Federal  and state  regulations  require  the Bank to  maintain a specified
minimum amount of liquid assets invested in certain  short-term  obligations and
other securities.  For additional  information regarding liquidity  requirements
and the Bank's compliance therewith,  see "Regulation - Regulation of the Bank -
Liquidity Requirements" on page 13 and "Management's  Discussion and Analysis of
Financial  Condition and Results of  Operations - Financial  Condition - Capital
Resources  and  Liquidity"  on  page  43.  As  a  federally   chartered  savings
association,  the  Bank  is also  permitted  to make  certain  other  securities
investments as prescribed under HOLA and OTS regulations.  Investment  decisions
are made by authorized officers of the Bank within guidelines established by the
Bank's Board of Directors.  Such investments are managed in an effort to produce
the highest yield consistent with maintaining safety of principal,  minimization
of interest rate risk and compliance  with  applicable  regulations.  Securities
held for investment are carried at cost,  adjusted for  amortization of premiums
and accretion of discounts  which are  recognized  as interest  income using the
interest  method.  For  further  information  on  the  composition  of  Downey's
investment  portfolio,  see  "Management's  Discussion and Analysis of Financial
Condition  and  Results  of  Operations  -  Financial   Condition  -  Investment
Securities" on page 27.

REAL ESTATE INVESTMENTS

     Historically,  real estate  development  and joint venture  operations have
been a significant part of Downey's business  activities.  These operations have
been conducted  principally  through the Bank's wholly owned service corporation
subsidiary,  DSL  Service  Company.  The Bank also  engaged in these  activities
directly, to a limited extent, but no longer has any such investments. Since the
passage in August  1989 of  FIRREA,  the  ability  to engage in new real  estate
development  and joint  venture  activities  and to retain  existing real estate
investments  has  been  curtailed  dramatically,  and  such  activities  may  be
economically unfeasible for the Bank because of the capital requirements imposed
on such activities.  FIRREA requires, with certain limited exceptions, a savings
institution  such  as the  Bank to  exclude  from  its  regulatory  capital  its
investments  in, and extensions of credit to, real estate  subsidiaries  such as
DSL Service Company, as well as its direct equity investments, and prohibits new
direct equity  investments  in real estate by the Bank.  Since July 1, 1996, the
Bank has been  required  to  deduct  the full  amount of its  investment  in DSL
Service  Company in calculating its applicable  ratios under the core,  tangible
and risk-based capital standards.  Savings associations  generally may invest in
service corporation subsidiaries,  such as DSL Service Company, to the extent of
2% of assets,  plus up to an additional 1% of assets for investments which serve
primarily community,  inner-city or community development purposes. In addition,
"conforming  loans" by an  association  to such  subsidiaries  and  their  joint
venture investments are limited to 50% of risk-based capital. "Conforming loans"
are those  generally  limited to 80% of appraised  value,  bear a market rate of
interest and require  payments  sufficient to amortize the principal  balance of
the loan. Downey is in compliance with each of these investment limitations.

     To the extent real estate investments are made by Downey or a subsidiary of
Downey  other than the Bank or its  subsidiaries,  the  above-mentioned  capital
deductions and limitations do not apply as they only pertain to such investments
by savings associations or their subsidiaries.

     For further  information,  see  "Management's  Discussion  and  Analysis of
Financial   Condition  and  Results  of  Operations  -  Financial   Condition  -
Investments in Real Estate and Joint Ventures" on page 28.

SOURCES OF FUNDS

Deposits

     Downey  prefers  to use  deposits  as the  principal  source  of funds  for
supporting its lending activities,  because the cost of these funds generally is
less  than  that  of  borrowings  or  other  funding   sources  with  comparable
maturities. Downey's savings deposits traditionally have been obtained primarily
from the areas in Southern and Northern California surrounding the Bank's branch
offices.  However,  Downey also  occasionally  raises  certain  retail  deposits
through Wall Street activities.

     Deposit flows are affected by general economic  conditions.  Funds may flow
from depository  institutions such as savings  associations into direct vehicles
such as government and corporate  securities or other financial  intermediaries.
The  ability  of Downey to attract  and  retain  deposits  will  continue  to be
affected by money market  conditions and prevailing  interest rates.  Generally,
rates set by Downey are not restricted by state or federal regulation.



                                       6
<PAGE>



     In 1996,  Downey  began  establishing  full-service  branch  facilities  in
selected market locations throughout Southern  California.  Each in-store branch
offers  a full  range of  financial  services  including  checking  and  savings
accounts as well as residential and consumer loans.

     When consistent with the maintenance of appropriate capital levels,  Downey
may consider  opportunities to augment its retail branch system and deposit base
through selected branch or deposit acquisitions.

     For further  information,  see  "Management's  Discussion  and  Analysis of
Financial  Condition and Results of Operations - Financial Condition - Deposits"
on page 30.

Borrowings

     Downey's  principal  source of funds has been and  continues to be deposits
raised through its retail branch system. At various times,  however,  Downey has
utilized  other  sources  to  fund  its  loan  origination  and  other  business
activities. Downey has from time to time relied upon borrowings from the FHLB of
San  Francisco as an additional  source of funds.  Advances are made pursuant to
several different credit programs offered by the FHLB.

     In 1994,  Downey  initiated a program to sell commercial paper supported by
an irrevocable letter of credit issued by the FHLB of San Francisco. At December
31, 1997, the irrevocable FHLB letter of credit was $300 million. The commercial
paper provides Downey with an alternative funding source to fund asset growth in
a cost effective manner.

     From time to time, Downey utilizes securities and mortgage loans sold under
agreements  to  repurchase  as  additional   sources  of  funds.  These  reverse
repurchase  agreements  are  generally  short term,  and are  collateralized  by
mortgage-backed or investment  securities and mortgage loans.  Downey only deals
with  investment  banking firms which are recognized as primary  dealers in U.S.
government  securities or major commercial banks in connection with such reverse
repurchase agreements. In addition, Downey limits the amounts of borrowings from
any single institution.

     For further  information,  see  "Management's  Discussion  and  Analysis of
Financial   Condition  and  Results  of  Operations  -  Financial   Condition  -
Borrowings" on page 31.

ASSET/LIABILITY MANAGEMENT

     Savings  institutions are subject to interest rate risks to the degree that
their interest-bearing liabilities, consisting principally of customer deposits,
FHLB  advances and other  borrowings,  mature or reprice more  rapidly,  or on a
different basis, than their interest-earning assets, which consist predominantly
of intermediate or long-term real estate loans. While having liabilities that on
average mature or reprice more frequently than assets may be beneficial in times
of declining  interest rates,  such an  asset/liability  structure may result in
declining net earnings  during  periods of rising  interest  rates.  A principal
objective  of Downey is to manage the  effects of  adverse  changes in  interest
rates on  Downey's  interest  income  while  maintaining  asset  quality  and an
acceptable  interest rate spread.  To improve the rate  sensitivity and maturity
balance of its interest-earning assets and liabilities, Downey has over the past
several years emphasized the origination of loans with adjustable interest rates
or relatively short  maturities.  Loans with adjustable  interest rates have the
beneficial  effect of allowing the yield on Downey's  assets to increase  during
periods  of  rising  interest  rates,   although  such  loans  have  contractual
limitations on the frequency and extent of interest rate adjustments.

     For  further   information   see  "Lending   Activities"   on  page  2  and
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations - Financial  Condition - Asset/Liability  Management and Market Risk"
on page 31.

EARNINGS SPREAD

     Downey's net interest income is determined by the difference (the "interest
rate  spread")  between  the  yields  earned by Downey  on its  loans,  MBSs and
investment securities ("interest-earning assets") and the interest rates paid by
Downey on its deposits and borrowings ("interest-bearing  liabilities"), as well
as  the  relative  dollar  amounts  of  Downey's   interest-earning  assets  and
interest-bearing liabilities.

     The effective  interest rate spread,  which  reflects the relative level of
interest-earning  assets  to  interest-bearing   liabilities,   equals  (i)  the
difference  between  interest  income on  interest-earning  assets and  interest
expense on interest-bearing


                                       7
<PAGE>



liabilities, (ii) divided by average interest-earning assets for the period. For
information regarding net income and the components thereof and for management's
analysis of financial  condition and results of  operations,  see  "Management's
Discussion  and  Analysis of  Financial  Condition  and  Results of  Operations"
beginning on page 19. For returns on assets and other  selected  financial  data
see "Selected Financial Data" on page 18.

COMPETITION

     Downey faces  competition  both in  attracting  deposits and in making real
estate  loans and other  loans.  Its most direct  competition  for  deposits has
historically  come from other savings  institutions  and from  commercial  banks
located  in  its  principal   market  areas,   including  many  large  financial
institutions  based in other  parts of the  country  or their  subsidiaries.  In
addition,  there is additional significant competition for investors' funds from
short-term   money  market   securities  and  other   corporate  and  government
securities.  The  ability  of Downey to  attract  and  retain  savings  deposits
depends,  generally,  on its ability to provide a rate of return,  liquidity and
risk comparable to that offered by competing  investment  opportunities  and the
appropriate level of customer service.

     Downey experiences competition for real estate loans principally from other
savings institutions, commercial banks, mortgage banking companies and insurance
companies.  Downey competes for loans principally through the interest rates and
loan fees it charges  and the  efficiency  and  quality of  services it provides
borrowers and real estate brokers.

EMPLOYEES

     At December 31, 1997, Downey had approximately 908 full-time  employees and
377 part-time  employees.  Downey provides its employees with certain health and
welfare benefits and a retirement and savings plan. Additionally,  Downey offers
qualifying employees participation in a stock purchase plan. See Notes 19 and 21
of Notes to the  Consolidated  Financial  Statements  on pages 77 and 79,  for a
further  discussion of employee benefit plans.  Employees are not represented by
any union or  collective  bargaining  group,  and Downey  considers its employee
relations to be good.

REGULATION

General

     Savings and loan holding companies and savings associations are extensively
regulated  under  both  federal  and state  law.  This  regulation  is  intended
primarily for the  protection of depositors and the SAIF and not for the benefit
of stockholders of Downey. The following  information  describes certain aspects
of that regulation applicable to Downey and the Bank, and does not purport to be
complete. The discussion is qualified in its entirety by reference to applicable
statutory or regulatory provisions.

Regulation of Downey

     General.  Downey is a unitary  savings and loan holding  company subject to
regulatory  oversight  by the OTS. As such,  Downey is required to register  and
file reports with the OTS and is subject to regulation  and  examination  by the
OTS.  In  addition,  the OTS  has  enforcement  authority  over  Downey  and its
subsidiaries, which also permits the OTS to restrict or prohibit activities that
are determined to be a serious risk to the subsidiary savings association.

     Activities  Restrictions.  As a unitary  savings and loan holding  company,
Downey  generally  is not subject to activity  restrictions,  provided  the Bank
satisfies the Qualified  Thrift Lender  ("QTL") test or meets the  definition of
domestic building and loan association  pursuant to section 7701 of the Internal
Revenue Code of 1986, as amended (the  "Code").  If Downey  acquires  control of
another savings association as a separate subsidiary, it would become a multiple
savings and loan holding  company,  and the  activities of Downey and any of its
subsidiaries (other than the Bank or any other SAIF-insured savings association)
would become subject to restrictions applicable to bank holding companies unless
such other associations each also qualify as a QTL or domestic building and loan
association and were acquired in a supervisory  acquisition.  See "Regulation of
the Bank - Qualified Thrift Lender Test" on page 11.

     Restrictions  on  Acquisitions.  Downey must obtain  approval  from the OTS
before  acquiring   control  of  any  other   SAIF-insured   association.   Such
acquisitions  are generally  prohibited if they result in a multiple savings and
loan holding company  controlling  savings  associations in more than one state.
However,  such  interstate  acquisitions  are permitted  based on specific state
authorization or in a supervisory acquisition of a failing savings association.


                                       8
<PAGE>



     Federal  law  generally  provides  that no  "person,"  acting  directly  or
indirectly or through or in concert with one or more other persons,  may acquire
"control," as that term is defined in OTS  regulations,  of a federally  insured
savings  association  without  giving at least 60 days written notice to the OTS
and providing the OTS an opportunity to disapprove the proposed acquisition.  In
addition,  no company may acquire  control of such an institution  without prior
OTS approval.  These provisions also prohibit,  among other things, any director
or officer of a savings and loan holding company,  or any individual who owns or
controls  more  than 25% of the  voting  shares of a  savings  and loan  holding
company,  from acquiring control of any savings  association not a subsidiary of
the savings and loan holding company,  unless the acquisition is approved by the
OTS.

Regulation of the Bank

     As a federally chartered,  SAIF-insured  savings  association,  the Bank is
subject to extensive  regulation by the OTS and the FDIC. Lending activities and
other  investments of the Bank must comply with various statutory and regulatory
requirements.   The  Bank  is  also  subject  to  certain  reserve  requirements
promulgated by the Federal Reserve Board.

     The OTS, in  conjunction  with the FDIC,  regularly  examines  the Bank and
prepares  reports for the  consideration of the Bank's Board of Directors on any
deficiencies  found in the operations of the Bank. The relationship  between the
Bank and its  depositors  and  borrowers is also  regulated by federal and state
laws,  especially in such matters as the  ownership of savings  accounts and the
form and content of mortgage documents utilized by the Bank.

     The  Bank  must  file  reports  with the OTS and the  FDIC  concerning  its
activities  and  financial  condition,   in  addition  to  obtaining  regulatory
approvals  prior to entering into certain  transactions  such as mergers with or
acquisitions  of other financial  institutions.  This regulation and supervision
establishes a comprehensive  framework of activities in which an institution may
engage and is intended  primarily for the protection of the SAIF and depositors.
The  regulatory  structure  also  gives  the  regulatory  authorities  extensive
discretion in connection with their  supervisory and enforcement  activities and
examination  policies,  including policies with respect to the classification of
assets and the  establishment  of adequate  loan loss  reserves  for  regulatory
purposes.  Any change in such  regulations,  whether by the OTS, the FDIC or the
Congress  could have a  material  adverse  impact on Downey,  the Bank and their
respective operations.

     Insurance of Deposit  Accounts.  The Bank's deposit accounts are insured by
the SAIF, as  administered  by the FDIC, up to the maximum  amount  permitted by
law. Insurance of deposits may be terminated by the FDIC upon a finding that the
institution  has  engaged  in unsafe or  unsound  practices,  is in an unsafe or
unsound  condition to continue  operations or has violated any  applicable  law,
regulation,  rule, order or condition  imposed by the FDIC or the  institution's
primary regulator.

     The FDIC charges an annual  assessment  for the insurance of deposits based
on the risk a particular  institution poses to its deposit insurance fund. Under
this system as of December  31,  1995,  SAIF  members  paid within a range of 23
cents  to  31  cents  per  $100  of  domestic   deposits,   depending  upon  the
institution's  risk  classification.  This  risk  classification  is based on an
institution's capital group and supervisory subgroup assignment. Pursuant to the
Economic  Growth  and  Paperwork  Reduction  Act of 1996 (the  "Act"),  the FDIC
imposed a special  assessment  on SAIF  members  to  capitalize  the SAIF at the
designated  reserve  level of 1.25% as of October  1, 1996.  Based on the Bank's
deposits as of March 31, 1995,  the date for measuring the amount of the special
assessment  pursuant  to the Act,  the Bank paid a special  assessment  of $24.6
million in November 1996 to  recapitalize  the SAIF. This expense was recognized
during the fourth quarter of 1996.

     Pursuant to the Act, the Bank pays its normal deposit  insurance premium as
a member of the SAIF  ranging  from  nothing  to 27 cents  per $100 of  domestic
deposits.  In addition,  the Bank also pays an amount equal to approximately 6.4
cents per $100 of  domestic  deposits  toward the  retirement  of the  Financing
Corporation  bonds ("Fico  Bonds") issued in the 1980s to assist in the recovery
of the savings and loan industry. Members of the Bank Insurance Fund ("BIF"), by
contrast,   pay,  in  addition  to  their  normal  deposit  insurance   premium,
approximately 1.3 cents per $100 of domestic  deposits.  Under the Act, the FDIC
also is not  permitted to establish  SAIF  assessment  rates that are lower than
comparable  BIF assessment  rates.  Beginning no later than January 1, 2000, the
rate paid to retire the Fico Bonds will be equal for  members of the BIF and the
SAIF.  The Act also  provides for the merging of the BIF and the SAIF by January
1, 1999 provided there are no financial  institutions still chartered as savings
associations  at that time.  Should the insurance funds be merged before January
1, 2000,  the rate paid by all members of this new fund to retire the Fico Bonds
would be equal.



                                       9
<PAGE>


     Regulatory Capital  Requirements.  OTS capital  regulations require savings
associations to meet three capital standards: (1) tangible capital equal to 1.5%
of total  adjusted  assets;  (2) leverage  capital (core capital) equal to 3% of
total  adjusted  assets;  and (3)  risk-based  capital  equal  to 8.0% of  total
risk-based  assets.  The Bank must meet each of these  standards  in order to be
deemed in compliance  with OTS capital  requirements.  In addition,  the OTS may
require a savings  association  to maintain  capital  above the minimum  capital
levels.

     The OTS has proposed to amend its leverage capital requirements.  Under the
proposed regulation,  a savings association which is assigned a composite rating
of 1 under the Uniform Financial  Institutions Rating System,  would be required
to  maintain a minimum  leverage  capital  ratio  equal to 3% of total  adjusted
assets.  All other savings  associations would be required to maintain a minimum
leverage capital ratio equal to 4% of total adjusted assets.

     Under OTS regulations,  a savings  association with a greater than "normal"
level of  interest  rate  exposure  must deduct an  interest  rate risk  ("IRR")
component in calculating  its total capital for purposes of determining  whether
it meets its risk-based capital requirement. Interest rate exposure is measured,
generally,  as the decline in an  institution's  net portfolio  value that would
result from a 200 basis point  increase  or  decrease in market  interest  rates
(whichever  would  result  in a  lower  net  portfolio  value),  divided  by the
estimated economic value of the savings  association's assets. The interest rate
risk  component  to be deducted  from total  capital is equal to one-half of the
difference between an institution's  measured exposure and "normal" IRR exposure
(which is defined as 2%),  multiplied  by the  estimated  economic  value of the
institution's assets. In August 1995, the OTS indicated that it intends to delay
implementation of its automatic capital deduction for interest rate risk pending
the testing of an OTS appeals  process and to provide an  opportunity  to assess
any further  guidance from the other three federal  banking  agencies  regarding
their  planned  implementation  of a capital  deduction.  This delay is still in
effect and, based on the Bank's  asset/liability  structure,  the Bank would not
have been subject to an IRR capital requirement at December 31, 1997.

     These capital  requirements are viewed as minimum standards by the OTS, and
most  institutions  are  expected  to  maintain  capital  levels  well above the
minimum.  In addition,  the OTS regulations  provide that minimum capital levels
higher than those provided in the  regulations may be established by the OTS for
individual  savings   associations,   upon  a  determination  that  the  savings
association's  capital is or may become inadequate in view of its circumstances.
The OTS regulations  provide that higher individual  minimum  regulatory capital
requirements  may be appropriate in  circumstances  where,  among others:  (1) a
savings  association  has a high  degree of  exposure  to  interest  rate  risk,
prepayment  risk,  credit  risk,  concentration  of credit risk,  certain  risks
arising from nontraditional  activities or similar risks or a high proportion of
off-balance sheet risk; (2) a savings association is growing,  either internally
or through acquisitions,  at such a rate that supervisory problems are presented
that  are not  dealt  with  adequately  by OTS  regulations;  and (3) a  savings
association may be adversely  affected by activities or condition of its holding
company, affiliates, subsidiaries or other persons with which it has significant
business  relationships.  The Bank is not subject to any such individual minimum
regulatory capital requirement.

     As shown in  "Management's  Discussion and Analysis of Financial  Condition
and Results of Operations - Financial Condition - Regulatory Capital Compliance"
on page 44 the Bank's regulatory capital exceeded all minimum regulatory capital
requirements as of December 31, 1997.

     HOLA permits  savings  associations  not in compliance with the OTS capital
standards  to  seek  an  exemption  from  certain  penalties  or  sanctions  for
noncompliance.  Such  an  exemption  will be  granted  only  if  certain  strict
requirements  are met, and must be denied  under  certain  circumstances.  If an
exemption is granted by the OTS, the savings association still may be subject to
enforcement  actions for other violations of law or unsafe or unsound  practices
or conditions.

     Prompt Corrective Action. The prompt corrective action regulations  adopted
by the OTS  require  certain  mandatory  actions  and  authorize  certain  other
discretionary  actions to be taken by the OTS against a savings association that
falls  within  certain  undercapitalized  capital  categories  specified  in the
regulation.

     The regulations establish five categories of capital classification:  "well
capitalized,"  "adequately  capitalized,"   "undercapitalized,"   "significantly
undercapitalized" and "critically  undercapitalized." Under the regulations,  an
institution's  risk-based capital,  leverage capital and tangible capital ratios
are used to determine the institution's capital classification.  At December 31,
1997,  the  Bank  exceeded  the  capital  requirements  of  a  well  capitalized
institution under applicable OTS regulations.



                                       10
<PAGE>


     In general,  the prompt corrective action  regulations  prohibit an insured
depository  institution  from declaring any dividends,  making any other capital
distribution  or paying a management fee to a controlling  person if,  following
the  distribution or payment,  the institution  would be within any of the three
undercapitalized  categories.  In addition,  adequately capitalized institutions
may accept  brokered  deposits (as defined) only with a waiver from the FDIC and
are  subject  to  restrictions  on the  interest  rates that can be paid on such
deposits.  Undercapitalized  institutions  may not  accept,  renew  or  rollover
brokered deposits.

     If the OTS  determines  that an  institution  is in an  unsafe  or  unsound
condition,  or if the  institution  is deemed to be  engaging  in an unsafe  and
unsound  practice,  the  OTS  may,  if  the  institution  is  well  capitalized,
reclassify  it as  adequately  capitalized;  if the  institution  is  adequately
capitalized  but not well  capitalized,  require it to comply with  restrictions
applicable  to  undercapitalized  institutions;   and,  if  the  institution  is
undercapitalized,  require it to comply with certain restrictions  applicable to
significantly undercapitalized institutions.

     Loans-to-One-Borrower.  Savings  associations  generally are subject to the
lending limits  applicable to national banks.  With certain limited  exceptions,
the maximum amount that a savings association or a national bank may lend to any
borrower  (including  certain related  entities of the borrower) at one time may
not exceed 15% of the unimpaired capital and surplus of the institution, plus an
additional  10% of  unimpaired  capital and  surplus for loans fully  secured by
readily marketable collateral.  Savings associations are additionally authorized
to make  loans to one  borrower,  for any  purpose,  in an amount  not to exceed
$500,000  or, by order of the  Director  of OTS,  in an amount not to exceed the
lesser of  $30,000,000  or 30% of  unimpaired  capital  and  surplus  to develop
residential  housing,  provided:  (i) the purchase  price of each  single-family
dwelling  in  the  development  does  not  exceed  $500,000;  (ii)  the  savings
association  is in compliance  with its fully  phased-in  capital  requirements;
(iii) the loans comply with applicable loan-to-value requirements,  and (iv) the
aggregate  amount of loans  made under this  authority  does not exceed  150% of
unimpaired   capital  and   surplus.   At   December   31,   1997,   the  Bank's
loans-to-one-borrower  limit was $67.3  million based upon the 15% of unimpaired
capital and surplus measurement.

     Qualified Thrift Lender Test.  Savings  associations  must meet a QTL test,
which  test may be met  either by  maintaining  a  specified  level of assets in
qualified  thrift  investments as specified in HOLA or by meeting the definition
of a "domestic  building and loan  association"  in section 7701 of the Code. If
the Bank  maintains  an  appropriate  level  of  certain  specified  investments
(primarily  residential  mortgages and related  investments,  including  certain
mortgage-related  securities)  and  otherwise  qualifies  as a QTL or a domestic
building  and  loan  association,  it will  continue  to  enjoy  full  borrowing
privileges from the FHLB. The required  percentage of investments  under HOLA is
65% of  assets  while  the  Code  requires  investments  of 60%  of  assets.  An
association  must be in  compliance  with  the QTL  test  or the  definition  of
domestic  building and loan  association on a monthly basis in nine out of every
12  months.  Associations  that  fail to meet the QTL  test  will  generally  be
prohibited  from engaging in any activity not permitted for both a national bank
and a savings  association.  As of December 31, 1997, the Bank was in compliance
with its QTL requirement and met the definition of a domestic  building and loan
association.

     Affiliate Transactions.  Transactions between a savings association and its
"affiliates"  are subject to  quantitative  and qualitative  restrictions  under
Sections  23A  and 23B of the  Federal  Reserve  Act.  Affiliates  of a  savings
association include,  among other entities,  the savings  association's  holding
company  and  companies   that  are  under  common   control  with  the  savings
association.

     In general,  Sections 23A and 23B and OTS regulations  issued in connection
therewith  limit the extent to which a savings  association or its  subsidiaries
may engage in certain "covered  transactions" with affiliates to an amount equal
to 10% of the  association's  capital  and  surplus,  in  the  case  of  covered
transactions  with  any one  affiliate,  and to an  amount  equal to 20% of such
capital and surplus, in the case of covered transactions with all affiliates. In
addition,  a savings  association  and its  subsidiaries  may  engage in covered
transactions   and  certain   other   transactions   only  on  terms  and  under
circumstances  that are  substantially the same, or at least as favorable to the
savings  association  or its  subsidiary,  as those  prevailing  at the time for
comparable transactions with nonaffiliated companies. A "covered transaction" is
defined to include a loan or extension of credit to an affiliate;  a purchase of
investment  securities  issued by an  affiliate;  a purchase  of assets  from an
affiliate,  with certain  exceptions;  the acceptance of securities issued by an
affiliate as collateral  for a loan or extension of credit to any party;  or the
issuance  of a  guarantee,  acceptance,  or  letter  of  credit  on behalf of an
affiliate.

     In addition, under the OTS regulations,  a savings association may not make
a loan or extension of credit to an  affiliate  unless the  affiliate is engaged
only in activities permissible for bank holding companies; a savings association
may not purchase or invest in securities of an affiliate  other than shares of a
subsidiary; a savings association and its subsidiaries


                                       11
<PAGE>


may not purchase a low-quality asset from an affiliate; and covered transactions
and certain other transactions between a savings association or its subsidiaries
and an affiliate must be on terms and conditions  that are consistent  with safe
and sound banking practices. With certain exceptions,  each loan or extension of
credit by a savings  association  to an affiliate  must be secured by collateral
with a  market  value  ranging  from  100% to  130%  (depending  on the  type of
collateral) of the amount of the loan or extension of credit.

     The  OTS  regulation   generally  excludes  all  non-bank  and  non-savings
association  subsidiaries of savings  associations from treatment as affiliates,
except to the extent that the OTS or the Federal  Reserve Board decides to treat
such   subsidiaries  as  affiliates.   The  regulation  also  requires   savings
associations to make and retain records that reflect  affiliate  transactions in
reasonable detail, and provides that certain classes of savings associations may
be required to give the OTS prior notice of affiliate transactions.

     Capital Distribution  Limitations.  OTS regulations impose limitations upon
all  capital  distributions  by savings  associations,  such as cash  dividends,
payments to repurchase or otherwise acquire its shares, payments to shareholders
of another  institution  in a cash-out  merger and other  distributions  charged
against capital. In general,  the Bank may not declare or pay a cash dividend on
its capital stock if the effect thereof would cause the Bank to fail to meet one
of its regulatory capital requirements.

     Under the regulation,  an association  that meets its capital  requirements
both before and after a proposed  distribution  and has not been notified by the
OTS that it is in need of more than normal  supervision (a "Tier 1 association")
may,  after prior  notice to but without the  approval of the OTS,  make capital
distributions  during a  calendar  year up to the higher of: (i) 100% of its net
income to date during the  calendar  year plus the amount  that would  reduce by
one-half its surplus  capital  ratio at the  beginning of the calendar  year, or
(ii) 75% of its net income over the most recent  four-quarter  period.  A Tier 1
association may make capital  distributions  in excess of the above amount if it
gives  notice  to the OTS and the OTS does not  object  to the  distribution.  A
savings  association that meets its regulatory capital  requirements both before
and after a proposed  distribution but does not meet its capital  requirement (a
"Tier 2 association")  is authorized,  after prior notice to the OTS but without
OTS approval,  to make capital  distributions  in an amount up to 75% of its net
income over the most recent four-quarter  period,  taking into account all prior
distributions  during the same period. Any distribution in excess of this amount
must be approved in advance by the OTS. A savings association that does not meet
its current regulatory capital requirements (a "Tier 3 association") cannot make
any capital distribution without prior approval from the OTS, unless the capital
distribution is consistent with the terms of a capital plan approved by the OTS.

     At December  31,  1997,  the Bank  qualified  as a Tier 1  association  for
purposes  of the  capital  distribution  rule.  The OTS may  prohibit a proposed
capital  distribution  that would  otherwise be permitted if the OTS  determines
that the distribution would constitute an unsafe or unsound practice.

     The OTS has  proposed  to amend  its  capital  distribution  regulation  to
conform its requirements to the OTS prompt corrective action  regulation.  Under
the proposed  regulation,  an institution  that would remain at least adequately
capitalized after making a capital distribution,  and was not owned by a holding
company,  would no  longer be  required  to  provide  notice to the OTS prior to
making a capital  distribution.  "Troubled"  associations  and  undercapitalized
associations  would be allowed to make capital  distributions  only by filing an
application and receiving OTS approval,  and such applications would be approved
under certain limited circumstances.

     Activities of Subsidiaries.  A savings  association  seeking to establish a
new subsidiary, acquire control of an existing company or conduct a new activity
through a  subsidiary  must provide 30 days prior notice to the FDIC and the OTS
and conduct any activities of the subsidiary in accordance with  regulations and
orders of the OTS.  The OTS has the power to  require a savings  association  to
divest any subsidiary or terminate any activity  conducted by a subsidiary  that
the OTS determines to pose a serious threat to the financial  safety,  soundness
or stability of the savings  association  or to be otherwise  inconsistent  with
sound banking practices.

     Community  Reinvestment Act and the Fair Lending Laws. Savings associations
have a responsibility  under CRA and related regulations of the OTS to help meet
the  credit  needs  of their  communities,  including  low- and  moderate-income
neighborhoods.  In  addition,  the  Equal  Credit  Opportunity  Act and the Fair
Housing  Act  (together,   the  "Fair  Lending  Laws")  prohibit   lenders  from
discriminating  in their  lending  practices  on the  basis  of  characteristics
specified  in those  statutes.  An  institution's  failure  to  comply  with the
provisions of CRA could, at a minimum,  result in regulatory restrictions on its
activities  and the denial of certain  applications,  and failure to comply with
the Fair Lending Laws could result in enforcement actions by the OTS, as well as
other federal regulatory agencies and the Department of Justice.


                                       12
<PAGE>



     Federal  Home Loan Bank  System.  The Bank is a member of the FHLB  system.
Among  other  benefits,  each FHLB  serves as a reserve or central  bank for its
members  within its assigned  region.  Each FHLB is financed  primarily from the
sale of consolidated  obligations of the FHLB system.  Each FHLB makes available
to members loans (i.e., advances) in accordance with the policies and procedures
established by the Board of Directors of the individual FHLB.

     As a member,  the Bank is required  to own  capital  stock in an FHLB in an
amount equal to the greater of: (i) 1% of its  aggregate  outstanding  principal
amount of its residential  mortgage loans,  home purchase  contracts and similar
obligations at the beginning of each calendar  year,  (ii) 0.3% of total assets,
or (iii) 5% of its FHLB advances  (borrowings).  At December 31, 1997,  the Bank
had $44.1 million in FHLB stock.  The Bank's required  investment in FHLB stock,
based on December 31, 1997 financial data, was $47.4 million.  The Bank received
a $0.7 million stock dividend and purchased  additional  stock amounting to $2.6
million in the first quarter of 1998,  thereby  increasing the Bank's investment
to the  required  amount.  See Note 11 of Notes  to the  Consolidated  Financial
Statements on page 69.

     Liquidity  Requirements.  Under OTS regulations,  a savings  association is
required to maintain an average daily balance of liquid assets  (including cash,
certain  time  deposits  and savings  accounts,  bankers'  acceptances,  certain
government obligations,  and certain other investments) in each calendar quarter
of not less than 4% of either: (i) its liquidity base (consisting of certain net
withdrawable accounts plus short-term borrowings) as of the end of the preceding
calendar quarter, or (ii) the average daily balance of its liquidity base during
the preceding  quarter.  This liquidity  requirement may be changed from time to
time by the  OTS to any  amount  between  4% and  10%,  depending  upon  certain
factors,  including  economic  conditions  and  savings  flows  of  all  savings
associations.  The  Bank  maintains  liquid  assets  in  compliance  with  these
regulations.   Monetary  penalties  may  be  imposed  upon  an  institution  for
violations of liquidity requirements.

     Federal Reserve  System.  The Federal Reserve Board requires all depository
institutions  to maintain  non-interest  bearing  reserves at  specified  levels
against  their  transaction  accounts  (primarily  checking,  NOW, and Super NOW
checking  accounts) and non-personal time deposits.  The balances  maintained to
meet the reserve  requirements  imposed by the Federal Reserve Board may be used
to satisfy the liquidity  requirements  that are imposed by the OTS. At December
31, 1997, the Bank was in compliance with these requirements.

     Recent Proposed Legislation.  Congress has been considering  legislation in
various forms that would require federal  thrifts,  such as the Bank, to convert
their charters to national or state bank charters.  The Treasury  Department has
been  studying  the   development  of  a  common  charter  for  federal  savings
associations  and  commercial  banks.  In the event that the  thrift  charter is
eliminated  by January 1, 1999,  the Act would require the merger of the BIF and
the SAIF into a single  Deposit  Insurance  Fund on that date. In the absence of
appropriate "grandfather" provisions, legislation eliminating the thrift charter
could have a material adverse effect on the Bank and Downey because, among other
things, the regulatory,  capital and accounting treatment for national and state
banks and savings associations differs in certain significant  respects.  Downey
cannot  determine  whether,  or in what form, such legislation may eventually be
enacted and there can be no assurance that any legislation that is enacted would
contain adequate grandfather rights for the Bank and Downey.

TAXATION

     Federal.  A savings  institution  generally  is  subject to tax in the same
manner as other  corporations  for federal  income tax purposes,  though savings
institutions  have historically  enjoyed  favorable  treatment under the Code in
determining the deduction allowed for bad debts. During 1996, however,  Congress
enacted  legislation  which repealed the reserve method of determining  bad debt
deductions for "large thrift  institutions"  (i.e.,  thrifts with assets greater
than $500 million),  subjecting  savings  associations to rules similar to those
currently applicable to large commercial banks. The repeal was effective for tax
years  beginning  after  1995.  Bad debt  reserves  accumulated  since 1987 were
subject to recapture as taxable income over a six-year period beginning in 1996.
However,  thrifts  were  allowed to defer  recapture  for up to two years if the
amount of mortgage  loans  originated  in 1996 and 1997  equaled or exceeded the
average  amount of mortgages  originated  in the six years prior to 1996.  Based
upon originations in 1996 and 1997, the Bank qualifies for the two-year deferral
under this  originations  test,  and thus will  recapture its post-1987 bad debt
reserve over a six-year  period  beginning in 1998. The bad debt  deductions for
1996 and 1997 were determined under the specific charge-off method, which allows
a tax deduction for loans determined to be wholly or partially worthless.



                                       13
<PAGE>



     Prior to 1996, a savings  institution which met certain  definitional tests
relating  to the  composition  of its  assets  and the  sources of its income (a
"qualifying savings institution") was permitted to take deductions for additions
to reserves for bad debts, rather than recognizing deductions for specific loans
as they became worthless.  A qualifying savings  institution was allowed to make
annual additions to such reserves based upon the institution's  actual loan loss
experience  (the  "experience  method").  Alternatively,  a  qualifying  savings
institution  could  elect to  compute  the  allowable  addition  to its bad debt
reserve for  qualifying  real  property  loans  (generally,  loans secured by an
interest in improved real estate) as a percentage of the  institution's  taxable
income (the "percentage-of-taxable-income method").

     Under applicable provisions of the Code, a savings institution organized in
stock form whose  accumulated  reserve for losses on  qualifying  real  property
loans  exceeds  the reserve as  calculated  under the  experience  method may be
subject  to  recapture  taxes  on such  reserve  if it  makes  certain  types of
distributions  to its  stockholders.  Dividends  may  be  paid  out of  retained
earnings  without the  imposition of any tax on the savings  institution  to the
extent  that  the  amounts   paid  as   dividends  do  not  exceed  the  savings
institution's   current  or  post-1951   accumulated  earnings  and  profits  as
calculated for federal income tax purposes. Stock redemptions, dividends paid in
excess of the savings  institution's  current or post-1951  accumulated earnings
and profits as calculated for tax purposes,  and other  distributions  made with
respect  to  the  savings  institution's  stock  (and  the  taxes  deemed  to be
attributable thereto), however, are deemed under applicable sections of the Code
to be made from the savings  institution's  tax bad debt  reserves to the extent
that such reserves exceed the amount that could have been accumulated  under the
experience method. Thus, certain  distributions to stockholders that are treated
as having  been paid from the  reserve for losses on  qualifying  real  property
loans could result in a federal recapture tax. The Bank, however, has not in the
past made distributions that resulted in federal recapture tax under these rules
and does not expect to make any such distributions in the foreseeable future.

     In addition to the regular  corporate income tax,  corporations,  including
qualifying savings institutions, are subject to an alternative minimum tax. This
20% tax is computed with respect to the  corporation's  regular  taxable  income
(with certain  adjustments),  as increased by tax preference items ("alternative
minimum  taxable  income")  and will  apply to the extent  that it  exceeds  the
corporation's  regular tax liability.  In addition, in computing a corporation's
alternative minimum taxable income, the corporation's  regular taxable income is
required  to be  increased  by 75% of the  excess of the  corporation's  current
earnings and profits  (subject to certain  adjustments)  over the  corporation's
alternative  minimum  taxable  income  determined  prior to this  adjustment and
without  regard  to  the  alternative  tax  net  operating  loss  deduction.   A
corporation  that incurs  alternative  minimum tax generally is entitled to take
such tax as a credit  against its regular tax in subsequent  years to the extent
that the  corporation's  regular tax liability in such subsequent years (reduced
by certain other tax credits)  exceeds the  corporation's  so-called  "tentative
minimum tax"  (generally,  an amount computed by multiplying  the  corporation's
alternative minimum taxable income for the year by the then-applicable  rate for
the alternative minimum tax).

     State.  The  California  franchise  tax  applicable to the Bank is computed
under a formula  which  results in a rate  higher  than the rate  applicable  to
non-financial  corporations  because  it  reflects  an amount "in lieu" of local
personal  property and business license taxes paid by such corporations (but not
generally  paid by  banks  or  financial  corporations  such as the  Bank).  The
variable tax rate was 10.84% in 1997, and 11.3% for 1996.  Downey and its wholly
owned  subsidiaries  file  a  California  franchise  tax  return  on a  combined
reporting   basis.   Additional   state  income  tax  returns  are  filed  on  a
separate-entity  basis in Arizona,  Colorado,  and Illinois for income-producing
property owned in those states.

     Downey's  federal income and state  franchise tax returns have been audited
by the  Internal  Revenue  Service  and  the  California  Franchise  Tax  Board,
respectively,  for all years  through  1989.  Federal tax returns for years 1990
through 1995 are currently  under  examination.  State franchise tax returns for
years subsequent to 1989 remain open to review.

FACTORS THAT MAY AFFECT FUTURE RESULTS

     The following discusses certain factors which may affect Downey's financial
results and operations and should be considered in evaluating Downey.

     Economic Conditions and Geographic Concentrations.  Downey is headquartered
in Southern  California,  and its  operations are  concentrated  in Southern and
Northern  California.  As a result of this  geographic  concentration,  Downey's
results  depend  largely upon  economic  conditions  in these  areas.  While the
California economy has exhibited positive economic and employment trends,  there
is no assurance  that such trends will  continue.  A  deterioration  in economic
conditions  could have a material adverse impact on the quality of Downey's loan
portfolio and the demand for its products and services.



                                       14
<PAGE>



     Interest Rates.  Downey  anticipates  that interest rate levels will remain
generally  constant  in 1998,  but if  interest  rates vary  substantially  from
present  levels,  Downey's  results  may  differ  materially  from  the  results
currently  anticipated.  Changes in interest  rates will influence the growth of
loans,  investments  and  deposits  and affect the rates  received  on loans and
investment securities and paid on deposits.

     Government  Regulation and Monetary Policy. The financial services industry
is  subject  to  extensive   federal  and  state   supervision  and  regulation.
Significant  new laws or changes  in, or  repeals  of,  existing  laws may cause
Downey's  results  to  differ  materially.  Further,  federal  monetary  policy,
particularly as implemented  through the Federal  Reserve System,  significantly
affects credit  conditions for Downey,  primarily through open market operations
in United States  government  securities,  the discount rate for  borrowings and
reserve requirements,  and a material change in these conditions would be likely
to have a material impact on Downey's results.

     Competition. The banking and financial services business in Downey's market
areas are highly  competitive.  The  increasingly  competitive  environment is a
result  primarily of changes in  regulation,  changes in technology  and product
delivery  systems,  and the accelerating  pace of consolidation  among financial
services providers.  Downey's results may differ if circumstances  affecting the
nature or level of competition change.

     Credit  Quality.  A significant  source of risk arises from the possibility
that losses will be sustained because borrowers,  guarantors and related parties
may fail to  perform in  accordance  with the terms of their  loans.  Downey has
adopted  underwriting  and  loan  monitoring  procedures  and  credit  policies,
including the  establishment  and review of the allowance for loan losses,  that
management  believes are  appropriate  to minimize  this risk by  assessing  the
likelihood  of  nonperformance,   tracking  loan  performance  and  diversifying
Downey's loan portfolio. Such policies and procedures,  however, may not prevent
unexpected losses that could materially adversely affect Downey's results.

     Year 2000.  Like most  financial  organizations,  Downey has many  computer
systems that  identify  dates using only the last two digits of the year.  These
systems must be prepared to distinguish  dates such as 1900 from 2000.  Computer
system failures due to processing errors  potentially  arising from calculations
using Year 2000 dates are a known  risk.  Downey has  established  processes  to
identify,  prioritize,  renovate or replace systems that may be affected by Year
2000  dates.  To date,  Downey has  completed  an  inventory  of all systems and
determined which processes are most critical to supporting customer  transaction
processing and providing  customer  services.  System renovation and replacement
plans have been started and are targeted for completion by the end of 1998, with
compliance  testing and  installation  processes  to be  completed  during 1999.
However,  third party vendor  dependency,  including  government  entities,  may
impact Downey's  efforts to  successfully  complete Year 2000 compliance for all
systems in a timely fashion.




                                       15
<PAGE>



ITEM 2. PROPERTIES

BRANCHES

     The  executive  offices  of both  Downey  and the Bank are  located at 3501
Jamboree  Road,  Newport  Beach,  California  92660,  in  a  six-story  building
containing  approximately  320,000 square feet. Part of the first floor houses a
branch office of the Bank. Certain departments  (warehousing,  record retention,
etc.)  are  located  in other  owned and  leased  facilities  in Orange  County,
California.  The majority of Downey's  administrative  operations,  however, are
located in the headquarters building.

     At December 31, 1997,  Downey owned the building and land occupied by 54 of
its branches and owned one building on leased land. Downey leases branches in 35
locations  (including  26 in-store  locations)  with leases  expiring at various
dates through  November 2009,  with options to extend the term. In 1997,  Downey
purchased land and buildings for three new branch locations opening in 1998.

     The net book value of the owned branches, including the one on leased land,
totaled $85.4 million at December 31, 1997, and the net book value of the leased
branch offices  totaled $1.5 million at December 31, 1997. The net book value of
Downey's furniture and fixtures, including electronic data processing equipment,
was $14.9 million at December 31, 1997.

     For additional  information  regarding Downey's offices and equipment,  see
Notes 1 and 10 of Notes to the Consolidated  Financial Statements on page 53 and
page 69, respectively.

ELECTRONIC DATA PROCESSING

     Downey utilizes a mainframe computer system with use of various third-party
vendors' software for retail deposit operations, loan servicing,  accounting and
loan  origination  functions.  The net book value of  Downey's  electronic  data
processing  equipment,  including  personal  computers and  software,  was $10.3
million at December 31, 1997.

ITEM 3. LEGAL PROCEEDINGS

     Downey  has been  named as a  defendant  in legal  actions  arising  in the
ordinary  course of business,  none of which,  in the opinion of management,  is
material.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS

     None.




                                       16
<PAGE>



                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     Downey's Common Stock is traded on the New York Stock Exchange ("NYSE") and
the Pacific  Exchange  ("PCX")  with the trading  symbol  "DSL." At February 27,
1998, Downey had approximately  1,078  stockholders of record (not including the
number of persons or entities  holding  stock in nominee or street name  through
various brokerage firms) and 26,755,938  outstanding shares of common stock. The
following table sets forth for the quarters  indicated the range of high and low
sale  prices per share of the  common  stock of Downey as  reported  on the NYSE
Composite Tape.

<TABLE>
<CAPTION>
                                  1997                                1996
                  -----------------------------------  ----------------------------------
                    4th       3rd      2nd      1st      4th      3rd      2nd      1st
                  Quarter   Quarter  Quarter  Quarter  Quarter  Quarter  Quarter  Quarter
-----------------------------------------------------------------------------------------
<S>             <C>          <C>      <C>      <C>      <C>      <C>      <C>      <C>                       
High ........   $   29.00$   24.50$   23.63$   22.50$   18.69$   16.03$   15.23$   15.23
Low .........       24.19    21.50    18.09    18.09    15.88    12.86    12.86    13.09
End of period       28.44    24.38    23.63    19.28    18.69    16.03    13.89    14.92
</TABLE>

     During 1997 and 1996, Downey paid quarterly cash dividends  totaling $0.315
and  $0.304 per  share,  aggregating  $8.5 and $8.1  million,  respectively.  On
February  27,  1998,  Downey  paid a $0.08 per share  quarterly  cash  dividend,
aggregating $2.1 million.

     Downey may pay additional dividends out of funds legally available therefor
at such times as the Board of Directors  determines  that dividend  payments are
appropriate.  The Board of Directors'  policy is to consider the  declaration of
dividends on a quarterly basis.

     The  payment  of  dividends  by  the  Bank  to  Downey  is  subject  to OTS
regulations. For further information regarding these regulations see "Business -
Regulation - Regulation of the Bank - Capital Distribution  Limitations" on page
12.



                                       17
<PAGE>

ITEM 6.       SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
(Dollars in Thousands, Except Per Share Data)                     1997         1996          1995          1994          1993
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                           <C>           <C>           <C>           <C>           <C> 
For the year:
Total interest income .....................................   $  420,418    $  346,360    $  318,828    $  228,970    $  220,745
Total interest expense ....................................      266,260       211,765       214,238       122,601       109,973
--------------------------------------------------------------------------------------------------------------------------------
    Net interest income ...................................      154,158       134,595       104,590       106,369       110,772
    Provision for loan losses .............................        8,640         9,137         9,293         4,211         1,085
--------------------------------------------------------------------------------------------------------------------------------
    Net interest income after provision for loan losses ...      145,518       125,458        95,297       102,158       109,687
--------------------------------------------------------------------------------------------------------------------------------
Other income, net:
    Loan and deposit related fees .........................       10,921         7,435         5,546         5,310         6,175
    Real estate and joint ventures held for investment, net       14,222         8,241        11,192         9,530         4,769
    Net gains (losses) on sales of:
      Loans and mortgage-backed securities ................        2,675         1,543           266           114         1,665
      Investment securities ...............................         --           4,473           (15)         --            --
    (Provision for) reduction of loss on investment in 
      lease residual ......................................         --            --             207          (920)       (2,184)
    Other .................................................        7,370         3,507         3,403         3,703         4,609
--------------------------------------------------------------------------------------------------------------------------------
    Total other income, net ...............................       35,188        25,199        20,599        17,737        15,034
--------------------------------------------------------------------------------------------------------------------------------
Operating expense:
    General and administrative expense ....................       99,556        86,460        74,470        75,566        73,502
    SAIF special assessment ...............................         --          24,644          --            --            --
    Net operation of real estate acquired in settlement of 
      loans ...............................................        1,184         2,567         4,206         3,595         2,337
    Amortization of excess of cost over fair value of net  
      assets acquired .....................................          532           532           530           532           532
--------------------------------------------------------------------------------------------------------------------------------
    Total operating expense ...............................      101,272       114,203        79,206        79,693        76,371
--------------------------------------------------------------------------------------------------------------------------------
Net income ................................................       45,234        20,704 (1)    21,093        23,532        43,666 (2)

Loans originated ..........................................    2,329,266     1,583,784       637,490     1,810,096     1,104,252
Loans and mortgage-backed securities purchased ............       35,828        30,296        44,194       196,255        19,625
Loans and mortgage-backed securities sold .................      557,511       166,503       102,097        45,770       153,146

Effective interest rate spread ............................         2.83%         2.96%         2.35%         3.02%         3.47%

At December 31:
Total assets ..............................................   $5,835,825    $5,198,157     4,656,267    $4,650,651    $3,467,155
Total loans and mortgage-backed securities ................    5,366,396     4,729,846     4,169,474     4,188,539     2,917,109
Investments and cash equivalents ..........................      221,201       222,255       237,904       215,960       313,989
Deposits ..................................................    4,869,978     4,173,102     3,790,221     3,557,398     3,068,929
Borrowings ................................................      483,735       595,345       436,218       674,776        13,718
Stockholders' equity ......................................      430,346       391,571       384,072       366,187       351,470
Loans serviced for others .................................      612,529       576,044       527,234       468,123       503,711
Allowance for loan losses as a percentage of
  non-performing loans ....................................        76.96%        66.84%        35.67%        49.29%        47.72%
Non-performing assets as a percentage of total assets .....         0.89          1.19          2.09          1.41          2.01

Selected ratios:
Return on average assets ..................................         0.79%         0.43% (1)     0.45%         0.62%         1.25%(3)
Return on average equity ..................................        11.07          5.33  (1)     5.69          6.56         12.83 (3)
Dividend payout ratio .....................................        18.69         39.35         36.78         33.97         12.96
Capital ratios:
    Average stockholders' equity to average assets ........         7.17          8.10          7.86          9.47          9.74
    Core and tangible capital .............................         6.61          6.56          7.28          7.22          9.45
    Risk-based capital ....................................        12.64         12.66         14.25         14.21         16.93

Per Share Data: (4)
Earnings per share - Basic/Diluted ........................       $ 1.69        $ 0.77 (1)    $ 0.79        $ 0.88        $ 1.64 (2)
Book value per share at end of period .....................        16.08         14.65         14.37         13.70         13.15
Stock price at end of period ..............................        28.44         18.69         13.81          9.14         12.02
Cash dividends paid .......................................        0.315         0.304         0.290         0.290         0.211
</TABLE>

(1)  Excluding  the SAIF  special  assessment,  net income would have been $34.7
     million or $1.29 per share and the  returns on average  assets and  average
     equity would have been 0.73% and 8.95%, respectively.
(2)  Includes $15.1  million,  or $0.56 per share,  cumulative  benefit from the
     adoption of SFAS 109, Accounting for Income Taxes.
(3)  Excluding the SFAS 109 benefit,  the returns on average  assets and average
     equity would have been 0.82% and 8.39%, respectively.
(4)  Adjusted for a 5% stock dividend paid in May 1997.


                                       18
<PAGE>


ITEM 7. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

     Certain   statements   under  this  caption   constitute   "forward-looking
statements" under the Reform Act which involve risks and uncertainties. Downey's
actual  results  may differ  significantly  from the results  discussed  in such
forward-looking  statements.  Factors that might cause such a difference include
but are not limited to economic  conditions,  competition  in the geographic and
business areas in which Downey conducts its operations, fluctuations in interest
rates,  credit quality and  government  regulation.  For additional  information
concerning these factors, see "Item 1. Business - Factors that May Affect Future
Results" on page 14.

                                    OVERVIEW

     Net income for 1997 totaled  $45.2  million or $1.69 per share on a diluted
basis,  more than double last year's $20.7 million or $0.77 per share.  The 1996
results included a one-time  assessment to recapitalize the Savings  Association
Insurance  Fund ("SAIF") which totaled $24.6 million ($14.0 million or $0.52 per
share on an after-tax  basis).  Excluding  that  assessment,  net income in 1997
would have been $10.5 million or 30.2% above a year ago.

     Excluding  the one-time  SAIF  assessment,  the increase in 1997 net income
primarily  reflected higher net interest  income.  Net interest income increased
$19.6 million or 14.5% due to higher average earning assets.  Also  contributing
to the  increase in net income  between  years was a $10.0  million  increase in
other income and a $1.4 million  decline in the net expense  associated with the
operation of real estate acquired in settlement of loans.  The increase in other
income  reflected  several  factors.   Favorably  impacting  other  income  were
increases of $6.0 million in income from real estate held for  investment,  $4.0
million in the all other  category of other income  representing a gain from the
sale of an  asset  obtained  as  part of the  1988  acquisition  of  Butterfield
Savings,  $3.5 million in loan and deposit  related fees and $1.1 million in net
gains from sales of loans and mortgage-backed securities.  These favorable other
income  items were  partially  offset by a decline of $4.5  million in net gains
from sales of investment securities. The favorable impact of higher net interest
and other income,  and lower net expense  associated  with the operation of real
estate  acquired in settlement  of loans was partially  offset by an increase of
$13.1 million in general and administrative expense. The increase in general and
administrative   expense  was  primarily   associated  with  branch   expansion,
particularly into in-store banking,  higher advertising  expenditures and growth
in auto lending.

     Assets  increased  $637.7  million or 12.3%  during 1997 to $5.8 billion at
year  end,   following  an  11.6%  increase  during  1996.  Single  family  loan
originations  increased  from $1.25  billion in 1996 to $2.0 billion in 1997. Of
the 1997 amount,  $221.2 million  represented higher yielding subprime loans. In
addition to single family loans,  $413.4 million of other loans were originated,
including $259.0 million of auto loans and $80.0 million of construction loans.

     Asset  growth was  primarily  funded with  deposits  as deposits  increased
$696.9  million or 16.7% to $4.9 billion at December 31, 1997.  Of the increase,
$102.6 million was generated by new branches opened in 1997.

     Non-performing  assets totaled $52.1 million or 0.89% of assets at December
31, 1997,  down from $62.0 million or 1.19% of assets at December 31, 1996.  The
decline in  non-performing  assets  was spread  throughout  most  categories.  A
detailed review of all criticized,  classified,  watch and non-performing assets
is  performed  at least  semi-annually.  All assets  greater than $1 million are
reviewed  annually.  The combined  provisions  for loan and real estate  losses,
including  real estate held for  investment and acquired in settlement of loans,
totaled $6.6 million for 1997, compared to $7.5 million in 1996 and $8.9 million
in 1995.

         At December  31, 1997,  the Bank met and exceeded all three  regulatory
capital  tests,  with  capital-to-asset  ratios  of 6.61% in  tangible  and core
capital and 12.64% in risk-based  capital.  These capital  levels are well above
the "well capitalized" standards defined by the federal banking regulators of 5%
for core and  tangible  capital  and 10% for  risk-based  capital.  For  further
information,  see "Business - Regulation - Regulation of the Bank - Insurance of
Deposit  Accounts" on page 9, "Financial  Condition - Investments in Real Estate
and Joint Ventures" on page 28 and "Regulatory Capital Compliance" on page 44.




                                       19
<PAGE>



                              RESULTS OF OPERATIONS

NET INTEREST INCOME

     Net interest  income is the  difference  between the interest and dividends
earned  on  loans,   mortgage-backed   securities  and   investment   securities
("interest-earning  assets")  and the interest  paid on deposits and  borrowings
("interest-bearing liabilities"). Net interest income is affected principally by
the  spread  between  the  yield  on  interest-earning  assets  and the  cost of
interest-bearing  liabilities  and by the relative dollar amounts of such assets
and liabilities.

     Net interest  income was $154.2  million in 1997, up $19.6 million or 14.5%
from 1996 and $49.6  million or 47.4%  greater than 1995.  The 1997  improvement
over 1996 primarily reflected a 19.7% increase in average earning assets to $5.4
billion.  In addition,  1997 benefited from approximately $1.3 million of higher
than usual  distributions from agreements in which Downey shares in the net cash
flows of  certain  shopping  centers  which  Downey  currently,  or in the past,
financed.  These  favorable  items  were  partially  offset by a decline  in the
effective  interest  rate spread.  The effective  interest rate spread  averaged
2.83% in 1997,  down from 2.96% in 1996 but up from 2.35% in 1995.  Between 1997
and 1996, the yield on earning assets increased 11 basis points,  while the cost
of funding  those  earnings  assets  increased 22 basis  points.  The more rapid
increase in funding costs occurred as the growth in earning assets was primarily
funded with higher cost certificates of deposit and borrowings.

     The  following  table  presents for the periods  indicated the total dollar
amount of interest  income from average  interest-earning  assets and  resultant
yields,  the interest  expense on average  interest-bearing  liabilities and the
resultant costs,  expressed both in dollars and rates. The table also sets forth
the  net  earning  balance  (the  difference  between  the  average  balance  of
interest-earning assets and the average balance of interest-bearing liabilities)
for the  periods  indicated.  Non-accrual  loans  are  included  in the  average
interest-earning assets balance.  Interest from non-accrual loans is included in
interest income only to the extent that payments were received and to the extent
that Downey  believes it will  recover the  remaining  principal  balance of the
loan.  Average  balances are computed using a monthly average balance during the
period.   The  effective   interest  rate  spread,   which  reflects  a  savings
association's  relative  level of  interest-earning  assets to  interest-bearing
liabilities,   equals   (i)  the   difference   between   interest   income   on
interest-earning  assets and interest expense on  interest-bearing  liabilities,
(ii) divided by average  interest-earning  assets for the period. The table also
sets forth the net interest  income,  the interest rate spread and the effective
interest rate spread.

<TABLE>
<CAPTION>
                                                 1997                           1996                               1995
                                   -------------------------------------------------------------------------------------------------
                                                         Average                          Average                            Average
                                   Average                Yield/    Average                Yield/     Average                 Yield/
(Dollars in Thousands)             Balance     Interest    Rate     Balance    Interest     Rate      Balance     Interest     Rate
------------------------------------------------------------------------------------------------------------------------------------
<S>                              <C>          <C>          <C>     <C>          <C>          <C>     <C>          <C>          <C>
Interest-earning assets:
  Loans .......................  $5,174,767   $  404,081   7.81%   $4,269,136   $  329,746   7.72%   $4,175,085   $  300,734   7.20%
  Mortgage-backed securities ..      55,045        3,633   6.60        64,957        4,317   6.65        63,772        4,311   6.76
  Investment securities .......     217,272       12,704   5.85       215,364       12,297   5.71       215,672       13,783   6.39
------------------------------------------------------------------------------------------------------------------------------------
   Total interest-earning 
     assets ...................   5,447,084      420,418   7.72     4,549,457      346,360   7.61     4,454,529      318,828   7.16
Non-interest-earning assets ...     246,785                           240,191                           263,430
------------------------------------------------------------------------------------------------------------------------------------
   Total assets ...............  $5,693,869                        $4,789,648                        $4,717,959
====================================================================================================================================

Interest-bearing liabilities:
  Deposits ....................  $4,588,320   $  227,521   4.96%   $3,892,981   $  184,402   4.74%   $3,758,948   $  180,859   4.81%
  Borrowings ..................     638,661       38,739   6.07       457,890       27,363   5.98       523,417       33,379   6.39
------------------------------------------------------------------------------------------------------------------------------------
   Total interest-bearing .....   5,226,981      266,260   5.09     4,350,871      211,765   4.87     4,282,365      214,238   5.00
    liabilities
Non-interest-bearing 
  liabilities .................      58,415                            50,590                            64,880
Stockholders' equity ..........     408,473                           388,187                           370,714
------------------------------------------------------------------------------------------------------------------------------------
   Total liabilities and
      stockholders' equity ....  $5,693,869                        $4,789,648                        $4,717,959
====================================================================================================================================
Net interest income/interest 
  rate spread .................               $  154,158   2.63%                $  134,595   2.74%                $  104,590   2.16%
Excess of interest-earning 
  assets over interest-bearing 
  liabilities                    $  220,103                        $  198,586                        $  172,164
Effective interest rate spread                             2.83                              2.96                              2.35
====================================================================================================================================
</TABLE>




                                       20
<PAGE>



     Changes in Downey's net  interest  income are a function of both changes in
rates and  changes in volumes of  interest-earning  assets and  interest-bearing
liabilities.  The following table sets forth  information  regarding  changes in
interest  income  and  expense  for  Downey  for the years  indicated.  For each
category of interest-earning asset and interest-bearing  liability,  information
is  provided  on changes  attributable  to:  (i) change in rate  (change in rate
multiplied by old volume), (ii) change in volume (change in volume multiplied by
old rate) and (iii) change in rate-volume  (change in rate  multiplied by change
in volume).  Interest-earning  asset and liability  balances in the calculations
are computed using monthly average balances.

<TABLE>
<CAPTION>
                                                1997 versus 1996                               1996 versus 1995
                                                 Change Due To                                  Change Due To
                                   -------------------------------------------  ----------------------------------------------
                                                           Rate/                                           Rate/
(In Thousands)                      Volume      Rate       Volume        Net        Volume      Rate       Volume       Net
------------------------------------------------------------------------------------------------------------------------------
<S>                               <C>         <C>         <C>         <C>         <C>         <C>         <C>         <C>     
Interest Income:
   Loans ......................   $ 69,951    $  3,617    $    767    $ 74,335    $  6,775    $ 21,747    $    490    $ 29,012
   Mortgage-backed securities .       (659)        (30)          5        (684)         80         (73)         (1)          6
   Investment securities ......        109         295           3         407         (20)     (1,468)          2      (1,486)
------------------------------------------------------------------------------------------------------------------------------
     Change in interest income      69,401       3,882         775      74,058       6,835      20,206         491      27,532
------------------------------------------------------------------------------------------------------------------------------
Interest Expense:
   Deposits ...................     32,937       8,639       1,543      43,119       6,449      (2,806)       (100)      3,543
   Borrowings .................     10,801         412         163      11,376      (4,184)     (2,094)        262      (6,016)
------------------------------------------------------------------------------------------------------------------------------
     Change in interest expense     43,738       9,051       1,706      54,495       2,265      (4,900)        162      (2,473)
------------------------------------------------------------------------------------------------------------------------------
Change in net interest income .   $ 25,663    $ (5,169)   $   (931)   $ 19,563    $  4,570    $ 25,106    $    329    $ 30,005
==============================================================================================================================
</TABLE>

PROVISION FOR LOAN LOSSES

     Provision  for loan  losses was $8.6  million in 1997,  as compared to $9.1
million in 1996 and $9.3 million in 1995.  The provision for loan losses in 1997
exceeded net loan  charge-offs by $2.0 million  primarily  reflecting  growth in
single family residential and automobile loans.

     For further information,  see "Financial Condition - Problem Loans and Real
Estate - Allowance for Losses on Loans and Real Estate" on page 40.

OTHER INCOME

     Other income  totaled $35.2  million in 1997,  compared to $25.2 million in
1996 and $20.6 million in 1995. The increase in 1997 reflected  several factors.
Favorably  impacting  other income were increases of $6.0 million in income from
real estate held for investment,  $4.0 million in the all other  category,  $3.5
million in loan and deposit related fees, and $1.1 million in net gains from the
sales of loans.  Partially offsetting those increases was a $4.5 million decline
in net gains from sales of investment  securities.  Below is a discussion of the
major other income categories.

Loan and Deposit Related Fees

     Loan and deposit  related fees totaled $10.9  million in 1997,  compared to
$7.4  million in 1996 and $5.5  million in 1995.  As depicted  in the  following
table,  the current year reflected an increase in both loan and deposit  related
fees,  the latter  primarily  the result of higher  fees from  automated  teller
machines.

(In Thousands)                             1997      1996     1995
--------------------------------------------------------------------
Loan related fees ....................   $ 3,837   $ 2,496   $ 1,508
Deposit related fees .................     7,084     4,939     4,038
--------------------------------------------------------------------
   Total loan and deposit related fees   $10,921   $ 7,435   $ 5,546
====================================================================






                                       21
<PAGE>



Real Estate and Joint Venture Operations Held for Investment

     Income from real estate and joint venture  operations totaled $14.2 million
in 1997,  compared to $8.2 million in 1996 and $11.2 million in 1995.  The table
below sets forth the key components comprising income from real estate and joint
venture operations.

<TABLE>
<CAPTION>
(In Thousands)                                                  1997       1996      1995
-------------------------------------------------------------------------------------------
<S>                                                          <C>        <C>        <C>     
Operations, net:
   Rental operations net of expenses .....................   $  2,317   $  2,417   $  3,711
   Equity in net income (loss) from joint ventures .......      3,931         55     (1,676)
   Interest from joint venture advances ..................      1,880      2,071      1,702
-------------------------------------------------------------------------------------------
      Total operations, net ..............................      8,128      4,543      3,737
Net gains on sales of wholly owned real estate ...........      2,904        392      4,539
Reduction of losses on real estate and joint ventures ....      3,190      3,306      2,916
-------------------------------------------------------------------------------------------
      Income from real estate and joint venture operations   $ 14,222   $  8,241   $ 11,192
===========================================================================================
</TABLE>

     Favorably  impacting  income from real estate and joint venture  operations
was a $5.5  million  gain  from an all  cash  sale of four  California  shopping
centers from one joint venture partnership relationship. The gain appears in two
categories,  $3.9 million in equity in net income (loss) from joint ventures and
$1.6  million  in  recovery  of losses on real  estate  and joint  ventures.  In
addition,  net gains on sales of wholly owned real estate increased $2.5 million
in 1997.

     For additional information,  see "Financial Condition - Investments in Real
Estate and Joint Ventures" on page 28, "Financial  Condition - Problem Loans and
Real  Estate -  Allowance  for Losses on Loans and Real  Estate" on page 40, and
Note 8 of Notes to the Consolidated Financial Statements on page 64.

Secondary Marketing Activities

     Sales  of  loans  and  mortgage-backed   securities  originated  by  Downey
increased  in 1997 to  $557.5  million  from  $161.9  million  in 1996 and $80.7
million in 1995. Of the current year's increase,  $290.5 million represented the
sale of single family adjustable rate mortgages from the loan portfolio held for
investment.  Gains  associated  with loan sales  totaled  $2.7  million in 1997,
compared to $1.5 million in 1996 and $0.3 million in 1995. The net gains include
$1.2 million in 1997 and $1.0 million in 1996 related to the  capitalization  of
mortgage servicing rights.

     Loan  servicing  fees from Downey's  portfolio of loans serviced for others
totaled $1.3  million for 1997,  down from $1.4 million in 1996 and $1.5 million
in 1995.  At December  31, 1997,  Downey  serviced  $612.5  million of loans for
others,  compared to $576.0  million at December 31, 1996, and $527.2 million at
December 31, 1995.

Net Gains (Losses) on Sales of Investment Securities

     No  investment  securities  were  sold in 1997 so  there  were no  gains or
losses.  This  compares to $4.5 million of net gains from the sale of investment
securities available for sale in 1996 and a loss of $15,000 in 1995.

Provision for Loss on Investment in Lease Residual

     Certain  mainframe  computer  equipment Downey leased to others was sold in
1995 upon  termination of the lease  resulting in a provision  reduction of $0.2
million. No such activity occurred in either 1997 or 1996.

Other Category

     The all other  category  of other  income  totaled  $6.1  million  in 1997,
compared  to $2.1  million  in 1996  and $1.9  million  in  1995.  The  increase
primarily reflects a gain from the sale of an asset obtained as part of the 1988
acquisition of Butterfield Savings.




                                       22
<PAGE>


OPERATING EXPENSES

     Operating  expenses totaled $101.3 million in 1997, down $12.9 million from
1996, which included a one-time SAIF assessment of $24.6 million. Excluding that
assessment,  operating  expense  would have  increased  $11.7  million or 13.1%.
Higher  general and  administrative  costs were  primarily  responsible  for the
increase.  General and  administrative  expense increased $13.1 million or 15.1%
and reflected  branch  expansion,  particularly  into in-store  banking,  higher
advertising  expenditures and growth in auto lending.  The $2.8 million increase
in advertising  expenditures  reflects,  in large part, the cost of a television
advertising  campaign to increase public awareness of the Bank, and specifically
the Bank's subprime  residential  lending  product,  a key component to Downey's
strategy of increasing  the loan portfolio  yield.  Also included in general and
administrative  costs in 1997 was $1.4 million of severance  paid pursuant to an
agreement with the former chief executive  officer.  The increase in general and
administrative  expense was partially  offset by a $1.4 million  decline to $1.2
million in costs  associated  with the net operation of real estate  acquired in
settlement of loans. The decline primarily reflects a $1.3 million gain from the
sale of a shopping center acquired in settlement of a loan.

<TABLE>
<CAPTION>
(In Thousands)                                                             1997      1996       1995
------------------------------------------------------------------------------------------------------
<S>                                                                     <C>        <C>        <C>     
Salaries and related costs ..........................................   $ 54,366   $ 45,811   $ 39,349
Premises and equipment costs ........................................     15,272     12,640     11,535
Advertising expense .................................................      6,847      4,071      2,028
Professional fees ...................................................      5,113      2,985      3,150
SAIF insurance premiums and regulatory assessments ..................      3,439      8,949      9,024
Other general and administrative expense ............................     14,519     12,004      9,384
------------------------------------------------------------------------------------------------------
   Total general and administrative expense .........................     99,556     86,460     74,470
SAIF Special Assessment .............................................       --       24,644       --
Net operation of real estate acquired in settlement of loans ........      1,184      2,567      4,206
Amortization of excess of cost over fair value of net assets acquired        532        532        530
------------------------------------------------------------------------------------------------------
   Total operating expense ..........................................   $101,272   $114,203   $ 79,206
======================================================================================================
</TABLE>

     For  information  regarding the potential  expense  impact of the Year 2000
computer issue, see "Financial Condition - Year 2000" on page 45.

PROVISION FOR INCOME TAXES

     Downey's  effective  tax rate for 1997 was 43.1%,  similar to 43.2% in 1996
and  42.5% in 1995.  See Notes 1 and 18 of Notes to the  Consolidated  Financial
Statements on pages 53 and 74, respectively,  for a further discussion of income
taxes and an  explanation  of the factors  which impact  Downey's  effective tax
rate.



                                       23
<PAGE>


                               FINANCIAL CONDITION

LOANS AND MORTGAGE-BACKED SECURITIES

     Loans  and  mortgage-backed  securities,  including  those  held for  sale,
totaled $5.4 billion,  or 92.0% of assets at December 31, 1997.  This represents
an increase  of $636.6  million or 13.5% from the $4.7  billion at December  31,
1996.

     The table below  presents  information  regarding  interest  rates and fees
collected on loans originated during the periods indicated.

<TABLE>
<CAPTION>
(Dollars in Thousands)                                   1997         1996         1995        1994         1993
-------------------------------------------------------------------------------------------------------------------
<S>                                                       <C>           <C>         <C>          <C>           <C>  
Average interest rate on new loans ..............         6.04%         6.06%       6.99%        4.94%         5.53%
Average total loan origination fees on new loans          0.80          0.79        1.08         0.85          0.63
Total loan fees (net of costs) and discounts (net
    of premiums) deferred during the year .......   $  (11,505)    $  (4,525)    $   880    $  (7,861)    $   1,572
===================================================================================================================
</TABLE>

     Downey  originates  one-to-four unit residential  adjustable rate mortgages
("ARMs") both with and without loan  origination  fees. In ARM  transactions for
which no origination fees are charged,  Downey receives a larger margin over the
index to which the loan pricing is tied than in those in which fees are charged.
In addition,  such loans are subject to a prepayment  fee if prepaid  within the
first  three  years.  This  trend  towards  loans with no  origination  fees has
generally   resulted  in  deferrable  loan  origination   costs  exceeding  loan
origination  fees except in 1995 and 1993 which  included  increases in interest
buydowns, or discounts, on new real estate loans.

     Residential  one-to-four unit ARM  originations  (including loans purchased
through  correspondent  lending  relationships)  were $1.7 billion  during 1997,
compared  to $1.1  billion  and $443.8  million in 1996 and 1995,  respectively.
Refinancing  activities  (including new loans to refinance  loans  originated by
Downey  and  other  lenders)   increased   during  1997,   constituting  38%  of
originations  during  the year  compared  to 35% and 31%  during  1996 and 1995,
respectively.  At December 31, 1997,  one-to-four unit ARMs constituted 82.7% of
the total loan and mortgage-backed  securities  portfolio,  compared to 81.9% at
December  31,  1996.  As market  interest  rates began to rise in 1994 and 1995,
one-to-four   unit   residential   borrower   preference   changed   from  being
predominantly interested in ARMs tied to the one-year constant maturity Treasury
("CMT") index,  a market rate index,  to ARMs tied to the Federal Home Loan Bank
("FHLB") Eleventh District Cost of Funds Index ("COFI"), an index which lags the
movement  in market  interest  rates.  For the  year,  79% of  one-to-four  unit
originations  for  investment  represented  monthly  adjusting  COFI ARMs  which
provide for negative amortization, 18% represented COFI ARMs which reprice every
six  months but do not  provide  for  negative  amortization,  with the  balance
represented  by a variety of other  pricing  terms.  At December 31, 1997,  $2.6
billion of one-to-four unit ARMs were subject to negative  amortization of which
$27.6  million  represented  the amount of  negative  amortization  added to the
unpaid loan balance. For further information, see "Business - Lending Activities
- Residential Real Estate Lending" on page 3.

     Originations  of commercial real estate loans totaled $7.8 million in 1997,
compared  to $1.5  million  in 1996  and  $10.6  million  in  1995.  Most of the
commercial real estate lending in these years was to facilitate the sale of real
estate  investments by the Bank and DSL Service  Company.  Originations of loans
secured by multi-family  properties  (including  loans  purchased)  totaled $5.9
million in 1997, compared to $19.7 million in 1996 and $0.5 million in 1995.

     During  1997,  Downey  originated  $80.0  million  of  construction  loans,
principally  for entry level and first time  move-up  residential  tracts.  This
compares to $71.7  million in 1996 and $28.9  million in 1995.  Originations  of
land development loans totaled $20.3 million in 1997,  compared to $10.5 million
in 1996 and $12.9 million in 1995.

     Originations of non-mortgage commercial loans increased to $14.3 million in
1997  from  $11.8  million  in 1996  as a  result  of  Downey's  expansion  into
commercial banking.  For the year, 95% of such originations  represented secured
loans.

     In 1995,  Downey augmented its direct  automobile  lending program with the
commencement  of an indirect  lending  program  through  preapproved  automobile
dealers to finance consumer  purchases of new and used automobiles.  These loans
are fixed rate with  maturities  generally  up to five  years.  Originations  of
automobile  loans totaled $259.0 million in 1997,  compared to $201.0 million in
1996 and $62.2 million in 1995.



                                       24
<PAGE>



     The following table sets forth the origination,  purchase and sale activity
relating to loans and mortgage-backed securities.

<TABLE>
<CAPTION>
(In Thousands)                                                        1997          1996          1995         1994         1993
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                               <C>            <C>           <C>          <C>           <C>
Investment Portfolio:
Loans originated:
   Loans secured by real estate:
    Residential:
      One-to-four units:
        Adjustable ............................................   $ 1,384,442    $1,026,812    $ 396,111    $1,673,822    $ 787,342
        Adjustable - subprime .................................       218,399        33,030         --            --           --
-----------------------------------------------------------------------------------------------------------------------------------
         Total adjustable .....................................     1,602,841     1,059,842      396,111     1,673,822      787,342
        Fixed .................................................        22,265        33,073       13,888         7,411        7,162
        Fixed - subprime ......................................         2,786           545         --            --           --
      Five or more units:
        Adjustable ............................................         4,600        17,409          128        18,385        8,500
        Fixed .................................................          --           2,253          419           953          404
-----------------------------------------------------------------------------------------------------------------------------------
         Total residential ....................................     1,632,492     1,113,122      410,546     1,700,571      803,408
    Commercial real estate ....................................         7,830         1,548       10,629        18,900       51,190
    Construction ..............................................        80,014        71,678       28,931        14,785       43,958
    Land ......................................................        20,295        10,468       12,906          --           --
   Non-mortgage:
    Commercial ................................................        14,336        11,835        1,115         1,605        3,500
    Consumer:
      Automobile ..............................................       259,040       200,966       62,234         1,869        1,871
      Other consumer ..........................................        25,988        14,226       17,633        39,945       38,823
-----------------------------------------------------------------------------------------------------------------------------------
        Total loans originated ................................     2,039,995     1,423,843      543,994     1,777,675      942,750
Real estate loans purchased (1) ...............................        35,828           223       44,194       145,117          612
-----------------------------------------------------------------------------------------------------------------------------------
   Total loans originated and purchased .......................     2,075,823     1,424,066      588,188     1,922,792      943,362
Loan repayments ...............................................    (1,130,357)     (832,713)    (538,217)     (631,836)    (759,881)
Other net changes (2), (3) ....................................      (319,183)      (39,978)     (50,544)      (38,330)     (41,977)
-----------------------------------------------------------------------------------------------------------------------------------
   Net increase (decrease) in loans held for investment .......       626,283       551,375         (573)    1,252,626      141,504
Mortgage-backed securities held to maturity, net:
   Purchased ..................................................          --            --           --            --         19,013
   Repayments .................................................          --            --         (5,588)      (11,917)     (17,292)
   Transferred to mortgage-backed securities available for sale          --            --        (33,555)         --           --
-----------------------------------------------------------------------------------------------------------------------------------
    Net increase (decrease) in mortgage-backed securities, net           --            --        (39,143)      (11,917)       1,721
-----------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in loans and mortgage-backed
         securities held for investment .......................       626,283       551,375      (39,716)    1,240,709      143,225
-----------------------------------------------------------------------------------------------------------------------------------
Sale Portfolio:
Residential, one-to-four units:
   Originated whole loans .....................................       289,271       159,941       93,496        32,421      161,502
   Loans transferred (to) from the investment portfolio (3) ...       290,558         1,791         (100)         --             82
   Originated whole loans sold (3) ............................      (467,989)     (135,426)     (80,725)      (45,770)    (152,156)
   Loans exchanged for mortgage-backed securities .............       (89,522)      (26,452)        --            --           (990)
   Other net changes ..........................................           (83)          (48)         (10)          (16)         (62)
-----------------------------------------------------------------------------------------------------------------------------------
    Net increase (decrease) in loans held for sale ............        22,235          (194)      12,661       (13,365)       8,376
-----------------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities, net:
   Received in exchange for loans .............................        89,522        26,452         --            --            990
   Purchased ..................................................          --          30,073         --          51,138         --
   Transferred from mortgage-backed securities held to maturity          --            --         33,555          --           --
   Sold .......................................................       (89,522)      (31,077)     (21,372)         --           (990)
   Repayments .................................................       (12,560)      (15,661)      (6,862)       (5,263)        --
   Other net changes ..........................................           592          (596)       2,669        (1,789)        --
-----------------------------------------------------------------------------------------------------------------------------------
    Net increase (decrease) in mortgage-backed securities .....       (11,968)        9,191        7,990        44,086         --
    available for sale
-----------------------------------------------------------------------------------------------------------------------------------
    Net increase in loans and mortgage-backed securities held
       for sale and available for sale ........................        10,267         8,997       20,651        30,721        8,376
-----------------------------------------------------------------------------------------------------------------------------------
    Total net increase (decrease) in loans and mortgage-backed
       securities .............................................   $   636,500    $  560,372     $(19,065)   $1,271,430    $ 151,601
===================================================================================================================================
</TABLE>
(1)  Primarily  one-to-four unit residential  loans.  Included in 1997 were $1.3
     million of five or more unit residential loans.
(2)  Primarily includes borrowings against and repayments of lines of credit and
     construction loans,  changes in loss allowances,  loans transferred to real
     estate  acquired in settlement of loans or to the held for sale  portfolio,
     and interest capitalized on loans (negative amortization).
(3)  Includes $290.5 million of one-to-four  unit  residential  ARMs transferred
     from the held  for  investment  portfolio  during  1997 and sold  servicing
     released.


                                       25
<PAGE>



     The  following  table  sets  forth the  composition  of  Downey's  loan and
mortgage-backed  securities  portfolio at the dates  indicated.  At December 31,
1997,  approximately  99.7% of Downey's  real estate  loans were secured by real
estate located in California  (principally in Los Angeles,  Orange, Santa Clara,
San Diego and San Mateo counties).

<TABLE>
<CAPTION>
                                                                                         December 31,
                                                           -----------------------------------------------------------------------
(In Thousands)                                                 1997           1996           1995           1994           1993
----------------------------------------------------------------------------------------------------------------------------------
<S>                                                        <C>            <C>            <C>            <C>            <C>        
Investment Portfolio:
    Loans secured by real estate:
      Residential:
         One-to-four units:
            Adjustable .................................   $ 4,190,160    $ 3,840,862    $ 3,486,774    $ 3,493,435    $ 2,127,312
            Adjustable - subprime ......................       245,749         32,715           --             --             --
            Fixed ......................................       168,315        172,328        169,738        194,845        249,274
            Fixed - subprime ...........................         3,321            543           --             --             --
----------------------------------------------------------------------------------------------------------------------------------
              Total one-to-four units ..................     4,607,545      4,046,448      3,656,512      3,688,280      2,376,586
         Five or more units:
            Adjustable .................................        29,246         43,050         44,438         48,782         37,819
            Fixed ......................................         9,032         13,857         12,883         15,000         35,686
      Commercial real estate:
         Adjustable ....................................        87,604        158,656        170,498        178,377        201,406
         Fixed .........................................       114,821        101,953        100,085        116,041        139,621
      Construction .....................................        70,865         66,651         28,593         11,367         37,180
      Land .............................................        25,687         21,177         21,867          9,822         11,826
    Non-mortgage:
      Commercial .......................................        26,024         22,136         12,864         12,975          8,229
      Consumer:
         Automobile ....................................       342,326        202,186         56,127          3,028          3,274
         Other consumer ................................        47,735         47,281         50,945         53,241         48,580
----------------------------------------------------------------------------------------------------------------------------------
            Total loans held for investment ............     5,360,885      4,723,395      4,154,812      4,136,913      2,900,207
    Increase (decrease) for:
      Undisbursed loan funds ...........................       (64,884)       (49,250)       (29,942)       (13,872)       (18,019)
      Deferral of fees and discounts, net of costs .....        18,088         11,663          7,412          7,468         (3,067)
      Allowance for estimated loss .....................       (32,092)       (30,094)       (27,943)       (25,597)       (26,835)
----------------------------------------------------------------------------------------------------------------------------------
            Total loans held for investment, net .......     5,281,997      4,655,714      4,104,339      4,104,912      2,852,286
----------------------------------------------------------------------------------------------------------------------------------
    Mortgage-backed securities held to maturity, net:
      Adjustable .......................................          --             --             --           19,897         25,352
      Fixed ............................................          --             --             --           19,246         25,708
----------------------------------------------------------------------------------------------------------------------------------
         Total mortgage-backed securities held
            to maturity, net ...........................          --             --             --           39,143         51,060
----------------------------------------------------------------------------------------------------------------------------------
         Total loans and mortgage-backed securities held
            for investment .............................     5,281,997      4,655,714      4,104,339      4,144,055      2,903,346
----------------------------------------------------------------------------------------------------------------------------------
Sale Portfolio, Net:
    Loans held for sale (all one-to-four units):
      Adjustable .......................................         1,617          1,145            238           --             --
      Fixed ............................................        33,483         11,720         12,821            398         13,763
----------------------------------------------------------------------------------------------------------------------------------
         Total loans held for sale .....................        35,100         12,865         13,059            398         13,763
    Mortgage-backed securities available for sale:
      Adjustable .......................................        17,751         23,620         34,355         44,086           --
      Fixed ............................................        31,548         37,647         17,721           --             --
----------------------------------------------------------------------------------------------------------------------------------
         Total mortgage-backed securities available ....        49,299         61,267         52,076         44,086           --
         for sale
----------------------------------------------------------------------------------------------------------------------------------
         Total loans and mortgage-backed securities held
             for sale and available for sale ...........        84,399         74,132         65,135         44,484         13,763
----------------------------------------------------------------------------------------------------------------------------------
         Total loans and mortgage-backed securities ....   $ 5,366,396    $ 4,729,846    $ 4,169,474    $ 4,188,539    $ 2,917,109
==================================================================================================================================
</TABLE>


                                       26
<PAGE>



     The table below sets forth the scheduled contractual maturities of Downey's
total loan and mortgage-backed securities portfolio as of December 31, 1997.


<TABLE>
<CAPTION>
                                  Within        1-2          2-3          3-5         5-10         10-15       Beyond
(In Thousands)                    1 year       years        years        years        years        years      15 years      Total
------------------------------------------------------------------------------------------------------------------------------------
<S>                            <C>          <C>          <C>          <C>          <C>          <C>          <C>          <C>       
Loans secured by real estate:
   Residential:
      One-to-four units:
        Adjustable (1) .....   $   37,778   $   40,730   $   43,914   $   98,395   $  321,710   $  468,703   $3,426,296   $4,437,526
        Fixed (1) ..........        3,216        3,503        3,815        8,680       29,446       45,130      111,329      205,119
      Five or more units:
        Adjustable .........          383          414          447        1,004        3,300        4,846       18,852       29,246
        Fixed ..............          351          383          419          959        3,292        3,628         --          9,032
      Commercial real estate
        Adjustable .........        1,898        2,053        2,221        4,999       16,528       24,453       35,452       87,604
        Fixed ..............       18,111       19,718       21,467       48,818        6,707         --           --        114,821
      Construction - .......       70,865         --           --           --           --           --           --         70,865
      adjustable
      Land:
        Adjustable .........       20,704        3,655         --           --           --           --           --         24,359
        Fixed ..............           55           61           67          155          551          439         --          1,328
Non-mortgage:
   Commercial ..............       23,041        1,247        1,372          364         --           --           --         26,024
   Consumer:
      Automobile ...........       71,751       80,276       89,814      100,485         --           --           --        342,326
      Other consumer (2) ...        1,742        1,919        2,115          752       41,207         --           --         47,735
------------------------------------------------------------------------------------------------------------------------------------
         Total loans .......      249,895      153,959      165,651      264,611      422,741      547,199    3,591,929    5,395,985
Mortgage-backed securities, 
   net .....................          934        1,004       20,454        1,796        5,912        7,750       11,449       49,299
------------------------------------------------------------------------------------------------------------------------------------
      Total loans and
         mortgage-backed 
         securities ........   $  250,829   $  154,963   $  186,105   $  266,407   $  428,653   $  554,949   $3,603,378   $5,445,284
====================================================================================================================================
</TABLE>

(1)  Includes loans held for sale.
(2)  Includes  home equity line of credit  loans which are interest  only,  with
     balances  due  at the  end of the  term.  All or  part  of the  outstanding
     balances may be paid off at any time during the term without penalty.

     At December 31, 1997,  the maximum amount the Bank could have loaned to any
one borrower (and related  entities) under regulatory  limits was $67.3 million,
or $112.2 million for loans secured by readily marketable  collateral,  compared
to $61.4 million and $102.4  million,  respectively,  at December 31, 1996.  The
Bank does not expect that these regulatory limitations will adversely impact its
proposed lending activities during 1998.

INVESTMENT SECURITIES

     The  following  table sets forth the  composition  of  Downey's  investment
securities  portfolio at the dates  indicated.  In the 1995 fourth quarter,  the
held to maturity U.S. Treasury and agency portfolio was transferred to available
for sale  consistent  with the "Guide to Statement 115 on Accounting for Certain
Investments in Debt and Equity  Securities"  issued by the Financial  Accounting
Standards Board.

<TABLE>
<CAPTION>
                                                           December 31,
                                       ----------------------------------------------------
(In Thousands)                            1997       1996       1995      1994       1993
-------------------------------------------------------------------------------------------
<S>                                    <C>        <C>        <C>        <C>        <C>     
Federal funds ......................   $  6,095   $  6,038   $  7,249   $  6,112   $ 38,547
U.S. Treasury and agency securities:
   Held to maturity ................       --         --         --      155,109    105,265
   Available for sale ..............    159,398    141,999    164,880       --         --
Municipal bonds - held to maturity .      6,885      6,997      7,194       --         --
-------------------------------------------------------------------------------------------
   Total ...........................   $172,378   $155,034   $179,323   $161,221   $143,812
===========================================================================================
</TABLE>



                                       27
<PAGE>



     As of December 31, 1997, the maturities of Downey's  investment  securities
and the weighted average yield of those securities were as follows.

<TABLE>
<CAPTION>
                                                                 After 1 Year
                                           1 Year or Less       Through 5 Years       After 5 Years           Total
                                        -----------------------------------------------------------------------------------
                                                  Weighted             Weighted             Weighted               Weighted
                                                   Average              Average              Average                Average
  (Dollars in Thousands)                 Amount     Yield      Amount     Yield     Amount    Yield      Amount      Yield
---------------------------------------------------------------------------------------------------------------------------
<S>                                     <C>         <C>      <C>                   <C>                  <C>          <C>  
Federal funds .......................   $  6,095    3.51%    $   --        -- %    $   --       -- %    $   6,095    3.51%
  U.S. Treasury and agency securities      9,999    5.85       149,399    5.73         --       --        159,398    5.74
  Municipal bonds (1) ...............       --       --          --        --         6,885    4.92         6,885    4.92
-------------------------------------------------------------------------------------------------------------------------
       Total ........................   $ 16,094    4.96%    $ 149,399    5.73%    $  6,885    4.92%    $ 172,378    5.63%
=========================================================================================================================
</TABLE>
(1) Yield on a fully tax-equivalent basis is 8.64%.

INVESTMENTS IN REAL ESTATE AND JOINT VENTURES

     DSL Service Company participates as an owner of, or a partner in, a variety
of real estate development  projects,  principally retail neighborhood  shopping
center  developments,  most of which are  located in  California.  In  addition,
Downey  Financial  Corp. owns one investment in land which it purchased from DSL
Service Company at fair value in 1995. For additional  information regarding the
location  of  these  real  estate  investments  see  Note  8  of  Notes  to  the
Consolidated   Financial  Statements  on  page  64.  Most  of  the  real  estate
development  projects have been completed and are  substantially  leased (with a
weighted average  occupancy of 87% for retail  neighborhood  shopping centers at
December 31,  1997).  At December 31, 1997,  the Bank had  outstanding  loans of
$53.0 million to such joint ventures.

     In its joint  ventures,  DSL Service Company is entitled to interest on its
equity invested in the project on a priority basis after  third-party  debt, and
shares  profits and losses with the  developer  partner,  generally  on an equal
basis. DSL Service Company has obtained personal  guarantees from the principals
of the  developer  partners  in a number of the  joint  ventures  and  generally
requires the  developer  partner to secure any  outstanding  obligations  to the
joint  venture,  such as its portion of  operating  losses,  when the partner is
unable to  satisfy  such  obligations  on a current  basis.  Partnership  equity
(deficit)  accounts  are  affected  by current  period  results  of  operations,
additional   partner   advances,   partnership   distributions  and  partnership
liquidations.

     As of December 31, 1997,  DSL Service  Company was involved with five joint
venture  partners.  Four of  these  partners  were  operators  of  eight  retail
neighborhood  shopping centers,  a commercial  building,  a residential  housing
development  and vacant land held for sale. The fifth partner is involved in the
rehabilitation of an apartment complex. DSL Service Company has ten wholly owned
retail neighborhood shopping centers located in California and Arizona.

     The following table sets forth the condensed  balance sheets of DSL Service
Company's  joint ventures by property type at December 31, 1997, on a historical
cost basis. Included in the following condensed balance sheet are allowances for
losses  recorded  by  DSL  Service  Company.  These  allowances  are  determined
quarterly by means of Downey's internal asset review process. See "Problem Loans
and Real Estate - Allowance  for Losses on Loans and Real Estate" on page 40. To
the  extent the fair  market  value of the real  estate  assets is less than the
carrying value, then a provision is made to create a valuation allowance for the
difference.  If such a valuation  allowance  is needed,  it is  reflected in the
investment  accounts for the joint ventures on DSL Service  Company's books. Not
all of the joint  venture  investments  have  valuation  allowances  as the fair
market value of the associated property exceeds its carrying value.




                                       28
<PAGE>



<TABLE>
<CAPTION>
                                                               Retail
                                                            Neighborhood
(Dollars In Thousands)                                    Shopping Centers   Commercial   Residential    Total
----------------------------------------------------------------------------------------------------------------
<S>                                                          <C>              <C>          <C>          <C>     
Cash ...................................................     $    382         $    118     $  1,203     $  1,703
Projects under development .............................         --                964         --            964
Completed projects .....................................       53,292            5,020        5,826       64,138
Other assets ...........................................        4,196              728          133        5,057
----------------------------------------------------------------------------------------------------------------
       Total assets ....................................     $ 57,870         $  6,830     $  7,162     $ 71,862
----------------------------------------------------------------------------------------------------------------
Secured notes payable to the Bank ......................     $ 46,546         $  1,081     $  5,365     $ 52,992
Secured notes payable to others ........................        9,768            3,974          116       13,858
Other liabilities ......................................        8,120            1,820         --          9,940
Equity (deficit):
    DSL Service Company (1) ............................        5,299               38        1,747        7,084
    Allowance for losses recorded by DSL Service Company          101            1,526         --          1,627
    Other partners' (2) ................................      (11,964)          (1,609)         (66)     (13,639)
----------------------------------------------------------------------------------------------------------------
       Total liabilities and equity ....................     $ 57,870         $  6,830     $  7,162     $ 71,862
================================================================================================================
Number of joint venture projects .......................            8                2            2           12
================================================================================================================
</TABLE>

(1)  Included in these amounts are interest-bearing  joint venture advances with
     priority interest payments from joint ventures to DSL Service Company.
(2)  The aggregate other  partners'  deficit of $13.6 million  represents  their
     equity  interest in the  accumulated  retained  earnings  (deficit)  of the
     respective joint ventures. Those results include not only the net profit on
     sales and the operating results of the real estate assets, but depreciation
     expense and funding costs as well.  Except for any secured  financing which
     has been obtained, DSL Service Company has provided all other financing. As
     part of Downey's internal asset review process, the fair value of the joint
     venture real estate  assets is compared to the secured notes payable to the
     Bank and others and DSL Service Company's equity investment.  To the extent
     the fair  value of the real  estate  assets is less than the  aggregate  of
     those amounts, a provision is made to create a valuation  allowance.  Those
     allowances totaled $1.6 million at December 31, 1997. At December 31, 1997,
     the  fair  value  of the  real  estate  assets  of  certain  joint  venture
     partnerships in which the other partners' equity was a deficit exceeded the
     amount of third party notes and DSL Service  Company's  investment  thereby
     eliminating  the need for a valuation  allowance since the sale of the real
     estate would allow DSL Service Company to realize its investment. Thus, the
     other  partners'  deficit of $13.6 million  exceeds the amount of valuation
     allowances established of $1.6 million.

     The  following  table sets forth by property  type  Downey's  wholly  owned
investments  in real estate and related  allowances  for losses at December  31,
1997.

<TABLE>
<CAPTION>
                                                                Retail
                                        Single Family        Neighborhood
(Dollars in Thousands)                  Developments (1)   Shopping Centers      Land        Total
----------------------------------------------------------------------------------------------------
<S>                                       <C>                <C>      <C>     <C>     <C>   <C>     
Wholly Owned Properties:
Investment in wholly owned projects ...   $ 12,164           $ 31,370 (2)     $10,355 (3)   $ 53,889
Allowance for losses ..................    (11,767)            (2,021)         (5,829)       (19,617)
----------------------------------------------------------------------------------------------------
Net investment in wholly owned projects   $    397           $ 29,349        $  4,526       $ 34,272
====================================================================================================
Number of projects ....................          3                 10              10             23
====================================================================================================
</TABLE>

(1)  These  developments  are joint ventures for legal  purposes.  However,  for
     financial  reporting  purposes,  they are reported as wholly owned,  as DSL
     Service Company assumed operating control effective in 1993.
(2)  Includes ten  free-standing  stores that are part of neighborhood  shopping
     centers totaling $1.9 million and are counted as one project.
(3)  Includes three properties totaling $8.4 million.

     Real estate investments entail risks similar to those presented by Downey's
construction and commercial lending activities.  In addition,  California courts
have imposed warranty-like responsibility upon developers of new housing for


                                       29
<PAGE>



     defects in structure and the housing site, including soil conditions.  This
responsibility  is not  necessarily  dependent upon a finding that the developer
was negligent.  Owners of real property also may incur  liabilities with respect
to environmental  matters,  including  financial  responsibility for clean-up of
hazardous waste or other conditions, under various federal and state laws.

DEPOSITS

     Deposits  increased  $696.9  million  or 16.7% in 1997,  and  totaled  $4.9
billion at December 31, 1997.  Transaction  accounts  (i.e.,  checking,  regular
passbook and money market) increased $104.3 million or 12.5%, while certificates
of  deposits  increased  $592.6  million  or  17.7%.  Of the total  increase  in
deposits, $102.6 million was associated with 13 new branches opened during 1997.
The following table sets forth the amount of deposits by classification.

<TABLE>
<CAPTION>
                                                                    December 31,
                                      --------------------------------------------------------------------
                                               1997                    1996                    1995
                                      --------------------------------------------------------------------
                                      Weighted                Weighted                Weighted
                                      Average                  Average                 Average
(Dollars in Thousands)                  Rate       Amount       Rate       Amount       Rate       Amount
----------------------------------------------------------------------------------------------------------
<S>                                     <C>     <C>             <C>     <C>             <C>     <C>       
Transaction accounts .............      2.15%   $  935,869      2.04%   $  831,598      1.87%   $  804,891
Certificates of deposit:
   Less than 3.00% ...............      2.64        30,623      2.65        39,061      2.82        57,786
   3.00-3.49 .....................      3.02           766      3.03           723      3.21         1,392
   3.50-3.99 .....................       --           --        3.99            79      3.75         7,781
   4.00-4.49 .....................      4.31        60,095      4.39        63,577      4.18        99,758
   4.50-4.99 .....................      4.87        40,356      4.87       186,576      4.88       262,065
   5.00-5.99 .....................      5.63     2,896,291      5.54     2,489,852      5.52     1,863,474
   6.00-6.99 .....................      6.06       901,920      6.17       536,307      6.46       596,803
   7.00 and greater ..............      7.22         4,058      7.15        25,329      7.29        96,271
----------------------------------------------------------------------------------------------------------
     Total certificates of deposit      5.68     3,934,109      5.56     3,341,504      5.61     2,985,330
----------------------------------------------------------------------------------------------------------
     Total deposits ..............      5.00%   $4,869,978      4.86%   $4,173,102      4.81%   $3,790,221
==========================================================================================================
</TABLE>

     The following table shows as of December 31, 1997,  certificates of deposit
maturities by interest rate category.

                         Less
<TABLE>
<CAPTION>
                         Than      4.00% -    4.50 % -    5.00% -       6.00% -     7.00 %                       Percent
(Dollars in Thousands)   4.00%     4.49%      4.99%       5.99%         6.99%     and greater     Total         of Total
------------------------------------------------------------------------------------------------------------------------
<S>    <C>             <C>        <C>         <C>        <C>          <C>           <C>         <C>               <C>   
Within 3 months.....   $ 30,125   $ 55,264    $ 29,771   $  885,301   $   47,856    $   721     $1,049,038        26.67%
3 to 6 months ......        479      4,418       2,721      640,938      193,965        445        842,966        21.43
6 to 12 months .....        465        284       4,628    1,076,647      524,374        578      1,606,976        40.84
12 to 24 months ....        313        129       3,169      254,828      114,084        988        373,511         9.49
24 to 36 months ....       --         --            24       19,158        8,276      1,326         28,784         0.73
36 to 60 months ....          7       --            43       19,250       13,230       --           32,530         0.83
Over 60 months .....       --         --          --            169          135       --              304         0.01
-----------------------------------------------------------------------------------------------------------------------
                       $ 31,389   $ 60,095    $ 40,356   $2,896,291   $  901,920    $ 4,058     $3,934,109 (1)   100.00%
=======================================================================================================================
</TABLE>

(1)  Includes  jumb$  100,000)  certificates  of deposit of $281.6  million with
     maturities of 3 months or less, $235.0 million and $466.8 million of 3 to 6
     month and 6 to 12 month maturities, respectively, and $119.2 million with a
     remaining term of over 12 months.




                                       30
<PAGE>



BORROWINGS

     At December 31, 1997, borrowings totaled $483.7 million, compared to $595.3
million at  December  31,  1996 and $436.2  million at December  31,  1995.  The
decline in 1997 occurred as deposit growth exceeded asset growth.  The following
table  sets  forth  information  concerning  Downey's  FHLB  advances  and other
borrowings at the dates indicated.

<TABLE>
<CAPTION>
                                                        December 31,
                                    ----------------------------------------------------
(Dollars in Thousands)                1997       1996       1995       1994       1993
----------------------------------------------------------------------------------------
<S>                                 <C>        <C>        <C>        <C>        <C>     
FHLB advances ...................   $352,458   $386,883   $220,715   $411,800   $  1,800
Other borrowings:
   Reverse repurchase agreements      34,803       --       16,099     53,946       --
   Commercial paper ............      83,811    198,113    196,602    197,839       --
   Industrial revenue bonds ....        --         --         --        6,421      6,496
   Real estate notes ...........      12,663     10,349      2,802      4,770      5,422
----------------------------------------------------------------------------------------
   Total borrowings ............    $483,735   $595,345   $436,218   $674,776   $ 13,718
========================================================================================
Weighted average rate on 
   borrowings during the period        6.07%      5.98%      6.39%      5.57%      6.53%

Total borrowings as a percentage 
   of total assets                     8.29      11.45       9.37      14.51       0.40
========================================================================================
</TABLE>

     The following table sets forth certain information with respect to Downey's
short-term borrowings.

<TABLE>
<CAPTION>
(Dollars in Thousands)                                                  1997        1996        1995
------------------------------------------------------------------------------------------------------
<S>                                                                   <C>         <C>         <C>     
FHLB advances with original maturities less than one year:
    Balance at end of year ........................................   $214,300    $279,000    $153,400
    Average balance outstanding during the year ...................    328,886     174,380     268,043
    Maximum amount outstanding at any month-end during the year ...    427,100     279,000     472,000
    Weighted average interest rate at the end of year .............       5.81%       5.70%       6.07%
    Weighted average interest rate during the year ................       5.83        5.78        6.32
Securities sold under agreement to repurchase:
    Balance at end of year ........................................   $ 34,803    $      -    $ 16,099
    Average balance outstanding during the year ...................      4,029      11,761      36,676
    Maximum amount outstanding at any month-end during the year ...     34,803      70,015      52,547
    Weighted average interest rate at the end of year .............       6.65%         -%        5.90%
    Weighted average interest rate during the year ................       5.61        5.19        6.21
Commercial paper sold:
    Balance at end of year ........................................   $ 83,811    $198,113    $196,602
    Average balance outstanding during the year ...................    182,296     174,739     191,313
    Maximum amount outstanding at any month-end during the year ...    272,818     198,113     198,341
    Weighted average interest rate at the end of year .............       5.61%       5.45%       5.56%
    Weighted average interest rate during the year ................       5.75        5.74        6.38
Total short-term borrowings:
    Total average short-term borrowings outstanding during the year   $515,211    $360,880    $496,032
    Total weighted average rate on borrowings during the year .....       5.80%       5.74%       6.34%
======================================================================================================
</TABLE>

ASSET/LIABILITY MANAGEMENT AND MARKET RISK

     Market risk is the risk of loss from adverse  changes in market  prices and
interest rates. Downey's market risk arises primarily from interest rate risk in
its lending and deposit taking activities. This interest rate risk occurs to the
degree that interest-bearing  liabilities reprice or mature more rapidly or on a
different basis than interest-earning assets.


                                       31
<PAGE>


     Since Downey's earnings depend primarily on its net interest income,  which
is the difference between the interest and dividends earned on  interest-earning
assets  and the  interest  paid on  interest-bearing  liabilities,  a  principal
objective  of Downey is to  actively  monitor  and manage the effects of adverse
changes  in  interest  rates on net  interest  income  while  maintaining  asset
quality.

     Downey's  Asset/Liability  Management Committee ("ALCO") is responsible for
implementing  the interest rate risk  management  policy which sets forth limits
established  by the Board of  Directors  on  acceptable  changes in net interest
income and net portfolio value ("NPV") from specified changes in interest rates.
NPV is defined by the OTS as the present  value of expected  net cash flows from
existing assets minus the present value of expected net cash flows from existing
liabilities  plus the  present  value  of  expected  cash  flows  from  existing
off-balance  sheet  contracts.   ALCO  reviews,   among  other  items,  economic
conditions, the interest rate outlook, the demand for loans, the availability of
deposits and borrowings,  and Downey's  current  operating  results,  liquidity,
capital and  interest  rate  exposure.  In  addition,  ALCO  monitors  asset and
liability  maturities  and  repricing  characteristics  on a  regular  basis and
performs  various  simulations  and other  analyzes to determine  the  potential
impact of various business strategies in controlling  interest rate risk and the
potential impact of those strategies upon future earnings under various interest
rate  scenarios.  Based on such  reviews,  ALCO  formulates  a strategy  that is
intended to implement the objectives set forth in Downey's business plan without
exceeding the net interest  income and NPV limits set forth in the interest rate
risk policy.

     One measure of Downey's exposure to differential  changes in interest rates
between assets and  liabilities is shown in the following table which sets forth
the repricing  frequency of Downey's major asset and liability  categories as of
December 31,  1997,  as well as certain  information  regarding  the  difference
between  interest-earning  assets  and  interest-bearing  liabilities  in future
periods.  The  repricing  frequencies  have  been  determined  by  reference  to
projected  maturities,   based  upon  contractual  maturities  as  adjusted  for
scheduled repayments and "repricing  mechanisms"  (provisions for changes in the
interest and dividend  rates of assets and  liabilities).  Prepayment  rates are
assumed,  in each period,  on substantially all of Downey's loan portfolio based
upon  its  historical   loan  prepayment   experience  and  anticipated   future
prepayments.  Repricing  mechanisms on certain of Downey's assets are subject to
limitations,  such as caps on the amount  that  interest  rates and  payments on
Downey's loans may adjust, and accordingly,  such assets do not normally respond
as completely or rapidly as Downey's  liabilities to changes in market  interest
rates.  The  interest  rate  sensitivity  of  Downey's  assets  and  liabilities
illustrated  in the  following  table  would  vary  substantially  if  different
assumptions were used or if actual experience  differed from the assumptions set
forth.




                                       32
<PAGE>





<TABLE>
<CAPTION>
                                                                             December 31, 1997
                                                  -----------------------------------------------------------------------------
                                                    Within        7 - 12        1 - 5       5 - 10        Over         Total
(Dollars in Thousands)                             6 Months       Months        Years        Years       10 Years     Balance
-------------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>           <C>           <C>          <C>          <C>          <C>       
Interest-earning assets:
   Investment securities and FHLB stock ..... (1) $   67,064    $     --      $ 149,399    $    --      $    --      $  216,463
   Loans and mortgage-backed securities:
     Mortgage-backed securities ............. (2)     22,420         4,438       17,770        3,216        1,455        49,299
     Loans secured by real estate:
       Residential:
         Adjustable ......................... (2)  4,340,466        114,246      10,430         --           --       4,465,142
         Fixed .............................. (2)     58,563         19,184      83,456       33,594       19,267       214,064
       Commercial real estate ............... (2)     96,340          9,505      77,692       13,761        1,593       198,891
       Construction ......................... (2)     27,835           --          --           --           --          27,835
       Land ................................. (2)     10,201             41         352          536          359        11,489
     Non-mortgage:
       Commercial ........................... (2)     17,343           --          --           --           --          17,343
       Consumer ............................. (2)    114,309         60,335     207,689         --           --         382,333
-------------------------------------------------------------------------------------------------------------------------------
   Total loans and mortgage-backed securities      4,687,477        207,749     397,389       51,107       22,674     5,366,396
-------------------------------------------------------------------------------------------------------------------------------
     Total ..................................     $4,754,541    $   207,749   $ 546,788    $  51,107    $  22,674    $5,582,859
===============================================================================================================================
Deposits and borrowings:
   Interest bearing deposits:
     Fixed maturity deposits ................ (1) $1,990,621    $ 1,553,704   $ 389,784    $    --      $    --      $3,934,109
     Transaction accounts ................... (3)    829,317           --          --           --           --         829,317
   Non-interest bearing transaction
     accounts ...............................        106,552           --          --           --           --         106,552
-------------------------------------------------------------------------------------------------------------------------------
     Total deposits .........................      2,926,490      1,553,704     389,784         --           --       4,869,978
-------------------------------------------------------------------------------------------------------------------------------
   Borrowings ...............................        379,379         24,029      77,527        2,800         --         483,735
-------------------------------------------------------------------------------------------------------------------------------
     Total deposits and borrowings ..........     $3,305,869    $ 1,577,733   $ 467,311    $   2,800    $    --      $5,353,713
===============================================================================================================================
Excess (shortfall) of interest-earning
   assets over interest-bearing liabilities .     $1,448,672    $(1,369,984)  $  79,477    $  48,307    $  22,674    $  229,146

Cumulative gap ..............................      1,448,672         78,688     158,165      206,472      229,146
Cumulative gap - as a % of total assets:
   December 31, 1997 ........................         24.82%          1.35%       2.71%        3.54%        3.93%
   December 31, 1996 ........................         16.71           2.68        0.50         1.47         3.04
   December 31, 1995 ........................         13.64           4.96        2.58         3.16         3.47
===============================================================================================================================
</TABLE>

(1)  Based upon contractual maturity and repricing date.
(2)  Based upon contractual maturity, repricing date and projected repayment and
     prepayments of principal.
(3)  Based upon contractual maturity or repricing date.

     Downey's  six-month gap at December 31, 1997, was a positive  24.82% (i.e.,
more interest  earning assets  reprice  within six months than  interest-bearing
liabilities).  This compares to a positive six-month gap of 16.71% and 13.64% at
December 31, 1996 and 1995,  respectively.  Downey's  primary strategy to manage
interest  rate  risk is to  emphasize  the  origination  of ARMs or  loans  with
relatively  short  maturities.  Interest rates on ARMs are primarily tied to the
CMT or COFI.  During  1997,  1996 and  1995,  Downey  originated  and  purchased
approximately  $2.0  billion,  $1.4 billion and $0.6 billion,  respectively,  of
loans  and   mortgage-backed   securities  with  adjustable  interest  rates  or
maturities of five years or less,  representing  approximately 96%, 95% and 96%,
respectively,  of  all  loans  and  mortgage-backed  securities  originated  and
purchased for  investment  during such periods.  ARM  originations  during those
three years were primarily tied to COFI rather than the CMT index.

     At December  31,  1997,  99% of Downey's  interest-earning  assets  mature,
reprice or are estimated to prepay within five years, compared to 97% and 99% at
December  31, 1996 and 1995,  respectively.  At December  31,  1997,  loans with
adjustable  interest rates represented 87% of Downey's loan and  mortgage-backed
securities  portfolio.  During 1998,  Downey will continue to offer  residential
fixed rate loan products to its customers to meet  customer  demand.  Fixed rate
loans are


                                       33
<PAGE>



primarily originated for sale in the secondary market and are priced accordingly
in order to create  loan  servicing  income and to  increase  opportunities  for
originating ARMs. However,  Downey occasionally originates for its own portfolio
fixed  rate  loans  to  facilitate  the  sale of real  estate  acquired  through
foreclosure  or that  meet  certain  yield and other  approved  guidelines.  See
"Business  -  Lending  Activities  -  Secondary  Marketing  and  Loan  Servicing
Activities" on page 4.

     Downey is better  protected  against rising  interest rates with a positive
six-month GAP. However,  Downey remains subject to possible interest rate spread
compression,  which would  adversely  impact  Downey's  net  interest  income if
interest  rates rise.  This is primarily  due to the lag in the repricing of the
indices to which Downey's  adjustable-rate loans and mortgage-backed  securities
are tied, as well as the repricing  frequencies and periodic  interest rate caps
on such adjustable-rate loans and mortgage-backed securities. The amount of such
interest rate spread compression would depend upon the frequency and severity of
such interest rate  fluctuations.  The positive  six-month GAP could decrease in
future periods due to, among other things,  the continued  expansion of the auto
and consumer loan portfolios.

     In addition to  measuring  interest  rate risk via a GAP  analysis,  Downey
establishes  limits on, and measures the sensitivity of, its net interest income
and NPV to changes in interest  rates.  Changes in interest rates are defined as
instantaneous  and  sustained  movements  in  interest  rates in 100 basis point
increments.   Downey  utilizes  an  internally   maintained  asset  /  liability
management  simulation  model  to make  the  calculations  which,  for  NPV,  is
calculated  on a discounted  cash flow basis.  First,  Downey  estimates its net
interest  income for the next  twelve  months and the  current  NPV  assuming no
change in interest  rates from those at period end.  Once the base case has been
estimated,  calculations  are made for each of the  defined  changes in interest
rates, to include any associated differences in the anticipated prepayment speed
of loans. Those results are then compared against the base case to determine the
estimated  change to net interest  income and NPV due to the changes in interest
rates.  Following are the estimated  impacts to net interest income and NPV from
various  instantaneous,  parallel  shifts in interest  rates based upon Downey's
asset and liability structure as of December 31, 1997. Since these estimates are
based upon  numerous  assumptions,  such as the expected  maturities of Downey's
interest-bearing assets and liabilities and the shape of the period-end interest
rate yield curve,  Downey's  actual  sensitivity  to interest rate changes could
vary  significantly if actual experience  differs from those assumptions used in
making the calculations.

                                                       Percentage Change In
   Change in Interest Rates            Net Interest        Net Portfolio
      (In Basis Points)                 Income (1)           Value (2)
   ------------------------            ---------------    -----------------
             +200                        (13.6)%               (9.3)%
             +100                         (5.7)                (3.4)
             (100)                         5.5                  3.2
             (200)                        12.0                  9.1

(1)  The percentage  change in this column represents net interest income for 12
     months in a stable interest rate environment versus the net interest income
     in the various rate scenarios.
(2)  The  percentage  change in this column  represents the NPV of the Bank in a
     stable  interest  rate  environment  versus  the  NPV in the  various  rate
     scenarios.



                                       34
<PAGE>


     The following table shows Downey's financial instruments that are sensitive
to  changes  in  interest  rates,  categorized  by  expected  maturity,  and the
instruments'  fair values at December 31,  1997.  This data differs from that in
the GAP table as it does not incorporate the repricing characteristics of assets
and liabilities.  Rather, it only reflects contractural  maturities adjusted for
anticipated prepayments. Market risk sensitive instruments are generally defined
as on and off balance sheet derivatives and other financial instruments.

<TABLE>
<CAPTION>
                                                         Expected Maturity Date at December 31, 1997 (1)
                                  --------------------------------------------------------------------------------------------------
                                                                                                                Total       Fair
(Dollars in Thousands)                1998         1999         2000       2001        2002      Thereafter    Balance      Value
------------------------------------------------------------------------------------------------------------------------------------
<S>                               <C>          <C>          <C>         <C>         <C>         <C>          <C>          <C>       
Interest-sensitive assets:
Investment securities .........   $   60,179   $     --     $  75,083   $  49,250   $  25,066   $    6,885   $  216,463   $  216,443
        Average interest rate .         6.04%           -%       5.68%       5.46%       6.42%        4.92%        5.79%
Loans held for sale ...........       35,100         --          --          --          --           --         35,100       35,395
        Average interest rate .         7.58%           -%          -%          -%          -%           -%        7.58%
Mortgage-backed securities
  held for sale ...............       11,156        9,923       8,953       2,511       2,220       14,536       49,299       49,348
        Average interest rate .         6.58%        6.55%       6.53%       7.66%       7.65%        7.52%        6.95%
Loans held for investment:
  Loans secured by real estate:
    Residential:
      Adjustable ..............    1,151,927      866,065     632,803     463,340     340,539    1,008,851    4,463,525    4,501,037
        Average interest rate .         7.61%        7.64%       7.63%       7.62%       7.71%        7.54%        7.61%
      Fixed ...................       41,433       30,790      22,566      17,045      13,056       55,691      180,581      185,348
        Average interest rate .         9.23%        9.16%       9.09%       9.01%       8.91%        7.95%        8.76%
    Other .....................       71,222       26,383      23,710      24,696      19,346       72,858      238,215      237,429
        Average interest rate .         9.17%        8.95%       8.78%       8.80%       8.92%        7.84%        8.64%
  Non-mortgage:
    Commercial ................       14,759        1,075       1,197         312        --           --         17,343       17,343
        Average interest rate .         9.37%        9.37%       9.37%       9.37%         -%           -%         9.37%
    Consumer ..................      124,387      110,891      99,825      47,230        --           --        382,333      386,070
        Average interest rate .        11.28%       11.28%      11.28%      10.01%         -%           -%        11.12%
Interest bearing advances to
  joint ventures ..............       32,122         --          --          --          --           --         32,122       32,122
        Average interest rate .         5.76%          -%          -%         - %          -%           -%         5.76%
Mortgage servicing assets .....          440          389         334         283         238          271        1,955        7,584
------------------------------------------------------------------------------------------------------------------------------------
Total interest-sensitive assets   $1,542,725   $1,045,516   $ 864,471   $ 604,667   $ 400,465   $1,159,092   $5,616,936   $5,668,119
====================================================================================================================================
Interest-sensitive liabilities:
Deposits:
  Transaction accounts ........   $  170,935   $  139,714   $ 114,194   $  93,338   $  76,290   $  341,398   $  935,869   $  935,869
        Average interest rate .         2.15%        2.15%       2.15%       2.15%       2.15%        2.15%        2.15%
  Certificates of deposit .....    3,544,325      330,498      27,251      18,612      13,423         --      3,934,109    3,947,913
        Average interest rate .         5.66%        5.85%       5.89%       5.71%       6.01%          -%         5.68%
Borrowings ....................      403,408       36,488      24,220      12,951       3,868        2,800      483,735      485,558
        Average interest rate .         6.10%        6.25%       6.25%       6.27%       6.15%        6.00%        6.12%
------------------------------------------------------------------------------------------------------------------------------------
Total interest-sensitive
  liabilities .................   $4,118,668   $  506,700   $ 165,665   $ 124,901   $  93,581   $  344,198   $5,353,713   $5,369,340
====================================================================================================================================
</TABLE>

(1)  Expected maturities are contractual  maturities adjusted for prepayments of
     principal.  Downey uses  certain  assumptions  to estimate  fair values and
     expected  maturities.  For  assets,  expected  maturities  are  based  upon
     contractual  maturity,  projected  repayments and prepayments of principal.
     The prepayment  experience reflected herein is based on Downey's historical
     experience.  Downey's average constant prepayment rate ("CPR") is 16.4% and
     21.7%   on  its   fixed-rate   and  ARM   portfolios,   respectively,   for
     interest-earning assets (excluding investment securities, which do not have
     prepayment features). For deposit liabilities,  in accordance with standard
     industry practice and Downey's own historical experience,  "decay factors",
     used to estimate  deposit runoff,  of 20% (CPR) per year have been applied.
     The actual  maturities of these  instruments  could vary  substantially  if
     future prepayments differ from the Downey's historical experience.




                                       35
<PAGE>



     The  following  table  sets  forth the  interest  rate  spread on  Downey's
interest-earning  assets  and  interest-bearing  liabilities  as  of  the  dates
indicated.

<TABLE>
<CAPTION>
                                                               December 31,
                                                  ------------------------------------
                                                  1997    1996    1995    1994    1993
--------------------------------------------------------------------------------------
<S>                                               <C>     <C>     <C>     <C>     <C>  
Weighted average yield:
   Loan and mortgage-backed securities .....      7.95%   7.77%   7.67%   6.24%   6.48%
   Investment securities ...................      5.79    6.11    6.29    6.09    4.59
--------------------------------------------------------------------------------------
   Earning assets yield ....................      7.87    7.71    7.60    6.24    6.31
--------------------------------------------------------------------------------------
Weighted average cost:
   Deposits ................................      5.00    4.86    4.81    4.23    3.32
   Borrowings:
      FHLB advances ........................      6.11    5.80    6.07    6.41    6.92
      Other borrowings .....................      6.15    5.60    5.62    5.88    5.03
--------------------------------------------------------------------------------------
   Combined borrowings .....................      6.12    5.73    5.84    6.20    5.28
--------------------------------------------------------------------------------------
   Combined funds ..........................      5.11    4.97    4.92    4.55    3.32
--------------------------------------------------------------------------------------
Interest rate spread .......................      2.76%   2.74%   2.68%   1.69%   2.99%
======================================================================================
End of period effective interest rate spread      2.97%   2.89%   2.87%   1.85%   3.10%
======================================================================================
</TABLE>

     The year-end  weighted  average  yield on the loan  portfolio  increased to
7.95%, compared to 7.77% as of December 31, 1996. The average yield on new loans
originated during 1997, 1996 and 1995 was 6.04%, 6.06% and 6.99%,  respectively.
At December 31, 1997,  the ARM  portfolio of single  family  residential  loans,
including  mortgage-backed  securities,  totaled  $4.5  billion  with a weighted
average rate of 7.58%,  compared to $3.9 billion and $3.5 billion with  weighted
average rates of 7.38% and 7.51% at December 31, 1996 and 1995, respectively.

PROBLEM LOANS AND REAL ESTATE

Non-Performing Assets

     Non-performing  assets  consist  of loans on which  Downey  has  ceased the
accrual of interest ("non-accrual loans") and real estate acquired in settlement
of loans.  Non-performing  assets  totaled  $52.1  million at December 31, 1997,
compared to $62.0  million at December 31, 1996,  and $97.2  million at December
31,  1995.  The  decline in  non-performing  assets was  spread  throughout  all
categories and is primarily  attributed to the improving  California economy. Of
the total,  real estate  acquired in  settlement  of loans,  net of  allowances,
represented  $9.6  million at December 31,  1997,  compared to $16.1  million at
December 31, 1996,  and $18.9  million at December 31, 1995.  The 1997  decrease
reflects a reduction in the single  family  inventory and the sale of a shopping
center taken in satisfaction of a loan.




                                       36
<PAGE>



     The following table summarizes the  non-performing  assets of Downey at the
dates indicated.

<TABLE>
<CAPTION>
                                                                             December 31,
                                                        ---------------------------------------------------
(Dollars in Thousands)                                    1997      1996        1995      1994       1993
-----------------------------------------------------------------------------------------------------------
<S>                                                     <C>        <C>        <C>        <C>        <C>    
Non-accrual loans:
   One-to-four unit residential .....................   $20,816    $22,885    $25,587    $24,012    $30,784
   One-to-four unit residential - subprime ..........      --         --         --         --         --
   Other ............................................    20,883     22,136     52,754     28,025     25,445
-----------------------------------------------------------------------------------------------------------
     Total non-accrual loans ........................    41,699     45,021     78,341     52,037     56,229
Real estate acquired in settlement of loans, net (1)      9,626     16,078     18,854     13,558     13,364
Repossessed automobiles .............................       795        928       --         --         --
-----------------------------------------------------------------------------------------------------------
   Gross non-performing assets ......................   $52,120    $62,027    $97,195    $65,595    $69,593
===========================================================================================================

===========================================================================================================
Allowance for loan losses (2):
   Amount ...........................................   $32,092    $30,094    $27,943    $25,650    $26,835
   As a percentage of non-performing loans ..........     76.96%     66.84%     35.67%     49.29%     47.72%
Non-performing assets as a percentage of total assets      0.89       1.19       2.09       1.41       2.01
===========================================================================================================
</TABLE>

(1)  Excludes  real estate  acquired in  settlement  of loans  covered under the
     Butterfield  Assistance Agreement.  All such assets were sold to the FDIC's
     Division of Resolution in December 1995.

(2)  Allowance  for loan losses does not include the  allowance  for real estate
     and real estate acquired in settlement of loans.

     When  resolving   problem  loans,   it  is  Downey's  policy  to  determine
collectibility  under  various   circumstances  which  will  result  in  maximum
financial  benefit to Downey.  It is also Downey's  policy to take  appropriate,
timely and aggressive  action when necessary to resolve  non-performing  assets.
This is  accomplished  by either  working  with the  borrower  to bring the loan
current or by foreclosing and selling the asset. Downey performs ongoing reviews
of loans that display  weaknesses and maintains  adequate loss allowances on the
loans.  For a discussion  on Downey's  internal  asset review  policy,  refer to
"Allowance for Losses on Loans and Real Estate" on page 40.

     All of Downey's non-performing assets at December 31, 1997, were located in
California,  with the exception of one property  acquired in settlement of loans
located in Arizona.

     Downey  evaluates the need for  appraisals for  non-performing  assets on a
periodic  basis. A new appraisal will generally be obtained when Downey believes
that there may have been an adverse change in the property  operations or in the
economic conditions of the geographic market of the property securing its loans.
Downey's  policy is to obtain new  appraisals  at least  annually for major real
estate  acquired in settlement of loans.  Throughout  1997,  Downey obtained new
appraisals for  non-performing  loans and real estate  acquired in settlement of
loans.

     Non-Accrual  Loans. It is Downey's  general policy to account for a loan as
non-accrual  when the loan  becomes 90 days  delinquent  or when  collection  of
interest appears doubtful.  In certain cases, loans may remain on accrual status
past 90 days when it is determined that continued  accrual is warranted  because
the loan is well-secured and in process of collection.  As of December 31, 1997,
Downey had no loans 90 days or more delinquent which remained on accrual status.
Any interest  previously  accrued with respect to non-accrual  loans is reversed
and  charged  against  interest   income.   Interest  income  is  recognized  on
non-accrual  loans to the extent that  payments  are  received and to the extent
that Downey  believes it will  recover the  remaining  principal  balance of the
loan. Such loans are restored to an accrual status only if all past due payments
are made by the borrower and the borrower has  demonstrated  the ability to make
future  payments of principal  and interest.  At December 31, 1997,  non-accrual
loans  aggregating  $2.0 million were less than 90 days  delinquent  relative to
their  contractual  terms.  Additional loans  aggregating $17.8 million were not
contractually  past  due,  but  were  deemed  non-accrual  due  to  management's
assessment of the borrower's ability to pay.

     Impaired Loans.  Impaired loans are carried on Downey's  accounting records
at either the present  value of expected  future  cash flows  discounted  at the
loan's effective  interest rate, or at the loan's observable market price or the
fair value of


                                       37
<PAGE>



the collateral securing the loan. Impaired loans exclude large groups of smaller
balance  homogeneous loans that are collectively  evaluated for impairment.  For
Downey,  loans  collectively  reviewed for impairment  include all single family
loans and performing  multi-family  and  non-residential  loans having principal
balances of less than $1 million.

     Downey considers a loan to be impaired when, based upon current information
and events, it believes it is probable that Downey will be unable to collect all
amounts  due  according  to the  contractual  terms  of the loan  agreement.  In
determining  impairment,  Downey considers large  non-homogeneous loans with the
following   characteristics:   non-accrual  loans,  debt   restructurings,   and
performing loans which exhibit, among other characteristics,  high loan-to-value
ratios or delinquent taxes. Downey bases the measurement of collateral dependent
impaired  loans  on the  fair  value of the  loan's  collateral.  Non-collateral
dependent  loans are valued  based on a present  value  calculation  of expected
future cash flows,  discounted at the loan's  effective  rate.  Cash receipts on
impaired loans not performing  according to contractual terms are generally used
to reduce the carrying value of the loan, unless Downey believes it will recover
the remaining  principal balance of the loan.  Impairment losses are included in
the  allowance  for loan losses  through a charge to provision  for loan losses.
Adjustments  to  impairment  losses  due to  changes  in the  fair  value of the
collateral  of impaired  loans are included in provision  for loan losses.  Upon
disposition  of an  impaired  loan,  loss of  principal  is  recorded  through a
charge-off to the allowance for loan losses.  At December 31, 1997, the recorded
investment  in loans for which  impairment  has been  recognized  totaled  $13.8
million,  compared to $46.7  million at December  31, 1996 (all of which were on
non-accrual  status).  The total  allowance for losses related to such loans was
$1.3 million at December 31,  1997,  and $4.4 million at December 31, 1996.  For
further  information  regarding  impaired loans,  see Note 6 of the Notes to the
Consolidated Financial Statements on page 62.

     Troubled Debt  Restructurings.  A  restructuring  of a debt is considered a
troubled debt  restructuring  when Downey, for economic or legal reasons related
to the borrower's  financial  difficulties,  grants a concession to the borrower
that it would not  otherwise  grant.  Troubled debt  restructurings  may include
changing  repayment  terms,  reducing the stated  interest rate and reducing the
amounts of principal  and/or  interest due or extending the maturity  date.  The
restructuring of a loan is intended to recover as much of Downey's investment as
possible and to achieve the highest yield possible.  There were no troubled debt
restructurings on accrual status at December 31, 1997 and 1996.

     Real  Estate  Acquired in  Settlement  of Loans.  Real  estate  acquired in
settlement of loans  consists of real estate  acquired  through  foreclosure  or
deeds in lieu of foreclosure.

Delinquent Loans

     When a borrower fails to make required payments on a loan and does not cure
the delinquency  within 60 days,  Downey  normally  records a notice of default,
subject to any required prior notice to the borrower,  and commences foreclosure
proceedings.  If the loan is not reinstated within the time permitted by law for
reinstatement,  which is normally  five  business days prior to the date set for
the non-judicial  trustee's sale, the property may then be sold at a foreclosure
sale. If Downey has elected to pursue a non-judicial foreclosure,  Downey is not
permitted  under  applicable  California  law to  obtain a  deficiency  judgment
against the borrower, even if the security property is insufficient to cover the
balance owed. In  foreclosure  sales,  Downey  generally  acquires  title to the
property. At December 31, 1997, loans delinquent 30 days or more as a percentage
of total  loans was 0.79%,  down from 0.90% and 1.99% at  December  31, 1996 and
1995, respectively.



                                       38
<PAGE>

     The following table indicates the amounts of Downey's past due loans at the
dates indicated.

<TABLE>
<CAPTION>
                                                                                 December 31,
                                               ------------------------------------------------------------------------------------
                                                               1997                                        1996
                                               ------------------------------------------------------------------------------------
                                                30-59      60-89     90+                   30-59      60-89     90+
(Dollars in Thousands)                           Days       Days     Days (1)    Total      Days       Days     Days (1)    Total
---------------------------------------------------------------------------------------   -----------------------------------------
<S>                                            <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>    
Loans secured by real estate:
   Residential:
     One-to-four units .....................   $12,099    $ 4,101    $18,579    $34,779    $14,519    $ 5,502    $18,549    $38,570
     One-to-four units - subprime (2) ......       185       --         --          185        198       --         --          198
     Five or more units ....................      --          222       --          222       --         --         --         --
   Commercial real estate ..................      --         --          279        279       --         --         --         --
   Construction ............................      --         --         --         --         --         --         --         --
   Land ....................................      --         --         --         --         --         --          566        566
---------------------------------------------------------------------------------------   -----------------------------------------
     Total real estate loans ...............    12,284      4,323     18,858     35,465     14,717      5,502     19,115     39,334
Non-mortgage:
   Commercial ..............................      --         --         --         --         --         --         --         --
   Consumer:
     Automobile ............................     4,167        981        961      6,109      2,080        328        274      2,682
     Other consumer ........................       218         54        533        805        158         15        181        354
---------------------------------------------------------------------------------------   -----------------------------------------
       Total loans .........................   $16,669    $ 5,358    $20,352    $42,379    $16,955    $ 5,845    $19,570    $42,370
=======================================================================================   =========================================
Delinquencies as a percentage of total loans      0.31%      0.10%      0.38%      0.79%      0.36%      0.12%      0.41%      0.90%
=======================================================================================   =========================================
                                                                                                                          
                                                                 1995                                        1994
                                               ----------------------------------------   -----------------------------------------
<S>                                            <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>    
Loans secured by real estate:
   Residential:
     One-to-four units .....................   $14,047    $ 6,645    $22,303    $42,995    $15,306    $ 9,273    $20,584    $45,163
     Five or more units ....................        89       --          447        536       --         --          149        149
   Commercial real estate ..................      --         --       30,675     30,675       --         --        1,139      1,139
   Construction ............................      --         --         --         --         --         --         --         --
   Land ....................................      --         --        6,516      6,516       --         --          836        836
---------------------------------------------------------------------------------------   -----------------------------------------
     Total real estate loans ...............    14,136      6,645     59,941     80,722     15,306      9,273     22,708     47,287
Non-mortgage:
   Commercial ..............................      --         --          115        115       --         --         --         --
   Consumer:
     Automobile ............................       667        249        540      1,456         22         12         24         58
     Other consumer ........................       257        410        170        837        291        171        334        796
---------------------------------------------------------------------------------------   -----------------------------------------
       Total loans .........................   $15,060    $ 7,304    $60,766    $83,130    $15,619    $ 9,456    $23,066    $48,141
=======================================================================================   =========================================
Delinquencies as a percentage of total loans      0.36%      0.18%      1.46%      1.99%      0.37%      0.23%      0.55%      1.15%
=======================================================================================   =========================================
                                                                                                                
                                                                 1993                                           
                                               ----------------------------------------
<S>                                            <C>        <C>        <C>        <C>         
Loans secured by real estate:
   Residential:
     One-to-four units .....................   $15,058    $ 5,565    $29,160    $49,783
     Five or more units ....................        58        205        183        446
   Commercial real estate ..................      --         --       20,882     20,882
   Construction ............................      --         --         --         --
   Land ....................................      --         --         --         --
---------------------------------------------------------------------------------------
     Total real estate loans ...............    15,116      5,770     50,225     71,111
Non-mortgage:
   Commercial ..............................      --         --         --         --
   Consumer:
     Automobile ............................        39          7        131        177
     Other consumer ........................       635        249        479      1,363
---------------------------------------------------------------------------------------
       Total loans .........................   $15,790    $ 6,026    $50,835    $72,651
=======================================================================================  
Delinquencies as a percentage of total loans      0.54%      0.21%      1.74%      2.49%
=======================================================================================  
</TABLE>

(1)  All 90 day or greater  delinquencies are on non-accrual status and reported
     as part of non-performing assets.
(2)  Downey commenced one-to-four subprime lending in the first quarter of 1996.



                                       39
<PAGE>



Allowance for Losses on Loans and Real Estate

     Valuation allowances for losses on loans and real estate are established on
a specific and general basis.  Specific  allowances are determined  based on the
difference  between the carrying value of the asset and its fair value.  General
valuation allowances are determined based on historical loss experience, current
and anticipated levels and trends of delinquent and non-performing loans and the
economic  environment  in  Downey's  market  areas.  See  Note 1 of Notes to the
Consolidated Financial Statements on page 53.

     Downey's Internal Asset Review Department  conducts  independent reviews to
evaluate  the risk and quality of all Downey  assets.  Downey's  Internal  Asset
Review Committee  ("IARC") is responsible for the review and  classification  of
assets. The IARC members include the Chief Internal Asset Review Officer,  Chief
Executive  Officer,  Chief Financial  Officer,  Chief Lending  Officer,  General
Counsel, Director of Compliance/Risk Management,  Credit Administrator and Chief
Appraiser.   The  IARC  meets   quarterly  to  review  and  to  determine  asset
classifications and to recommend any changes to asset valuation allowances. With
the exception of payoffs or asset sales, the  classification  of an asset,  once
established,  can be removed or upgraded  only upon  approval  of the IARC.  The
Chief Internal Asset Review Officer reports  quarterly to the Audit Committee of
the  Board of  Directors  regarding  overall  asset  quality,  the  adequacy  of
valuation allowances on classified assets and Downey's adherence to policies and
procedures regarding asset classification and valuation.

     Downey  adheres to an  internal  asset  review  system  and loss  allowance
methodology  designed to provide for timely  recognition  of problem  assets and
adequate general  valuation  allowances to cover asset losses.  Downey's current
asset monitoring process includes the use of asset  classifications to segregate
the assets, largely loans and real estate, into various risk categories.  Downey
uses  the  various  asset  classifications  as a means  of  measuring  risk  for
determining  the  general  valuation  allowances  at a  point  in  time.  Downey
currently uses a six grade system to classify its assets. The current grades are
Pass,  Watch,  Special  Mention,  Substandard,  Doubtful and Loss.  Substandard,
Doubtful  and Loss assets are  considered  "classified  assets"  for  regulatory
purposes. A brief description of these classifications follows:

     The Pass classification represents a level of credit quality which contains
no well-defined deficiency or weakness.

o    The  Watch  classification  is used to  identify  an asset  that  currently
     contains no well-defined deficiency or weakness, but it is determined to be
     desirable to closely monitor the asset (e.g.,  loans to facilitate the sale
     of real estate acquired in settlement of loans).  This category may also be
     used for  assets  upgraded  from  lower  classifications  where  continuing
     monitoring is deemed appropriate.

o    A Special  Mention asset does not  currently  expose Downey to a sufficient
     degree of risk to  warrant an adverse  classification,  but does  possess a
     correctable  deficiency or potential weakness deserving  management's close
     attention.

o    Substandard  assets have a well-defined  weakness or  weaknesses.  They are
     characterized  by the  distinct  possibility  that Downey will sustain some
     loss if the deficiencies are not corrected.

o    An asset  classified  Doubtful  has all the  weaknesses  inherent  in those
     classified  Substandard with the added  characteristic  that the weaknesses
     make collection or liquidation in full, on the basis of currently  existing
     facts,  conditions and values,  highly questionable and improbable.  Downey
     considers  Doubtful to be a temporary  classification  until  resolution of
     pending weakness issues enables Downey to more clearly define the potential
     for loss.

o    That portion of an asset classified Loss is considered uncollectible and of
     such little value that its continuance as an asset,  without  establishment
     of a specific valuation allowance,  is not warranted. A Loss classification
     does not mean that an asset has  absolutely  no recovery or salvage  value,
     but rather it is not  reasonable  to defer writing off or providing for all
     or a portion of an  impaired  asset even  though  partial  recovery  may be
     effected in the future.  Downey will generally classify as Loss the balance
     of the  asset  that is  greater  than the fair  value of the  asset  unless
     payment from another  source can be expected.  Therefore,  the amount of an
     asset  classified  as  Loss  reflects  the  total  of  specific   valuation
     allowances   established  for  the  particular  asset.  Specific  valuation
     allowances are not includable in  determining  the Bank's total  regulatory
     capital.

     The  OTS  has  the  authority  to  require   Downey  to  change  its  asset
classifications.  If such a change results in an asset being classified in whole
or in part as Loss, a specific allowance must be established  against the amount
so  classified  or that amount must be charged  off.  OTS  guidelines  set forth
quantitative benchmarks as a starting point for the determination of appropriate
levels of general valuation allowances. The OTS directs its examiners to rely on
management's estimates of


                                       40
<PAGE>



adequate  general  valuation   allowances  if  the  association's   process  for
determining adequate allowances is deemed to be sound.

     It is Downey's  policy to provide an allowance for losses on loans and real
estate when it is probable that the value of the asset has been impaired and the
loss can be  reasonably  estimated.  To comply  with  this  policy,  Downey  has
established  a monitoring  system that requires at least an annual review of all
assets in excess of $1 million and a semiannual  review of all assets considered
adversely  classified or criticized.  The monitoring system requires a review of
current operating  statements,  an evaluation of the property's current and past
performance,   an  evaluation  of  the  borrower's  ability  to  repay  and  the
preparation  of a  discounted  cash flow  analysis.  Based on the results of the
review, a new appraisal may be required.

     Downey's  provision for loan losses totaled $8.6 million in 1997, down $0.5
million from 1996. The provision for loan losses  exceeded net loan  charge-offs
by $2.0  million  resulting in an increase in the  allowance  for loan losses to
$32.1 million at December 31, 1997. This increase reflected the growth in single
family  residential  and  automobile  loans.  Included in the  current  year-end
allowance of $32.1 million was $31.7 million of general valuation  allowances of
which  $2.8  million  was  unallocated  to any  specific  loan  category  and is
maintained due to the uncertain, but improving, economy of California.

     A summary of activity in the  allowances for loan losses is set forth below
for the years indicated.

<TABLE>
<CAPTION>
(In Thousands)                     1997        1996        1995        1994       1993
-----------------------------------------------------------------------------------------
<S>                              <C>         <C>         <C>         <C>         <C>     
Balance at beginning of period   $ 30,094    $ 27,943    $ 25,650    $ 26,835    $ 28,425
Provision ....................      8,640       9,137       9,293       4,211       1,085
Charge-offs ..................     (7,773)     (7,660)     (8,017)     (5,511)     (2,675)
Recoveries ...................      1,131         674       1,017         115          22
Transfers ....................       --          --          --          --           (22)
-----------------------------------------------------------------------------------------
Balance at end of period .....   $ 32,092    $ 30,094    $ 27,943    $ 25,650    $ 26,835
=========================================================================================
</TABLE>

     Net loan  charge-offs  were $6.6 million in 1997, down from $7.0 million in
both 1996 and 1995. The decline  primarily  reflected a $2.8 million  decline in
net charge-offs of one-to-four  unit residential  loans,  partially offset by an
increase of $2.7 million in automobile  loans. The growth in automobile loan net
charge-offs reflects the growth in that portfolio as the ratio of automobile net
charge-offs  to the average of such loans was 1.58% in 1997 compared to 1.37% in
1996. Charge-offs, net of recoveries, by category of loan are as follows for the
years indicated.

<TABLE>
<CAPTION>
(Dollars in Thousands)                                        1997        1996        1995        1994       1993
-------------------------------------------------------------------------------------------------------------------
<S>                    <C>                                  <C>         <C>         <C>         <C>         <C>    
Loans secured by real estate:
    Residential:
      One-to-four unit (1) ..............................   $ 2,165     $ 4,982     $ 5,165     $ 4,051     $ 1,431
      Five or more unit .................................      --           102         469         264         320
    Commercial real estate ..............................      (261)       (250)        807         959         617
    Land ................................................      --          --             4        --          --
Non-mortgage:
    Commercial ..........................................      --           115        (152)        (52)       --
    Consumer:
      Automobile ........................................     4,468       1,791         398           9          51
      Other consumer ....................................       270         246         309         165         234
-------------------------------------------------------------------------------------------------------------------
      Total net loan charge-offs ........................   $ 6,642     $ 6,986     $ 7,000     $ 5,396     $ 2,653
===================================================================================================================
Net loan charge-offs as a percentage of average loans and
    mortgage-backed securities held to maturity .........      0.13%       0.16%       0.17%       0.16%       0.09%
===================================================================================================================
</TABLE>

(1)  Includes  net  charge-offs  associated  with the  January  1994  Northridge
     earthquake of $1.0 million, $1.1 million and $0.8 million in 1996, 1995 and
     1994, respectively.



                                       41
<PAGE>


     The  allocation of the allowance for loan losses at the dates  indicated is
as set forth in the following table.

<TABLE>
<CAPTION>
                                                                            December 31,
                               -----------------------------------------------------------------------------------------------------
                                               1997                             1996                            1995
                               ----------------------------------- -------------------------------- --------------------------------
                                              Gross      Allowance              Gross     Allowance             Gross     Allowance
                                               Loan      Percentage              Loan     Percentage             Loan     Percentage
                                             Portfolio    to Loan              Portfolio   to Loan             Portfolio   to Loan
(Dollars in Thousands)         Allowance      Balance     Balance  Allowance    Balance    Balance  Allowance   Balance    Balance
------------------------------------------------------------------------------------------------------------------------------------
<S>                             <C>          <C>            <C>     <C>       <C>            <C>     <C>       <C>            <C>  
Loans secured by real estate:
   Residential:
     One-to-four units ......   $14,652      $4,607,545     0.32%   $13,241   $4,046,448     0.33%   $12,254   $3,656,512     0.34%
     Five or more units .....       314          38,278     0.82        517       56,907     0.91        895       57,321     1.56
   Commercial real estate ...     4,112         202,425     2.03      6,956      260,609     2.67      8,456      270,583     3.13
   Construction .............       847          70,865     1.20        773       66,651     1.16        335       28,593     1.17
   Land .....................       331          25,687     1.29        466       21,177     2.20        973       21,867     4.45
Non-mortgage:
   Commercial ...............       196          26,024     0.75        236       22,136     1.07        259       12,864     2.01
   Consumer:
     Automobile .............     8,016         342,326     2.34      4,303      202,186     2.13        849       56,127     1.51
     Other consumer .........       824          47,735     1.73        802       47,281     1.70      1,122       50,945     2.20
Other .......................      --              --        --        --           --        --        --           --        --
Not specifically allocated ..     2,800            --        --       2,800         --        --       2,800         --        --
----------------------------------------------------------------------------------------------------------------------------------
     Total loans held for
       investment ...........   $32,092      $5,360,885     0.60%$   30,094   $4,723,395     0.64%$   27,943   $ 4,154,812    0.67%
==================================================================================================================================

                                                1994                            1993                   
                               ----------------------------------- --------------------------------
<S>                             <C>     <C>  <C>            <C>     <C>       <C>            <C>  
Loans secured by real estate:
   Residential:
     One-to-four units ......   $12,404 (1)  $3,688,280     0.34%   $ 7,598   $2,376,586     0.32%
     Five or more units .....       978          63,782     1.53      1,052       73,505     1.43
   Commercial real estate ...     6,814         294,418     2.31     10,551      341,027     3.09
   Construction .............       131          11,367     1.15        372       37,180     1.00
   Land .....................       862           9,822     8.78        608       11,826     5.14
Non-mortgage:
   Commercial ...............       472          12,975     3.64        339        8,229     4.12
   Consumer:
     Automobile .............        42           3,028     1.39         53        3,274     1.62
     Other consumer .........     1,094          53,241     2.05      1,362       48,580     2.80
Other .......................        53          39,143     0.14       --         51,060      --
Not specifically allocated ..     2,800 (1)        --        --       4,900         --        --
-------------------------------------------------------------------------------------------------
     Total loans held for
       investment ...........   $25,650      $4,176,056     0.61    $26,835   $2,951,267     0.91%
=================================================================================================
</TABLE>

(1)  At March 31, 1994, $2.1 million was reallocated from the "not  specifically
     allocated" category to the "one-to-four unit residential"  category for the
     potential Northridge earthquake loss exposure. During 1994, $1.2 million in
     loss  provision  was  recorded  to  further  increase  the  loss  allowance
     associated with the Northridge earthquake.




                                       42
<PAGE>



     The following table is a summary of the activity of Downey's  allowance for
real estate held for investment and  non-conforming  loans to joint ventures for
the years indicated.  The $3.2 million,  $3.3 million and $2.9 million provision
reductions  in  1997,  1996  and 1995  respectively,  were  due to a  continuing
improvement in the real estate market which favorably  impacted the valuation of
certain  neighborhood  retail shopping center  investments and to a reduction in
the investment in certain joint  ventures.  Charge-offs in 1997 amounted to $5.6
million related to the sale of four properties held for investment.

<TABLE>
<CAPTION>
(In Thousands)                      1997        1996       1995        1994        1993
-----------------------------------------------------------------------------------------
<S>                              <C>         <C>         <C>         <C>         <C>     
Balance at beginning of period   $ 30,071    $ 34,338    $ 37,198    $ 38,674    $ 34,921
Provision (reduction) ........     (3,190)     (3,306)     (2,916)     (1,400)      4,128
Charge-offs ..................     (5,637)     (1,035)       --           (76)       (355)
Recoveries ...................       --            74          56        --          --
Transfers ....................       --          --          --          --           (20)
-----------------------------------------------------------------------------------------
Balance at end of period .....   $ 21,244    $ 30,071    $ 34,338    $ 37,198    $ 38,674
=========================================================================================
</TABLE>
         
     In addition to losses charged against the allowance for loan losses, Downey
has recorded  losses on real estate  acquired in  settlement  of loans by direct
write-off to net  operations of real estate  acquired in settlement of loans and
against an allowance for losses  specifically  established for such assets.  The
following  table is a summary of the  activity  of Downey's  allowance  for real
estate acquired in settlement of loans for the years indicated.

<TABLE>
<CAPTION>
(In Thousands)                     1997       1996       1995       1994       1993
------------------------------------------------------------------------------------
<S>                              <C>        <C>        <C>        <C>        <C>    
Balance at beginning of period   $ 1,078    $ 1,217    $   743    $   747    $   255
Provision ....................     1,107      1,658      2,498      2,035      1,360
Charge-offs ..................    (1,346)    (1,797)    (2,024)    (2,039)      (890)
Recoveries ...................      --         --         --         --         --
Transfers ....................      --         --         --         --           22
------------------------------------------------------------------------------------
Balance at end of period .....   $   839    $ 1,078    $ 1,217    $   743    $   747
====================================================================================
</TABLE>

CAPITAL RESOURCES AND LIQUIDITY

     Downey's  sources of funds  include  deposits,  advances  from the FHLB and
other  borrowings,  proceeds  from the sale of real  estate,  sales of loans and
mortgaged-backed securities,  payments of loans and mortgaged-backed securities,
payments  for and sales of loan  servicing  and income  from other  investments.
Repayments  on loans and  mortgage-backed  securities  and  deposit  inflows and
outflows  are  affected  significantly  by interest  rates,  real  estate  sales
activity and general economic  conditions.  Loan repayments totaled $1.1 billion
for 1997,  compared to $0.8  billion in 1996.  These  repayments  were more than
offset by new loan  originations and purchases for portfolio of $2.1 billion and
$1.4 billion, respectively.

     During 1997, Downey experienced a net deposit inflow of $696.9 million,  of
which $104.3 million  represented  transaction  accounts with the balance of the
increase in  certificates  of deposit.  Aggregate  borrowings  decreased  $111.6
million as deposit growth exceeded new loan fundings.

     Downey  expects  to meet its 1998  funding  needs  primarily  from  deposit
growth.  If those sources fall short of satisfying  ongoing  commitments to fund
maturing and withdrawable deposits,  repay borrowings,  fund existing and future
loan and other investment commitments,  continue branch improvement programs and
maintenance of regulatory liquidity requirements,  Downey will utilize borrowing
arrangements  with the FHLB and other sources.  At December 31, 1997, Downey had
commitments  to fund loans  amounting  to $125.4  million,  stand-by  letters of
credit of $0.5  million,  undrawn  lines of credit of $69.8 million and loans in
process of $56.3  million.  Downey  believes  its current  sources of funds will
enable  it  to  meet  these  obligations  while  maintaining  its  liquidity  at
appropriate levels.

     The principal  measure of liquidity in the savings and loan industry is the
regulatory  ratio of cash and eligible  investments  to the sum of  withdrawable
savings and borrowings due within one year. The minimum  liquidity  ratio set by
federal  regulators was reduced in 1997 from 5% to 4%. At December 31, 1997, the
Bank's  ratio was 4.80%  compared  to 5.26% and 5.03% at  December  31, 1996 and
1995, respectively.


                                       43
<PAGE>



REGULATORY CAPITAL COMPLIANCE

     The following table is a reconciliation of the Bank's  stockholder's equity
to federal  regulatory  capital as of December 31,  1997.  The core and tangible
capital  ratios were 6.61% and the  risk-based  capital ratio was 12.64%.  These
levels  are  little  changed  from  comparable   ratios  of  6.56%  and  12.66%,
respectively,   at  December  31,  1996,   but  continue  to  exceed  the  "well
capitalized"  standards of 5% for core and tangible and 10% for  risk-based,  as
defined by  regulation.  During  1997,  the amount of the Bank's  non-includable
investment  in real  estate  required  to be deducted  from  regulatory  capital
declined by $8.1 million  primarily as a result of dividends paid to the Bank by
DSL Service Company.


<TABLE>
<CAPTION>
                                                         Tangible Capital       Core Capital       Risk-Based Capital
                                                        ------------------    -----------------    -------------------
(Dollars in Thousands)                                    Amount    Ratio       Amount    Ratio      Amount     Ratio
----------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>           <C>      <C>          <C>     <C>           <C>
Stockholder's Equity ...............................   $ 421,230              $ 421,230            $ 421,230
Adjustments:
   Deductions:
    Investment in subsidiary, primarily real estate      (35,585)               (35,585)             (35,585)
    Goodwill .......................................      (5,053)                (5,053)              (5,053)
    Core deposit premium ...........................        (214)                  (214)                (214)
    Non-permitted mortgage servicing rights ........        (195)                  (195)                (195)
   Additions:
    Unrealized gain on securities available for sale        (110)                  (110)                (110)
    General loss allowance - Investment in DSL .....       1,606                  1,606                1,606
    Loan general valuation allowances (1) ..........        --                     --                 31,713
----------------------------------------------------------------------------------------------------------------------
Regulatory capital .................................     381,679     6.61%      381,679    6.61%      413,392    12.64%
Well capitalized requirement .......................      86,614     1.50 (2)   288,715    5.00       326,959    10.00 (3)
----------------------------------------------------------------------------------------------------------------------
Excess .............................................   $ 295,065     5.11%$   $  92,964    1.61%    $  86,433     2.64%
======================================================================================================================
</TABLE>
 
(1)  Limited to 1.25% of risk-weighted assets.
(2)  Represents  the  minimum  requirement  for  tangible  capital,  as no "well
     capitalized" requirement has been established for this category.
(3)  A third requirement is Tier 1 capital to risk-weighted  assets of 6%, which
     the Bank meets and exceeds with a ratio of 11.67%.

CURRENT ACCOUNTING ISSUE

     In September 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related Information" ("SFAS 131").

     SFAS 131 establishes standards for the way that public business enterprises
report information about operating  segments in annual financial  statements and
requires that those  enterprises  report  selected  information  about operating
segments  in  interim  financial   reports  issued  to  shareholders.   It  also
establishes  standards  for related  disclosures  about  products and  services,
geographic areas and major customers. SFAS 131 supersedes FASB Statement No. 14,
"Financial  Reporting  for Segments of a Business  Enterprise,"  but retains the
requirement  to  report  information  about  major  customers.  It  amends  FASB
Statement No. 94, "Consolidation of All Majority-Owned  Subsidiaries," to remove
the special disclosure requirements for previously unconsolidated subsidiaries.

     SFAS 131 requires that a public business  enterprise  report  financial and
descriptive  information  about its  reportable  operating  segments.  Operating
segments  are  components  of  an  enterprise  about  which  separate  financial
information  is  available  that is evaluated  regularly by the chief  operating
decision  maker  in  deciding  how  to  allocate   resources  and  in  assessing
performance.  Generally, financial information is required to be reported on the
basis that it is used internally for evaluating segment performance and deciding
how to allocate resources to segments.

     SFAS 131 requires  that a public  business  enterprise  report a measure of
segment profit or loss,  certain specific revenue and expense items, and segment
assets. It requires  reconciliations  of total segment  revenues,  total segment
profit or loss, total segment assets,  and other amounts  disclosed for segments
to  corresponding   amounts  in  the  enterprise's   general-purpose   financial
statements.  It requires that all public business enterprises report information
about the revenues derived from the enterprise's products or services (or groups
of similar  products and services),  about the countries in which the enterprise
earns revenues and holds assets, and about major customers regardless of whether
that information is used in making operating decisions.  However,  SFAS 131 does
not require an enterprise to report information that is not


                                       44
<PAGE>


prepared for internal use if reporting it would be impracticable.

     SFAS 131 also requires that a public business enterprise report descriptive
information  about the way that the  operating  segments  were  determined,  the
products and services provided by the operating  segments,  differences  between
the  measurements  used in reporting  segment  information and those used in the
enterprise's   general-purpose   financial   statements,   and  changes  in  the
measurement of segment amounts from period to period.

     SFAS 131 is effective for financial  statements for periods beginning after
December 15, 1997. In the initial year of application,  comparative  information
for  earlier  years is to be  restated.  SFAS 131 need not be applied to interim
financial  statements in the initial year of its  application,  but  comparative
information  for interim  periods in the initial  year of  application  is to be
reported  in  financial  statements  for  interim  periods in the second year of
application.

YEAR 2000

     Like most financial  organizations,  Downey has many computer  systems that
identify dates using only the last two digits of the year. These systems must be
prepared to distinguish  dates such as 1900 from 2000.  Computer system failures
due to processing errors  potentially  arising from calculations using Year 2000
dates are a known risk.

     Downey has  established  processes  to  identify,  prioritize,  renovate or
replace  systems  that may be affected by Year 2000 dates.  To date,  Downey has
completed an inventory of all systems and  determined  which  processes are most
critical to supporting  customer  transaction  processing and providing customer
services.  System  renovation  and  replacement  plans have been started and are
targeted  for  completion  by the  end of  1998,  with  compliance  testing  and
installation processes to be completed during 1999.

     Downey  believes that this process is designed to be successful and will be
utilizing current  technology in seeking to assure Year 2000 compliant  systems.
However,  third party vendor  dependency,  including  government  entities,  may
impact Downey's  efforts to  successfully  complete Year 2000 compliance for all
systems  in a timely  fashion.  Downey is  requiring  that third  party  vendors
represent  their products to be Year 2000 compliant and has planned a program to
test for compliance.  Contingency  plans are being developed in the event that a
vendor is not able to provide a Year 2000 compliant solution.

     Commercial  loan  borrowers  of Downey  may also be  impacted  by Year 2000
issues. Downey has embarked on an awareness program to bring these issues to the
borrower's  attention and to determine the extent of their preparations for Year
2000. In addition, lending guidelines will take into consideration how Year 2000
issues will impact  their  business  and  possibly  their  ability to repay loan
obligations to Downey.

     Downey   currently   estimates   that  the  Year  2000   project  may  cost
approximately $5 million. This cost is in addition to existing personnel who may
participate  in the project and  includes  estimates  for  hardware and software
renovation or  replacement,  as well as additions to existing  staff who will be
specifically  devoted to the project.  Approximately  55% of the cost represents
costs to migrate to a new personal  computer  environment and to replace certain
older  automated  teller  machines,  both of which Downey might  otherwise  have
implemented/replaced  during the period  notwithstanding the Year 2000 issue. As
such, that portion of the Year 2000 costs are projected to be amortized over the
useful  life  of  the  equipment.  Of  the  estimated  $5  million  total  cost,
approximately $0.1 million was incurred in 1997, with approximately $1.5 million
to be expensed  in each of 1998 and 1999,  approximately  $1.0  million in 2000,
with the balance in subsequent  years.  As Downey  progresses in addressing  the
Year 2000 issue, estimates of costs could change, including failure of any third
party vendor to provide Year 2000 compliant solutions in a timely fashion.




                                       45
<PAGE>



ITEM 8. FINANCIAL STATEMENTS

                   Index to Consolidated Financial Statements

                                                                     Page

      Independent Auditors' Report..............................      47
      Consolidated Balance Sheets...............................      48
      Consolidated Statements of Income.........................      49
      Consolidated Statements of Comprehensive Income...........      50
      Consolidated Statements of Stockholders' Equity...........      50
      Consolidated Statements of Cash Flows.....................      51
      Notes to Consolidated Financial Statements................      53



                                       46
<PAGE>















                          Independent Auditors' Report


The Board of Directors and Stockholders
Downey Financial Corp.:

We have audited the accompanying consolidated balance sheets of Downey Financial
Corp.  and  subsidiaries  ("Downey")  as of December 31, 1997 and 1996,  and the
related consolidated statements of income,  comprehensive income,  stockholders'
equity  and cash  flows for each of the  years in the  three-year  period  ended
December  31,   1997.   These   consolidated   financial   statements   are  the
responsibility  of  Downey's  management.  Our  responsibility  is to express an
opinion on these consolidated financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated  financial statements referred to above present
fairly,  in all material  respects,  the financial  position of Downey Financial
Corp.  and  subsidiaries  as of December  31, 1997 and 1996,  and the results of
their  operations  and their cash flows for each of the years in the  three-year
period ended December 31, 1997, in conformity with generally accepted accounting
principles.


/s/ KPMG Peat Marwick LLP


Los Angeles, California
January 14, 1998



                                       47
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                           December 31,
(Dollars in Thousands, Except Per Share Data)                                           1997         1996
------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>           <C>        
ASSETS
Cash ...........................................................................   $    48,823   $    67,221
Federal funds ..................................................................         6,095         6,038
------------------------------------------------------------------------------------------------------------
    Cash and cash equivalents ..................................................        54,918        73,259
U.S. Treasury and agency obligations and other investment securities
    available for sale, at fair value ..........................................       159,398       141,999
Municipal securities being held to maturity, at amortized cost (estimated market
    value of $6,865 at December 31, 1997, and $6,975 at December 31, 1996) .....         6,885         6,997
Loans held for sale, at the lower of cost or market ............................        35,100        12,865
Mortgage-backed securities available for sale, at fair value ...................        49,299        61,267
Loans receivable held for investment ...........................................     5,281,997     4,655,714
Investments in real estate and joint ventures ..................................        41,356        46,498
Real estate acquired in settlement of loans ....................................         9,626        16,078
Premises and equipment .........................................................       101,901        96,643
Federal Home Loan Bank stock, at cost ..........................................        44,085        41,447
Other assets ...................................................................        51,260        45,390
------------------------------------------------------------------------------------------------------------
                                                                                   $ 5,835,825   $ 5,198,157
============================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits .......................................................................   $ 4,869,978   $ 4,173,102
Government securities sold under agreements to repurchase ......................        34,803          --
Federal Home Loan Bank advances ................................................       352,458       386,883
Commercial paper ...............................................................        83,811       198,113
Other borrowings ...............................................................        12,663        10,349
Accounts payable and accrued liabilities .......................................        40,579        28,357
Deferred income taxes ..........................................................        11,187         9,782
------------------------------------------------------------------------------------------------------------
    Total liabilities ..........................................................     5,405,479     4,806,586
------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY:
Common stock,  par  value of $0.01  per  share;  authorized 50,000,000 shares;
    outstanding 26,755,938 shares at December 31, 1997, and 25,459,079
    shares at December 31, 1996 ................................................           268           255
Additional paid-in capital .....................................................        45,954        22,607
Unrealized gains (losses) on securities available for sale .....................           110        (1,559)
Retained earnings ..............................................................       384,014       370,268
------------------------------------------------------------------------------------------------------------
    Total stockholders' equity .................................................       430,346       391,571
------------------------------------------------------------------------------------------------------------
                                                                                   $ 5,835,825   $ 5,198,157
============================================================================================================
</TABLE>










See accompanying notes to consolidated financial statements.



                                       48
<PAGE>



                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                        Consolidated Statements of Income

<TABLE>
<CAPTION>
                                                                                    Years ended December 31,
                                                                           ------------------------------------------
(Dollars in Thousands, Except Per Share Data)                                   1997           1996           1995
---------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>            <C>            <C>         
INTEREST INCOME:
   Loans receivable ....................................................      $ 404,081      $ 329,746      $ 300,098
   U.S. Treasury and agency securities .................................          8,300          7,765         11,122
   Mortgage-backed securities ..........................................          3,633          4,317          4,311
   Other investments ...................................................          4,404          4,532          2,661
   Yield maintenance on covered assets, net ............................           --             --              636
---------------------------------------------------------------------------------------------------------------------
       Total interest income ...........................................        420,418        346,360        318,828
---------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE:
   Deposits ............................................................        227,521        184,402        180,859
   Borrowings ..........................................................         38,739         27,363         33,379
---------------------------------------------------------------------------------------------------------------------
       Total interest expense ..........................................        266,260        211,765        214,238
---------------------------------------------------------------------------------------------------------------------
   NET INTEREST INCOME .................................................        154,158        134,595        104,590
   PROVISION FOR LOAN LOSSES ...........................................          8,640          9,137          9,293
---------------------------------------------------------------------------------------------------------------------
       Net interest income after provision for loan losses .............        145,518        125,458         95,297
---------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET:
   Loan and deposit related fees .......................................         10,921          7,435          5,546
   Real estate and joint ventures held for investment, net:
     Net gains on sales of wholly owned real estate ....................          2,904            392          4,539
     Reduction of loss on real estate and joint ventures ...............          3,190          3,306          2,916
     Operations, net ...................................................          8,128          4,543          3,737
   Secondary marketing activities:
     Loan servicing fees ...............................................          1,276          1,415          1,460
     Net gains on sales of loans and mortgage-backed securities ........          2,675          1,543            266
   Net gains (losses) on sales of investment securities ................           --            4,473            (15)
   Reduction of loss on investment in lease residual ...................           --             --              207
   Other ...............................................................          6,094          2,092          1,943
---------------------------------------------------------------------------------------------------------------------
       Total other income, net .........................................         35,188         25,199         20,599
---------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE:
   Salaries and related costs ..........................................         54,366         45,811         39,349
   Premises and equipment costs ........................................         15,272         12,640         11,535
   Advertising expense .................................................          6,847          4,071          2,028
   Professional fees ...................................................          5,113          2,985          3,150
   SAIF insurance premiums and regulatory assessments ..................          3,439          8,949          9,024
   Other general and administrative expense ............................         14,519         12,004          9,384
---------------------------------------------------------------------------------------------------------------------
     Total general and administrative expense ..........................         99,556         86,460         74,470
---------------------------------------------------------------------------------------------------------------------
   SAIF Special Assessment .............................................           --           24,644           --
   Net operation of real estate acquired in settlement of loans ........          1,184          2,567          4,206
   Amortization of excess of cost over fair value of net assets acquired            532            532            530
---------------------------------------------------------------------------------------------------------------------
       Total operating expense .........................................        101,272        114,203         79,206
---------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES .............................................         79,434         36,454         36,690
Income taxes ...........................................................         34,200         15,750         15,597
---------------------------------------------------------------------------------------------------------------------
   NET INCOME ..........................................................      $  45,234      $  20,704      $  21,093
=====================================================================================================================
PER SHARE INFORMATION:
Basic ..................................................................      $    1.69      $    0.77      $    0.79
=====================================================================================================================
DILUTED ................................................................      $    1.69      $    0.77      $    0.79
=====================================================================================================================
CASH DIVIDENDS PAID ....................................................      $   0.315      $   0.304      $   0.290
=====================================================================================================================
Weighted average shares outstanding ....................................     26,800,190     26,765,039     26,731,528
=====================================================================================================================
</TABLE>

See accompanying notes to consolidated financial statements.


                                       49
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                 Consolidated Statements of Comprehensive Income

<TABLE>
<CAPTION>
                                                                                      Years ended December 31,
                                                                                   -------------------------------
(Dollars in Thousands)                                                               1997       1996        1995
------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>        <C>         <C>     
NET INCOME .....................................................................   $ 45,234   $ 20,704    $ 21,093
------------------------------------------------------------------------------------------------------------------
Other  comprehensive  income  (loss),  net of  income  taxes:  Unrealized  gains
   (losses) on securities available for sale:
     U.S. Treasury and agency obligations and other investment securities
       available for sale, at fair value .......................................      1,331     (4,710)      2,985
     Mortgage-backed securities available for sale, at fair value ..............        338       (344)      1,566
------------------------------------------------------------------------------------------------------------------
   Other comprehensive income (loss) ...........................................      1,669     (5,054)      4,551
------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME ...........................................................   $ 46,903   $ 15,650    $ 25,644
==================================================================================================================
</TABLE>


                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>
                                                                              Unrealized
                                                                 Additional   Gain (Loss)
                                                      Common      Paid-in    on Securities       Retained
(Dollars in Thousands, Except Per Share Data)          Stock      Capital   Available for Sale   Earnings      Total
----------------------------------------------------------------------------------------------------------------------
<S>                                                   <C>          <C>           <C>              <C>          <C>      
Balances at December 31, 1994 .....................   $   162    $   3,720     $  (1,056)       $ 363,361    $ 366,187
Cash dividends, $0.290 per share ..................      --           --            --             (7,759)      (7,759)
Stock dividend ....................................         8       18,976          --            (18,984)        --
Unrealized gain on securities available for sale ..      --           --           4,551             --          4,551
Net income ........................................      --           --            --             21,093       21,093
----------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995 .....................       170       22,696         3,495          357,711      384,072
Cash dividends, $0.304 per share ..................      --           --            --             (8,147)      (8,147)
Three-for-two stock split effected in the form of a
   stock dividend .................................        85          (89)         --               --             (4)
Unrealized loss on securities available for sale ..      --           --          (5,054)            --         (5,054)
Net income ........................................      --           --            --             20,704       20,704
----------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 .....................       255       22,607        (1,559)         370,268      391,571
Cash dividends, $0.315 per share ..................      --           --            --             (8,454)      (8,454)
Stock dividend ....................................        13       23,012          --            (23,034)          (9)
Exercise of stock options .........................      --            335          --               --            335
Unrealized gain on securities available for sale ..      --           --           1,669             --          1,669
Net income ........................................      --           --            --             45,234       45,234
----------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 .....................   $   268    $  45,954     $     110        $ 384,014    $ 430,346
======================================================================================================================
</TABLE>








See accompanying notes to consolidated financial statements.



                                       50
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                           Years Ended December 31,
                                                                                --------------------------------------------
(In Thousands)                                                                           1997         1996         1995
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>            <C>            <C>        
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income ...................................................................   $    45,234    $    20,704    $    21,093
  Adjustments  to  reconcile  net  income  to net cash  provided  by  operating
    activities:
      Depreciation and amortization ............................................         9,389          8,279          7,390
      Provision for losses on loans, leases, real estate acquired in settlement
        of loans, investments in real estate and joint ventures and other assets         6,780          7,533          8,693
      Net gains on sales of loans and mortgage-backed securities, investment
        securities, real estate and other assets ...............................        (9,210)        (6,827)        (4,799)
      Interest capitalized on loans (negative amortization) ....................       (12,885)        (9,388)        (2,600)
      Federal Home Loan Bank dividends .........................................        (2,638)        (2,301)        (1,808)
  Loans originated for sale ....................................................      (289,271)      (159,941)       (93,496)
  Proceeds from sales of loans originated for sale .............................       179,046        135,074         80,972
  Other, net ...................................................................         1,559          4,112        (11,643)
----------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities ...........................       (71,996)        (2,755)         3,802
----------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Proceeds from:
    Maturities of U.S. Treasury and agency obligations .........................         9,875           --           30,000
    Sales of loans held for investment .........................................       294,469           --             --
    Sales of investment securities available for sale ..........................          --          189,541           --
    Sales of mortgage-backed securities available for sale .....................        88,723         31,314         21,135
    Sales of wholly owned real estate and real estate acquired in settlement of         15,043         10,337         45,393
      loans
  Purchase of:
    U.S. Treasury and agency obligations and other investment securities .......       (25,000)      (170,455)       (42,089)
    Mortgage-backed securities available for sale ..............................          --          (30,073)          --
    Loans receivable held for investment .......................................       (35,828)          (223)       (44,194)
  Loans receivable originated held for investment (net of refinances of
    $56,366, $90,824, and $50,039 during 1997, 1996 and 1995, respectively) ....    (1,961,710)    (1,309,663)      (493,955)
  Principal payments on loans receivable held for investment and mortgage-backed
    securities held to maturity and available for sale .........................     1,086,551        757,550        501,367
  Net change in undisbursed loan funds .........................................        13,356         12,147         11,605
  Investments in real estate held for investment ...............................         5,115         (6,454)        (1,377)
  Other, net ...................................................................       (14,086)        (7,698)       (13,214)
----------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ...........................      (523,492)      (523,677)        14,671
----------------------------------------------------------------------------------------------------------------------------
</TABLE>




















See accompanying notes to consolidated financial statements.



                                       51
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES
                Consolidated Statements of Cash Flows (Continued)

<TABLE>
<CAPTION>
                                                                                            Years Ended December 31,
                                                                                     ---------------------------------------
(In Thousands)                                                                           1997         1996         1995
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>            <C>            <C>        
CASH FLOWS FROM FINANCING ACTIVITIES:
  Net increase in deposits .....................................................   $   696,876    $   382,881    $   232,823
  Net increase (decrease) in securities sold under agreements to repurchase ....        34,803        (16,099)          --
  Proceeds from Federal Home Loan Bank advances ................................       872,900      1,018,700        844,800
  Repayments of Federal Home Loan Bank advances ................................      (907,325)      (852,532)    (1,035,885)
  Net increase (decrease) in other borrowings ..................................      (111,988)         9,058        (47,473)
  Proceeds from exercise of stock options ......................................           335           --             --
  Cash dividends ...............................................................        (8,454)        (8,147)        (7,759)
----------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities ...........................       577,147        533,861        (13,494)
----------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents ...........................       (18,341)         7,429          4,979
Cash and cash equivalents at beginning of year .................................        73,259         65,830         60,851
----------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD .....................................   $    54,918    $    73,259    $    65,830
============================================================================================================================
Supplemental  disclosure of cash flow  information:  Cash paid during the period
  for:
    Interest ...................................................................   $   267,589    $   212,482    $   215,696
    Income taxes ...............................................................        23,572         19,753         13,965
Supplemental disclosure of non-cash investing:
  Loans transferred from held for investment to held for sale ..................       290,558          1,791           --
  U.S Treasury and agency obligations transferred from held to maturity to
   available for sale ..........................................................          --             --          164,880
  Loans exchanged for mortgage-backed securities ...............................        89,522         26,452           --
  Mortgage-backed securities transferred from held to maturity to available for           --             --           33,555
  sale
  Real estate acquired in settlement of loans ..................................        23,686         27,367         36,991
  Loans to facilitate the sale of real estate acquired in settlement of loans ..        21,919         23,356         13,777
============================================================================================================================
</TABLE>
























See accompanying notes to consolidated financial statements.



                                       52
<PAGE>





                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

                        December 31, 1997, 1996 and 1995


(1)  Summary of Significant Accounting Policies

     Principles of Consolidation

     The  consolidated  financial  statements  of  Downey  Financial  Corp.  and
     subsidiaries  ("Downey") include all accounts of Downey Financial Corp. and
     the consolidated accounts of all subsidiaries, including Downey Savings and
     Loan Association,  F.A. (the "Bank"). All significant intercompany balances
     and transactions have been eliminated.

     Business

     Downey  provides a full  range of  financial  services  to  individual  and
     corporate   customers   through   subsidiaries   and  branches  located  in
     California.   Downey  is  subject  to  competition   from  other  financial
     institutions.  Downey is subject to the regulations of certain governmental
     agencies  and  undergoes   periodic   examinations   by  those   regulatory
     authorities.

     Basis of Financial Statement Presentation

     The consolidated financial statements have been prepared in conformity with
     generally  accepted  accounting  principles.  In preparing the consolidated
     financial  statements,   management  is  required  to  make  estimates  and
     assumptions  that affect the reported  amounts of assets and liabilities as
     of the dates of the balance  sheets and the results of  operations  for the
     periods. Actual results could differ significantly from those estimates.

     Material estimates that are particularly  susceptible to significant change
     in the  near-term  relate to the  determination  of the  allowance for loan
     losses and the  valuation  of real  estate.  Management  believes  that the
     allowances  established  for losses on loans and real estate are  adequate.
     While  management uses available  information to recognize  losses on loans
     and real estate,  future additions to the allowances may be necessary based
     on  changes  in  economic  conditions.  In  addition,   various  regulatory
     agencies,  as an integral part of their examination  process,  periodically
     review  Downey's  allowances  for  losses  on loans and real  estate.  Such
     agencies may require Downey to recognize  additions to the allowances based
     on their judgments about information available to them at the time of their
     examination.

     Downey  is  required  to  carry  its  available  for  sale  mortgage-backed
     securities portfolio, real estate acquired in settlement of loans, and real
     estate held for  investment  or under  development  at the lower of cost or
     fair value or in certain  cases,  at fair value.  Fair value  estimates are
     made at a specific point in time based upon relevant market information and
     other   information   about  the  asset.  Such  estimates  related  to  the
     mortgage-backed and investment  securities portfolios include published bid
     prices or bid  quotations  received  from  securities  dealers.  Fair value
     estimates  for real estate  acquired in settlement of loans and real estate
     held  for  investment  or  under   development  is  determined  by  current
     appraisals  and,  where no active market exists for a particular  property,
     discounting a forecast of expected cash flows at a rate  commensurate  with
     the risk involved.

     Cash and Cash Equivalents

     For purposes of the  statements  of cash flows,  cash and cash  equivalents
     include  cash on hand,  amounts  due from  banks and  Federal  funds  sold.
     Generally, Federal funds are purchased and sold for one-day periods.

     Mortgage-Backed Securities Purchased Under Resale Agreements, U.S. Treasury
     and Agency Obligations,  Other Investment Securities,  Municipal Securities
     and Mortgage-Backed Securities

     Downey has established  written guidelines and objectives for its investing
     activities. At the time of purchase of a mortgage-backed security purchased
     under resale agreement, U.S. Treasury and agency obligation, other


                                       53
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     investment  security or a  mortgage-backed  security,  management of Downey
     designates  the security as either held to maturity,  available for sale or
     held for trading based on Downey's investment objectives, operational needs
     and intent.  Downey then monitors its investment  activities to ensure that
     those  activities  are  consistent  with  the  established  guidelines  and
     objectives.

     Held to Maturity

     Securities held to maturity are carried at cost,  adjusted for amortization
     of premiums and  accretion of discounts  which are  recognized  in interest
     income  using the interest  method.  Mortgage-backed  securities  represent
     participating   interests  in  pools  of  long-term  first  mortgage  loans
     originated and serviced by the issuers of the  securities.  Mortgage-backed
     securities  held to  maturity  are  carried at unpaid  principal  balances,
     adjusted for  unamortized  premiums and  unearned  discounts.  Premiums and
     discounts on  mortgage-backed  securities are amortized  using the interest
     method over the  remaining  period to  contractual  maturity,  adjusted for
     anticipated  prepayments.  It is the positive intent of Downey,  and Downey
     has the ability,  to hold these  securities  until  maturity as part of its
     portfolio of long-term  interest earning assets. If the cost basis of these
     securities is determined to be other than temporarily impaired,  the amount
     of the impairment is charged to operations.

     Available for Sale

     Securities  available  for sale are  carried  at market  value.  Unrealized
     holding  gains and losses,  or  valuation  allowances  established  for net
     unrealized  losses,  are excluded  from earnings and reported as a separate
     component of stockholders'  equity and comprehensive  income, net of income
     taxes, unless the security is deemed permanently  impaired. If the security
     is  determined  to be other than  temporarily  impaired,  the amount of the
     impairment is charged to operations.

     Realized  gains and losses on the sale of  securities  available  for sale,
     determined using the specific identification method and recorded on a trade
     date basis, are reflected in earnings.

     Held for Trading

     Securities  held for  trading  are carried at market  value.  Realized  and
     unrealized gains and losses are reflected in earnings.

     Loans Held for Sale

     Downey  identifies  those  loans  which  foreseeably  may be sold  prior to
     maturity.  These  loans  have  been  classified  as  held  for  sale in the
     Consolidated Balance Sheets and are recorded at the lower of amortized cost
     or market  value.  In  response  to  unforeseen  events  such as changes in
     regulatory  capital  requirements,  liquidity  shortfalls,  changes  in the
     availability of sources of funds,  and excess loan demand by borrowers that
     could not be controlled immediately by loan price changes,  Downey may sell
     loans which had been held for investment.  In such  occurrences,  the loans
     are transferred at amortized cost and the lower of cost or market method is
     then applied.

     Gains or Losses on Sales of Loans and Mortgage Servicing Assets

     Gains or losses on sales of loans  are  recognized  at the time of sale and
     are  determined by the  difference  between the net sales  proceeds and the
     allocated  basis of the loans sold.  Downey adopted,  effective  January 1,
     1997,  Statement of Financial Accounting Standards No. 125, "Accounting for
     Transfers  and  Servicing  of  Financial  Assets  and   Extinguishments  of
     Liabilities," ("SFAS 125"). In accordance with SFAS 125, Downey capitalizes
     mortgage  servicing rights ("MSRs") acquired through either the purchase or
     origination  of mortgage  loans for sale or  securitization  with servicing
     rights  retained.  The total cost of the mortgage loans designated for sale
     is allocated to the MSRs and the mortgage  loans  without the MSRs based on
     their relative fair values.  The MSRs are included in other assets and as a
     component of gain on sale of loans. The MSRs are amortized in proportion to
     and over the


                                       54
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     estimated period of net servicing income. Such amortization is reflected as
     a component of loan servicing fees.

     The MSRs are  periodically  reviewed  for  impairment  based on their  fair
     value.  The fair value of the MSRs,  for the  purposes  of  impairment,  is
     measured using a discounted cash flow analysis based on Downey's  estimated
     net servicing income, market prepayment rates and market-adjusted  discount
     rates. Impairment is measured on a disaggregated basis based on predominant
     risk   characteristics   of  the  underlying   mortgage  loans.   The  risk
     characteristics  used by Downey  for the  purposes  of  capitalization  and
     impairment evaluation include loan type, interest rate tranches,  loan term
     and collateral type.  Impairment losses are recognized  through a valuation
     allowance,  with any associated  provision  recorded as a component of loan
     servicing fees.

     Derivative Financial Instruments

     As part of its secondary marketing activities, Downey utilizes forward sale
     contracts to hedge the value of loans  originated for sale against  adverse
     changes in interest rates.  These contracts have a high  correlation to the
     price  movement  of the loans  being  hedged.  There is no  recognition  of
     unrealized  gains and losses on these  contracts  in the  balance  sheet or
     statement of income. When the related loans are sold, the deferred gains or
     losses from these  contracts are recognized in the statement of income as a
     component  of net gains or  losses  on sales of loans  and  mortgage-backed
     securities.

     Loans Receivable Held for Investment

     Loans  receivable  are  recorded at cost,  net of discounts  and  premiums,
     undisbursed  loan  proceeds,  net deferred fees and costs and the allowance
     for loan losses.

     Interest  income on loans is  accrued  based on the  outstanding  principal
     amount of loans using the interest method.  Discounts and premiums on loans
     are amortized to income using the interest method over the remaining period
     to  contractual  maturity.  The  amortization  of discounts  into income is
     discontinued on loans that are contractually ninety days past due.

     Loan origination fees and related incremental direct loan origination costs
     are  deferred and  amortized  to income using the interest  method over the
     contractual  life of the  loans,  adjusted  for  actual  prepayments.  Fees
     received for a commitment to originate or purchase a loan or group of loans
     are deferred and, if the commitment is exercised,  recognized over the life
     of the  loan as an  adjustment  of  yield  or,  if the  commitment  expires
     unexercised,  recognized as income upon expiration of the  commitment.  The
     amortization  of deferred fees and costs is  discontinued on loans that are
     contractually ninety days past due.

     Accrued interest on loans that are  contractually  ninety days or more past
     due or when collection of interest appears  doubtful is generally  reversed
     and charged against interest income. Income is subsequently recognized only
     to the extent cash  payments  are  received  and the  principal  balance is
     expected to be recovered. Such loans are restored to an accrual status only
     if  the  loan  is  brought  contractually  current  and  the  borrower  has
     demonstrated the ability to make future payments of principal and interest.

     Allowance for Loan Losses

     The allowance for loan losses is maintained at an amount  management  deems
     adequate to cover estimated  losses.  Downey has implemented and adheres to
     an  internal  asset  review  system  and loan  loss  allowance  methodology
     designed  to  provide  for the  detection  of problem  assets and  adequate
     general  valuation  allowances  to cover loan losses.  In  determining  the
     allowance  for loan losses  related to  specific  major  loans,  management
     evaluates its allowance on an individual loan basis,  including an analysis
     of the  creditworthiness,  cash flows and financial status of the borrower,
     and the condition and the estimated value of the collateral. Downey reviews
     all loans under $1 million by analyzing  their  performance and composition
     of their  collateral  as a whole,  because  of the  relatively  homogeneous
     nature of the portfolios.  Specific valuation  allowances for secured loans
     are determined by the excess of


                                       55
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     the recorded investment in the loan over the fair value, where appropriate,
     of the collateral.  In determining overall general valuation  allowances to
     be maintained and the loan loss allowance ratios, management evaluates many
     factors including  prevailing and forecasted economic  conditions,  regular
     reviews  of  the  quality  of  loans  by  Downey's  Internal  Asset  Review
     Committee,  industry  experience,   historical  loss  experience,  year  of
     origination,   composition  and  geographic   concentrations  of  the  loan
     portfolio,  the borrowers'  ability to repay and repayment  performance and
     estimated collateral values.

     Downey considers a loan to be impaired when, based upon current information
     and  events,  it  believes  it is  probable  that  Downey will be unable to
     collect all  amounts due  according  to the  contractual  terms of the loan
     agreement.    In   determining    impairment,    Downey   considers   large
     non-homogeneous  loans  with  the  following  characteristics:  non-accrual
     loans, debt restructurings, and performing loans which exhibit, among other
     characteristics,  high  loan-to-value  ratios or delinquent  taxes.  Downey
     bases the  measurement of collateral  dependent  impaired loans on the fair
     value of the loan's collateral.  Non-collateral  dependent loans are valued
     based on a  present  value  calculation  of  expected  future  cash  flows,
     discounted at the loan's  effective  rate.  Cash receipts on impaired loans
     not performing  according to contractual terms are generally used to reduce
     the carrying value of the loan,  unless Downey believes it will recover the
     remaining principal balance of the loan.  Impairment losses are included in
     the  allowance  for loan  losses  through  a charge to  provision  for loan
     losses.  Adjustments to impairment  losses due to changes in the fair value
     of collateral of impaired  loans are included in provision for loan losses.
     Upon  disposition  of an  impaired  loan,  loss of  principal,  if any,  is
     recorded through a charge-off to the allowance for loan losses.

     In the  opinion  of  management,  and in  accordance  with  the  loan  loss
     allowance  methodology,  the present  allowance is  considered  adequate to
     absorb estimable and probable loan losses.  Additions to the allowances are
     reflected in current operations. Charge-offs to the allowance are made when
     the loan is  considered  uncollectible  or is  transferred  to real  estate
     owned. Recoveries are credited to the allowance.

     For regulatory  capital  purposes,  the Bank's  general  allowance for loan
     losses is included to a limit of 1.25% of regulatory risk-weighted assets.

     Loan Servicing

     Downey  services  mortgage loans for  investors.  Fees earned for servicing
     loans owned by investors  are reported as income when the related  mortgage
     loan payments are collected. Loan servicing costs are charged to expense as
     incurred.

     Investment in Real Estate and Joint Ventures

     Real estate held for  investment or under  development is held at the lower
     of cost (less  accumulated  depreciation) or fair value.  Costs,  including
     interest,  of  holding  real  estate  in  the  process  of  development  or
     improvement are  capitalized,  whereas costs relating to holding  completed
     property are expensed.  An allowance for losses is  established by a charge
     to operations if the carrying  value of a property  exceeds its fair value,
     including the consideration of disposition costs.

     Downey  utilizes  the  equity  method  of  accounting  for  investments  in
     non-controlled joint ventures, and the consolidation method for investments
     in controlled joint ventures. All intercompany profits are eliminated.

     Income from the sale of real estate is recognized principally when title to
     the property has passed to the buyer, minimum down payment requirements are
     met,  and the terms of any notes  received  by  Downey  satisfy  continuing
     investment requirements.  At the time of sale, costs are relieved from real
     estate projects on a relative sales value basis and charged to operations.



                                       56
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Real Estate Acquired in Settlement of Loans

     Real estate  acquired  through  foreclosure  is initially  recorded at fair
     value (net of an  allowance  for  estimated  selling  costs and  delinquent
     property  taxes) at the date of foreclosure,  and a valuation  allowance is
     established for any subsequent  declines in fair value.  All legal fees and
     direct costs,  including  foreclosure and other related costs, are expensed
     as incurred.

     Premises and Equipment

     Buildings,  leasehold  improvements and furniture,  fixtures, and equipment
     are  carried  at cost,  less  accumulated  depreciation  and  amortization.
     Buildings and furniture,  fixtures, and equipment are depreciated using the
     straight-line  method over the  estimated  useful lives of the assets.  The
     cost of leasehold  improvements is being amortized using the  straight-line
     method  over the shorter of the  estimated  useful life of the asset or the
     terms of the related leases.

     Impairment of Long-Lived Assets

     Downey reviews long-lived assets and certain  identifiable  intangibles for
     impairment  whenever events or changes in  circumstances  indicate that the
     carrying  amount  of an asset  may not be  recoverable.  Recoverability  of
     assets to be held and used is  measured  by a  comparison  of the  carrying
     amount of an asset to future net cash flows expected to be generated by the
     asset.  If such assets are considered to be impaired,  the impairment to be
     recognized  is measured by the amount by which the  carrying  amount of the
     assets  exceed the fair value of the  assets.  Assets to be disposed of are
     reported  at the lower of the  carrying  amount or fair value less costs to
     sell.

     Securities Sold Under Agreements to Repurchase

     Downey  enters into sales of  securities  under  agreements  to  repurchase
     ("reverse  repurchase  agreements").   Reverse  repurchase  agreements  are
     treated as financing  arrangements  and,  accordingly,  the  obligations to
     repurchase  the  securities  sold are reflected as  liabilities in Downey's
     consolidated financial statements.  The securities  collateralizing reverse
     repurchase  agreements  are delivered to several major  national  brokerage
     firms who arranged the  transactions.  These  securities  are  reflected as
     assets in Downey's consolidated  financial statements.  The brokerage firms
     may loan such  securities  to other  parties in the normal  course of their
     operations  and agree to return the  identical  securities to Downey at the
     maturity of the agreements.

     Income Taxes

     Downey  applies the asset and  liability  method of  accounting  for income
     taxes. The asset and liability method recognizes  deferred income taxes for
     the  tax  consequences  of  "temporary  differences"  by  applying  enacted
     statutory tax rates  applicable to future years to differences  between the
     financial  statement  carrying amounts and the tax bases of existing assets
     and  liabilities.  The effect on deferred taxes of a change in tax rates is
     recognized in income in the period that includes the enactment date.

     Deferred tax assets are to be  recognized  for temporary  differences  that
     will result in deductible amounts in future years and for tax carryforwards
     if, in the  opinion  of  management,  it is more  likely  than not that the
     deferred tax assets will be realized.

     Stock Option Plan

     Prior to January 1, 1996,  Downey  accounted  for its stock  option plan in
     accordance with the provisions of Accounting  Principles  Board Opinion No.
     25,  "Accounting  for Stock Issued to  Employees"  ("APB 25"),  and related
     interpretations.  As such,  compensation  expense  would be recorded on the
     date of grant only if the  current  market  price of the  underlying  stock
     exceeded the exercise price. On January 1, 1996,  Downey adopted  Statement
     of


                                       57
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Financial   Accounting  Standards  No.  123,  "Accounting  for  Stock-Based
     Compensation"  ("SFAS 123"), which permits entities to recognize as expense
     over the  vesting  period the fair value of all  stock-based  awards on the
     date of grant. Alternatively,  SFAS 123 also allows entities to continue to
     apply the  provisions  of APB 25 and  provide  pro forma net income and pro
     forma net income per share  disclosures  for employee  stock option  grants
     made in 1995 and future years as if the fair-value-based  method defined in
     SFAS 123 had been  applied.  Downey has  elected to  continue  to apply the
     provisions  of APB 25 and provide the pro forma  disclosure  provisions  of
     SFAS 123.

     Per Share Information

     Downey  adopted,  effective  December  31, 1997,  Statement  of  Accounting
     Standards No. 128,  "Earnings Per Share" ("SFAS 128").  SFAS 128 simplifies
     the standards for  computing and  presenting  earnings per share ("EPS") as
     previously  prescribed  by  Accounting  Principles  Board  Opinion  No. 15,
     "Earnings  per  Share."  SFAS 128  replaces  primary EPS with basic EPS and
     fully  diluted EPS with  diluted EPS.  Basic EPS  excludes  dilution and is
     computed  by  dividing  income  available  to  common  stockholders  by the
     weighted  average  number  of common  shares  outstanding  for the  period.
     Diluted EPS reflects the potential  dilution that could occur if securities
     or other  contracts to issue common stock were  exercised or converted into
     common stock or resulted  from issuance of common stock that then shared in
     earnings.

     Current Accounting Pronouncement

     In September 1997, the Financial Accounting Standards Board ("FASB") issued
     Statement of Financial  Accounting  Standards No. 131,  "Disclosures  about
     Segments of an Enterprise and Related Information" ("SFAS 131").

     SFAS 131 establishes standards for the way that public business enterprises
     report information about operating segments in annual financial  statements
     and requires  that those  enterprises  report  selected  information  about
     operating segments in interim financial reports issued to shareholders.  It
     also  establishes  standards  for related  disclosures  about  products and
     services,  geographic areas and major  customers.  SFAS 131 supersedes FASB
     Statement  No.  14,  "Financial   Reporting  for  Segments  of  a  Business
     Enterprise," but retains the requirement to report  information about major
     customers.   It  amends  FASB  Statement  No.  94,  "Consolidation  of  All
     Majority-Owned Subsidiaries," to remove the special disclosure requirements
     for previously unconsolidated subsidiaries.

     SFAS 131 requires that a public business  enterprise  report  financial and
     descriptive information about its reportable operating segments.  Operating
     segments are  components of an enterprise  about which  separate  financial
     information is available that is evaluated regularly by the chief operating
     decision  maker in deciding  how to  allocate  resources  and in  assessing
     performance. Generally, financial information is required to be reported on
     the basis that it is used internally for evaluating segment performance and
     deciding how to allocate resources to segments.

     SFAS 131 requires  that a public  business  enterprise  report a measure of
     segment profit or loss,  certain  specific  revenue and expense items,  and
     segment  assets.  It requires  reconciliations  of total segment  revenues,
     total  segment  profit or loss,  total  segment  assets,  and other amounts
     disclosed  for  segments  to  corresponding  amounts  in  the  enterprise's
     general-purpose  financial statements. It requires that all public business
     enterprises   report  information  about  the  revenues  derived  from  the
     enterprise's  products  or  services  (or  groups of similar  products  and
     services),  for the countries in which the  enterprise  earns  revenues and
     holds  assets,  and  about  major  customers  regardless  of  whether  that
     information is used in making operating decisions.  However,  SFAS 131 does
     not require an  enterprise to report  information  that is not prepared for
     internal use if reporting it would be impracticable.

     SFAS 131 also requires that a public business enterprise report descriptive
     information about the way that the operating segments were determined,  the
     products  and  services  provided by the  operating  segments,  differences
     between the measurements  used in reporting  segment  information and those
     used in the enterprise's  general-purpose financial statements, and changes
     in the measurement of segment amounts from period to period.

     SFAS 131 is effective for financial  statements for periods beginning after
     December 15, 1997. In the initial


                                       58
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     year of  application,  comparative  information  for earlier years is to be
     restated.  SFAS 131 need not be applied to interim financial  statements in
     the  initial  year of its  application,  but  comparative  information  for
     interim  periods in the initial  year of  application  is to be reported in
     financial statements for interim periods in the second year of application.

(2)  Business Combination

     During 1988, the Bank acquired  Butterfield  Savings and Loan  Association,
     FSA ("Butterfield") from the Federal Savings and Loan Insurance Corporation
     ("FSLIC") in a FSLIC assisted acquisition.

     Concurrent  with the  acquisition,  the Bank and the FSLIC  entered into an
     assistance agreement ("Butterfield Assistance Agreement") that provides for
     the  indemnification of the Bank against losses incurred on the disposal of
     certain  defined  covered assets and the  settlement of certain  unreserved
     preacquisition   liabilities  or  contingencies  reduced  by  tax  benefits
     associated with those expenses as defined.  Additionally,  the FSLIC agreed
     to provide yield  maintenance  assistance on certain  covered assets at the
     Federal  Home Loan Bank  ("FHLB")  Eleventh  District  Cost of Funds  Index
     ("COFI").  All such  amounts  received  are  nontaxable  under the Internal
     Revenue Code.

     During 1995,  the estimated  losses on covered assets which were covered by
     the  Butterfield  Assistance  Agreement  totaled $12.9  million.  The yield
     maintenance  on  covered  assets  totaled  $0.6  million  for 1995,  and is
     included in interest  income.  The remaining  covered  assets which consist
     primarily  of real  estate of $9.2  million  and loans  receivable  of $2.5
     million  were  repurchased  by the Federal  Deposit  Insurance  Corporation
     ("FDIC")  on  December  29,  1995,  as it  exercised  its  right  under the
     Butterfield Assistance Agreement.

     As all assets  subject to the  Butterfield  Assistance  Agreement have been
     sold or  repurchased  by the  FDIC,  Downey  and the  FDIC  terminated  the
     Butterfield Assistance Agreement on March 31, 1997.

(3)  U.S.  Treasury  and  Agency  Obligations  and Other  Investment  Securities
     Available for Sale

     The amortized cost and estimated  market value of U.S.  Treasury and agency
     obligations  and  other  investment   securities  available  for  sale  are
     summarized as follows:

                                                Gross        Gross     Estimated
                                 Amortized    Unrealized   Unrealized    Market
     (In Thousands)                 Cost         Gains       Losses      Value
     ---------------------------------------------------------------------------
     December 31, 1997 ........   $160,089    $    441      $  1,132    $159,398
     ===========================================================================
     December 31, 1996 ........   $145,025    $    317      $  3,343    $141,999
     ===========================================================================

     The amortized cost and estimated  market value of U.S.  Treasury and agency
     obligations and other  securities  available for sale at December 31, 1997,
     by contractual maturity, are shown below.


                                                 Amortized    Market
         (In Thousands)                             Cost      Value
     ----------------------------------------------------------------
     Due in one year or less .................   $  9,990    $  9,999
     Due after one year through five years (1)    150,099     149,399
     ----------------------------------------------------------------
     Total .................................     $160,089    $159,398
     ================================================================
     
     (1) No investment matures beyond five years.




                                       59
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Proceeds, gross realized gains and losses on the sales of U.S. Treasury and
     agency obligations and other investment  securities  available for sale are
     summarized as follows:

     (In Thousands)               1997      1996      1995
     ------------------------------------------------------
     Proceeds ................   $ --     $189,541   $  --
     ======================================================
     Gross realized gains ....   $ --     $  4,578   $  --
     ======================================================
     Gross realized losses ...   $ --     $    105   $  --
     ======================================================

     Net  unrealized  losses on  investment  securities  available for sale were
     recognized in stockholders'  equity in the amount of $0.7 million,  or $0.4
     million  net of  income  taxes,  at  December  31,  1997,  compared  to net
     unrealized losses of $3.0 million,  or $1.7 million net of income taxes, at
     December 31, 1996.

(4)  Loans and  Mortgage-Backed  Securities  Purchased Under Resale  Agreements,
     U.S. Treasury and Agency  Obligations and Other Investment  Securities Held
     to Maturity

     Loans and Mortgage-Backed Securities Purchased Under Resale Agreements

     There were no loans or  mortgage-backed  securities  purchased under resale
     agreements  at December  31, 1997 or 1996.  The average  interest  rate and
     balance was 5.72% and $8.0 million,  respectively,  during 1997,  and 5.52%
     and  $18.1   million,   respectively,   during  1996.  The  maximum  amount
     outstanding  at any  month-end  during 1997 and 1996 was $20.0  million and
     $40.0 million, respectively.

     U.S. Treasury and Agency Obligations and Other Investment Securities

     The loss on sale during 1995 of $15,000 was realized upon the  in-substance
     maturity of $15.0 million in U.S. Treasury obligations.

     Municipal Securities Held to Maturity

     The amortized cost and estimated market value of municipal  securities held
     to maturity are summarized as follows:

                                             Gross         Gross     Estimated
                               Amortized   Unrealized    Unrealized    Market
     (In Thousands)              Cost        Gains        Losses       Value
     ------------------------------------------------------------------------
     December 31, 1997 .....    $6,885      $    --        $   20      $6,865
     ========================================================================
     December 31, 1996 .....    $6,997      $    --        $   22      $6,975
     ========================================================================

     The  investment  at December  31, 1997 and 1996  represents  an  industrial
     revenue bond on which the interest  income is not subject to federal income
     taxes.





                                       60
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(5)  Mortgage-Backed Securities Available for Sale

     The  amortized  cost and  estimated  market  value  of the  mortgage-backed
     securities available for sale are summarized as follows:

                                               Gross        Gross     Estimated
                                 Amortized   Unrealized  Unrealized     Market
     (In Thousands)                Cost        Gains       Losses       Value
     -------------------------------------------------------------------------
     December 31, 1997:
       GNMA certificates .....    $ 9,623      $   459     $  --       $10,082
       FNMA certificates .....        201            9        --           210
       FHLMC certificates ....     19,659         --           163      19,496
       Non-agency certificates     18,933          583           5      19,511
     -------------------------------------------------------------------------
         Total ...............    $48,416      $ 1,051     $   168     $49,299
     =========================================================================
     December 31, 1996:
       GNMA certificates .....    $11,669      $   241     $     6     $11,904
       FNMA certificates .....        225            9        --           234
       FHLMC certificates ....     23,475         --           351      23,124
       Non-agency certificates     25,607          596         198      26,005
     -------------------------------------------------------------------------
         Total ...............    $60,976      $   846     $   555     $61,267
     =========================================================================

     Net unrealized gains on mortgage-backed  securities available for sale were
     recognized in stockholders'  equity in the amount of $0.9 million,  or $0.5
     million net of income  taxes,  at December 31, 1997.  At December 31, 1996,
     net unrealized gains were recognized in stockholders'  equity in the amount
     of $0.3 million, or $0.2 million net of income taxes.

     Proceeds,  gross realized gains and losses on the sales of  mortgage-backed
     securities available for sale are summarized as follows:

     (In Thousands)              1997       1996     1995
     ------------------------------------------------------
     Proceeds ...............   $88,723   $31,314   $21,135
     ======================================================
     Gross realized gains ...   $   728   $   809   $    46
     ======================================================
     Gross realized losses ..   $   928   $   221   $   283
     ======================================================




                                       61
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(6)  Loans Receivable

     Loans receivable are summarized as follows:

<TABLE>
<CAPTION>
                                                                December 31,
                                                        --------------------------
     (In Thousands)                                         1997           1996
     -----------------------------------------------------------------------------
<S>                                                     <C>            <C>        
     Held for investment:
       Loans secured by real estate:
         Residential:
           One-to-four units ........................   $ 4,358,475    $ 4,013,190
           One-to-four units - subprime .............       249,070         33,258
           Five or more units .......................        38,278         56,907
         Commercial real estate .....................       202,425        260,609
         Construction ...............................        70,865         66,651
         Land .......................................        25,687         21,177
       Non-mortgage:
         Commercial .................................        26,024         22,136
         Consumer:
           Automobile ...............................       342,326        202,186
           Other consumer ...........................        47,735         47,281
     -----------------------------------------------------------------------------
                                                          5,360,885      4,723,395
       Less:
         Undisbursed loan funds .....................       (64,884)       (49,250)
         Net deferred costs and premiums ............        18,088         11,663
         Allowance for estimated losses .............       (32,092)       (30,094)
     -----------------------------------------------------------------------------
           Loans receivable held for investment .....   $ 5,281,997    $ 4,655,714
     -----------------------------------------------------------------------------
     Held for sale:
       Loans secured by residential one-to-four units   $    35,100    $    12,865
     =============================================================================
</TABLE>
     
     Over  99%  of the  real  estate  securing  Downey's  loans  is  located  in
     California.

     Downey has had,  and  expects in the  future to have,  transactions  in the
     ordinary  course of business with executive  officers,  directors and their
     associates  ("related parties") on substantially the same terms,  including
     interest  rates  and  collateral,  as  those  prevailing  at the  time  for
     comparable  transactions with other non-related parties. Those transactions
     neither involve more than the normal risk of collectibility nor present any
     unfavorable  features. At December 31, 1997 and 1996, the Bank had extended
     loans  to  certain  directors,  executive  officers  and  their  associates
     totaling $27.1 million and $28.8 million,  respectively. All such loans are
     performing  in  accordance  with their  loan  terms.  Presented  below is a
     summary  of  activity  with  respect  to such  loans for the  years  ending
     December 31, 1997 and 1996:

     (In Thousands)                     1997        1996
     -----------------------------------------------------
     Balance at beginning of period   $ 28,835    $ 29,681
     Additions ....................      3,857        --
     Repayments ...................     (5,598)       (846)
     -----------------------------------------------------
     Balance at end of period .....   $ 27,094    $ 28,835
     =====================================================



                                       62
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     A summary of activity in the allowance for loan losses for loans receivable
     held for investment during 1997, 1996 and 1995 follows:

<TABLE>
<CAPTION>
                                                                                                   Not
                                                  Real                                Other    Specifically
     (In Thousands)                              Estate     Commercial  Automobile   Consumer   Allocated    Total
     ---------------------------------------------------------------------------------------------------------------
<S>                                            <C>         <C>          <C>         <C>         <C>        <C>     
     Balance at December 31, 1994 ...........   $ 21,189    $    472     $     42    $  1,094    $  2,800   $ 25,597
     Provision for (reduction of) loan losses      8,116        (365)       1,205         337        --        9,293
     Charge-offs ............................     (7,247)       --           (401)       (316)       --       (7,964)
     Recoveries .............................        855         152            3           7        --        1,017
     ---------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1995 ...........     22,913         259          849       1,122       2,800     27,943
     Provision for (reduction of) loan losses      3,874          92        5,245         (74)       --        9,137
     Charge-offs ............................     (5,200)       (115)      (2,096)       (249)       --       (7,660)
     Recoveries .............................        366        --            305           3        --          674
     ---------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1996 ...........     21,953         236        4,303         802       2,800     30,094
     Provision for (reduction of) loan losses        207         (40)       8,181         292        --        8,640
     Charge-offs ............................     (2,389)       --         (5,109)       (275)       --       (7,773)
     Recoveries .............................        485        --            641           5        --        1,131
     ---------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1997 ...........   $ 20,256    $    196     $  8,016    $    824    $  2,800   $ 32,092
     ===============================================================================================================
</TABLE>

     Net  charge-offs  represented  0.13%,  0.16% and 0.17% of average loans for
     1997, 1996 and 1995, respectively.

     All impaired loans at December 31, 1997 and 1996 were secured by commercial
     real estate.  The following  table  presents  impaired  loans with specific
     allowances  and the amount of such  allowances,  and impaired loans without
     specific allowances.

<TABLE>
<CAPTION>
                                                  Net          Specific        Net
     (In Thousands)                          Carrying Value    Allowance     Balance
     -------------------------------------------------------------------------------
<S>                                             <C>             <C>          <C>  
     December 31, 1997:
         Loans with specific allowances ..      $  --           $  --        $  --
         Loans without specific allowances       13,798            --         13,798
     -------------------------------------------------------------------------------
         Total impaired loans ............      $13,798         $  --        $13,798
     ===============================================================================
     December 31, 1996:
         Loans with specific allowances ..      $ 2,967         $  (276)     $ 2,691
         Loans without specific allowances       43,763            --         43,763
     -------------------------------------------------------------------------------
         Total impaired loans ............      $46,730         $  (276)     $46,454
     ===============================================================================
</TABLE>

     The average recorded investment in impaired loans during 1997 totaled $15.1
     million and $45.8 million in 1996.  During 1997, total interest  recognized
     on the impaired loan portfolio, on a cash basis, was $2.0 million, compared
     to $3.5 million in 1996.

     The combined  weighted  average interest yield on loans receivable held for
     investment  and sale was 7.96% and 7.77% as of December  31, 1997 and 1996,
     respectively,  and averaged  7.81%,  7.72% and 7.20% during 1997,  1996 and
     1995, respectively.

     The aggregate amount of non-accrual loans receivable that are contractually
     past due 90 days or more as


                                       63
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     to principal or interest, in the foreclosure process, restructured, or upon
     which interest  collection is doubtful were $41.7 million and $45.0 million
     as of December 31, 1997 and 1996, respectively. There were no troubled debt
     restructurings on accrual status as of December 31, 1997 and 1996.

     Interest due on  non-accrual  loans but excluded from  interest  income was
     approximately $1.8 million for 1997, $4.1 million for 1996 and $6.1 million
     for 1995.

(7)  Loan Servicing

     Mortgage  loans  serviced for others are not  included in the  accompanying
     consolidated  balance  sheets.  The unpaid  principal  balances of mortgage
     loans serviced for others was $612.5 million and $576.0 million at December
     31, 1997 and 1996, respectively.

     Custodial escrow balances  maintained in connection with the foregoing loan
     servicing,  and  included in demand  deposits,  were $2.1  million and $2.0
     million at December 31, 1997 and 1996, respectively.

     Mortgage servicing rights of $1.2 million and $1.0 million related to loans
     sold with  servicing  rights  retained were  capitalized  in 1997 and 1996,
     respectively,  and $0.4 million related to purchased  servicing  rights was
     capitalized in 1995.  Mortgage  servicing  rights have been written down to
     their fair value of $2.0 million, $1.2 million and $0.4 million at December
     31, 1997, 1996 and 1995,  respectively.  Amortization of mortgage servicing
     rights was $295,000 in 1997, $179,000 in 1996 and $48,000 in 1995.

     Starting in 1996, a valuation  reserve was provided for mortgage  servicing
     rights.  The allowance for mortgage  servicing  rights during 1997 and 1996
     are summarized as follows:

     (In Thousands)                    1997    1996
     -----------------------------------------------
     Balance at beginning of period   $ 101    $--
     Additions ....................     249      129
     Reductions ...................    (144)     (28)
     -----------------------------------------------
     Balance at end of period .....   $ 206    $ 101
     ===============================================



                                       64
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(8)  Investments in Real Estate and Joint Ventures

     Investments in real estate and joint ventures are summarized as follows:

<TABLE>
<CAPTION>
                                                                          December 31,
                                                                      --------------------
         (In Thousands)                                                 1997        1996
     -------------------------------------------------------------------------------------
<S>                                                                   <C>         <C>     
     Gross investments in real estate .............................   $ 63,321    $ 66,745
     Accumulated depreciation .....................................     (9,432)    (11,094)
     Allowance for estimated losses ...............................    (19,617)    (22,294)
     -------------------------------------------------------------------------------------
        Investments in real estate (1) ............................     34,272      33,357
     -------------------------------------------------------------------------------------
     Investments in and interest bearing advances to joint ventures      8,711      20,918
     Joint venture valuation allowance ............................     (1,627)     (7,777)
     -------------------------------------------------------------------------------------
        Investments in joint ventures .............................      7,084      13,141
     -------------------------------------------------------------------------------------
        Total investments in real estate and joint ventures .......   $ 41,356    $ 46,498
     =====================================================================================
</TABLE>

     (1)  Includes  $0.4 million and $0.6 million at December 31, 1997 and 1996,
          respectively, associated with three single family housing developments
          which are joint  ventures  for legal  purposes.  They are  reported as
          wholly  owned for  financial  reporting  purposes  because DSL Service
          Company assumed  operating  control effective in the fourth quarter of
          1993.

     The table set forth below describes the type, location, and amount invested
     in real estate and joint ventures,  net of specific valuation allowances of
     $19.5 million and general valuation allowances of $1.7 million, at December
     31, 1997:

<TABLE>
<CAPTION>
     (In Thousands)                                         California   Arizona    Other       Total
     -------------------------------------------------------------------------------------------------
<S>                                                           <C>        <C>        <C>        <C>    
     Shopping centers .....................................   $18,061    $17,954    $  --      $36,015
     Office buildings .....................................       573       --         --          573
     Residential ..........................................     2,250       --         --        2,250
     Land .................................................     3,490        309        459      4,258
     -------------------------------------------------------------------------------------------------
       Total real estate before general valuation allowance   $24,374    $18,263    $   459    $43,096
     =================================================================================================
     General valuation allowance                                                                (1,740)
                                                                                                ------
     Net investment in real estate and joint ventures                                          $41,356
                                                                                                ======
</TABLE>




                                       65
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     A summary of real estate and joint venture operations  included in Downey's
     results of operations follows:

<TABLE>
<CAPTION>
     (In Thousands)                                             1997        1996       1995
     ----------------------------------------------------------------------------------------
<S>                                                          <C>         <C>         <C>     
     Wholly owned operations:
       Rental operations:
          Rental income ..................................   $  4,689    $  4,649    $  5,837
          Costs and expenses .............................     (2,372)     (2,232)     (2,126)
     ----------------------------------------------------------------------------------------
             Net rental operations .......................      2,317       2,417       3,711
       Net gains on sales of real estate .................      2,904         392       4,539
       Reduction of losses on real estate ................        985       1,263       2,085
     ----------------------------------------------------------------------------------------
          Total wholly owned operations ..................      6,206       4,072      10,335
     ----------------------------------------------------------------------------------------
     Joint venture operations:
       Equity in net income (loss) from joint ventures ...      3,931          55      (1,676)
       Reduction of losses provided by DSL Service Company      2,205       2,043         831
     ----------------------------------------------------------------------------------------
          Net joint venture operations ...................      6,136       2,098        (845)
     Interest from joint venture advances ................      1,880       2,071       1,702
     ----------------------------------------------------------------------------------------
       Total joint venture operations ....................      8,016       4,169         857
     ----------------------------------------------------------------------------------------
          Total ..........................................   $ 14,222    $  8,241    $ 11,192
     ========================================================================================
</TABLE>

     Activity  in the  allowance  for losses on real estate and  investments  in
     joint ventures for 1997, 1996 and 1995 is as follows:

<TABLE>
<CAPTION>
                                                    Real Estate    Commercial    Residential    Investments
                                                      Held for     Real Estate   Real Estate        In
                                                      or Under      Held for       Held for        Joint
     (In Thousands)                                 Development    Investment     Investment     Ventures      Total
     ----------------------------------------------------------------------------------------------------------------
<S>                                                  <C>           <C>            <C>            <C>         <C>     
     Balance at December 31, 1994 ................   $  6,173      $  8,093       $ 12,328       $ 10,604    $ 37,198
     Reduction of estimated losses ...............       (206)       (1,410)          (469)          (831)     (2,916)
     Charge-offs .................................       --            --             --             --          --
     Recoveries ..................................       --            --             --               56          56
     ----------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1995 ................      5,967         6,683         11,859          9,829      34,338
     Provision for (reduction of) estimated losses         50        (1,567)           254         (2,043)     (3,306)
     Charge-offs .................................       (680)         --             (272)           (83)     (1,035)
     Recoveries ..................................       --            --             --               74          74
     ----------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1996 ................      5,337         5,116         11,841          7,777      30,071
     Provision for (reduction of) estimated losses        492        (1,403)           (74)        (2,205)     (3,190)
     Charge-offs .................................       --          (1,692)          --           (3,945)     (5,637)
     Recoveries ..................................       --            --             --             --          --
     ----------------------------------------------------------------------------------------------------------------
     Balance at December 31, 1997 ................   $  5,829      $  2,021       $ 11,767       $  1,627    $ 21,244
     ================================================================================================================
</TABLE>



                                       66
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Condensed  financial  information of joint ventures  reported on the equity
     method is as follows:

               Condensed Combined Balance Sheets - Joint Ventures

<TABLE>
<CAPTION>
                                                                        December 31,
                                                                   ----------------------
     (In Thousands)                                                   1997        1996
     ------------------------------------------------------------------------------------
<S>                                                                <C>          <C>      
     Assets
     Cash ......................................................   $   1,703    $   1,778
     Projects under development ................................         964       13,039
     Completed projects ........................................      64,138       91,049
     Other assets ..............................................       5,057        6,310
     ------------------------------------------------------------------------------------
                                                                   $  71,862    $ 112,176
     ====================================================================================
     Liabilities and Equity
     Liabilities:
        Notes payable to the Bank ..............................   $  52,992    $  77,598
        Notes payable to others ................................      13,858       28,562
        Other ..................................................       9,940       11,152
     Equity (deficit):
        DSL Service Company (1) ................................       7,084       13,141
        Allowance for losses recorded by DSL Service Company (2)       1,627        7,777
        Other partners' (2) ....................................     (13,639)     (26,054)
     ------------------------------------------------------------------------------------
          Net deficit ..........................................      (4,928)      (5,136)
     ------------------------------------------------------------------------------------
                                                                   $  71,862    $ 112,176
     ====================================================================================
</TABLE>

     (1)  Included in these amounts are interest-bearing  joint venture advances
          with priority  interest  payments  from joint  ventures to DSL Service
          Company.
     (2)  The  aggregate  other  partners'  deficit of $13.6  million  and $26.1
          million at December 31, 1997 and 1996, respectively,  represents their
          equity interest in the accumulated  retained earnings (deficit) of the
          respective  joint  ventures.  Those  results  include not only the net
          profit on sales and the operating  results of the real estate  assets,
          but  depreciation  expense and funding  costs as well.  Except for any
          secured  financing  which has been obtained,  DSL Service  Company has
          provided  all other  financing.  As part of  Downey's  internal  asset
          review process, the fair value of the joint venture real estate assets
          is compared to the  secured  notes  payable to the Bank and others and
          DSL Service Company's equity investment.  To the extent the fair value
          of the real estate assets is less than the aggregate of those amounts,
          a provision is made to create a valuation allowance.  Those allowances
          totaled  $1.6  million and $7.8 million at December 31, 1997 and 1996,
          respectively.  At December 31, 1997, the fair value of the real estate
          assets  of  certain  joint  venture  partnerships  in which  the other
          partners'  equity was a deficit  exceeded  the  amount of third  party
          notes and DSL Service  Company's  investment  thereby  eliminating the
          need for a valuation allowance since the sale of the real estate would
          allow DSL  Service  Company  to  realize  its  investment.  Thus,  the
          aforementioned  other  partners'  deficit of $13.6  million  and $26.1
          million at  December  31,  1997 and 1996,  respectively,  exceeds  the
          amount of  aforementioned  valuation  allowances  established  of $1.6
          million and $7.8 million at December 31, 1997 and 1996, respectively.



                                       67
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

          Condensed Combined Statements of Operations - Joint Ventures

<TABLE>
<CAPTION>
     (In Thousands)                                           1997       1996       1995
     --------------------------------------------------------------------------------------
<S>                                                        <C>         <C>         <C>   
     Real estate sales:
        Sales ..........................................   $ 82,696    $  2,901    $   --
        Cost of sales ..................................    (72,255)     (1,401)       --
     --------------------------------------------------------------------------------------
          Net gains on sales ...........................     10,441       1,500        --
     --------------------------------------------------------------------------------------
     Rental operations:
        Rental income ..................................      8,280      13,674      16,587
        Operating expenses .............................     (1,729)     (1,781)     (3,574)
        Interest, depreciation and other expenses ......     (9,130)    (14,784)    (16,365)
     --------------------------------------------------------------------------------------
          Net loss on rental operations ................     (2,579)     (2,891)     (3,352)
     --------------------------------------------------------------------------------------
     Net income (loss) .................................      7,862      (1,391)     (3,352)
     Less other partners' share of net income (loss) ...      3,931      (1,446)     (1,676)
     --------------------------------------------------------------------------------------
     DSL Service Company's share of net income (loss) ..      3,931          55      (1,676)
     Reduction of losses provided by DSL Service Company      2,205       2,043         831
     --------------------------------------------------------------------------------------
     DSL Service Company's share of net income (loss) ..   $  6,136    $  2,098    $   (845)
     ======================================================================================
</TABLE>

(9)  Real Estate Acquired in Settlement of Loans

     The type and  amount of real  estate  acquired  in  settlement  of loans is
     summarized as follows:

                                                                December 31,
                                                           ---------------------
     (In Thousands)                                           1997        1996
     ---------------------------------------------------------------------------
     One-to-four unit residential ......................   $  9,295    $ 12,690
     Commercial shopping centers .......................        477       3,754
     Land ..............................................        693         712
     ---------------------------------------------------------------------------
                                                             10,465      17,156
     Allowance for estimated losses ....................       (839)     (1,078)
     ---------------------------------------------------------------------------
       Total real estate acquired in settlement of loans   $  9,626    $ 16,078
     ===========================================================================
     
     A summary of net  operation of real estate  acquired in settlement of loans
     included in Downey's results of operations follows:

<TABLE>
<CAPTION>
     (In Thousands)                                                      1997       1996      1995
     -----------------------------------------------------------------------------------------------
<S>                     <C>                                            <C>        <C>        <C>     
     Net gains on sales (1) ........................................   $(1,299)   $  (389)   $   (25)
     Net operating expense .........................................     1,376      1,298      1,733
     Provision for estimated losses ................................     1,107      1,658      2,498
     -----------------------------------------------------------------------------------------------
       Net operations of real estate acquired in settlement of loans   $ 1,184    $ 2,567    $ 4,206
     ===============================================================================================
</TABLE>

     (1)  Includes $1.1 million in 1997  associated  with the sale of a shopping
          center.




                                       68
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Activity in the  allowance  for  estimated  losses on real estate  acquired
     through foreclosure for 1997, 1996 and 1995 is as follows:

     (In Thousands)                     1997       1996      1995
     --------------------------------------------------------------
     Balance at beginning of period   $ 1,078    $ 1,217    $   743
     Provision ....................     1,107      1,658      2,498
     Charge-offs ..................    (1,346)    (1,797)    (2,024)
     --------------------------------------------------------------
     Balance at end of period .....   $   839    $ 1,078    $ 1,217
     ==============================================================

(10) Premises and Equipment

     Premises and equipment are summarized as follows:

                                                       December 31,
                                                 ----------------------
     (In Thousands)                                1997          1996
     ------------------------------------------------------------------
     Land ....................................   $  23,413    $  21,287
     Building and improvements ...............      86,444       84,612
     Furniture, fixtures and equipment .......      46,970       39,828
     Construction in progress ................         705           37
     Other ...................................          76           91
     ------------------------------------------------------------------
                                                   157,608      145,855
     Accumulated depreciation and amortization     (55,707)     (49,212)
     ------------------------------------------------------------------
       Total premises and equipment ..........   $ 101,901    $  96,643
     ==================================================================
     
     Downey has commitments  under long term operating  leases,  principally for
     building space and land.  Lease terms generally  cover a five-year  period.
     Rental  expense  was $1.4  million in 1997,  $0.8  million in 1996 and $0.7
     million in 1995.  The following  table  summarizes  future  minimum  rental
     commitments under noncancelable leases.

     (In Thousands)
     -----------------------------------------
     1998 ...........................   $1,418
     1999 ...........................    1,194
     2000 ...........................      757
     2001 ...........................      534
     2002 ...........................      126
     Thereafter (1) .................      193
                                        ------
       Total future lease commitments   $4,222
                                        ------

     (1)  There are no lease commitments  beyond the year 2009 though options to
          renew at that time are available.

(11) Federal Home Loan Bank Stock

     The Bank's  required  investment in FHLB stock,  based on December 31, 1997
     financial data, was $47.4 million. The investment in FHLB stock amounted to
     $44.1   million  and  $41.4   million  at  December   31,  1997  and  1996,
     respectively. The Bank received a $0.7 million stock dividend and purchased
     additional  stock  amounting to $2.6  million in the first  quarter of 1998
     thereby increasing the Bank's investment to the required amount.



                                       69
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(12) Other Assets

     Other assets are summarized as follows:

                                                             December 31,
                                                          -----------------
     (In Thousands)                                         1997      1996
     ----------------------------------------------------------------------
     Accounts receivable ..............................   $ 3,798   $ 2,465
     Accrued interest receivable:
       Loans ..........................................    27,279    24,259
       Mortgage-backed securities .....................       281       356
       Investment securities ..........................     2,824     2,186
     Prepaid expenses .................................     8,598     7,261
     Excess of purchase price over fair value of assets
       acquired and liabilities assumed, net ..........     5,054     5,586
     Core deposit premium .............................       214       513
     Mortgage servicing rights ........................     1,945     1,175
     Repossessed automobiles, net .....................       795       928
     Other ............................................       472       661
     ----------------------------------------------------------------------
       Total other assets .............................   $51,260   $45,390
     ======================================================================

(13) Deposits

     Deposits are summarized as follows:

<TABLE>
<CAPTION>
                                                        December 31,
                                         -------------------------------------------
                                                  1997                  1996
                                         -------------------------------------------
                                         Weighted               Weighted
                                          Average                Average
     (Dollars in Thousands)                Rate       Amount      Rate      Amount
     -------------------------------------------------------------------------------
<S>                                        <C>     <C>            <C>     <C>       
     Transaction accounts (1) .......      2.15%   $  935,869     2.04%   $  831,598
     Certificates of deposit:
      Less than 3.00% ...............      2.64        30,623     2.65        39,061
      3.00-3.49 .....................      3.02           766     3.03           723
      3.50-3.99 .....................       --           --       3.99            79
      4.00-4.49 .....................      4.31        60,095     4.39        63,577
      4.50-4.99 .....................      4.87        40,356     4.87       186,576
      5.00-5.99 .....................      5.63     2,896,291     5.54     2,489,852
      6.00-6.99 .....................      6.06       901,920     6.17       536,307
      7.00 and greater ..............      7.22         4,058     7.15        25,329
     -------------------------------------------------------------------------------
        Total certificates of deposit      5.68     3,934,109     5.56     3,341,504
     -------------------------------------------------------------------------------
        Total deposits ..............      5.00%   $4,869,978     4.86%   $4,173,102
     ===============================================================================
</TABLE>

     (1)  Included  in these  amounts  is $106.5  million  and $81.0  million of
          non-interest   bearing   accounts  at  December  31,  1997  and  1996,
          respectively

     The  aggregate  amount  of jumbo  certificates  of  deposit  with a minimum
     denomination  of $100,000 was $1.1 billion and $0.8 billion at December 31,
     1997 and 1996, respectively.


                                       70
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     At December 31, 1997,  scheduled  maturities of certificates of deposit are
     as follows:

                                    Weighted
     (Dollars in Thousands)        Average Rate     Amount
     ------------------------------------------------------
     1998 ........................     5.66%     $3,498,980
     1999 ........................     5.82         373,511
     2000 ........................     5.87          28,784
     2001 ........................     5.74          15,096
     2002 ........................     5.92          17,434
     Thereafter ..................     6.01             304
     ------------------------------------------------------
       Total .....................     5.68%     $3,934,109
     ======================================================
     
     The  weighted  average  cost of deposits  averaged  4.96%,  4.74% and 4.81%
     during 1997, 1996 and 1995, respectively.

     As of  December  31,  1997 and 1996,  public  funds of  approximately  $6.2
     million and $1.8 million,  respectively, are secured by mortgage loans with
     a  carrying  value  of   approximately   $9.3  million  and  $2.6  million,
     respectively.

     Interest expense on deposits by type is summarized as follows:

     (In Thousands)                       1997       1996       1995
     -----------------------------------------------------------------
     Transaction accounts ...........   $ 18,239   $ 16,087   $ 14,028
     Certificate accounts ...........    209,282    168,315    166,831
     -----------------------------------------------------------------
       Total deposit interest expense   $227,521   $184,402   $180,859
     =================================================================
     
     Accrued  interest on  deposits,  which is included in accounts  payable and
     accrued liabilities, was $2.3 million at both December 31, 1997 and 1996.

(14) Securities Sold Under Agreements to Repurchase

     Securities sold under agreements to repurchase are summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1997      1996       1995
     -------------------------------------------------------------------------------------------
<S>                                                                <C>        <C>        <C>    
     Balance at year end .......................................   $34,803    $  --      $16,099
     Average balance outstanding during the year ...............     4,029     11,761     36,676
     Maximum amount outstanding at any month-end during the year    34,803     70,015     52,547
     Weighted average interest rate during the year ............      5.61%      5.19%      6.21%
     Weighted average interest rate at year end ................      6.65       --         5.90

     Secured by:
        U.S. Treasury note .....................................   $34,798    $  --      $  --
        Mortgage-backed securities .............................      --         --       17,342
     ===========================================================================================
</TABLE>

     The securities  collateralizing  these transactions were delivered to major
     national  brokerage  firms who arranged the  transactions.  Securities sold
     under  agreements  to  repurchase  generally  mature  within 30 days of the
     various dates of sale.


                                       71
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(15) Federal Home Loan Bank Advances

     FHLB advances are summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1997        1996        1995
     ----------------------------------------------------------------------------------------------
<S>                                                                <C>         <C>         <C>     
     Balance at year end .......................................   $352,458    $386,883    $220,715
     Average balance outstanding during the year ...............    444,408     266,252     284,003
     Maximum amount outstanding at any month-end during the year    550,736     397,147     473,800
     Weighted average interest rate during the year ............       6.02%       5.85%       6.30%
     Weighted average interest rate at year end ................       6.11        5.80        6.07
     
     Secured by:
       Loans receivable ........................................   $368,480    $345,463    $276,375
       Mortgage-backed securities ..............................     25,527      31,651      10,523
       FHLB stock ..............................................       --        41,447      39,146
     ==============================================================================================
</TABLE>

     In addition to the collateral  securing  existing  advances,  Downey had an
     additional  $1.2 billion in loans  available as  collateral  for any future
     advances as of December 31, 1997.

     FHLB advances have the following maturities at December 31, 1997:

     (In Thousands)
     ------------------------------------------
     1998 ........................     $272,131
     1999 ........................       36,488
     2000 ........................       24,220
     2001 ........................       12,951
     2002 ........................        3,868
     Thereafter ..................        2,800 (1)
     ------------------------------------------
       Total .....................     $352,458
     ==========================================

     (1)  Includes  a  $1.8  million   advance  which  carries  a   penalty-free
          prepayment  option  beginning  in April  1996  and  every  six  months
          thereafter.



                                       72
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(16) Commercial Paper

     Commercial paper borrowings are summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1997        1996        1995
     ----------------------------------------------------------------------------------------------
<S>                                                                <C>         <C>         <C>     
     Balance at year end .......................................   $ 83,811    $198,113    $196,602
     Average balance outstanding during the year ...............    182,296     174,739     191,313
     Maximum amount outstanding at any month-end during the year    272,818     198,113     198,341
     Weighted average interest rate during the year ............       5.75%       5.74%       6.38%
     Weighted average interest rate at end of year .............       5.61        5.45        5.56

     Secured by:
       FHLB Letter of Credit (1) ...............................   $300,000    $200,000    $200,000
     ==============================================================================================
</TABLE>

     (1)  This letter of credit is secured by loans  receivable  of $348 million
          at December 31, 1997.

     Commercial  paper  borrowings  at  December  31, 1997 bear  interest  rates
     ranging from 5.57% to 5.68% and mature within six months of year end.

(17) Other Borrowings

     Other borrowings are summarized as follows:

<TABLE>
<CAPTION>
                                                                                 December 31,
                                                                              ------------------
     (Dollars In Thousands)                                                     1997      1996
     -------------------------------------------------------------------------------------------
<S>                                                                            <C>       <C>    
     Long-term notes  payable to banks,  secured by real estate and mortgage
        loans with a carrying value of $17,725 at December 31, 1997, bearing
        interest
        rates from 7.50% to 9.21%  .........................................   $12,663   $10,349
     ===========================================================================================
</TABLE>
        
     Other borrowings have the following maturities at December 31, 1997:

     (In Thousands)
     -----------------------------------------
     1998 ........................     $ 2,224
     1999 ........................       2,415
     2000 ........................       2,211
     2001 ........................       1,106
     2002 ........................         927
     Thereafter ..................       3,780
     -----------------------------------------
       Total .....................     $12,663
     =========================================




                                       73
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(18) Income Taxes

     Income taxes are summarized as follows:

     (In Thousands)                        1997        1996        1995
     --------------------------------------------------------------------
     Federal:
        Current ......................   $ 26,681    $  8,310    $ 11,538
        Deferred .....................       (886)      3,317          17
     --------------------------------------------------------------------
                                         $ 25,795    $ 11,627    $ 11,555
     ====================================================================
     State:
        Current ......................   $  7,373    $  2,602    $  2,144
        Deferred .....................      1,032       1,521       1,898
     --------------------------------------------------------------------
                                         $  8,405    $  4,123    $  4,042
     ====================================================================
     Total:
        Current ......................   $ 34,054    $ 10,912    $ 13,682
        Deferred .....................        146       4,838       1,915
     --------------------------------------------------------------------
           Total .....................   $ 34,200    $ 15,750    $ 15,597
     ====================================================================

     Current  income  taxes  payable  were  $11.0  million  and $0.6  million at
     December 31, 1997 and 1996, respectively.




                                       74
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Deferred tax liabilities  (assets) are comprised of the following temporary
     differences  between the financial  statement  carrying amounts and the tax
     bases of assets:

<TABLE>
<CAPTION>
                                                                       December 31,
                                                                  --------------------
     (In Thousands)                                                 1997       1996
     ---------------------------------------------------------------------------------
<S>                                                               <C>         <C>     
     Deferred tax liabilities:
         Tax reserves in excess of base year ..................   $ 21,095    $ 22,652
         Deferred loan fees ...................................     19,498      22,049
         Equity in joint ventures .............................      7,260       2,250
         FHLB stock dividends .................................      5,600       4,777
         Installment sales ....................................      5,011       5,927
         Depreciation on premises and equipment ...............      4,497       1,012
         Capitalized interest .................................      1,530       1,730
         Accrual to cash adjustment ...........................        259         422
         Unrealized gains on investment securities (1) ........         86        --
         SAIF insurance premiums ..............................         62       2,544
         Other deferred income items ..........................         54         118
     ---------------------------------------------------------------------------------
                                                                    64,952      63,481
     ---------------------------------------------------------------------------------
     Deferred tax assets:
         Loan valuation allowances, net of bad debt charge-offs    (32,875)    (31,573)
         Real estate and joint venture valuation allowances ...    (15,190)    (16,150)
         California franchise tax .............................     (2,941)     (1,475)
         Deferred compensation ................................     (1,899)     (2,244)
         Mark to market adjustment on securities held for sale        (217)        (20)
         Interest expense on deferred gain ....................       (131)       (107)
         Unrealized losses on investment securities (1) .......       --        (1,177)
         Alternative minimum tax credit carryforward ..........       --          (734)
         Other deferred expense items .........................       (512)       (219)
     ---------------------------------------------------------------------------------
                                                                   (53,765)    (53,699)
     Deferred tax assets valuation allowance ..................       --          --   
     ---------------------------------------------------------------------------------
     Net deferred tax liability ...............................   $ 11,187    $  9,782
     =================================================================================
</TABLE>

     (1)  Generally  accepted  accounting  principles  require the tax effect of
          unrealized  gains and losses on  securities  available  for sale to be
          reported as a separate component of stockholders' equity.




                                       75
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     A  reconciliation  of income taxes  (benefits)  to the  expected  statutory
     federal corporate income taxes follows:

<TABLE>
<CAPTION>
                                                               1997                 1996                 1995
                                                       ---------------------------------------------------------------
     (Dollars in Thousands)                             Amount     Percent    Amount     Percent    Amount     Percent
     -----------------------------------------------------------------------------------------------------------------
<S>                                                    <C>           <C>     <C>           <C>     <C>           <C>  
     Expected statutory income taxes ...............   $ 27,802      35.0%   $ 12,759      35.0%   $ 12,842      35.0%
     California franchise tax, net of federal income
         tax benefit ...............................      5,461       6.9       2,680       7.4       2,640       7.2
     Increase (decrease) resulting from:
         Non-taxable federal financial assistance ..       --          --        --          --        (223)     (0.6)
         Amortization of goodwill ..................        291       0.4         295       0.8         295       0.8
         Interest on municipal bonds ...............       (103)     (0.1)       (103)     (0.3)        (21)     (0.1)
         Interest expense on deferred gain .........         58       0.1        --          --        --          --
         Other .....................................        691       0.8         119       0.3          64       0.2
     -----------------------------------------------------------------------------------------------------------------
     Income taxes ..................................   $ 34,200      43.1%   $ 15,750      43.2%   $ 15,597      42.5%
     =================================================================================================================
</TABLE>

     The Small  Business Job  Protection Act of 1996 repealed the reserve method
     of accounting  for bad debts by savings  institutions  for years  beginning
     after 1995. Under prior law, savings  associations  calculated additions to
     reserves  using either a  percentage-of-taxable-income  or historical  loan
     loss experience. The new law allows deductions for bad debts only when such
     debts are actually  charged off against income (the  "specific  charge-off"
     method).  Downey  calculated its bad debt deduction for 1997 and 1996 under
     the specific charge-off method.

     Downey  made  income  tax  payments,  net of  refunds,  amounting  to $23.6
     million,  $19.8  million,  and  $14.0  million  in  1997,  1996  and  1995,
     respectively.

     Downey and its wholly owned subsidiaries file a consolidated federal income
     tax  return and a combined  California  franchise  tax report on a calendar
     year basis.  Downey's  federal and state tax returns have been  examined by
     the Internal  Revenue  Service and the Franchise  Tax Board of  California,
     respectively,  for all prior years through 1989. Federal income tax returns
     for  years  1990  through  1995  are  currently  under  examination.  State
     franchise tax returns for years subsequent to 1989 remain open to review.




                                       76
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(19) Stockholders' Equity

     Regulatory Capital

     Downey is not subject to any regulatory capital requirements.  However, the
     Bank is subject to regulation by the Office of Thrift  Supervision  ("OTS")
     which  has  adopted  regulations  ("Capital  Regulations")  that  contain a
     capital standard for savings  institutions.  The Bank is in compliance with
     the Capital Regulations at December 31, 1997 and 1996.

<TABLE>
<CAPTION>
                                                                                         To Be Well
                                                                                      Capitalized Under
                                                                  For Capital         Prompt Corrective
                                               Actual          Adequacy Purposes      Action Provisions
                                       -------------------    -------------------     ------------------
     (Dollars in Thousands)              Amount     Ratio       Amount     Ratio        Amount     Ratio
     ---------------------------------------------------------------------------------------------------
<S>                                    <C>          <C>       <C>           <C>       <C>          <C>   
     1997
       Risk-based capital
         (to risk-weighted assets)     $ 413,392    12.64%    $ 261,567     8.00%     $ 326,959    10.00%
       Core capital
         (to adjusted assets) ....       381,679     6.61       173,229     3.00        288,715     5.00
       Tangible capital
         (to adjusted assets) ....       381,679     6.61        86,614     1.50           --        --  (1)
       Tier I capital
         (to risk-weighted assets)       381,679    11.67          --        --  (1)    196,175     6.00
     ===================================================================================================
     1996
       Risk-based capital
         (to risk-weighted assets)     $ 366,079    12.66%    $ 231,376     8.00%     $ 289,220    10.00%
       Core capital
         (to adjusted assets) ....       336,921     6.56       153,976     3.00        256,627     5.00
       Tangible capital
         (to adjusted assets) ....       336,921     6.56        76,988     1.50           --        --  (1)
       Tier I capital
         (to risk-weighted assets)       336,921    11.65          --        --  (1)    173,532     6.00
     ===================================================================================================
</TABLE>

     (1)  Ratio is not specified under capital regulations.

     Capital Distributions

     The OTS rules impose certain  limitations  regarding stock  repurchases and
     redemptions,  cash-out mergers and any other distributions  charged against
     an institution's capital accounts.  The payment of dividends by the Bank is
     subject to OTS regulations.  Safe-harbor  amounts of capital  distributions
     can be made after  providing  notice to the OTS, but without  needing prior
     approval.  For  institutions,  such as the Bank,  that meet  their  capital
     requirements,  the  safe-harbor  amount  is the  greater  of (a) 75% of net
     income  for the  prior  four  quarters,  or (b) the sum of (1) the  current
     year's  net  income  and (2) the  amount  that  causes  the  excess  of the
     institution's  total  capital-to-risk  weighted  assets ratio over 8% to be
     only one-half of such excess at the beginning of the year. Institutions can
     distribute amounts in excess of the safe-harbor amounts only with the prior
     approval of the OTS.

     As of December  31, 1997,  the Bank had the  capacity to declare  dividends
     totaling $75.4 million under the safe-harbor limitations.




                                       77
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Stock Dividend

     On April 23,  1997,  the Board of Directors  declared a five percent  stock
     dividend on Downey's  common stock payable on May 22, 1997 to  stockholders
     of record on May 8, 1997.  The stock  dividend  resulted in the issuance of
     1,272,542  shares and the par value of the common stock  remained at $0.01.
     Accordingly,   $13,000  and  $23,012,000  were  transferred  from  retained
     earnings to common stock and additional paid-in-capital,  respectively. All
     share and per share data,  including  stock option plan  information,  have
     been restated to reflect this distribution.

     Employee Stock Option Plans

     During  1994,  the Bank  adopted and the  stockholders  approved the Downey
     Savings and Loan  Association  1994 Long Term  Incentive Plan (the "LTIP").
     The LTIP provides for the granting of stock appreciation rights, restricted
     stock,   performance  awards  and  other  awards.  The  LTIP  specifies  an
     authorization  of 413,438 shares  (adjusted for stock dividends and splits)
     of the Bank's common stock available for issuance under the LTIP. Effective
     January 23, 1995, Downey Financial Corp. and the Bank executed an amendment
     to the LTIP by which Downey  Financial Corp.  adopted and ratified the LTIP
     such that shares of Downey Financial Corp. shall be issued upon exercise of
     options  or  payment of other  awards,  for which  payment is to be made in
     stock, in lieu of the Bank's common stock.

     During 1997, no options were granted under the LTIP,  compared to 15,750 in
     1996.

     Options  outstanding  under  the  LTIP at  December  31,  1997 and 1996 are
     summarized as follows:

                                        Outstanding Options
                                       --------------------
                                        Number      Average
                                          of        Option
                                        Shares      Price
     ------------------------------------------------------
     December 31, 1995 ............    343,353    $   13.38
     Options granted ..............     15,750        16.19
     Options canceled and exercised    (32,288)       13.90
     ------------------------------------------------------
     December 31, 1996 ............    326,815        13.46
     Options granted ..............       --            --
     Options canceled and exercised   (189,786)       13.02
     ------------------------------------------------------
     December 31, 1997 ............    137,029    $   14.07
     =======================================================

     Under the LTIP,  options are exercisable in cumulative annual  installments
     commencing one year after the date of the grant and, unless exercised,  the
     options terminate five years from the date of the grant. Further, under the
     LTIP, the option price shall at least equal or exceed the fair market value
     of such shares on the date the options are granted.

     At December 31, 1997, 73,037 options were exercisable at a weighted average
     option price per share of $13.87,  with 236,428 shares available for future
     grants  under  the  LTIP.  At  December  31,  1996,  139,776  options  were
     exercisable at a weighted average option price per share of $13.24.



                                       78
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Downey measures its employee  stock-based  compensation  arrangements under
     the provisions of APB 25.  Accordingly,  no  compensation  expense has been
     recognized for the stock option plan. Had compensation expense for Downey's
     stock option plan been determined based on the fair value at the grant date
     for awards in 1997, 1996 and 1995, Downey's net income and income per share
     would have been reduced to the pro forma amounts indicated below:

     (In Thousands, Except Per Share Data)     1997        1996        1995
     ------------------------------------------------------------------------
     Net income:
         As reported ....................    $ 45,234    $ 20,704    $ 21,093
         Pro forma ......................      45,195      20,673      20,192
     Income per share - Basic/Diluted:
         As reported ....................    $   1.69    $   0.77    $   0.79
         Pro forma ......................        1.69        0.77        0.79
     ========================================================================

     The weighted  average fair value at date of grant of options granted during
     1996 and 1995 was $4.09 and $3.01 per option, respectively.  The fair value
     of options at date of grant was  estimated  using the  Black-Scholes  model
     with the following weighted average assumptions:

                                  1997 (1)  1996     1995
     ----------------------------------------------------
     Expected life (years) ....    --       3.79     3.74
     Interest rate ............    -- %     6.08%    5.60%
     Volatility ...............    --      24.58    24.92
     Dividend yield ...........    --       1.88     2.17
     ====================================================
     
     (1)  No options were granted.

(20) Earnings Per Share

     A  reconciliation  of the  components  used to  derive  basic  and  diluted
     earnings per share for 1997, 1996 and 1995 follows:

<TABLE>
<CAPTION>
                                                       Net      Weighted Average     Per-Share
     Dollars in Thousands, Except Per Share Data)     Income   Shares Outstanding     Amount
     -----------------------------------------------------------------------------------------
<S>                                                <C>             <C>               <C>     
     1997:
        Basic earnings per share ...............   $   45,234      26,739,577        $   1.69
        Effect of dilutive stock options .......         --            60,613             --
     ----------------------------------------------------------------------------------------
        Diluted earnings per share .............   $   45,234      26,800,190        $   1.69
     ========================================================================================
     1996:
        Basic earnings per share ...............   $   20,704      26,731,528        $   0.77
        Effect of dilutive stock options .......         --            33,511             --
     ----------------------------------------------------------------------------------------
        Diluted earnings per share .............   $   20,704      26,765,039        $   0.77
     ========================================================================================
     1995:
        Basic earnings per share ...............   $   21,093      26,731,528        $   0.79
        Effect of dilutive stock options .......         --              --               --
     ----------------------------------------------------------------------------------------
        Diluted earnings per share .............   $   21,093      26,731,528        $   0.79
     ========================================================================================
</TABLE>



                                       79
<PAGE>



                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(21) Employee Benefit Plans

     Retirement and Savings Plan

     In August 1993, Downey amended its profit sharing plan so that it qualifies
     as a profit  sharing and savings plan under Section  401(k) of the Internal
     Revenue Code ("the Plan"),  covering  substantially all salaried employees.
     Under the Plan,  employee  contributions  are partially  matched by Downey.
     Downey's  matching  contribution  is equal to 25% of an  employee's  pretax
     contributions which do not exceed 4% of the employee's annual compensation.
     In addition,  Downey makes an annual retirement  contribution  based on the
     employee's age and salary.  Downey's contributions to the Plan totaled $1.5
     million  for 1997,  compared  to $1.3  million in 1996 and $1.2  million in
     1995.

     Group Benefit Plan

     Downey provides  certain health and welfare  benefits for active  employees
     under a cafeteria  plan ("the  Benefit  Plan") as defined by section 125 of
     the  Internal  Revenue  Code.  Under  the  Benefit  Plan,   employees  make
     appropriate  selections  as to the  type  of  benefits  and the  amount  of
     coverage desired. The benefits are provided through insurance companies and
     other health  organizations  and are funded by  contributions  from Downey,
     employees and retirees and include deductibles, co-insurance provisions and
     other  limitations.  Downey's  expense for health and welfare  benefits was
     $2.5  million,  $3.1  million  and $2.7  million  in 1997,  1996 and  1995,
     respectively.

(22) Commitments and Contingencies

     Litigation

     Downey  has been  named as a  defendant  in legal  actions  arising  in the
     ordinary  course of business,  none of which, in the opinion of management,
     is material.

     Financial Instruments with Off-Balance-Sheet Risk

     Downey is a party to financial instruments with  off-balance-sheet  risk in
     the normal course of business to meet the financing  needs of its customers
     and to reduce its own exposure to  fluctuations  in interest  rates.  These
     financial  instruments  include commitments to originate fixed and variable
     rate  mortgage  loans,  letters  of  credit,  lines of credit  and loans in
     process.  The contract or notional amounts of those instruments reflect the
     extent  of  involvement  Downey  has in  particular  classes  of  financial
     instruments.

     Downey uses the same credit  policies in making  commitments  to  originate
     loans,   lines  of   credit   and   letters   of  credit  as  it  does  for
     on-balance-sheet  instruments.  For  commitments  to  originate  fixed rate
     loans,  the  contract  amounts  represent  exposure  to  loss  from  market
     fluctuations as well as credit loss. Downey controls the credit risk of its
     commitments to originate fixed rate loans through credit approvals,  limits
     and monitoring procedures.



                                       80
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     The following is a summary of commitments and contingent liabilities:

<TABLE>
<CAPTION>
                                                                          December 31,
                                                                      -------------------
     (In Thousands)                                                      1997      1996
     ------------------------------------------------------------------------------------
<S>                                                                   <C>        <C>     
     Commitments to originate loans and mortgage-backed securities:
          Adjustable ..............................................   $ 90,136   $131,767
          Fixed ...................................................     35,225     12,339
     Commitments to sell loans and mortgage-backed securities .....     50,893     12,353
     Unused lines of credit .......................................     69,810     72,646
     Loans in process .............................................     56,325     40.535
     Standby letters of credit and other contingent liabilities ...      3,080       --
     ====================================================================================
</TABLE>

     Commitments  to  originate  fixed  and  variable  rate  mortgage  loans are
     agreements  to lend to a customer as long as there is no  violation  of any
     condition  established  in the contract.  Commitments  generally have fixed
     expiration dates or other termination  clauses and may require payment of a
     fee. Since some of the commitments may expire without being drawn upon, the
     total  commitment   amounts  do  not  necessarily   represent  future  cash
     requirements.  The credit  risk  involved  in issuing  lines and letters of
     credit  requires the same  creditworthiness  evaluation as that involved in
     extending loan  facilities to customers.  Downey  evaluates each customer's
     creditworthiness on a case-by-case basis.


     Standby letters of credit are conditional commitments issued by the Bank to
     guarantee the performance of a customer to a third party.

     Downey receives  collateral to support  commitments for which collateral is
     deemed  necessary.  The most significant  categories of collateral  include
     real  estate  properties  underlying  mortgage  loans,  liens  on  personal
     property, and cash on deposit with Downey. At December 31, 1997, the extent
     of  collateral  supporting  mortgage and other loans varied from nothing to
     100% of the maximum credit exposure.

     In connection with its interest rate risk management,  Downey  occasionally
     enters into interest  rate  exchange  agreements  ("swap  contracts")  with
     certain national  investment  banking firms under terms that provide mutual
     payment of interest on the  outstanding  notional  amount of the swap.  The
     effect of these swaps serve to reduce  Downey's  interest rate risk between
     repricing assets and  liabilities,  At December 31, 1997, no swap contracts
     were outstanding.

(23) Risk Management

     Derivative  financial  instruments  are  utilized to minimize the effect of
     future  fluctuations  in the  interest  rates  as  part  of  its  secondary
     marketing  activities.  Downey utilizes forward sale contracts to hedge the
     value of loans  originated  for sale  against  adverse  changes in interest
     rates. At December 31, 1997, such contracts amounted to $31 million.

(24) Fair Value of Financial Instruments

     Fair  value  estimates  are made at a  specific  point in time  based  upon
     relevant  market  information  and other  information  about the  financial
     instrument. The estimates do not necessarily reflect the price Downey might
     receive if it were to sell at one time its entire  holding of a  particular
     financial  instrument.  Because no active  market  exists for a significant
     portion of Downey's financial  instruments,  fair value estimates are based
     upon the following methods and assumptions, some of which are subjective in
     nature. Changes in assumptions could significantly affect the estimates.



                                       81
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Cash, Federal Funds Sold, and Securities Purchased Under Resale Agreements

     The  carrying  amounts  reported  in the  balance  sheet  for  these  items
     approximate fair value.

     Investment   Securities   Including  U.S.  Treasuries  and  Mortgage-Backed
     Securities

     Fair value is based upon bid prices  published in financial  newspapers  or
     bid quotations received from securities dealers.

     Loans Receivable

     For residential  mortgage loans,  fair value is estimated based upon market
     prices obtained from readily available market quote systems.  The remaining
     portfolio was  segregated  into those loans with variable rates of interest
     and those with fixed rates of interest.  For non-residential  variable rate
     loans which reprice  frequently,  fair values approximate  carrying values.
     For non-residential  fixed rate loans, fair values are based on discounting
     future contractual cash flows using the current rate offered for such loans
     with  similar  remaining   maturities  and  credit  risk.  The  amounts  so
     determined  for  each  category  of  loan  are  reduced  by the  associated
     allowance for loan losses which thereby takes into consideration changes in
     credit risk.

     Interest-Bearing Advances to Joint Ventures

     The carrying amounts approximate fair value as the interest earned is based
     upon a variable rate.

     Deposits

     The fair value of deposits with no stated maturity such as regular passbook
     accounts,  money market accounts,  and checking  accounts,  is the carrying
     amount  reported in the balance  sheet.  The fair value of deposits  with a
     stated  maturity such as  certificates  of deposit is based on  discounting
     future contractual cash flows by the current rate offered for such deposits
     with similar remaining maturities.

     Borrowings

     For short-term borrowings, fair value approximates carrying value. The fair
     value  of   long-term   borrowings   is  based  on  their   interest   rate
     characteristics.  For variable  rate  borrowings,  fair values  approximate
     carrying  values.  For  fixed  rate  borrowings,  fair  value  is  based on
     discounting  future contractual cash flows by the current rate paid on such
     borrowings with similar remaining maturities.

     Off-Balance-Sheet Financial Instruments

     The fair  value of  commitments  to extend  credit and  standby  letters of
     credit are estimated using the fees currently charged to enter into similar
     agreements taking into  consideration the remaining terms of the agreements
     and the creditworthiness of the counterparties.  The fair value of loans in
     process is determined in the same manner as described for loans receivable.
     The fair value of commitments to sell loans and mortgage-backed  securities
     is based upon bid quotations  received from  securities  dealers.  The fair
     value of loans  serviced for others is  determined by computing the present
     value of the expected net servicing income from the portfolio.



                                       82
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Based on the above methods and  assumptions,  the following  table presents
     the estimated fair value of Downey's financial instruments:

<TABLE>
<CAPTION>
                                                                         December 31,1997           December 31,1996
                                                                      -----------------------    ----------------------
                                                                      Carrying     Estimated     Carrying    Estimated
     (In Thousands)                                                   Amount (1)   Fair Value    Amount (1)  Fair Value
     ------------------------------------------------------------------------------------------------------------------
<S>                                                                   <C>          <C>          <C>          <C>       
     ASSETS:
     Cash .........................................................   $   48,823   $   48,823   $   67,221   $   67,221
     Federal funds ................................................        6,095        6,095        6,038        6,038
     U.S. Government and agency obligations and other
       investment securities available for sale ...................      159,398      159,398      141,999      141,999
     Municipal securities held to maturity ........................        6,885        6,865        6,997        6,975
     Loans held for sale ..........................................       35,100       35,395       12,865       12,919
     Mortgage-backed securities available for sale ................       49,299       49,348       61,267       61,316
     Loans receivable held for investment: Loans secured by
       real estate:
         Residential:
            Adjustable ............................................    4,463,525    4,501,037    3,910,895    3,888,656
            Fixed .................................................      180,581      185,348      186,402      194,029
         Other ....................................................      238,215      237,429      291,791      297,361
       Non-mortgage loans:
         Commercial ...............................................       17,343       17,343       21,796       21,807
         Consumer .................................................      382,333      386,070      244,830      245,333
     Interest-bearing advances to joint ventures ..................       32,122       32,122       57,563       57,563
     MSRs and loan servicing portfolio ............................        1,955        7,584        1,180        6,943

     LIABILITIES:
     Deposits:
       Transaction accounts .......................................      935,869      935,869      831,598      831,598
       Certificates of deposit ....................................    3,934,109    3,947,913    3,341,504    3,351,342
     Borrowings ...................................................      483,735      485,558      595,345      596,346

     OFF-BALANCE SHEET INSTRUMENTS:
     Commitments to sell loans and mortgage-backed securities .....       50,893       50,893       12,353       12,353
     Standby letters of credit ....................................          480          480         --           --
     Unused lines of credit .......................................       69,810       69,810       72,646       72,646
     Commitments to originate loans and mortgage-backed securities:
          Adjustable ..............................................       90,136       90,136      131,767      131,767
          Fixed ...................................................       35,225       35,225       12,339       12,339
     ==================================================================================================================
</TABLE>

     (1)  The carrying amount of loans is stated net of undisbursed  loan funds,
          unearned fees and discounts and allowances for losses.




                                       83
<PAGE>

                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(25) Selected Quarterly Financial Data (Unaudited)

     Selected  quarterly  financial data are presented  below by quarter for the
     years ended December 31, 1997 and 1996:

<TABLE>
<CAPTION>
                                                     December 31,  September 30,    June 30,   March 31,
     (In Thousands, Except Per Share Data)              1997          1997           1997        1997
     ---------------------------------------------------------------------------------------------------
<S>                                                   <C>           <C>            <C>        <C>     
     Total interest income ........................   $110,457      $109,101       $103,276   $ 97,584
     Total interest expense .......................     69,254        71,547         65,993     59,466
     -------------------------------------------------------------------------------------------------
       Net interest income ........................     41,203        37,554         37,283     38,118
     Provision for loan losses ....................      3,034         1,578          1,873      2,155
     -------------------------------------------------------------------------------------------------
       Net interest income after provision for loan     38,169        35,976         35,410     35,963
       losses
     Total other income ...........................     10,826         8,018          5,353     10,991
     Total operating expense ......................     24,339        25,477         26,280     25,176
     -------------------------------------------------------------------------------------------------
     Income before income taxes ...................     24,656        18,517         14,483     21,778
     Income  taxes ................................     10,619         7,960          6,173      9,448
     -------------------------------------------------------------------------------------------------
     Net income ...................................   $ 14,037      $ 10,557       $  8,310   $ 12,330
     ==================================================================================================
     Net income per share
       Basic ......................................   $   0.53      $   0.39       $   0.31   $   0.46
       Diluted ....................................   $   0.53      $   0.39       $   0.31   $   0.46
     ==================================================================================================
     Market range:
       High bid ...................................   $  29.00      $  24.50       $  23.63   $   22.50
       Low bid ....................................      24.19         21.50          18.09       18.09
       End of period ..............................      28.44         24.38          23.63       19.28
     ==================================================================================================

                                                     December 31,  September 30,    June 30,   March 31,
                                                         1996         1996            1996       1996
     ---------------------------------------------------------------------------------------------------
<S>                                                   <C>           <C>            <C>         <C>     
     Total interest income ........................   $ 92,922      $ 87,950       $ 83,149    $ 82,339
     Total interest expense .......................     57,364        52,915         50,034      51,452
     -------------------------------------------------------------------------------------------------
       Net interest income ........................     35,558        35,035         33,115      30,887
     Provision for loan losses ....................      1,674         4,092          2,200       1,171
     -------------------------------------------------------------------------------------------------
       Net interest income after provision for loan     33,884        30,943         30,915      29,716
       losses
     Total other income ...........................      6,203         5,172          4,002       9,822
     Total operating expense ......................     24,670        47,464         21,107      20,962
     -------------------------------------------------------------------------------------------------
     Income (loss) before income taxes ............     15,417       (11,349)        13,810      18,576
     Income taxes (benefit) .......................      6,671        (4,879)         5,946       8,012
     -------------------------------------------------------------------------------------------------
     Net income (loss) ............................   $  8,746      $ (6,470) (1)  $  7,864    $ 10,564
     ==================================================================================================
     Net income (loss) per share
       Basic ......................................   $   0.32      $  (0.24)      $   0.30    $   0.39
       Diluted ....................................   $   0.32      $  (0.24)      $   0.30    $   0.39
     ==================================================================================================
     Market range:
       High bid ...................................   $  18.69      $   16.03       $  15.23   $  15.23
       Low bid ....................................      15.88          12.86          12.86      13.09
       End of period ..............................      18.69          16.03          13.89      14.92
     ==================================================================================================
</TABLE>

     (1)  Net income totaled $7.6 million or $0.28 per share before an after-tax
          charge of $14.0  million or $0.52 per share for a  government-mandated
          industry-wide  one-time assessment to all institutions who are insured
          by the Federal  Deposit  Insurance  Corporation as part of its Savings
          Association Insurance Fund.



                                       84
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(26) Parent Company Financial Information

     Downey Financial Corp. was incorporated in Delaware on October 21, 1994. On
     January 23, 1995,  after  obtaining  necessary  stockholder  and regulatory
     approvals,   Downey  Financial  Corp.  acquired  100%  of  the  issued  and
     outstanding  capital stock of the Bank, and the Bank's  stockholders became
     stockholders of Downey Financial Corp. The transaction was accounted for in
     a  manner  similar  to  a  pooling-of-interests  under  generally  accepted
     accounting  principles.  Downey Financial Corp. was thereafter  funded by a
     $15 million  dividend  from the Bank.  Condensed  financial  statements  of
     Downey Financial Corp. only are as follow:

     CONDENSED BALANCE SHEETS

                                                 December 31,
                                             -------------------
     (In Thousands)                             1997      1996
     -----------------------------------------------------------
     ASSETS
     Cash ................................   $     11    $  --
     -----------------------------------------------------------
     Due from Bank - interest bearing ....      6,635      7,333
     Investment in subsidiaries:
       Bank ..............................    421,230    382,932
       Downey Affiliated Insurance Agency         182        162
     Real estate held for investment .....        551        704
     Other assets ........................      1,862        558
     -----------------------------------------------------------
                                             $430,471   $391,689
     ===========================================================

     LIABILITIES AND STOCKHOLDERS' EQUITY
     Accounts payable and accrued expenses   $    125   $    118
     -----------------------------------------------------------
       Total liabilities .................        125        118
     -----------------------------------------------------------
     Stockholders' equity ................    430,346    391,571
     -----------------------------------------------------------
                                             $430,471   $391,689
     ===========================================================




                                       85
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     CONDENSED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
                                                                                    Years Ended December 31,
                                                                                -------------------------------
     (In Thousands)                                                                1997      1996       1995
     ----------------------------------------------------------------------------------------------------------
<S>                                                                             <C>        <C>         <C>     
     INCOME:
       Dividends from the Bank ..............................................   $  8,891   $  8,406    $ 16,940
       Interest income ......................................................        380        382         603
       Other income .........................................................         57         82        --
     ----------------------------------------------------------------------------------------------------------
         Total income .......................................................      9,328      8,870      17,543
     ----------------------------------------------------------------------------------------------------------
     EXPENSE:
       Provision for losses on real estate ..................................        153       --           171
       General and administrative expense ...................................        805        883         909
     ----------------------------------------------------------------------------------------------------------
         Total expense ......................................................        958        883       1,080
     ----------------------------------------------------------------------------------------------------------
     INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED NET INCOME OF
       SUBSIDIARIES .........................................................      8,370      7,987      16,463
     Income tax benefit .....................................................        215        168         194
     ----------------------------------------------------------------------------------------------------------
     INCOME BEFORE EQUITY IN UNDISTRIBUTED NET INCOME OF SUBSIDIARIES .......      8,585      8,155      16,657
     Equity in undistributed net income of subsidiaries .....................     36,649     12,549       4,436
     ----------------------------------------------------------------------------------------------------------
       NET INCOME ...........................................................     45,234     20,704      21,093
     OTHER  COMPREHENSIVE  INCOME  (LOSS),  NET OF INCOME TAXES:  UNREALIZED
       gains (losses) on securities available for sale:
         U.S. Treasury and agency obligations and other investment securities
            available for sale, at fair value ...............................      1,331     (4,710)      2,985
         Mortgage-backed securities available for sale, at fair value .......        338       (344)      1,566
     ----------------------------------------------------------------------------------------------------------
            Other comprehensive income (loss) ...............................      1,669     (5,054)      4,551
     ----------------------------------------------------------------------------------------------------------
       COMPREHENSIVE INCOME .................................................   $ 46,903   $ 15,650    $ 25,644
     ==========================================================================================================
</TABLE>




                                       86
<PAGE>


                     DOWNEY FINANCIAL CORP. AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     CONDENSED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                        Years Ended December 31,
                                                                    --------------------------------
     (In Thousands)                                                    1997       1996       1995
     -----------------------------------------------------------------------------------------------
<S>                                                                 <C>         <C>         <C>     
     CASH FLOWS FROM OPERATING ACTIVITIES:
       Net income ...............................................   $ 45,234    $ 20,704    $ 21,093
       Equity in undistributed net income of subsidiaries .......    (36,649)    (12,549)     (4,436)
       Provision for losses on real estate ......................        153        --           171
       Increase in other assets .................................     (1,304)       (296)       (262)
       Increase (decrease) in liabilities .......................          7         (69)        187
     ------------------------------------------------------------------------------------------------
          Net cash provided by operating activities ..............      7,441       7,790      16,753
     ------------------------------------------------------------------------------------------------

     CASH FLOWS FROM INVESTING ACTIVITIES:
       Capital contribution to Downey Affiliated Insurance Agency       --          --          (400)
       (Issuance) decrease of note to the Bank - interest bearing        698         346      (7,679)
       Purchase of real estate from subsidiary ..................       --          --          (900)
     ------------------------------------------------------------------------------------------------
         Net cash provided by (used for) investing activities ...        698         346      (8,979)
     ------------------------------------------------------------------------------------------------

     CASH FLOWS FROM FINANCING ACTIVITIES:
       Exercise of stock options ................................        335        --          --
       Dividends on common stock ................................     (8,454)     (8,147)     (7,759)
       Other ....................................................         (9)         (4)       --
     ------------------------------------------------------------------------------------------------
         Net cash used for financing activities .................     (8,128)     (8,151)     (7,759)
     ------------------------------------------------------------------------------------------------
     Net increase (decrease) in cash and cash equivalents .......         11         (15)         15
     Cash and cash equivalents at beginning of year .............       --            15        --
     ------------------------------------------------------------------------------------------------
     CASH AND CASH EQUIVALENTS AT END OF PERIOD .................   $     11    $   --      $     15
     ================================================================================================
</TABLE>






                                       87
<PAGE>







ITEM 9.  CHANGES  IN  AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND
         FINANCIAL DISCLOSURES


     None.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Downey  Financial  Corp.  intends to file with the  Securities and Exchange
Commission a definitive  proxy  statement  (the "Proxy  Statement")  pursuant to
Regulation 14A, which will involve the election of directors, within 120 days of
the end of the year covered by this Form 10-K.  Information  regarding directors
of Downey Financial Corp. will appear under the caption  "Election of Directors"
in the Proxy  Statement  for the Annual  Meeting of  Stockholders  to be held on
April 22, 1998, and is incorporated herein by reference.  Information  regarding
executive  officers of Downey  Financial  Corp.  will  appear  under the caption
"Executive  Officers" in the Proxy Statement and is incorporated  herein by this
reference.

ITEM 11. EXECUTIVE COMPENSATION

     Information regarding executive  compensation will appear under the caption
"Executive  Compensation"  in the Proxy Statement and is incorporated  herein by
this reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     Information  to be included  under the  captions  "Securities  Ownership of
Certain Beneficial Owners and Management" in the Proxy Statement is incorporated
herein by this reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Information to be included  under the caption  "Certain  Relationships  and
Related  Transactions"  in the Proxy  Statement is  incorporated  herein by this
reference.

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)  1.  Financial  Statements.  
         These  documents  are  listed  in  the  Index to Consolidated Financial
         Statements under Item 8.
     2.  Financial Statement Schedules.
         Financial  Statement  Schedules have been omitted  because they are not
         applicable  or the required  information  is shown in the  Consolidated
         Financial Statements or Notes thereto.
(b)  Reports on Form 8-K during the last quarter of 1997.
     None.
(c)  Exhibits.



                                       88
<PAGE>

    Exhibit
    Number                      Description

      3.1  (1) Certificate of Incorporation of Downey Financial Corp.
      3.3  (2) Bylaws of Downey Financial Corp.
     10.1      Downey Savings and Loan Association, F.A. Employee Stock Purchase
               Plan (Amended and Restated as of January 1, 1996).
     10.2      Amendment  No. 1,  Downey  Savings  and  Loan  Association,  F.A.
               Employee  Stock  Purchase  Plan.  Amendment  No. 1, Effective and
               Adopted  January 22, 1997.
     10.3      Downey  Savings  and Loan Association, F.A. Employees' Retirement
               and Savings Plan (October 1, 1997 Restatement).
     10.4      Amendment  No. 1,  Downey  Savings  and  Loan  Association,  F.A.
               Employees'   Retirement   and  Savings   Plan  (October  1,  1997
               Restatement)  Amendment  No. 1, Effective and Adopted January 28,
               1998.
     10.5      Trust  Agreement  for  Downey  Savings and Loan Association, F.A.
               Employees' Retirement and Savings Plan, Effective October 1, 1997
               between  Downey  Savings  and Loan Association, F.A. and Fidelity
               Management Trust Company.
     10.6  (1) Downey Savings and Loan Association 1994 Long-Term Incentive Plan
               (as amended).
     10.7  (2) Asset  Purchase  Agreement  among  Butterfield  Savings  and Loan
               Association, FSA, Mortgage Investment, Inc.,  Property Management
               Service,   Inc.   and   Butterfield  Capital  Corporation,  dated
               September 1, 1988.
     10.8  (2) Assistance  Agreement  between and among the Federal Savings  and
               Loan   Insurance  Corporation,   Butterfield   Savings  and  Loan
               Association,  FSA and Downey Savings and Loan Association,  dated
               September  29, 1988  (confidential treatment   requested  due  to
               contractual prohibition against disclosure).
     10.9  (2) Merger of  Butterfield  Savings and Loan  Association,  FSA, into
               Downey Savings and Loan  Association, dated September 29, 1989.
     10.10 (2) Founder  Retirement  Agreement  of  Maurice L. McAlister,   dated
               December 21, 1989.
     10.11 (2) Founder   Retirement   Agreement  of  Gerald H. McQuarrie,  dated
               December 21, 1989.
     10.13 (2) Employment Agreement and Nonqualified  Stock Option  Agreement of
               Stephen W. Prough, dated June 14, 1994.
     10.14 (3) First Addendum to Employment Agreement of Stephen W. Prough dated
               June 14, 1994, as amended June 30, 1995.
     10.15 (4) Severance  Agreement and General Release, dated February 6, 1997,
               by  and  among  Downey  Financial  Corp., Downey Savings and Loan
               Association, F.A. and Stephen W. Prough.
     22.   (2) Subsidiaries
     23.1      Consent of Independent Auditors.

(1)  Filed as part of Downey's report on Form S-8 filed February 3, 1995.
(2)  Filed as part of Downey's report on Form 8-B/A filed January 17, 1995.
(3)  Filed as part of Downey's report on Form 10-K filed March 12, 1996.
(4)  Filed as part of Downey's report on Form 10-K filed March 14, 1997.

     Downey  Financial  Corp.  will  furnish any or all of the  non-confidential
exhibits  upon  payment of a  reasonable  fee.  Please send request for exhibits
and/or fee information to:

                             Downey Financial Corp.
                               3501 Jamboree Road
                         Newport Beach, California 92660
                         Attention: Corporate Secretary



                                       89
<PAGE>



                                   SIGNATURES

     Pursuant  to the  requirements  of  Section  13 or 15(d) of the  Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.



                                   DOWNEY FINANCIAL CORP.



                                   By:    /s/   JAMES W. LOKEY
                                      -------------------------------------
                                      James W. Lokey
                                      President and Chief Executive Officer

DATED:  March 16, 1998

     Pursuant to the  requirements of the Securities  Exchange Act of 1934, this
report  has  been  signed  below  by the  following  persons  on  behalf  of the
Registrant and in the capacities and on the dates indicated.

       Signature                        Title                        Date

 /s/ MAURICE L. McALISTER         Chairman of the Board
--------------------------
   Maurice L. McAlister                 Director                 March 16, 1998

   /s/ CHERYL E. JONES          Vice Chairman of the Board
--------------------------
     Cheryl E. Jones                    Director                 March 16, 1998

   /s/ JAMES W. LOKEY                 President and
--------------------------
     James W. Lokey               Chief Executive Officer        March 16, 1998

  /s/ THOMAS E. PRINCE           Executive Vice President,
--------------------------
    Thomas E. Prince              Chief Financial Officer        March 16, 1998
                                 (Principal Financial and 
                                    Accounting Officer)

                                        Director
--------------------------
    Brent McQuarrie

   /s/ DR. PAUL KOURI
--------------------------
     Dr. Paul Kouri                     Director                 March 16, 1998

   /s/ LESTER C. SMULL
--------------------------
    Lester C. Smull                     Director                 March 16, 1998

 /s/ DR. DENNIS J. AIGNER
--------------------------
  Dr. Dennis J. Aigner                  Director                 March 16, 1998

   /s/ SAM YELLEN
--------------------------
     Sam Yellen                         Director                 March 16, 1998