================================================================================
                       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, 1996

                                       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 Stock 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 28, 1997, on the New York Stock Exchange was $455,508,829.

     At February 28, 1997,  25,460,954 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 23, 1997 are incorporated by reference in Part III
hereof.
================================================================================


<PAGE>



ii





                                               DOWNEY FINANCIAL CORP.

                                          1996 ANNUAL REPORT ON FORM 10-K

                                                 TABLE OF CONTENTS



                                                    PART I

<TABLE>
<S>                                                                         <C>        
ITEM 1  BUSINESS
          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 ............................................    6
            Loans-to-One Borrower Limitations ...........................    6
          Investment Activities .........................................    6
          Real Estate Investments .......................................    6
          Sources of Funds ..............................................    7
            Deposits ....................................................    7
            Borrowings ..................................................    7
          Asset/Liability Management ....................................    8
          Earnings Spread ...............................................    8
          Competition ...................................................    8
          Employees .....................................................    8
          Regulation ....................................................    9
            General .....................................................    9
            Regulation of the Bank ......................................    9
            Capital Requirements ........................................    9
            Deposit Insurance ...........................................   11
            Charter Revision Legislation ................................   13
            Enforcement Provisions ......................................   13
            Other Regulatory Matters ....................................   13
            Regulation of Downey ........................................   16
          Taxation ......................................................   17
          Factors That May Affect Future Results ........................   19
ITEM 2  PROPE20IES.......................................................   20
           Branches .....................................................   20
           Electronic Data Processing ...................................   20
ITEM 3  LEGAL PROCEEDINGS ...............................................   20
ITEM 4  SUBMI20ION OF MATTERS TO A VOTE OF SHAREHOLDERS .................   20
</TABLE>

                                       i
<PAGE>


                                     PART II

<TABLE>
<S>                                                                         <C>                                                  
ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
            STOCKHOLDER MATTERS ...........................................  21
ITEM 6.  SELECTED FINANCIAL DATA ..........................................  22
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
          AND RESULTS OF OPERATIONS .......................................  23
            Overview ......................................................  23
            Results of Operations .........................................  24
              Net Interest Income .........................................  24
              Provision for Loan Losses ...................................  26
              Other Income ................................................  26
                Loan and Deposit Related Fees .............................  26
                Real Estate and Joint Venture Operations Held for Investment 26
                Secondary Marketing Activities ............................  27
                Net Gains (Losses) on Sales of Investment Securities ......  27
                Provision for Loss on Investment in Lease Residual.........  27
                Other Category ............................................  27
              Operating Expenses ..........................................  27
              Provision for Income Taxes ..................................  27
            Financial Condition ...........................................  29
              Loans and Mortgage-Backed Securities.........................  29
              Investment Securities........................................  32
              Investments in Real Estate and Joint Ventures................  33
              Deposits.....................................................  35
              Borrowings...................................................  37
              Asset/Liability Management...................................  37
              Problem Loans and Real Estate................................  40
                Non-Performing Assets......................................  40
                Delinquent Loans...........................................  42
                Allowance for Losses on Loans and Real Estate..............  44
              Capital Resources and Liquidity..............................  47
              Regulatory Capital Compliance................................  48
              Current Accounting Issues....................................  48
              Subsequent Event.............................................  49
ITEM 8.  FINANCIAL STATEMENTS..............................................  50
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
           AND FINANCIAL DISCLOSURES.......................................  91

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................  91
ITEM 11. EXECUTIVE COMPENSATION............................................  91
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT......................................................  91
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................  91

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
           ON FORM 8-K.....................................................  91
SIGNATURES ................................................................  93
</TABLE>

                                       ii

<PAGE>




                                     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 19.

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 73 retail deposit branches (17 of
which are full-service  supermarket  branches),  and 41 loan origination offices
(29 of  which  are  contained  in  retail  deposit  branches),  all  located  in
California.  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  and  Pacific  Stock
Exchanges  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 will  begin  offering  such  policies  on auto  loans in 1997.  Downey
Affiliated  Insurance  Agency ceased offering annuity products during the fourth
quarter of 1996 due to a lack of customer interest.

     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,  including deposits and borrowings,  and general and administrative
costs. Downey's primary sources of funds are deposits,




                                       1
<PAGE>




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 1997,  Downey's primary focus will continue to be the origination of
adjustable  rate single family  mortgage loans 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.   The  secondary  marketing
activities are expected to increase Downey's loan servicing portfolio,  which is
a source of fee income. See "Lending  Activities - Secondary  Marketing and Loan
Servicing  Activities" on page 4. Downey also intends to expand its auto lending
operations  through the  establishment  of a new wholly owned  subsidiary of the
Bank, Downey Auto Finance Corp.

     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 29.

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  gains or losses are  recognized  in a  valuation  allowance  by
credits or charges to income.





                                       2
<PAGE>




     MBSs  available  for sale and held for trading are carried at market value.
For MBSs available for sale,  net  unrealized  gains or losses are excluded from
income and reported net of income taxes as a component of  stockholders'  equity
until realized.  Such amounts for the trading portfolio are reflected as credits
or charges to income.

     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.  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 8. 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.

     In general,  Downey sells loans and loan  participations  on a non-recourse
basis for cash to manage its interest  rate risk and to build its  recurring net
revenues from loan servicing  income. In most cases, when loans are sold, Downey
retains the servicing of the loans for the purchaser.

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,  for its portfolio of loans held for  investment,  Downey is
primarily  originating  ARMs and loans  which have a fixed  rate only  during an
initial period of up to five years and then convert to an adjustable  rate based
upon a specified index. See "Asset/Liability  Management" on page 8. 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 the first 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 1996,  approximately  33% of Downey's  one-to-four  unit residential
real estate  loans were  originated  by retail loan  representatives  of Downey.
Retail loan representatives  generally are compensated on a commission basis and
typically receive loan referrals from real estate agents,  builders,  depositors
and customers obtained from retail advertising and other sources.  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 also 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 1996,
the  average  loan  size  was  $223,000.   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



                                       3
<PAGE>




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.   For  borrowers  and  properties   qualifying  under  established
criteria,  certain loan  programs  permit a maximum  loan-to-value  ratio of 85%
without  requiring  private  mortgage  insurance.  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 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%. For loans which have a fixed rate for the initial term of up to five years,
Downey qualifies applicants using the initial start rate.

     Late in 1996,  Downey began offering  one-to-four unit residential loans to
borrower's  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,
and  borrowers  are  qualified at the fully indexed rate on ARM loans and at the
note rate on fixed rate loans.

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 57 and 66,  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 8.

     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.

     Downey  records gains or losses from the sale of loans that it continues to
service,  including  the present value gain which is determined by computing the
present value of servicing  related income,  after deducting a normal  servicing
fee,  and  less any  applicable  securitization  fees  paid  over the  estimated
remaining life of the loans. The present value gain or loss is based upon market
prepayment and discount rate assumptions.  An asset (mortgage  servicing rights)
equal to the  present  value gain is  recorded at the time a loan is sold and is
amortized  over the estimated  remaining  life of the loan.  Mortgage  servicing
rights  ("MSRs") are  included in the  financial  statements  in the category of
"other assets." At December 31, 1996,



                                       4
<PAGE>




MSRs totaled $1.2 million.  Impairment losses are recognized through a valuation
allowance,  with  any  associated  provision  recorded  as a  component  of loan
servicing fees.

     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 so
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 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.  At  present,  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 accompany the relationship.





                                       5
<PAGE>




Consumer Lending

     Downey originates fixed rate automobile loans primarily through an indirect
lending  program  which  utilizes  preapproved  automobile  dealers  to  finance
consumer  purchases of new and used  automobiles;  variable  rate  open-end home
equity  lines of credit;  and  variable  rate  overdraft  lines of credit.  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.  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  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.

Loans-to-One Borrower Limitations

     Savings  institutions are generally  subject to the  loans-to-one  borrower
limitations  that  are  applicable  to  national  banks.  With  certain  limited
exceptions,  the  maximum  amount  that a  savings  institution  may lend to one
borrower  (including  certain  related  entities of such  borrower) is an amount
equal to 15% of the savings  institution's  unimpaired  capital  and  unimpaired
capital  surplus,  plus an  additional  10% for loans  fully  secured by readily
marketable  collateral.  Real estate is not included  within the  definition  of
"readily marketable collateral" for this purpose.  Pursuant to recent regulatory
amendments,  the  definition  of the term  "unimpaired  capital  and  unimpaired
surplus" has been changed to now refer to an institution's  regulatory  capital,
and also to include  within the basic 15% of capital  lending limit that portion
of an  institution's  general  valuation  allowance  that is not  includable  in
regulatory capital as calculated for other regulatory purposes.

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 - Other Regulatory Matters
- Liquidity  Requirements" on page 15 and "Management's  Discussion and Analysis
of Financial Condition and Results of Operations - Financial Condition - Capital
Resources  and  Liquidity"  on  page  47.  As  a  federally   chartered  savings
association,  the  Bank  is also  permitted  to make  certain  other  securities
investments  as  prescribed   under  HOLA  and   implementing  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 32.

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. Until June 30, 1996, only
a portion of the Bank's  investment  in DSL Service  Company was  required to be
deducted from capital,  pursuant to a "phase-in  schedule"  adopted under FIRREA
and later extended by the Housing and Community  Development Act of 1992.  Under
the "phase-in  schedule,"  from July 1, 1995 through June 30, 1996, the Bank was
required to deduct 60% of its  investment  in DSL Service  Company from capital.
Effective July 1, 1996, however,  the "phase-in schedule" expired,  and the Bank
has been required since that date 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,



                                       6
<PAGE>



"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 33.

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.

     In  1996,  Downey  began a  relationship  with  Hughes  Family  Markets  by
establishing   full-service  branch  facilities  in  selected  market  locations
throughout Southern  California.  Each supermarket 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 35.

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 up to  $200  million  of
commercial   paper.  The  commercial  paper  is  supported  by  a  $200  million
irrevocable letter of credit issued by the FHLB of San Francisco. The commercial
paper provides Downey with an alternative funding source to fund asset growth in
a cost effective manner.  Currently,  Downey is arranging to increase the amount
of funds available under this program to $500 million.

     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
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 37.





                                       7
<PAGE>




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  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" on page 37.

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    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 23. For returns and other
selected financial data see "Selected Financial Data" on page 22.

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 investor's funds from
short-term   money  market   securities  and  other   corporate  and  government
securities. The ability of Downey to attract and retain savings deposits depends
on its  ability  generally  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, 1996, Downey had approximately 886 full-time  employees and
369 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 20
of Notes to the  Consolidated  Financial  Statements,  on pages 80 and 82, 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.





                                       8
<PAGE>




REGULATION

General

     Downey, as a savings and loan holding company, and the Bank, as a federally
chartered savings  association,  are subject to extensive regulation by the OTS.
The  lending  activities  and other  investments  of the Bank must  comply  with
various federal regulatory  requirements,  and the OTS periodically examines the
Bank  for   compliance.   The  FDIC  also  has  authority  to  conduct   special
examinations.  The Bank must file reports with the OTS describing its activities
and  financial  condition  and is also subject to certain  reserve  requirements
promulgated  by the  Federal  Reserve  Board.  Downey  is  also  subject  to OTS
supervision  and reporting  requirements.  This  supervision  and  regulation is
intended primarily for the protection of depositors. Certain of these regulatory
requirements are referred to below or appear elsewhere herein.

Regulation of the Bank

     The Bank's deposits are insured by the FDIC through the SAIF.  Federal laws
and regulations applicable to the Bank govern such matters as capital standards,
dividends,  mergers  and changes of control,  establishment  of branch  offices,
subsidiary  investments  and  activities,   loans-to-one-borrower   and  general
investment  authority.  The Bank is subject to the examination,  supervision and
reporting  requirements of the OTS, its primary federal  regulator.  The Bank is
also subject to examination and supervision by the FDIC.

     FIRREA.  Enacted on August 9, 1989, FIRREA  significantly  restructured the
regulatory  structure  applicable  to the Bank.  In addition,  FIRREA  contained
provisions  affecting  numerous  aspects  of the  operation  and  regulation  of
federally  insured  savings  institutions  and empowered the OTS and the FDIC to
promulgate regulations implementing such provisions.

     FDICIA.   FIRREA  was   supplemented  by  the  Federal  Deposit   Insurance
Corporation Improvement Act of 1991 ("FDICIA"), which increased the authority of
the OTS and FDIC over the operations of savings associations. FDICIA was enacted
on December  19, 1991.  The  following  sets forth some of the more  significant
provisions of FDICIA that affect savings  associations,  such as the Bank,  that
exceed their current minimum capital standards.  Among other things, FDICIA made
several  changes to the deposit  insurance  system and expanded the authority of
the  federal  regulatory   agencies  to  ensure  that  associations  have  sound
management and adequate capital.

     FDICIA   contains  a  number  of  measures   intended   to  promote   early
identification of management  problems at depository  institutions and to ensure
that regulators  intervene promptly to require corrective action by institutions
with insufficient  capital or inadequate  operational and managerial  standards.
For example,  each depository  institution must prepare an annual report, signed
by the chief executive officer and chief financial officer, on the effectiveness
of the  institution's  internal control  structures and procedures for financial
reporting, and on the institution's compliance with certain laws and regulations
relating to the payment of dividends  and loans to insiders.  The  institution's
independent  auditor  must  attest to, and report  separately  on,  management's
assertions  on  internal  controls  in the  annual  report.  The  report and the
attestation,   along  with  financial   statements  and  such  other  disclosure
requirements  as the FDIC and the OTS may  prescribe,  must be  submitted to the
FDIC and OTS and will be made available to the public.

     FDICIA  requires  the OTS to  prescribe by  regulation  minimum  acceptable
standards in the areas of operations and management, asset quality and earnings,
compensation and, to the extent feasible,  stock valuation. On February 2, 1995,
the federal banking  agencies  adopted final safety and soundness  standards for
all insured  depository  institutions.  The standards,  which were issued in the
form of  guidelines  rather  than  regulations,  relate  to  internal  controls,
information systems,  internal audit systems,  loan underwriting  documentation,
compensation and interest rate exposure.  In general, the standards are designed
to assist the federal banking agencies in identifying and addressing problems at
insured  depository   institutions  before  capital  becomes  impaired.   If  an
institution  fails to meet these  standards,  the  appropriate  federal  banking
agency (in the Bank's  case,  the OTS) may require the  institution  to submit a
compliance  plan.  Failure to submit a compliance plan may result in enforcement
proceedings.  Additional standards on earnings and classified assets were issued
by the federal banking agencies on October 1, 1996.

Capital Requirements

     FIRREA   established  new  capital  standards  for  savings   institutions,
including  three capital  requirements:  a "leverage  (core) limit," a "tangible
capital  requirement"  and a "risk-based  capital  requirement."  On November 6,
1989, the OTS Director issued minimum capital regulations which became effective
on December 7, 1989. In 1992, the OTS



                                       9
<PAGE>




defined capital  standards for all  classifications  of  institutions  including
standards applicable to a  "well-capitalized"  institution as discussed later in
this  section.   The  Bank  is  in  compliance  with  all  current  OTS  capital
requirements  and  qualifies  as a  "well  capitalized"  institution  under  the
provisions of FDICIA. The current minimum capital standards are as follows:

o    Tangible  capital  of 1.5%  of  adjusted  total  assets.  Tangible  capital
     consists of common  stockholders' equity (including retained earnings) plus
     noncumulative  perpetual  preferred  stock and related  earnings,  minority
     interests in the equity  accounts of fully  consolidated  subsidiaries  and
     qualifying  non-withdrawable  accounts  and  pledged  deposits,  minus  (i)
     intangible assets other than certain purchased  mortgage  servicing rights,
     and (ii) the institution's investments,  including extensions of credit, in
     subsidiaries  engaged  as  principal  in  activities  not  permissible  for
     national banks, net of any general valuation allowances established against
     such  investments  and subject to a phased-in  deduction  for the amount of
     investments made or committed to be made prior to April 12, 1989.
     This phase-in is described in more detail below.

o    A leverage ratio requiring core capital of 3% of adjusted total assets.  In
     the Bank's case,  core capital is identical to tangible  capital.  In April
     1991, the OTS proposed to amend its core capital requirement to establish a
     3% core capital ratio for savings  associations in the strongest  financial
     and managerial condition.  For all other savings associations,  the minimum
     core  capital  ratio  would  be 3% plus at least  an  additional  1% to 2%,
     determined  on a  case-by-case  basis by the OTS after  assessing  both the
     quality of risk  management  systems and the level of overall  risk in each
     individual savings  association.  In addition to the proposed rule, the OTS
     has  adopted  a  prompt  corrective  action  rule  under  which  a  savings
     association  that has a core capital  ratio of less than 4% would be deemed
     to be "undercapitalized"  and may be subject to certain sanctions under the
     OTS "prompt corrective action" regulations, as further discussed below.

o    Risk-based  capital  of at least  8% of  risk-weighted  assets.  Risk-based
     capital consists of core capital plus "supplementary"  capital items deemed
     less permanent  than core capital,  such as  subordinated  debt and general
     loan and lease loss  allowances,  but  reciprocal  holdings  of  depository
     institution capital instruments,  equity investments (including investments
     in equity  securities and in real property that would be considered  equity
     investments  under  generally  accepted  accounting  principles,   but  not
     including   investments  in  subsidiaries,   equity  investments  that  are
     permissible  for national  banks,  ownership  interests in certain pools of
     assets or the stock of the Federal Reserve Banks or the FHLB) and a portion
     of certain  high-risk land and construction  loans are subject to deduction
     from total capital. Risk-weighted assets are determined by multiplying each
     category of an  institution's  assets,  including  off-balance  sheet asset
     equivalents, by an assigned risk-weight based on the credit risk associated
     with those  assets and adding the  resulting  sums.  The four  risk-weights
     range from zero  percent for cash to 100% for  delinquent  loans,  property
     acquired through foreclosure, commercial loans and other assets.

     FDICIA established a similar but separate set of capital measures which the
regulators must use in determining  whether to take corrective action against an
institution.  Under this "prompt  corrective  action" system,  institutions  are
classified  into  one  of  five  categories:   "well  capitalized,"  "adequately
capitalized,"    "undercapitalized,"    "significantly   undercapitalized"   and
"critically  undercapitalized."  Under  regulations  promulgated  by the  OTS to
implement FDICIA,  an institution is considered to be "well  capitalized" if its
ratio of Tier 1 (core) capital to adjusted assets is 5%, its ratio of risk-based
capital  to  risk-weighted  assets  is  10%,  its  ratio  of Tier 1  capital  to
risk-weighted  assets is 6% and it is not subject to any OTS  agreement or order
to  maintain  a  specified  level of  capital.  An  institution  is deemed to be
"adequately capitalized" if its respective ratios are 4%, 8% and 4%. Conversely,
an   institution   that  does  not  meet   these   targets  is   classified   as
"undercapitalized,"     "significantly    undercapitalized"    or    "critically
undercapitalized,"  depending upon the institution's specific capital ratios and
certain other factors.

     The OTS can treat an  "adequately  capitalized"  association  as if it were
"undercapitalized"  if the OTS  determines,  after notice and  opportunity for a
hearing, that (i) an association is in an unsafe and unsound condition,  or (ii)
an  association  received,   in  its  most  recent  report  of  examination,   a
less-than-satisfactory  rating  for  asset  quality,  management,  earnings,  or
liquidity,  and the deficiency has not been  corrected.  In such a case, the OTS
would  be  authorized  to  restrict  an  association's  asset  growth,   capital
distributions,  and payment of management fees and to require prior OTS approval
for  any  new  line  of  business.  The  Bank  currently  qualifies  as a  "well
capitalized" institution and is not subject to such sanctions. See "Management's
Discussion  and  Analysis of  Financial  Condition  and Results of  Operations -
Financial Condition - Regulatory Capital Compliance" on page 48.

     Under all  three of the OTS  capital  standards,  the Bank is  required  to
deduct from capital its investment in (which  generally  includes  extensions of
credit to and guarantees made on behalf of) its  non-includable  subsidiary (DSL
Service Company). Until June 30, 1996, a portion of the Bank's investment in DSL
Service Company was not required to be



                                       10
<PAGE>




deducted from capital,  pursuant to a "phase-in  schedule"  adopted under FIRREA
and later extended by the Housing and Community  Development Act of 1992.  Under
the "phase-in  schedule,"  from July 1, 1995 through June 30, 1996, the Bank was
required to deduct 60% of its  investment  in DSL Service  Company from capital.
Effective July 1, 1996, however,  the "phase-in schedule" expired,  and the Bank
has been required since that date 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.

     FDICIA  required that the OTS and the federal banking  regulatory  agencies
revise their risk-based  capital  standards to take adequate account of interest
rate risk, concentration of credit risk and risks of non-traditional activities.
On August 13, 1993, the OTS published  final  regulations on interest rate risk.
The regulations require savings  associations that have a level of interest rate
exposure that is deemed to be higher than "normal" (i.e., greater than 2% of the
estimated  economic  value of an  association's  assets)  to deduct  from  total
capital for purposes of  calculating  their  risk-based  capital  requirement an
amount  equal to  one-half  the  difference  between an  institution's  measured
interest  rate  exposure  and  the  "normal"  level  of  such  exposure  for the
institution.  Under  the  regulations,  the  OTS may  waive  or  defer,  but not
decrease, absent a formal appeal, an institution's interest rate risk component.
The regulations also provide for the reduction of the risk-weighting assigned to
certain "high-quality  mortgage derivative"  securities,  removing them from the
100% risk-weight category and placing them in the 20% risk-weight category.  The
new interest rate risk  regulations  were  effective on January 1, 1994. The new
risk-weight for high quality mortgage  derivative  securities was effective July
1,  1994.  In  August  1995,   the  OTS  indicated  that  it  intends  to  delay
implementation  of an 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.  Based upon the Bank's  asset/liability  structure,  the Bank would have
been subject to an interest rate risk capital  requirement at December 31, 1996.
See "Management's  Discussion and Analysis of Financial Condition and Results of
Operations - Financial Condition - Regulatory Capital Compliance" on page 48 for
further information.

     On  January  20,  1993,  the  OTS  issued  a  statement   imposing  certain
limitations  on the  inclusion  of net  deferred  tax  assets  calculated  under
Statement of Financial  Accounting  Standards  No. 109,  "Accounting  for Income
Taxes"  ("SFAS  109")  in  regulatory  capital.  Deferred  tax  assets  that are
dependent  upon  future  taxable  income  or  the   institution's  tax  planning
strategies  may only be counted as a  component  of Tier 1 capital to the extent
they do not exceed the lesser of: (i) 10% of Tier 1 capital,  or (ii) the amount
of such benefits which may be realized based upon one year's projected earnings.
The Bank adopted SFAS No. 109 on January 1, 1993, at which time this  regulation
became applicable in the determination of its capital ratios.  See "Taxation" on
page 17.  Management  anticipates that for future periods,  this regulation will
not significantly affect the Bank's capital position.

     Savings   institutions   that  fail  to  meet  their   regulatory   capital
requirements  are  subject  to a number  of  restrictions  on  various  business
activities and generally are subject to greater regulatory scrutiny and approval
requirements.  In addition to generally applicable capital standards for savings
associations,  the Director of the OTS is  authorized  to establish  the minimum
level of capital  for a savings  association  at such amount or at such ratio of
capital-to-assets  as the Director determines to be necessary or appropriate for
such  institution in light of the particular  circumstances  of the institution.
The  Director  of the OTS may treat the failure of any  savings  association  to
maintain capital at or above such level as an unsafe or unsound practice and may
issue a  directive  requiring  any savings  association  which fails to maintain
capital at or above the minimum  level  required  by the  Director to submit and
adhere to a plan for  increasing  capital.  Such an order may be enforced in the
same manner as an order issued by the FDIC.

Deposit Insurance

     The Bank's  deposits  are insured by the FDIC to a maximum of $100,000  for
each insured depositor.  Under FIRREA, the FDIC administers two separate deposit
insurance  funds:  the Bank Insurance Fund ("BIF") which insures the deposits of
institutions  that were insured by the FDIC prior to FIRREA,  and the SAIF which
maintains a fund to insure the deposits of institutions that were insured by the
FSLIC prior to FIRREA.

     In 1993,  the FDIC  adopted a final  regulation  implementing  a risk-based
assessment system for deposit insurance. Under the risk-based assessment system,
a SAIF-insured  savings  institution  is  categorized  into one of three capital
categories ("well capitalized,"  "adequately capitalized" or "undercapitalized")
and one of three categories based on supervisory evaluations  (financially sound
with only a few minor weaknesses (Group A),  demonstrates  weaknesses that could
result in significant deterioration (Group B) and pose a substantial probability
of loss (Group C)). The capital ratios used by the FDIC



                                       11
<PAGE>




to define "well capitalized," "adequately capitalized" or "undercapitalized" are
the same as in the OTS' prompt corrective action regulation.

     The same system  initially  was also in place for BIF member  institutions,
although  the FDIC was  authorized  to impose  different  rates for BIF and SAIF
members based on the reserves in the BIF and the SAIF. On November 14, 1995, the
FDIC announced that premium rates for BIF members would be reduced to a range of
0% to 0.27% of  deposits  because  the BIF  reserve  ratio had  reached  certain
prescribed levels. Premium rates for SAIF members,  however,  remained unchanged
under the FDIC's  1995  rulemaking  because the SAIF  reserve  fund had not been
sufficiently  recapitalized as of that time. As a result, SAIF members,  such as
the Bank,  were required to pay  significantly  higher premiums for FDIC deposit
insurance than similarly situated BIF member institutions.

     In part to resolve the disparity  between bank and thrift deposit insurance
premiums and resulting  competitive  inequalities,  Congress passed the Economic
Growth and  Regulatory  Paperwork  Reduction  Act of 1996 (the "Budget  Act") on
September 30, 1996 which, among other things, authorized the recapitalization of
the SAIF. To effect the recapitalization,  SAIF member institutions, such as the
Bank,  were  required to pay a one-time  special  assessment  equal to 0.657% of
deposits  based upon  deposit  levels as of March 31, 1995.  For the Bank,  this
assessment was equal to $24.6 million or, on an after-tax  basis,  $14.0 million
or $0.55 per share.  The charge for this  assessment was reflected in the Bank's
third  quarter 1996  results and was paid to the FDIC on November 27, 1996.  The
Budget Act also provided  that,  effective  January 1, 1997,  SAIF members would
have the same risk-based  deposit  insurance  assessment  schedule as BIF member
institutions.  The  assessment  schedule  proposed by the FDIC ranges from 0% to
0.27% of  deposits  and is based upon the  capital  position  and a  supervisory
evaluation of each institution. As of January 1, 1997, assessments have been set
at the following percentages of deposits:


<TABLE>
<CAPTION>
                                               Group A     Group B     Group C
<S>                                             <C>         <C>         <C>  
Well Capitalized ..........................     0.00%       0.03%       0.17%

Adequately Capitalized ....................     0.03        0.10        0.24

Undercapitalized ..........................     0.10        0.24        0.27
</TABLE>

     In  addition  to these FDIC  assessments,  FIRREA  provides  the  Financing
Corporation  ("FICO") and the Resolution  Funding  Corporation  with  assessment
authority to obtain funds for interest  payments on its bond  obligations and to
raise  capital,  respectively.  Prior to the enactment of the Budget Act,  these
assessments  were only paid by SAIF  members  and  could  not  exceed,  and were
subtracted  from,  the amounts  SAIF members paid to the FDIC for the funding of
the SAIF.  However,  under the Budget Act,  both BIF and SAIF  members  will now
share in the cost of the FICO bond interest payments.  Beginning January 1, 1997
and continuing  through  December 31, 1999,  partial sharing will occur.  During
this  initial  period,  SAIF  member  institutions,  such as the Bank,  will pay
0.0648% of domestic  deposits while BIF member  institutions  will pay 0.013% of
domestic deposits. Full pro rata sharing of the FICO bond interest payments will
take effect on January 1, 2000. Based upon the new deposit insurance  assessment
schedule,  required FICO bond interest payments and current deposit levels,  the
Bank expects that its deposit  insurance  expense will decline by  approximately
70%  in  1997,  and  anticipates  an  on-going  annual   after-tax   savings  of
approximately $3.9 million or $0.15 per share.

     Other components of the Budget Act (i) authorize banking regulators to take
action to prevent  SAIF-insured  institutions from "facilitating or encouraging"
customers to shift their deposits to  BIF-insured  affiliates for the purpose of
evading the thrift  assessment  rate premium;  (ii) provide for the  conditional
merger of the BIF and SAIF to form the  Deposit  Insurance  Fund on  January  1,
1999,   provided  that  there  are  no  savings   associations   (not  including
state-chartered  savings  banks) in existence on that date; and (iii) direct the
Treasury Department to report to Congress by March 31, 1997 with recommendations
on a common charter for banks and savings institutions. Additionally, the Budget
Act  provides  regulatory  relief with respect to lender  liability  and certain
other matters.

     Brokered Deposits. An "undercapitalized" savings institution cannot accept,
renew,  or rollover  deposits  obtained  through a deposit  broker,  and may not
solicit  deposits by offering  interest rates that are more than 75 basis points
higher than market rates. Savings institutions that are "adequately capitalized"
but not  "well  capitalized"  must  obtain  a  waiver  from the FDIC in order to
accept,  renew, or rollover brokered  deposits,  and even if a waiver is granted
may not solicit  deposits,  through a broker or otherwise,  by offering interest
rates that exceed market rates by more than 75 basis points.  The Bank currently
qualifies  as "well  capitalized,"  and  therefore  is not  subject to the above
limits.





                                       12
<PAGE>




Charter Revision Legislation

     By  its  resolution  of the  disparity  between  bank  and  thrift  deposit
insurance  premiums,  the Budget Act has improved the  prospects of  legislative
proposals to merge the federal thrift and federal banking charters.  A number of
proposals  have  recently  been  introduced in Congress to effect such a merger.
While it is impossible  to predict the outcome of the  legislative  process,  if
passed,  these proposals could have a significant  impact on both Downey and the
Bank.  Potential  consequences of these  proposals  include (i) the placement of
restrictions on savings and loan holding companies, such as Downey, to engage in
certain activities through their subsidiaries; (ii) the modification of existing
restrictions (such as the qualified thrift lender test) on savings associations;
and (iii) the possibility that savings  associations,  such as the Bank, will be
subject to a new federal regulatory body.

Enforcement Provisions

     FIRREA  introduced  the  term  "institution-affiliated   party"  to  agency
enforcement authority.  The term includes: (i) directors,  officers,  employees,
agents  and  controlling   stockholders;   (ii)  persons   required  to  file  a
change-in-control  notice;  (iii) any person who  participates in the affairs of
the savings institution  (including certain stockholders,  consultants and joint
venture  partners);  and  (iv)  independent  contractors  (including  attorneys,
appraisers and  accountants) who knowingly or recklessly cause or participate in
a  violation,  breach of duty or unsafe  practice  likely to cause a loss to the
savings institution.

     Applicable  regulations provide for significant penalties for violations of
law,  regulation,  cease-and-desist  orders and other regulatory  orders.  These
regulations  impose a three-tier  system of penalties  against  institutions and
their  institution-affiliated  parties,  which  applies to  violations  of laws,
regulations, orders or written agreements with regulators. Simple violations may
result in a maximum  daily  penalty of $5,000,  while  violations,  breaches  of
fiduciary  duty, or reckless  practices that are part of a pattern or are likely
to cause more than minimal loss (or result in gain to the wrongdoer) are subject
to a $25,000 daily penalty. Knowing violations, practices or breaches that cause
a  substantial  loss  to the  savings  institution  or  substantial  gain to the
wrongdoer   are  subject  to  a  potential  $1  million  daily  penalty  for  an
institution-affiliated party or the lesser of $1 million or 1% of assets per day
for a savings institution.

Other Regulatory Matters

     Qualified  Thrift  Lender Test.  The qualified  thrift lender  ("QTL") test
generally  requires  that  65% of  certain  of a  savings  institution's  assets
("portfolio  assets")  must be invested in a limited  list of  qualified  thrift
investments.  The Budget Act  expanded  the amounts of certain  types of assets,
including  credit card and  education  loans,  that may be treated as  qualified
thrift investments for this purpose.  In addition,  the Budget Act provided that
an institution may  alternatively  be deemed to be "qualified  thrift lender" by
meeting  the  standards   for  treatment  as  a  "domestic   building  and  loan
association"  under  applicable  provisions  of the Internal  Revenue  Code.  At
December 31, 1996,  90% of the Bank's  portfolio  assets  constituted  qualified
thrift investments. The Bank's failure to remain a qualified thrift lender would
have  potentially  significant  adverse  effects on the Bank and would also have
certain adverse  consequences on Downey.  See "Regulation of Downey - Activities
Restrictions"  on page 16.  The Bank  believes  that  the QTL  test  should  not
materially  adversely  affect its  business,  financial  condition or results of
operations  of the Bank or Downey or require  material  changes in the manner in
which they conduct their respective business and operations.

     Affiliate  Transactions.  Savings institutions are generally subject to the
affiliate and insider  lending  rules  applicable to member banks of the Federal
Reserve  System set forth in Sections 23A,  23B,  22(g) and 22(h) of the Federal
Reserve Act, as well as certain  limitations set forth in HOLA and  implementing
OTS  regulations.  These  limitations,  among other  things,  prohibit a savings
institution  from  extending  credit to an  affiliate,  unless the  affiliate is
engaged only in activities that the Federal  Reserve Board,  by regulation,  has
determined  to be  permissible  for bank  holding  companies  and  which the OTS
Director has not disapproved.  In addition, a savings association  generally may
not extend  credit to any one  affiliate  in an amount  that  exceeds 10% of the
savings  association's  capital  (20%  of  capital  to  all  affiliates  in  the
aggregate) and is subject to certain collateralization and other requirements in
connection with all such extensions of credit to affiliates.  These restrictions
will apply to certain  transactions that may be entered into between the Bank or
its  subsidiaries,  on the one hand, and Downey or its subsidiaries  (other than
the Bank) on the other hand.

     Savings  associations  are also  subject to the  restrictions  contained in
Section  22(h)  of the  Federal  Reserve  Act and the  Federal  Reserve  Board's
Regulation O thereunder on loans to executive officers,  directors and principal
stockholders. Under Section 22(h), loans to a director, executive officer and to
a greater than 10% stockholder of a savings association and



                                       13
<PAGE>




certain affiliated interests of such persons, may not exceed,  together with all
other   outstanding  loans  to  such  person  and  affiliated   interests,   the
institution's  loans-to-one-borrower  limit  (generally  equal  to  15%  of  the
institution's unimpaired capital and surplus).  Section 22(h) also prohibits the
making of loans above amounts  prescribed  by the  appropriate  federal  banking
agency, to directors,  executive officers and greater than 10% stockholders of a
savings  association  and  their  respective  affiliates,  unless  such  loan is
approved in advance by a majority of the board of directors  of the  institution
with any "interested"  director not  participating  in the voting.  Regulation O
prescribes the loan amount (which includes all other  outstanding  loans to such
person) as to which such prior board of  director  approval is required as being
the greater of $25,000 or 5% of capital and surplus (up to  $500,000).  Further,
Section 22(h) requires that loans to directors, executive officers and principal
stockholders  be made on terms  substantially  the same as offered in comparable
transactions  to  other  persons.  Section  22(h)  also  generally  prohibits  a
depository  institution  from  paying  the  overdrafts  of any of its  executive
officers or directors.

     In  addition,  savings  associations  are subject to the  requirements  and
restrictions  of Section  22(g) of the Federal  Reserve Act and  Regulation O on
loans to  executive  officers  and the  restrictions  of 12 U.S.C.  ss.  1972 on
certain tying  arrangements  and  extensions of credit by  correspondent  banks.
Section  22(g) of the  Federal  Reserve  Act  requires  approval by the board of
directors  of a  depository  institution  for  extension  of credit to executive
officers  of  the  institution  and  imposes  reporting   requirements  for  and
additional  restrictions  on the  type,  amount  and  terms of  credits  to such
officers.  Section 1972: (i) prohibits a depository  institution  from extending
credit to or offering any other services, or fixing or varying the consideration
for such  extension  of credit or service,  on the  condition  that the customer
obtain some additional service from the institution or certain of its affiliates
or not obtain  services of a competitor of the  institution,  subject to certain
exceptions;  and (ii)  prohibits  extensions  of credit to  executive  officers,
directors or greater than 10%  stockholders  of a depository  institution by any
other  institution  which  has a  correspondent  banking  relationship  with the
institution,  unless such extension of credit is on substantially the same terms
as those prevailing at the time for comparable  transactions  with other persons
and does not involve  more than the normal risk of  repayment  or present  other
unfavorable features.

     Neither the Bank nor Downey  anticipate that these affiliated  transactions
restrictions  will materially  adversely affect the manner in which the Bank and
Downey conduct their respective business and operations.

     Payment of  Dividends.  The payment of  dividends by the Bank is subject to
OTS regulations.  Currently, 30 days' prior notice to the OTS of intent to pay a
dividend is  required.  The OTS has  promulgated  a regulation  that  measures a
savings institution's ability to pay dividends, make stock repurchases, or enter
into  other  types of  capital  distributions,  according  to the  institution's
capital  position.  The  rule  establishes   "safe-harbor"  amounts  of  capital
distributions  that institutions can make after providing notice to the OTS, but
without needing prior approval  unless the OTS determines that the  distribution
would  constitute an unsafe or unsound  practice.  Institutions  can  distribute
amounts in excess of the safe-harbor  amount only with the prior approval of the
OTS.

     For institutions, such as the Bank, that meet their fully phased-in capital
requirements, the safe-harbor amount is the greater of (i) 75% of net income for
the prior four  quarters,  or (ii) the sum of (a) the current  year's net income
and  (b)  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. For  institutions  that meet their current capital
requirements but do not meet their fully phased-in requirements, the safe-harbor
distribution is 75% of net income for the prior four quarters.

     The OTS has  proposed  a new  regulation  that  would  simplify  the  rules
governing  capital  distributions by savings  associations and would conform the
rules to the system of prompt  corrective  action  established  by  FDICIA.  The
proposal  applies to dividends to stockholders  (including  holding  companies),
stock  repurchases  and  cash-out  mergers.  Under  the  proposal,  any  savings
association  that is not a subsidiary of a holding company and that has received
a composite rating of "1" or "2" in its most recent regulatory examination would
be permitted  to make  capital  distributions  without  having to provide  prior
notice to the OTS. Other savings associations, however, including those that are
subsidiaries  of holding  companies,  would  generally be required to provide 30
days' prior notice, and troubled  institutions would have to file an application
and receive OTS approval prior to making a proposed  capital  distribution.  The
proposal would replace the current system which uses the multi-tiered  approach,
described  above,  under  which an  association's  authority  to make a  capital
distribution  varies according to the association's  capital levels. The comment
period for the proposal expired on February 3, 1995, and it is uncertain whether
or when a final regulation will be issued.

     Activities of Subsidiaries.  A savings  institution  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



                                       14
<PAGE>




require a savings institution 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.

     Acquisitions   of  Savings   Institutions.   Subject  to  certain   limited
exceptions,  control  of a savings  association  or a savings  and loan  holding
company may only be obtained with the approval (or in the case of an acquisition
of control by an individual, non-disapproval) of the OTS, after a public comment
and application  review process.  Under OTS  regulations  defining  "control," a
rebuttable  presumption  of control  arises if an acquiring  party acquires more
than 10% of any class of the voting stock of a savings association (or more than
25% of any class of stock,  whether voting or non-voting)  and is subject to any
"control factors" as defined in the regulation.  Control is conclusively  deemed
to exist if an  acquirer  holds more than 25% of any class of voting  stock of a
savings  association or has the power to control in any manner the election of a
majority of directors.

     Community  Reinvestment  Act. The CRA  requires  that  regulated  financial
institutions,  including savings associations such as the Bank, demonstrate that
their deposit  facilities  serve the convenience and needs of the communities in
which  they  are  chartered  to  do  business.  The  convenience  and  needs  of
communities  include the need for credit  services as well as deposit  services,
and  regulated   financial   institutions  have  a  continuing  and  affirmative
obligation  to help meet the credit  needs of the local  communities.  Financial
institutions  are  encouraged  to  help  meet  the  credit  needs  of the  local
communities  in which  they are  chartered  consistent  with the safe and  sound
operation  of such  institutions.  The CRA also  requires  the OTS to assess the
performance of the  institution in meeting the credit needs of its community and
to take  such  assessment  into  consideration  in  reviewing  applications  for
mergers,  acquisitions and other transactions.  An unsatisfactory CRA rating may
be the basis for denying such an application.

     In connection  with its  assessment of CRA  performance,  the OTS assigns a
rating of  "outstanding,"  "satisfactory,"  "needs to improve," or  "substantial
noncompliance." Based on a 1995 examination,  the Bank was rated "satisfactory."
The Bank's policy is to offer equal access to its credit  services to all of the
residents  of  the  communities  it  serves,  including   low-to-moderate-income
neighborhoods. See "Lending Activities" on page 2.

     In March 1994, the Federal  Interagency Task Force on Fair Lending issued a
policy statement on  discrimination in lending.  The policy statement  describes
the three methods that federal agencies will use to prove discrimination:  overt
evidence of  discrimination,  evidence of  disparate  treatment  and evidence of
disparate  impact.  In May 1995,  the  federal  banking  agencies  issued  final
regulations  which  change  the manner in which  they  measure an  institution's
compliance   with  its  CRA   obligations.   The  final   regulations   adopt  a
performance-based  evaluation system which bases CRA ratings on an institution's
actual  lending  service and  investment  performance  rather than the extent to
which the institution  conducts needs assessments,  documents community outreach
or complies with other procedural requirements.

     Federal Home Loan Bank System. The Federal Home Loan Banks provide a credit
facility for member  institutions.  As a member of the FHLB System,  the Bank is
required to own  capital  stock in the FHLB in an amount at least equal to 1% of
the aggregate principal amount of its unpaid home loans, home purchase contracts
and similar  obligations  at the end of each  calendar  year,  assuming for such
purposes that at least 30% of its assets were home mortgage  loans.  At December
31, 1996, the Bank's investment in the stock of the FHLB was $41.4 million.  The
Bank's required  investment in FHLB stock,  based on December 31, 1996 financial
data, was $41.9 million.  The Bank received a $0.7 million stock dividend in the
first  quarter  of 1997  thereby  increasing  the  Bank's  investment  above the
required limit. See Note 11 of Notes to the Consolidated Financial Statements on
page 74.

     Liquidity  Requirements.  The Bank is required to  maintain  average  daily
balances of liquid assets (cash,  certain time deposits,  bankers'  acceptances,
highly rated corporate debt and commercial  paper,  securities of certain mutual
funds  and  specified  United  States   government,   state  or  federal  agency
obligations)  equal  to the  monthly  average  of  not  less  than  a  specified
percentage  (currently  5%)  of  its  net  withdrawable  savings  deposits  plus
short-term  borrowings.  Savings  associations  are also  required  to  maintain
average  daily  balances of short-term  liquid assets at a specified  percentage
(currently  1%) of the  total of their net  withdrawable  savings  accounts  and
borrowings  payable in one year or less.  Monetary  penalties may be imposed for
failure to meet liquidity requirements.

     Federal  Reserve  System.   The  Federal  Reserve  Board  requires  savings
institutions to maintain  non-interest-earning reserves against certain of their
transactional  accounts  (primarily  deposit  accounts  that may be  accessed by
writing  checks) and  non-personal  time deposits.  For the  calculation  period
including  December 31, 1996, the Bank was required to maintain $24.7 million in
non-interest-earning  reserves and was in compliance with this requirement.  The
balance maintained to meet



                                       15
<PAGE>




the reserve  requirements  imposed by the Federal  Reserve  Board may be used to
satisfy the Bank's liquidity requirements discussed above.

     As a creditor and a financial  institution,  the Bank is subject to certain
regulations  promulgated  by  the  Federal  Reserve  Board,  including,  without
limitation,   Regulation  B  (Equal  Credit   Opportunity  Act),   Regulation  D
(Reserves),  Regulation E (Electronic Funds Transfers Act), Regulation F (Limits
on Exposure to Other Banks),  Regulation Z (Truth in Lending Act), Regulation CC
(Expedited Funds Availability Act), and Regulation DD (Truth in Savings Act). As
creditors  of loans  secured by real  property  and as owners of real  property,
financial  institutions,  including  the  Bank,  may  be  subject  to  potential
liability under various  statutes and regulations  applicable to property owners
generally,  including  statutes and  regulations  relating to the  environmental
condition of the property.

     Interstate  Banking and  Branching.  In  September  1994,  the  Riegle-Neal
Interstate  Banking and Branching  Efficiency Act of 1994 (the "Interstate Act")
became  law.  Under the  Interstate  Act,  beginning  one year after the date of
enactment, a bank holding company that is adequately capitalized and managed may
obtain  approval to acquire an existing  bank located in another  state  without
regard to state law. A bank holding  company would not be permitted to make such
an acquisition if, upon consummation,  it would control (a) more than 10% of the
total amount of deposits of insured depository institutions in the United States
or (b) 30% or more of the deposits in the state in which the bank is located.  A
state may limit the  percentage of total deposits that may be held in that state
by any one bank or bank holding  company if application of such  limitation does
not  discriminate  against  out-of-state  banks.  An  out-of-state  bank holding
company may not acquire a state bank in existence for less than a minimum length
of time that may be  prescribed  by state law except that a state may not impose
more than a five year existence requirement.

     The Interstate Act also permits, beginning June 1, 1997, mergers of insured
banks located in different states and conversion of the branches of the acquired
bank  into  branches  of  the  resulting   bank.  Each  state  may  permit  such
combinations  earlier than June 1, 1997,  and may adopt  legislation to prohibit
interstate  mergers  after  that date in that  state or in other  states by that
state's  banks.  The  same  concentration  limits  discussed  in  the  preceding
paragraph  apply.  The  Interstate  Act also permits a national or state bank to
establish branches in a state other than its home state if permitted by the laws
of that state,  subject to the same  requirements and conditions as for a merger
transaction.

     In  October  1995,  California  adopted  "opt  in"  legislation  under  the
Interstate Act that permits  out-of-state banks to acquire California banks that
satisfy  a  five-year  minimum  age  requirement   (subject  to  exceptions  for
supervisory  transactions)  by means of merger or purchases of assets,  although
entry through acquisition of individual branches of California  institutions and
de novo branching into California are not permitted.  The Interstate Act and the
California  branching statute will likely increase competition from out-of-state
banks in the markets in which the Bank  operates,  although it is  difficult  to
assess  the  impact  that  such  increased  competition  may have on the  Bank's
operations.

Regulation of Downey

     General.  Downey is a savings  and loan  holding  company as defined by the
HOLA.  As  such,  Downey  is  registered  with  the  OTS and is  subject  to OTS
regulation, examination, supervision and reporting requirements. As a subsidiary
of a  savings  and  loan  holding  company,  the  Bank  is  subject  to  certain
restrictions in its dealings with Downey and affiliates thereof.

     Activities  Restrictions.  Downey is a  unitary  savings  and loan  holding
company.  There are  generally no  restrictions  on the  activities of a unitary
savings and loan holding company. However, if the Director of the OTS determines
that there is reasonable cause to believe that the continuation by a savings and
loan holding company of an activity  constitutes a serious risk to the financial
safety,  soundness or  stability  of its  subsidiary  savings  association,  the
Director of the OTS may impose such  restrictions as deemed necessary to address
such  risk  including  limiting:   (i)  payment  of  dividends  by  the  savings
association;   (ii)  transactions   between  the  savings  association  and  its
affiliates;  and (iii) any  activities  of the  savings  association  that might
create a serious  risk  that the  liabilities  of the  holding  company  and its
affiliates may be imposed on the savings association.  Notwithstanding the above
rules as to permissible  business activities of unitary savings and loan holding
companies, if the savings association subsidiary of such a holding company fails
to meet the QTL test,  then such unitary  holding  company shall also  presently
become subject to the  activities  restrictions  applicable to multiple  holding
companies and,  unless the savings  association  requalifies as a QTL within one
year thereafter, register as, and become subject to, the restrictions applicable
to a bank  holding  company.  See  "Regulation  -  Other  Regulatory  Matters  -
Qualified Thrift Lender Test" on page 13.

     If Downey were to acquire  control of another  savings  association,  other
than through merger or other business  combination  with the Bank,  Downey would
thereupon become a multiple savings and loan holding company. Except where



                                       16
<PAGE>




such  acquisition  is  pursuant to the  authority  to approve  emergency  thrift
acquisitions and where each subsidiary  savings  association meets the QTL test,
the  activities  of Downey and any of its  subsidiaries  (other than the Bank or
other subsidiary  savings  associations)  would thereafter be subject to further
restrictions.  Among other things,  no multiple savings and loan holding company
or  subsidiary  thereof  which is not a savings  association  shall  commence or
continue for a limited period of time after becoming a multiple savings and loan
holding company or subsidiary thereof, any business activity,  upon prior notice
to, and no objection  by, the OTS,  other than:  (i)  furnishing  or  performing
management  services for a subsidiary  savings  association;  (ii) conducting an
insurance  agency or escrow  business;  (iii)  holding,  managing or liquidating
assets owned by or acquired from a subsidiary savings association;  (iv) holding
or managing properties used or occupied by a subsidiary savings association; (v)
acting as trustee  under deeds of trust;  (vi) those  activities  authorized  by
regulation  as of March 5, 1987 to be engaged in by  multiple  savings  and loan
holding  companies;  or  (vii)  unless  the  Director  of the OTS by  regulation
prohibits  or limits such  activities  for savings and loan  holding  companies,
those activities authorized by the Federal Reserve Board as permissible for bank
holding  companies.  Those  activities  described  in (vii)  above  must also be
approved  by the  Director  of the OTS prior to being  engaged  in by a multiple
savings and loan holding company.

     Restrictions  on  Acquisitions.  Savings  and loan  holding  companies  are
prohibited  from  acquiring,  without prior approval of the Director of the OTS:
(i) control of any other savings association or savings and loan holding company
or  substantially  all the  assets  thereof;  or (ii) more than 5% of the voting
shares  of a savings  association  or  holding  company  thereof  which is not a
subsidiary.  Under certain circumstances,  a registered savings and loan holding
company is permitted  to acquire,  with the approval of the Director of the OTS,
up to 15% of the  voting  shares of an  "undercapitalized"  savings  association
pursuant to a "qualified stock issuance" without that savings  association being
deemed  controlled by the holding  company.  In order for the shares acquired to
constitute a "qualified  stock  issuance," the shares must consist of previously
unissued  stock or treasury  shares,  the shares must be acquired for cash,  the
savings and loan holding company's other subsidiaries must have tangible capital
of at least  6.5% of  total  assets,  there  must  not be more  than one  common
director or officer between the savings and loan holding company and the issuing
savings  association,  and transactions  between the savings association and the
savings and loan  holding  company  and any of its  affiliates  must  conform to
Sections 23A and 23B of the Federal  Reserve Act. Except with the prior approval
of the Director of the OTS, no director or officer of a savings and loan holding
company or person owning or  controlling  by proxy or otherwise more than 25% of
such company's stock, may also acquire control of any savings association, other
than a subsidiary savings association,  or of any other savings and loan holding
company.

     The  Director of the OTS may only  approve  acquisitions  resulting  in the
formation of a multiple  savings and loan holding company which controls savings
associations  in more than one  state  if:  (i) the  multiple  savings  and loan
holding company involved controls a savings association which operated a home or
branch  office in the state of the  institution  to be  acquired  as of March 5,
1987;  (ii) the  acquirer  is  authorized  to  acquire  control  of the  savings
association  pursuant to the  emergency  acquisition  provisions  of the Federal
Deposit  Insurance  Act;  or (iii)  the  statutes  of the  state  in  which  the
institution to be acquired is located  specifically  permit  institutions  to be
acquired by  state-chartered  institutions or savings and loan holding companies
located in the state  where the  acquiring  entity is  located  (or by a holding
company that controls such state-chartered savings associations).

     Under the Bank  Holding  Company  Act of 1956,  as  amended,  bank  holding
companies  are  specifically  authorized  to  acquire  control  of  any  savings
association. Pursuant to rules promulgated by the Federal Reserve Board, owning,
controlling  or operating a savings  association  is a permissible  activity for
bank   holding   companies,   if  the  savings   association   engages  only  in
deposit-taking  activities and lending and other activities that are permissible
for bank  holding  companies.  A bank holding  company  that  controls a savings
association  may merge or consolidate  the assets and liabilities of the savings
association  with, or transfer  assets and  liabilities  to, any subsidiary bank
which  is a  member  of the BIF with the  approval  of the  appropriate  federal
banking  agency  and the  Federal  Reserve  Board.  The  resulting  bank will be
required to continue to pay assessments to the SAIF at the rates  prescribed for
SAIF members on the deposits attributable to the merged savings association plus
an annual growth  increment.  In addition,  the transaction must comply with the
restrictions  on  interstate  acquisitions  of  commercial  banks under the Bank
Holding Company Act.

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 Internal
Revenue Code (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  applied to large  commercial  banks.  The
repeal is  effective  for tax years  beginning  after  1995.  Bad debt  reserves
accumulated since 1987 are subject to



                                       17
<PAGE>




recapture as taxable income over a six-year period  beginning in 1996.  However,
thrifts may defer  recapture for up to two years if the amount of mortgage loans
originated  in 1996 and 1997 equals or exceeds the average  amount of  mortgages
originated  in the six years  prior to 1996.  Based upon 1996  originations  and
anticipated  1997  originations,  the Bank  expects to qualify for the  two-year
deferral under this  originations  test, and thus  anticipates  recapturing  its
post-1987  bad debt reserve over a six-year  period  beginning in 1998.  The bad
debt deduction for 1996 was  determined  under the specific  charge-off  method,
which  allows a tax  deduction  for loans  determined  to be wholly or partially
worthless.

     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"). In 1995 and 1994, the Bank
based its bad debt  deduction  on the  percentage-of-taxable-income  method.  As
discussed above, this method was repealed for years beginning after 1995.

     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. Prior to 1996, a tax preference item common
to savings  institutions was the excess, if any, of the institution's annual tax
bad debt deduction  calculated  under the reserve method over the deduction that
would have been available under the experience method. 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 a variable
rate tax,  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 11.3% for 1996, and declines to 10.84% in 1997. Downey
Financial Corp. and its wholly owned subsidiaries file California  franchise tax
returns on a combined reporting basis. Additional state tax returns are filed on
a separate-entity basis in Arizona,  Colorado,  and Illinois, for 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 -
1994  are  currently  under  examination.  Downey  believes  it has  established
appropriate  liabilities  for any resulting  deficiencies.  State  franchise tax
returns for years subsequent to 1989 remain open to review.





                                       18
<PAGE>




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, which have been
relatively  volatile over the last several years.  While the California  economy
recently 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.

     Interest Rates.  Downey  anticipates  that interest rate levels will remain
generally  constant  in 1997,  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.





                                       19
<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, 1996,  Downey owned the building and land occupied by 48 of
its branches and owned one building on leased land. Downey leases branches in 24
locations  (including 17 supermarket  locations) with leases expiring at various
dates through  November 2001,  with options to extend the term. In 1996,  Downey
purchased  land for two new branch  locations  opening in 1997 and one  existing
branch relocating in 1997.

     The net book value of the owned branches, including the one on leased land,
totaled $84.1 million at December 31, 1996, and the net book value of the leased
branch offices  totaled $1.2 million at December 31, 1996. The net book value of
Downey's furniture and fixtures, including electronic data processing equipment,
was $11.4 million at December 31, 1996.

     For additional  information  regarding Downey's offices and equipment,  see
Notes 1 and 10 of Notes to the Consolidated  Financial Statements on page 57 and
page 73, 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 $7.5
million at December 31, 1996.

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.





                                       20
<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 Stock  Exchange  ("PSE") with the trading  symbol "DSL." At February
28, 1997, Downey had approximately 978 stockholders of record (not including the
number of persons or entities  holding  stock in nominee or street name  through
various brokerage firms) and 25,460,954  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,  with prior periods  adjusted for a  three-for-two  stock split
effected in the form of a stock dividend in December 1996.

<TABLE>
<CAPTION>
                                                    1996                                                  1995
                             --------------------------------------------------  ------------------------------------------------
                                 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 .................       $   19.63    $   16.83    $   16.00    $   16.00    $   16.03    $   13.89    $   11.75    $   10.56
Low ..................           16.67        13.50        13.50        13.75        12.63        11.34        10.16         9.44
End of Period ........           19.63        16.83        14.58        15.67        14.50        12.70        11.59        10.16
</TABLE>

     During 1996 and 1995, Downey paid quarterly cash dividends  totaling $0.320
and  $0.305 per  share,  aggregating  $8.1 and $7.8  million,  respectively.  On
February 21, 1997, Downey paid a $0.08 per share cash dividend, aggregating $2.0
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 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 current and fully-phased-in capital requirements,  the
safe  harbor  amount is the  greater of (i) 75% of net income for the prior four
quarters;  or (ii) the sum of (a) the  current  year's  net  income  and (b) 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.




                                       21
<PAGE>



ITEM 6.       SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
(Dollars In Thousands, Except Per Share Data)                    1996           1995           1994           1993           1992
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                          <C>            <C>            <C>            <C>            <C>       
FOR THE YEAR:
Total interest income ....................................   $  346,360     $  318,828     $  228,970     $  220,745     $  259,212
Total interest expense ...................................      211,765        214,238        122,601        109,973        142,786
-----------------------------------------------------------------------------------------------------------------------------------
   Net interest income ...................................      134,595        104,590        106,369        110,772        116,426
   Provision for loan losses .............................        9,137          9,293          4,211          1,085          8,729
-----------------------------------------------------------------------------------------------------------------------------------
   Net interest income after provision for loan losses ...      125,458         95,297        102,158        109,687        107,697
-----------------------------------------------------------------------------------------------------------------------------------
Other income, net:
   Loan and deposit related fees .........................        7,435          5,546          5,310          6,175          7,281
   Real estate and joint ventures held for investment, net        8,241         11,192          9,530          4,769          5,112
   Net gains (losses) on sales of:
     Loans and mortgage-backed securities ................        1,543            266            114          1,665         (2,588)
     Investment securities ...............................        4,473            (15)          --             --               25
   (Provision for) reduction of loss on investment in ....         --              207           (920)        (2,184)          --
   lease residual
   Other .................................................        3,507          3,403          3,703          4,609          5,054
-----------------------------------------------------------------------------------------------------------------------------------
   Total other income, net ...............................       25,199         20,599         17,737         15,034         14,884
-----------------------------------------------------------------------------------------------------------------------------------
Operating expense:
   General and administrative expense ....................       86,460         74,470         75,566         73,502         72,624
   SAIF special assessment ...............................       24,644           --             --             --             --
   Net operation of real estate acquired in settlement of
     loans ...............................................        2,567          4,206          3,595          2,337           (105)
   Amortization of excess of cost over fair value of net
     assets acquired .....................................          532            530            532            532            555
-----------------------------------------------------------------------------------------------------------------------------------
   Total operating expense ...............................      114,203         79,206         79,693         76,371         73,074
-----------------------------------------------------------------------------------------------------------------------------------
Net income ...............................................       20,704 (1)     21,093         23,532         43,666 (2)     41,850

Loans originated .........................................    1,583,784        637,490      1,810,096      1,104,252      1,147,036
Loans and mortgage-backed securities purchased ...........       30,296         44,194        196,255         19,625            671
Loans and mortgage-backed securities sold ................      166,503        102,097         45,770        153,146        417,455

Effective interest rate spread ...........................        2.96%          2.35%          3.02%          3.47%          3.66%

AT DECEMBER 31:
Total assets .............................................   $5,198,157     $4,656,267     $4,650,651     $3,467,155     $3,478,333
Total loans and mortgage-backed securities ...............    4,729,846      4,169,474      4,188,539      2,917,109      2,765,508
Investments and cash equivalents .........................      222,255        237,904        215,960        313,989        439,584
Deposits .................................................    4,173,102      3,790,221      3,557,398      3,068,929      3,108,386
Borrowings ...............................................      595,345        436,218        674,776         13,718         14,508
Stockholders' equity .....................................      391,571        384,072        366,187        351,470        313,462
Loans serviced for others ................................      576,044        527,234        468,123        503,711        553,971
Allowance for loan losses as a percentage of .............       66.84%         35.67%         49.29%         47.72%         45.30%
non-performing loans
Non-performing assets as a percentage of total assets ....        1.19           2.09           1.41           2.01           1.94

SELECTED RATIOS:
Return on average assets .................................        0.43% (1)      0.45%          0.62%          1.25% (3)      1.18%
Return on average equity .................................         5.3  (1)       5.7            6.6           12.8  (3)      14.1
Dividend payout ratio ....................................        39.3           36.8           33.0           12.9           12.3
Capital ratios:
   Average stockholders' equity to average assets ........         8.1            7.9            9.5            9.7            8.3
   Core and tangible capital .............................         6.6            7.3            7.2            9.5            8.1
   Risk-based capital ....................................        12.7           14.3           14.2           17.0           14.4

PER SHARE DATA: (4)
Earnings per share .......................................       $ 0.81 (1)     $ 0.83         $ 0.92         $ 1.72 (2)     $ 1.64
Book value per share at end of period ....................        15.38          15.09          14.38          13.81          12.31
Stock price at end of period .............................        19.63          14.50           9.61          12.63           9.53
Cash dividends paid ......................................        0.320          0.305          0.305          0.222          0.203
</TABLE>
(1)  Excluding  the SAIF  special  assessment,  net income would have been $34.7
     million or $1.36 per share and the  returns on average  assets and  average
     equity would have been 0.73% and 9.0%, respectively.
(2)  Includes $15.1  million,  or $0.59 per share,  cumulative  benefit from the
     adoption of SFAS 109, Accounting for Income Taxes.
(3)  Excluding  SFAS 109  benefit,  the  returns on average  assets and  average
     equity would have been 0.82% and 8.39%, respectively.
(4)  Adjusted  for  three-for-two  stock  split  effected in the form of a stock
     dividend paid in December 1996.




                                       22
<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 19.

                                    OVERVIEW

     Net income for 1996 totaled $20.7 million or $0.81 per share and included a
one-time  assessment to  recapitalize  the Savings  Association  Insurance  Fund
("SAIF").  The one-time SAIF assessment  totaled $24.6 million ($14.0 million or
$0.55 per share on an after-tax  basis) and was  mandated  for all  institutions
insured by the Federal  Deposit  Insurance  Corporation  ("FDIC") as part of its
SAIF.  With  SAIF  now  recapitalized,  1997  deposit  premiums  will be  lower.
Excluding  the  one-time  SAIF  assessment,  net income for 1996 would have been
$34.7 million or $1.36 per share, up 64.7% from $21.1 million or $0.83 per share
in 1995 and $23.5 million or $0.92 per share in 1994.

     Excluding  the one-time  SAIF  assessment,  the increase in 1996 net income
from 1995 primarily  reflected higher net interest  income.  Net interest income
increased $30.0 million or 28.7% due to both a higher effective  interest spread
and higher average  earning  assets.  Also  contributing  to the increase in net
income  between  years was a $4.6  million  increase in other  income and a $1.6
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 $4.5 million in net
gains from sales of  investment  securities,  $1.8  million in loan and  deposit
related fees, and $1.3 million in net gains from sales of loans. These favorable
other income items were partially  offset by a decline of $3.0 million in income
from real estate  held for  investment  as net gains from sales of wholly  owned
real estate were lower in 1996. 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 $12.0
million in general  and  administrative  expense.  The  increase  in general and
administrative  expense was primarily associated with expansion into supermarket
banking  and  commercial  banking as well as  increased  single  family and auto
lending volumes.

     Assets  increased $542 million or 11.6% during 1996 to $5.2 billion at year
end,  whereas asset growth was constrained in 1995 following record asset growth
in 1994 when  assets  increased  $1.2  billion  or  34.1%.  Single  family  loan
originations  more than doubled  from $0.5  billion in 1995 to $1.25  billion in
1996.  In addition to single family  loans,  $330.4  million of other loans were
originated  including  $201.0  million  of  auto  loans  and  $71.7  million  of
construction loans.

     Asset growth was primarily funded with deposits as deposits increased 10.1%
to $4.2 billion at December 31, 1996. Branch generated deposits increased $472.9
million or 12.8%, while all remaining Wall Street generated deposits matured and
were not renewed. Of the branch generated increase, $92.8 million was associated
with 17 supermarket  branches opened since mid-June and $43.1 million with 4 new
traditional branches opened during the year.

     Non-performing  assets totaled $62.0 million or 1.19% of assets at December
31, 1996,  down from $97.2 million or 2.09% of assets at December 31, 1995.  The
decline in  non-performing  assets was spread  throughout  most  categories  but
primarily  reflected the return to accrual status of one large  commercial  real
estate loan  secured by a Northern  California  shopping  center  which had been
placed on non-accrual  status during the first quarter of 1995 when the borrower
declared bankruptcy. A detailed review of all criticized,  classified, watch and
non-performing  assets is performed  at least  semi-annually.  One-to-four  unit
residential  loans with  balances  greater  than  $750,000  and all other assets
greater than $500,000 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 $7.5 million for 1996, compared to $8.9 million
in 1995 and $4.8 million in 1994.

     At  December  31,  1996,  the Bank met and  exceeded  all three  regulatory
capital  tests,  with  capital-to-asset  ratios  of 6.56% in  tangible  and core
capital and 12.66% 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  -  Deposit  Insurance"  on page 11,
"Investments  in Real  Estate  and Joint  Ventures"  on page 33 and  "Regulatory
Capital Compliance" on page 48.





                                       23
<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 $134.6  million in 1996, up $30.0 million or 28.7%
from 1995 and $28.2  million or 26.5%  greater than 1994.  The 1996  improvement
over 1995 primarily  reflected a higher effective interest spread. The effective
interest  spread  averaged  2.96% in 1996,  up from  2.35% in 1995 but down from
3.02% in 1994.  The  increase  in the  effective  interest  spread  during  1996
reflected  several  factors  including a growing  proportion of higher  yielding
automobile  loans,  a lower  proportion  of ARMs in their  initial low incentive
period,  and a decline in the cost of funding sources.  Also contributing to the
1996 increase in net interest income was a 2% increase in average earning assets
to $4.55  billion.  This  followed a 26% increase in average  earning  assets in
1995.

     Interest from Downey's loans and mortgage-backed  securities  accounted for
96% of  Downey's  interest  income  in 1996,  compared  to 95% in 1995 and 1994.
Interest and dividends on investments,  including  yield  maintenance on covered
assets,  amounted to $12.3 million in 1996, as compared to $14.4 million in 1995
and $11.7 million in 1994.

     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.





                                       24
<PAGE>




<TABLE>
<CAPTION>
                                                 1996                            1995                             1994
                                    -----------------------------------------------------------------------------------------------
                                                           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 (1) ....................   $4,269,136   $329,746   7.72%   $4,175,085   $300,734   7.20%   $3,241,390   $213,051   6.57%
   Mortgage-backed securities           64,957      4,317   6.65        63,772      4,311   6.76        80,404      4,768   5.93
   Investment securities ........      215,364     12,297   5.71       215,672     13,783   6.39       199,240     11,151   5.60
-----------------------------------------------------------------------------------------------------------------------------------
    Total interest-earning assets    4,549,457    346,360   7.61     4,454,529    318,828   7.16     3,521,034    228,970   6.50
Non-interest-earning assets......      240,191                         263,430                         268,675
-----------------------------------------------------------------------------------------------------------------------------------
    Total assets                    $4,789,648                      $4,717,959                      $3,789,709
===================================================================================================================================
Interest-bearing liabilities:
   Deposits .....................   $3,892,981   $184,402   4.74%   $3,758,948   $180,859   4.81%   $3,153,777   $109,995   3.49%
   Borrowings ...................      457,890     27,363   5.98       523,417     33,379   6.39       226,316     12,606   5.57
-----------------------------------------------------------------------------------------------------------------------------------
    Total interest-bearing            
      liabilities ...............    4,350,871    211,765   4.87      4,282,365   214,238   5.00     3,380,093    122,601   3.63
Non-interest-bearing liabilities        50,590                           64,880                         50,868
Stockholders' equity ............      388,187                          370,714                        358,748
-----------------------------------------------------------------------------------------------------------------------------------
    Total liabilities and     
      stockholders' equity ......   $4,789,648                       $4,717,959                     $3,789,709
===================================================================================================================================
Net interest income/interest
  rate spread ...................                $134,595   2.74%                $104,590   2.16%                $106,369   2.87%
Excess of interest-earning 
  assets over interest-bearing
  liabilities ...................   $  198,586                       $  172,164                     $  140,941
Effective interest rate spread ..                           2.96                            2.35                            3.02
===================================================================================================================================
</TABLE>
(1)  Included in loan interest  income for 1994 were $5.1 million of higher than
     usual income  distributions  from  agreements in which Downey shares in the
     net cash flows of certain  shopping centers which Downey  currently,  or in
     the past, financed. Excluding that income, the average loan yield, interest
     earning asset yield,  and effective  interest spread would have been 6.41%,
     6.36% and 2.88%, respectively.

     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) changes in rate  (changes in rate
multiplied by old volume),  (ii) changes in volume (changes 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>
                                                                     Volume/Rate Analysis
                                       ---------------------------------------------------------------------------------------------
                                                   1996 versus 1995                             1995 versus 1994
                                                    Changes Due To                               Changes 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 ...........................   $  6,775    $ 21,747    $    490    $ 29,012    $ 61,371    $ 20,428    $  5,884    $ 87,683
   Mortgage-backed securities ......         80         (73)         (1)          6        (986)        667        (138)       (457)
   Investment securities ...........        (20)     (1,468)          2      (1,486)        920       1,582         130       2,632
------------------------------------------------------------------------------------------------------------------------------------
     Total interest income .........      6,835      20,206         491      27,532      61,305      22,677       5,876      89,858
------------------------------------------------------------------------------------------------------------------------------------
Interest Expense:
   Deposits ........................      6,449      (2,806)       (100)      3,543      21,107      41,746       8,011      70,864
   Borrowings ......................     (4,184)     (2,094)        262      (6,016)     16,549       1,826       2,398      20,773
------------------------------------------------------------------------------------------------------------------------------------
     Total interest expense ........      2,265      (4,900)        162      (2,473)     37,656      43,572      10,409      91,637
------------------------------------------------------------------------------------------------------------------------------------
Change in net interest income ......   $  4,570    $ 25,106    $    329    $ 30,005    $ 23,649    $(20,895)   $ (4,533)   $ (1,779)
====================================================================================================================================
</TABLE>





                                       25
<PAGE>




PROVISION FOR LOAN LOSSES

     Provision  for loan  losses was $9.1  million in 1996,  as compared to $9.3
million in 1995 and $4.2 million in 1994. The provision for loan losses exceeded
net loan  charge-offs  by $2.2  million  primarily  reflecting  growth in single
family residential and automobile loans.

     For further information, see "Problem Loans and Real Estate - Allowance for
Losses on Loans and Real Estate" on page 44.

OTHER INCOME

     Other income  totaled $25.2  million in 1996,  compared to $20.6 million in
1995 and $17.7 million in 1994. The increase in 1996 reflected  several factors.
Favorably  impacting  other  income were  increases of $4.5 million in net gains
from sales of investment  securities,  $1.9 million in loan and deposit  related
fees,  and $1.3  million  in net  gains  from  the  sales  of  loans.  Partially
offsetting those increases was a $3.0 million decline in income from real estate
held for investment. Below is a discussion of the major other income categories.

Loan and Deposit Related Fees

     Loan and deposit  related fees  totaled  $7.4 million in 1996,  compared to
$5.5  million in 1995 and $5.3  million in 1994.  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.

<TABLE>
<CAPTION>
 (In Thousands)                                     1996        1995       1994
--------------------------------------------------------------------------------
<S>                                                 <C>        <C>        <C>   
Loan related fees .............................     $2,496     $1,508     $1,513
Deposit related fees ..........................      4,939      4,038      3,797
--------------------------------------------------------------------------------
   Total loan and deposit related fees ........     $7,435     $5,546     $5,310
================================================================================
</TABLE>

Real Estate and Joint Venture Operations Held for Investment

     Income from real estate and joint venture  operations  totaled $8.2 million
in 1996,  compared to $11.2 million in 1995 and $9.5 million in 1994.  The table
below sets forth the key components comprising income from real estate and joint
venture operations.

<TABLE>
<CAPTION>
(In Thousands)                                                               1996         1995         1994
-------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>          <C>           <C>     
Operations, net:
   Rental operations net of expenses of wholly owned real estate ....     $  2,417     $  3,711      $  4,507
   Equity in net income (loss) from joint ventures ..................           55       (1,676)        1,512
   Interest from joint venture ......................................        2,071        1,702         1,579
-------------------------------------------------------------------------------------------------------------

      Total operations, net .........................................        4,543        3,737         7,598
Net gains on sales of wholly owned real estate ......................          392        4,539           532
Recovery of losses on real estate and joint ventures ................        3,306        2,916         1,400
-------------------------------------------------------------------------------------------------------------

      Income from real estate and joint venture operations ..........     $  8,241     $ 11,192      $  9,530
=============================================================================================================
</TABLE>

     The decrease  during 1996 primarily  reflected a decline of $4.1 million to
$0.4 million in net gains on the sales of wholly owned real estate. In addition,
as a result of the sale of two  properties  in 1995,  rental  operations  net of
expenses of wholly  owned real estate  declined  $1.3  million to $2.4  million.
Offsetting  these  items was an  improvement  in equity in net income from joint
ventures of $1.7  million due  primarily  to a gain from the sale of a property,
and an  increase  of $0.4  million in the  recovery of losses on real estate and
joint ventures due to further  improvements  in the value of certain real estate
investments.





                                       26
<PAGE>




     For  additional  information,  see  "Investments  in Real  Estate and Joint
Ventures" on page 33,  "Problem  Loans and Real Estate - Allowance for Losses on
Loans  and  Real  Estate"  on page 44,  and Note 8 of Notes to the  Consolidated
Financial Statements on page 69.

Secondary Marketing Activities

     Sales  of  loans  and  mortgage-backed   securities  originated  by  Downey
increased in 1996 to $161.9 million from $80.7 million in 1995 and $45.8 million
in 1994.  Gains  associated  with  those  sales  totaled  $1.5  million in 1996,
compared to $0.3 million in 1995 and $0.1 million in 1994. The current year gain
includes $1.0 million related to the capitalization of mortgage servicing rights
in accordance with the adoption of Statement of Financial  Accounting  Standards
No. 122, "Accounting for Mortgage Servicing Rights, an Amendment to FASB No. 65"
("SFAS 122").

     Loan  servicing  fees from Downey's  portfolio of loans serviced for others
totaled  $1.4 million for 1996,  down from $1.5  million in 1995 and 1994.  Loan
servicing  fee  income in 1996  includes  a charge of  $179,000  related  to the
amortization  of  capitalized  mortgage  servicing  rights and a  provision  for
impairment  losses  on such  mortgage  servicing  rights  totaling  $101,000  in
accordance  with SFAS 122. At December 31, 1996,  Downey serviced $576.0 million
of loans for others, compared to $527.2 million at December 31, 1995, and $468.1
million at December 31, 1994.

Net Gains (Losses) on Sales of Investment Securities

     Gains on sales of  investment  securities  totaled  $4.5  million  in 1996,
compared to a loss of $15,000 in 1995. The gain in the current year was from the
sale of U.S. Treasury securities carried in the available for sale portfolio.

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. This compares to a provision for losses of $0.9 million in 1994.

Other Category

     The all other  category  of other  income  totaled  $2.1  million  in 1996,
compared to $1.9 million in 1995 and $2.2 million in 1994.

OPERATING EXPENSES

     Operating expenses totaled $114.2 million in 1996 which included a one-time
SAIF assessment of $24.6 million.  Excluding that assessment,  operating expense
would have totaled  $89.6 million as compared to $79.2 million in 1995 and $79.7
million in 1994.  The increase  was  primarily  explained by higher  general and
administrative  costs.  Factors  contributing  to the increase were higher costs
associated with expansion into supermarket  banking and commercial  banking,  as
well as  increased  single  family and auto  lending  volumes.  The  increase in
general and  administrative  expense was partially  offset by a decline in costs
associated with the net operation of real estate acquired  through  foreclosure,
as such operations resulted in a net expense of $2.6 million in 1996 compared to
$4.2 million in 1995.

<TABLE>
<CAPTION>
(In Thousands)                                                                1996          1995            1994
-------------------------------------------------------------------------------------------------------------------
<S>                                                                        <C>             <C>             <C>     
General and administrative expense .....................................   $ 86,460        $ 74,470        $ 75,566
SAIF special assessment ................................................     24,644            --              --
Net operation of real estate acquired in settlement of loans ...........      2,567           4,206           3,595
Amortization of excess of cost over fair value of net assets acquired ..        532             530             532
-------------------------------------------------------------------------------------------------------------------

      Total operating expense ..........................................   $114,203        $ 79,206        $ 79,693
===================================================================================================================
</TABLE>

PROVISION FOR INCOME TAXES

     Downey's  effective tax rate for 1996 was 43.2%,  up from 42.5% in 1995 and
41.5% in 1994.  This  increase  resulted  primarily  from the  effect of certain
permanent  differences  between  income  reported  for tax  purposes  and income
reported for



                                       27
<PAGE>



financial  statement  purposes,  and the  manner  in  which  taxable  income  is
allocated among the states in which Downey and its subsidiaries do business.

     See Notes 1 and 18 of Notes to the  Consolidated  Financial  Statements  on
pages 57 and 78,  respectively,  for a further discussion of income taxes and an
explanation of the factors which impact Downey's effective tax rate.




                                       28
<PAGE>



                               FINANCIAL CONDITION

LOANS AND MORTGAGE-BACKED SECURITIES

     Loans  and  mortgage-backed  securities,  including  those  held for  sale,
totaled $4.7 billion,  or 91.0% of assets at December 31, 1996.  This represents
an increase  of $560.4  million or 13.4% from the $4.2  billion at December  31,
1995.

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

<TABLE>
<CAPTION>
(Dollars in Thousands)                                             1996          1995          1994            1993          1992
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>           <C>            <C>             <C>          <C>  
Average interest rate on new loans .......................         6.06%         6.99%          4.94%           5.53%        6.81%
Average total loan origination fees on new loans .........         0.79          1.08           0.85            0.63         0.63
Total loan fees (net of costs) and discounts (net
    of premiums) deferred during the year ................     $  (4,525)      $   880      $  (7,861)      $   1,572      $  (485)
===================================================================================================================================
</TABLE>

     Beginning in 1992,  average loan origination  fees decreased  significantly
due  primarily  to  the  origination  of a  large  volume  of  one-to-four  unit
residential ARMs associated with transactions for which no origination fees were
charged.  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 $1.1 billion  during 1996,
compared  to $443.8  million  and $1.8  billion in 1995 and 1994,  respectively.
Refinancing  activities  (including new loans to refinance  loans  originated by
Downey  and  other  lenders)   increased   during  1996,   constituting  35%  of
originations  during  the year  compared  to 31% and 41%  during  1995 and 1994,
respectively.  At December 31, 1996,  one-to-four unit ARMs constituted 81.9% of
the total loan and mortgage-backed  securities  portfolio,  compared to 83.6% at
December  31,  1995.  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 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, 15% 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, 1996,  $1.8
billion of one-to-four unit ARMs were subject to negative  amortization of which
$14.7  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 $1.5 million in 1996,
compared to $10.6 million in 1995 and $18.9 million in 1994.  Substantially  all
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 totaled $19.7 million in 1996, compared
to $0.5 million in 1995 and $19.3 million in 1994.

     During  1996,  Downey  originated  $71.7  million  of  construction  loans,
principally  for entry level and first time  move-up  residential  tracts.  This
compares to $28.9  million in 1995 and $14.8  million in 1994.  Originations  of
land development loans totaled $10.5 million in 1996,  compared to $12.9 million
in 1995.

     Originations of non-mortgage commercial loans increased to $11.8 million in
1996 from $1.1 million in 1995 as a result of Downey's expansion into commercial
banking. For the year, 79% of originations represented secured loans.

     In 1995,  Downey commenced 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 $201.0  million in 1996,  compared to
$62.2 million in 1995 and $1.9 million in 1994.





                                       29
<PAGE>




     The following table sets forth the origination,  purchase and sale activity
relating to loans and mortgage-backed  securities of Downey held for investment,
held for sale and held for trading.

<TABLE>
<CAPTION>
(In Thousands)                                                  1996            1995         1994            1993           1992
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                         <C>            <C>            <C>            <C>            <C>        
INVESTMENT PORTFOLIO:
Loans originated:
   Loans secured by real estate:
    Residential:
      One-to-four units:
       Adjustable .......................................   $ 1,039,978    $   384,265    $ 1,652,855    $   761,292    $   676,014
       Adjustable - fixed for first three or five years .        19,864         11,846         20,967         26,050        173,638
------------------------------------------------------------------------------------------------------------------------------------
         Total adjustable ...............................     1,059,842        396,111      1,673,822        787,342        849,652
       Fixed ............................................        33,618         13,888          7,411          7,162          2,325
      Five or more units:
       Adjustable .......................................        17,409            128         18,385          8,500          8,820
       Fixed ............................................         2,253            419            953            404          2,000
------------------------------------------------------------------------------------------------------------------------------------
         Total residential ..............................     1,113,122        410,546      1,700,571        803,408        862,797
    Commercial real estate ..............................         1,548         10,629         18,900         51,190         25,584
    Construction ........................................        71,678         28,931         14,785         43,958         18,825
    Land ................................................        10,468         12,906           --             --              825
   Non-mortgage:
    Commercial - secured ................................         9,385           --             --             --               14
    Commercial - unsecured ..............................         2,450          1,115          1,605          3,500            347
    Automobile ..........................................       200,966         62,234          1,869          1,871          1,537
    Other consumer ......................................        14,226         17,633         39,945         38,823         54,214
------------------------------------------------------------------------------------------------------------------------------------
         Total loans originated .........................     1,423,843        543,994      1,777,675        942,750        964,143
Real estate loans purchased (1) .........................           223         44,194        145,117            612            421
------------------------------------------------------------------------------------------------------------------------------------
      Total loans originated and purchased ..............     1,424,066        588,188      1,922,792        943,362        964,564
Loan repayments .........................................      (832,713)      (538,217)      (631,836)      (759,881)      (890,724)
Other net changes (2) ...................................       (39,978)       (50,544)       (38,330)       (41,977)        (1,220)
------------------------------------------------------------------------------------------------------------------------------------
    Net increase (decrease) in loans held for investment        551,375           (573)     1,252,626        141,504         72,620
Mortgage-backed securities held to maturity, net:
    Purchased ...........................................          --             --             --           19,013           --
    Repayments ..........................................          --           (5,588)       (11,917)       (17,292)       (16,915)
    Transferred to mortgage-backed securities available 
      for sale...........................................          --          (33,555)          --             --             --
------------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in mortgage-backed ........          --          (39,143)       (11,917)         1,721        (16,915)
      securities, net
------------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in loans and mortgage-
        backed securities held for investment ...........       551,375        (39,716)     1,240,709        143,225         55,705
------------------------------------------------------------------------------------------------------------------------------------
SALE PORTFOLIO:
   Residential, one-to-four units:
    Originated whole loans ..............................       159,941         93,496         32,421        161,502        182,893
    Loans transferred from (to) the investment portfolio          1,791           (100)          --               82           (330)
    Originated whole loans sold .........................      (135,426)       (80,725)       (45,770)      (152,156)       (87,063)
    Loans exchanged for mortgage-backed securities ......       (26,452)          --             --             (990)      (111,646)
    Purchased loans .....................................          --             --             --             --              250
    Purchased whole loans resold ........................          --             --             --             --             (125)
    Other net changes ...................................           (48)           (10)           (16)           (62)           (27)
------------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in loans held for sale ....          (194)        12,661        (13,365)         8,376        (16,048)
------------------------------------------------------------------------------------------------------------------------------------
   Mortgage-backed securities, net:
    Received in exchange for loans ......................        26,452           --             --              990        111,646
    Purchased ...........................................        30,073           --           51,138           --             --
    Transferred from mortgage-backed securities held to
      maturity ..........................................          --           33,555           --             --             --
    Sold ................................................       (31,077)       (21,372)          --             (990)      (330,267)
    Repayments ..........................................       (15,661)        (6,862)        (5,263)          --          (26,847)
    Other net changes ...................................          (596)         2,669         (1,789)          --              (11)
------------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in mortgage-backed
        securities available for sale ...................         9,191          7,990         44,086           --         (245,479)
------------------------------------------------------------------------------------------------------------------------------------
      Net increase (decrease) in loans and
      mortgage-backed
       securities held for sale and available for sale ..         8,997         20,651         30,721          8,376       (261,527)
------------------------------------------------------------------------------------------------------------------------------------
    Total net increase (decrease) in loans and mortgage-
      backed securities .................................   $   560,372    $   (19,065)   $ 1,271,430    $   151,601    $  (205,822)
====================================================================================================================================
</TABLE>
(1)  Primarily one-to-four 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).





                                       30
<PAGE>




     The  following  table  sets  forth the  composition  of  Downey's  loan and
mortgage-backed securities portfolio held for investment, held for sale and held
for  trading  by type of loan at the dates  indicated.  At  December  31,  1996,
approximately  99% of  Downey's  real estate  loans were  secured by real estate
located in California  (principally  in Los Angeles,  Orange,  Santa Clara,  San
Diego and Ventura counties).

<TABLE>
<CAPTION>
                                                                                           December 31,
                                                             -----------------------------------------------------------------------
(In Thousands)                                                    1996          1995           1994          1993           1992
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                          <C>            <C>            <C>            <C>            <C>        
INVESTMENT PORTFOLIO:
   Loans secured by real estate:
     Residential:
       One-to-four units:
         Adjustable ......................................   $ 3,873,577    $ 3,486,774    $ 3,493,435   $ 2,127,312    $ 1,844,223
         Fixed ...........................................       172,871        169,738        194,845       249,274        420,909
------------------------------------------------------------------------------------------------------------------------------------
           Total one-to-four units .......................     4,046,448      3,656,512      3,688,280     2,376,586      2,265,132
       Five or more units:
         Adjustable ......................................        43,050         44,438         48,782        37,819         32,128
         Fixed ...........................................        13,857         12,883         15,000        35,686         37,958
     Commercial real estate:
       Adjustable ........................................       158,656        170,498        178,377       201,406        104,244
       Fixed .............................................       101,953        100,085        116,041       139,621        160,123
     Construction ........................................        66,651         28,593         11,367        37,180         82,186
     Land ................................................        21,177         21,867          9,822        11,826         15,817
   Non-mortgage:
     Commercial:
       Secured ...........................................         9,610            250            225           253          1,395
       Unsecured .........................................        12,526         12,614         12,750         7,976         19,397
     Consumer:
       Automobile ........................................       202,186         56,127          3,028         3,274          4,577
       Other consumer ....................................        47,281         50,945         53,241        48,580         42,915
------------------------------------------------------------------------------------------------------------------------------------
         Total loans held for investment .................     4,723,395      4,154,812      4,136,913     2,900,207      2,765,872
   Increase (decrease) for:
     Undisbursed loan funds ..............................       (49,250)       (29,942)       (13,872)      (18,019)       (21,044)
     Deferral of fees and discounts, net of costs ........        11,663          7,412          7,468        (3,067)        (5,621)
     Allowance for estimated loss ........................       (30,094)       (27,943)       (25,597)      (26,835)       (28,425)
------------------------------------------------------------------------------------------------------------------------------------
         Total loans held for investment, net ............     4,655,714      4,104,339      4,104,912     2,852,286      2,710,782
------------------------------------------------------------------------------------------------------------------------------------
   Mortgage-backed securities held to maturity, net:
     Adjustable ..........................................          --             --           19,897        25,352         12,678
     Fixed ...............................................          --             --           19,246        25,708         36,661
------------------------------------------------------------------------------------------------------------------------------------
       Total mortgage-backed securities held to
         maturity, net ...................................          --             --           39,143        51,060         49,339
------------------------------------------------------------------------------------------------------------------------------------
         Total loans and mortgage-backed securities
           held for investment ...........................     4,655,714      4,104,339      4,144,055     2,903,346      2,760,121
------------------------------------------------------------------------------------------------------------------------------------
SALE AND TRADING PORTFOLIOS, NET:
   Loans held for sale (all one-to-four units):
     Adjustable ..........................................         1,145            238           --            --             --
     Fixed ...............................................        11,720         12,821            398        13,763          5,387
------------------------------------------------------------------------------------------------------------------------------------
       Total loans held for sale .........................        12,865         13,059            398        13,763          5,387
   Mortgage-backed securities available for sale
     Adjustable ..........................................        23,620         34,355         44,086          --             --
     Fixed ...............................................        37,647         17,721           --            --             --
------------------------------------------------------------------------------------------------------------------------------------
       Total mortgage-backed securities available for sale        61,267         52,076         44,086          --             --
------------------------------------------------------------------------------------------------------------------------------------
           Total loans and mortgage-backed securities
              held for sale and available for sale .......        74,132         65,135         44,484        13,763          5,387
------------------------------------------------------------------------------------------------------------------------------------
           Total loans and mortgage-backed securities ....   $ 4,729,846    $ 4,169,474    $ 4,188,539   $ 2,917,109    $ 2,765,508
====================================================================================================================================
</TABLE>





                                       31
<PAGE>




     The table below sets forth the scheduled contractual maturities of Downey's
total loan and mortgage-backed securities portfolios as of December 31, 1996.

<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) .......  $   35,106   $   37,796   $   40,692   $   90,977   $  295,924   $  428,095   $2,946,132   $3,874,722
       Fixed (1) ............       3,020        3,301        3,609        8,260       28,410       44,371       93,620      184,591
     Five or more units:
       Adjustable ...........         681          736          796        1,791        5,912        8,730       24,404       43,050
       Fixed ................         548          601          660        1,522        5,318        5,208         --         13,857
   Commercial real estate:
     Adjustable .............       4,758        5,156        5,587       12,616       42,015       62,782       25,742      158,656
     Fixed ..................       4,960        5,432        5,950       13,656       47,296       24,659         --        101,953
   Construction -
     adjustable .............      66,651         --           --           --           --           --           --         66,651
   Land:
     Adjustable .............      18,186        2,745         --           --           --           --           --         20,931
     Fixed ..................          10           11           12           28          101           84         --            246
Non-mortgage:
   Commercial:
     Secured ................       8,581          372          405          252         --           --           --          9,610
     Unsecured ..............      11,257        1,269         --           --           --           --           --         12,526
   Automobile ...............      45,759       51,292       57,495       47,640         --           --           --        202,186
   Consumer and other (2) ...       1,549        1,760        2,001          913       41,058         --           --         47,281
------------------------------------------------------------------------------------------------------------------------------------
     Total loans ............     201,066      110,471      117,207      177,655      466,034      573,929    3,089,898    4,736,260
Mortgage-backed securities,
  net .......................       1,073        1,153        1,239       24,888        6,721        9,728       16,465       61,267
------------------------------------------------------------------------------------------------------------------------------------
     Total loans and
       mortgage-backed
       secuities ............  $  202,139   $  111,624   $  118,446   $  202,543   $  472,755   $  583,657   $3,106,363   $4,797,527
====================================================================================================================================
</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, 1996,  the maximum amount the Bank could have loaned to any
one borrower (and related  entities) under regulatory  limits was $61.4 million,
or $102.4 million for loans secured by readily marketable  collateral,  compared
to $59.0 million and $98.4 million, respectively, at December 31, 1995. The Bank
does not expect that these  regulatory  limitations  will  adversely  impact its
proposed lending activities during 1997.

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.  In  January  1996,  approximately  $135  million  of the U.S.
Treasury  securities  with remaining  maturities of four years or less were sold
for a pre-tax gain of approximately $4.5 million. Those securities were replaced
with a like amount of liquidity eligible investments with five-year maturities.





                                       32
<PAGE>




<TABLE>
<CAPTION>
                                                                              December 31,
                                                ------------------------------------------------------------------------
(In Thousands)                                     1996            1995           1994            1993            1992
------------------------------------------------------------------------------------------------------------------------
<S>                                             <C>             <C>             <C>             <C>             <C>     
Federal funds ............................      $  6,038        $  7,249        $  6,112        $ 38,547        $  8,834
U.S. Treasury and agency securities:
   Held to maturity ......................          --              --           155,109         105,265          95,248
   Available for sale ....................       141,999         164,880            --              --              --
Municipal bonds - held to maturity .......         6,997           7,194            --              --              --
------------------------------------------------------------------------------------------------------------------------

   Total .................................      $155,034        $179,323        $161,221        $143,812        $104,082
========================================================================================================================
</TABLE>

     As of December 31, 1996, 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>      <C>         <C>  
Federal funds .........................    $  6,038       4.70%    $  --        -- %    $   --       -- %    $  6,038    4.70%
U.S. Treasury and agency securities ...       9,997       5.45      132,002    5.66         --       --       141,999    5.65
Municipal bonds (1) ...................        --          --         --        --         6,997    6.12        6,997    6.12
-------------------------------------------------------------------------------------------------------------------------------
   Total ..............................    $ 16,035       5.17%    $132,002    5.66%    $  6,997    6.12%    $155,034    5.63%
===============================================================================================================================
</TABLE>
(1)  Yields on fully tax-equivalent basis.

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  69.  Most  of  the  real  estate
development  projects have been completed and are  substantially  leased (with a
weighted average  occupancy of 85% for retail  neighborhood  shopping centers at
December 31,  1996).  At December 31, 1996,  the Bank had  outstanding  loans of
$77.6 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, 1996, DSL Service  Company was the operator and managing
joint venture partner for five  neighborhood  shopping  centers and was involved
with three developers who were operators of seven retail  neighborhood  shopping
centers.  In addition,  DSL Service  Company was involved with one joint venture
partner in the  development of a new  neighborhood  shopping  center.  All joint
venture shopping  centers are located in California.  DSL Service Company has 12
wholly owned retail neighborhood shopping centers located in California, Arizona
and Texas.

     The following table sets forth the condensed  balance sheets of DSL Service
Company's  joint ventures by property type at December 31, 1996, 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 44. 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



                                       33
<PAGE>




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.

<TABLE>
<CAPTION>
                                                                        Retail
                                                                     Neighborhood
(Dollars In Thousands)                                             Shopping Centers     Commercial      Residential         Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>              <C>              <C>             <C>      
Cash ............................................................       $     665        $     177        $     936       $   1,778
Projects under development ......................................             719            2,225           10,095          13,039
Completed projects ..............................................          85,742            5,307             --            91,049
Other assets ....................................................           5,982               47              281           6,310
------------------------------------------------------------------------------------------------------------------------------------

       Total assets .............................................       $  93,108        $   7,756        $  11,312       $ 112,176
====================================================================================================================================

Secured notes payable to the Bank ...............................       $  73,598        $   1,694        $   2,306       $  77,598
Secured notes payable to others .................................          19,224            4,471            4,867          28,562
Other liabilities ...............................................           8,207            1,546            1,399          11,152
Equity (deficit):
    DSL Service Company (1) .....................................          10,594             (112)           2,659          13,141
    Allowance for losses recorded by DSL Service Company ........           6,144            1,633             --             7,777
    Other partners' (2) .........................................         (24,659)          (1,476)              81         (26,054)
------------------------------------------------------------------------------------------------------------------------------------

       Total liabilities and equity .............................       $  93,108        $   7,756        $  11,312       $ 112,176
====================================================================================================================================

Number of joint venture projects ................................              13                2                1              16
====================================================================================================================================
</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 $26.1 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 $7.8 million at December 31, 1996. At December 31, 1996,
     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 $26.1 million  exceeds the amount of valuation
     allowances established of $7.8 million.

     In January  1997,  DSL Service  Company  completed an all cash sale of four
California shopping centers from one joint partnership  relationship pursuant to
an agreement  between DSL Service  Company and its joint  venture  partner.  The
aggregate  assets  involved  totaled  $41.6  million of which $30.8  million was
financed  by  secured  notes  from the  Bank.  The sale  will  result  in Downey
recognizing  an after-tax  gain of  approximately  $2.5 million in first quarter
1997 results. For further information  regarding the pro forma regulatory impact
of this event see "Regulatory Capital Compliance" on page 48.





                                       34
<PAGE>




     The  following  table sets forth by property  type  Downey's  wholly  owned
investments  in real estate and related  allowances  for losses at December  31,
1996.

<TABLE>
<CAPTION>
                                                                             Retail
                                                   Single Family          Neighborhood
(Dollars in Thousands)                            Developments (1)      Shopping Centers         Land            Total
--------------------------------------------------------------------------------------------------------------------------
<S>                                                   <C>                  <C>                <C>                <C>
Wholly Owned Properties:
Investment in wholly owned projects .............     $ 12,483             $ 35,226  (2)      $  7,942  (3)      $ 55,651
Allowance for losses ............................      (11,841)              (5,116)            (5,337)           (22,294)
--------------------------------------------------------------------------------------------------------------------------
Net investment in wholly owned projects .........     $    642             $ 30,110           $  2,605           $ 33,357

Number of projects ..............................            3                   12                 10                 25
==========================================================================================================================
</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 which amount to $3.9 million and are counted as one project.
(3)  Includes three properties that amount to $6.8 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
defects in structure  and the housing site,  including  soil  conditions,  which
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.

     The Bank's various components of equity investments were in compliance with
FIRREA  limitations  since the Bank sold its real estate  assets for cash to DSL
Service  Company  during 1994.  For further  information,  see  "Business - Real
Estate Investments" on page 6.

DEPOSITS

     Deposits  increased  $382.9  million  or 10.1% in 1996,  and  totaled  $4.2
billion at December 31, 1996. All account types increased during the year except
money market accounts which decreased $19.1 million.  Branch generated  deposits
increased  $472.9 million or 12.8%,  while all remaining  Wall Street  generated
deposits matured and were not renewed. Of the branch generated  deposits,  $92.8
million was associated  with 17 supermarket  branches  opened since mid-June and
$43.1 million with four new traditional branches opened during the year. Regular
savings  accounts  increased by $28.9  million and checking  accounts  increased
$17.0 million. The following table sets forth the amounts of savings deposits by
various classifications.




                                       35
<PAGE>




<TABLE>
<CAPTION>
                                                                                      December 31,
                                                    --------------------------------------------------------------------------------
                                                             1996                         1995                         1994
                                                    --------------------------------------------------------------------------------
                                                    Weighted                     Weighted                     Weighted
                                                     Average                      Average                      Average
(Dollars in Thousands)                                 Rate        Amount           Rate        Amount           Rate        Amount
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>      <C>                 <C>      <C>                 <C>      <C>       
Regular passbook ............................          2.90%    $  416,868          2.59%    $  387,986          2.17%    $  370,801
Money market accounts .......................          2.52        100,750          2.30        119,891          2.31        157,157
Checking accounts ...........................          0.74        313,980          0.76        297,014          0.85        282,234
Certificates of deposit:
   Less than 3.00% ..........................          2.65         39,061          2.82         57,786          2.84         33,827
   3.00-3.49 ................................          3.03            723          3.21          1,392          3.29        293,035
   3.50-3.99 ................................          3.99             79          3.75          7,781          3.75        212,154
   4.00-4.49 ................................          4.39         63,577          4.18         99,758          4.23        348,551
   4.50-4.99 ................................          4.87        186,576          4.88        262,065          4.72        335,808
   5.00-5.99 ................................          5.54      2,489,852          5.52      1,863,474          5.38      1,043,588
   6.00-6.99 ................................          6.17        536,307          6.46        596,803          6.30        391,376
   7.00 and greater .........................          7.15         25,329          7.29         96,271          7.46         88,867
------------------------------------------------------------------------------------------------------------------------------------

     Total certificates of deposit ..........          5.56      3,341,504          5.61      2,985,330          4.97      2,747,206
------------------------------------------------------------------------------------------------------------------------------------

     Total deposits .........................          4.86%    $4,173,102          4.81%    $3,790,221          4.23%    $3,557,398
====================================================================================================================================
</TABLE>

     The following table shows as of December 31, 1996,  certificates of deposit
maturities by interest rate categories.

<TABLE>
<CAPTION>
                                 Less
                                 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>   
Within 3 months ...........   $   38,445   $   59,012   $   88,776   $  548,961   $   37,030   $   16,547   $  788,771        23.60%
3 to 6 months .............          402        3,914       65,616      768,760       48,616        4,609      891,917        26.69
6 to 12 months ............          552          318       23,217      857,466      352,655          651    1,234,859        36.95
12 to 24 months ...........          380          189        5,542      274,017       76,137        1,477      357,742        10.71
24 to 36 months ...........           20          144        3,360       20,996       14,226          872       39,618         1.19
36 to 60 months ...........           64         --             65       19,339        7,380        1,173       28,021         0.84
Over 60 months ............         --           --           --            313          263         --            576         0.02
------------------------------------------------------------------------------------------------------------------------------------

                             $   39,863   $   63,577   $  186,576   $2,489,852   $  536,307   $   25,329   $3,341,504 (1)   100.00%
====================================================================================================================================
</TABLE>
(1)  Includes jumbo (over  $100,000)  certificates  of deposit of $195.8 million
     with maturities of 3 months or less, $192.5 million and $302.8 million of 3
     to 6 month and 6 to 12 month maturities,  respectively,  and $100.5 million
     with a remaining term of over 12 months.





                                       36
<PAGE>




BORROWINGS

     At December 31, 1996, borrowings totaled $595.3 million, compared to $436.2
million at  December  31,  1995 and $674.8  million at December  31,  1994.  The
increase in 1996 occurred as asset growth exceeded deposit 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)                                               1996          1995          1994          1993          1992
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>           <C>           <C>           <C>           <C>   
FHLB advances ................................................     $386,883      $220,715      $411,800      $  1,800      $   --
Other borrowings:
    Reverse repurchase agreements ............................         --          16,099        53,946          --            --
    Commercial paper .........................................      198,113       196,602       197,839          --            --
    Industrial revenue bonds .................................         --            --           6,421         6,496         8,572
    Real estate notes ........................................       10,349         2,802         4,770         5,422         5,936
------------------------------------------------------------------------------------------------------------------------------------

    Total borrowings .........................................     $595,345      $436,218      $674,776      $ 13,718      $ 14,508
====================================================================================================================================

Weighted average rate on borrowings during the period ........         5.98%         6.39%         5.57%         6.53%         7.92%
Total borrowings as a percentage of total assets .............        11.45          9.37         14.51          0.40          0.42
====================================================================================================================================
</TABLE>

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

<TABLE>
<CAPTION>
(Dollars in Thousands)                                                                     1996            1995              1994
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>              <C>              <C>     
FHLB advances with original maturities less than one year:
    Balance at end of year ......................................................        $279,000         $153,400         $410,000
    Average balance outstanding during the year .................................         174,380          268,043          156,258
    Maximum amount outstanding at any month-end during the year .................         279,000          472,000          410,000
    Weighted average interest rate at the end of year ...........................            5.70%            6.07%            6.41%
    Weighted average interest rate during the year ..............................            5.78             6.32             5.42
Securities sold under agreement to repurchase:
    Balance at end of year ......................................................        $   --           $ 16,099         $ 53,946
    Average balance outstanding during the year .................................          11,761           36,676           32,441
    Maximum amount outstanding at any month-end during the year .................          70,015           52,547           59,720
    Weighted average interest rate at the end of year ...........................             -- %            5.90%            6.09%
    Weighted average interest rate during the year ..............................            5.19             6.21             5.18
Commercial paper sold:
    Balance at end of year ......................................................        $198,113         $196,602         $197,839
    Average balance outstanding during the year .................................         174,739          191,313           25,177
    Maximum amount outstanding at any month-end during the year .................         198,113          198,341          197,839
    Weighted average interest rate at the end of year ...........................            5.45%            5.56%            6.00%
    Weighted average interest rate during the year ..............................            5.74             6.38             5.90
Total short-term borrowing:
    Total average short-term borrowings outstanding during the year .............        $360,880         $496,032         $213,876
    Total weighted average rate on borrowings during the year ...................            5.74%            6.34%            5.44%
====================================================================================================================================
</TABLE>

ASSET/LIABILITY MANAGEMENT

     Savings  institutions are subject to interest rate risks to the degree that
interest-bearing  liabilities  reprice or mature more  rapidly or on a different
basis than interest-earning assets. 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. To improve the rate



                                       37
<PAGE>




sensitivity and maturity balance of its interest-earning assets and liabilities,
Downey has over the past  several  years  emphasized  origination  of loans with
adjustable interest rates or relatively short maturities.

     Downey's  six-month gap at December 31, 1996, was a positive  16.71% (i.e.,
more interest  earning assets  reprice  within six months than  interest-bearing
liabilities).  This compares to a positive  six-month gap of 13.64% and 9.44% at
December 31, 1995 and 1994, respectively.  Downey's strategy is to emphasize the
origination  of  adjustable  rate  mortgages  or  loans  with  relatively  short
maturities.  During  1996,  1995  and  1994,  Downey  originated  and  purchased
approximately  $1.4  billion,  $563 million and $2.0 billion,  respectively,  of
loans  and   mortgage-backed   securities  with  adjustable  interest  rates  or
maturities of five years or less,  representing  approximately 95%, 96% and 99%,
respectively,  of  all  loans  and  mortgage-backed  securities  originated  and
purchased  for  investment  during  such  periods.  Downey  monitors  asset  and
liability  maturities on a regular basis, and performs  various  simulations and
other analyses as a means of quantifying and controlling  interest rate risk and
determining the potential impact of interest rate changes upon future earnings.

     At December  31,  1996,  97% of Downey's  interest-earning  assets  mature,
reprice or are estimated to prepay within five years, compared to 99% and 98% at
December  31, 1995 and 1994,  respectively.  At December  31,  1996,  loans with
adjustable  interest rates represented 89% of Downey's loan and  mortgage-backed
securities  portfolio.  During 1997,  Downey will continue to offer  residential
fixed rate loan products to its customers to meet  customer  demand.  Fixed rate
loans are 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 has emphasized the  origination of ARMs in order to reduce  interest
rate risk through the  restructuring  of its loan  portfolio to include a higher
percentage of  interest-sensitive  assets.  Interest rates on ARMs are primarily
tied to the CMT and COFI.  During 1996,  1995 and 1994,  ARM  originations  were
primarily  tied to COFI rather than the CMT index.  At December 31,  1996,  $4.5
billion,  or  94%,  of  the  total  loan  portfolio  (including  mortgage-backed
securities)  consisted of adjustable  rate loans,  construction  loans and loans
with a due date of five years or less,  compared  to $4.0  billion,  or 95%,  at
December 31, 1995 and $4.0  billion,  or 94%, at December 31, 1994.  Included in
the  adjustable  rate loan portfolio are $131.4 million of loans earning a fixed
rate of interest for an initial three or five-year  period which then convert to
an adjustable rate.

     The following  table sets forth the repricing  frequency of Downey's  major
asset and  liability  categories  as of December  31,  1996,  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.




                                       38
<PAGE>




<TABLE>
<CAPTION>
                                                                                 December 31, 1996
                                                  ----------------------------------------------------------------------------------
                                                     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 Federal
     Home Loan Bank stock ................  (1)   $    47,485   $    10,298   $    83,560   $      --     $    55,138   $   196,481
   Loans and mortgage-backed securities:
     Mortgage-backed securities ..........  (2)        29,706         4,073        21,912         3,589         1,987        61,267
     Real estate - mortgage:
      Residential:
        ARM ..............................  (2)     3,365,060       532,094        14,886          --            --       3,912,040
        Fixed ............................  (2)        31,647        15,781        84,439        41,836        24,419       198,122
      Commercial .........................  (2)       188,565         7,740        45,568        18,651          --         260,524
      Construction .......................  (2)        31,267          --            --            --            --          31,267
     Consumer ............................  (2)        80,973        30,089       133,768          --            --         244,830
     Commercial ..........................  (2)        21,796          --            --            --            --          21,796
------------------------------------------------------------------------------------------------------------------------------------

   Total loans and mortgage-backed 
     securities ..........................          3,749,014       589,777       300,573        64,076        26,406     4,729,846
------------------------------------------------------------------------------------------------------------------------------------

     Total ...............................        $ 3,796,499   $   600,075   $   384,133   $    64,076   $    81,544   $ 4,926,327
====================================================================================================================================

Deposits and borrowings:
   Interest bearing deposits:
     Fixed maturity deposits .............  (3)   $ 1,680,688   $ 1,234,859   $   425,381    $      576   $      --     $ 3,341,504
     Money market accounts ...............  (4)       100,750         --             --            --            --         100,750
     Checking accounts ...................  (4)       232,969         --             --            --            --         232,969
     Passbook accounts ...................  (4)       416,868         --             --            --            --         416,868
   Non-interest bearing deposits ..........            81,011         --             --            --            --          81,011
------------------------------------------------------------------------------------------------------------------------------------

      Total deposits ......................         2,512,286     1,234,859      425,381            576          --       4,173,102
------------------------------------------------------------------------------------------------------------------------------------

   Borrowings .............................           415,710        94,470       72,016         13,149          --         595,345
------------------------------------------------------------------------------------------------------------------------------------

     Total deposits and borrowings ........        $2,927,996   $ 1,329,329   $  497,397     $   13,725   $      --     $ 4,768,447
====================================================================================================================================

Excess (shortfall) of interest-earning
   assets over interest-bearing liabilities        $  868,503   $  (729,254)    (113,264)    $   50,351   $    81,544   $   157,880

Cumulative gap ............................           868,503       139,249       25,985         76,336       157,880

Cumulative gap - as a % of total assets:
   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
   December 31, 1994 ......................             9.44          5.35         1.29            2.48          3.27
====================================================================================================================================
</TABLE>
(1)  Based upon contractual maturity.
(2)  Based upon contractual maturity, repricing date and projected repayment and
     prepayments of principal.
(3)  Based upon contractual maturity or repricing date.
(4)  Subject to immediate repricing.





                                       39
<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,
                                                               ---------------------------------------------------------
                                                               1996         1995         1994         1993         1992
------------------------------------------------------------------------------------------------------------------------
<S>                                                            <C>          <C>          <C>          <C>          <C>  
Weighted average yield:
   Loan and mortgage-backed securities portfolio ...           7.77%        7.67%        6.24%        6.48%        7.54%
   Investment securities ...........................           6.11         6.29         6.09         4.59         4.45
------------------------------------------------------------------------------------------------------------------------

   Earning assets yield ............................           7.71         7.60         6.24         6.31         7.15
------------------------------------------------------------------------------------------------------------------------

Weighted average cost:
   Savings deposits ................................           4.86         4.81         4.23         3.32         3.79
   Borrowings:
      FHLB advances ................................           5.80         6.07         6.41         6.92          --
      Other borrowings .............................           5.60         5.62         5.88         5.03         6.11
------------------------------------------------------------------------------------------------------------------------

   Combined borrowings .............................           5.73         5.84         6.20         5.28         6.11
------------------------------------------------------------------------------------------------------------------------

   Combined funds ..................................           4.97         4.92         4.55         3.32         3.80
------------------------------------------------------------------------------------------------------------------------

Interest rate spread ...............................           2.74%        2.68%        1.69%        2.99%        3.35%
========================================================================================================================

End of period effective interest spread ............           2.89%        2.87%        1.85%        3.10%        3.40%
========================================================================================================================
</TABLE>

     The year-end  weighted  average  yield on the loan  portfolio  increased to
7.77%, compared to 7.67% as of December 31, 1995. The average yield on new loans
originated during 1996, 1995 and 1994 was 6.06%, 6.99% and 4.94%,  respectively.
At December 31, 1996,  the ARM  portfolio of single  family  residential  loans,
including  mortgage-backed  securities,  totaled  $3.3  billion  with a weighted
average rate of 7.38%,  compared to $3.5 billion and $3.6 billion with  weighted
average rates of 7.51% and 5.82% at December 31, 1995 and 1994, 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  $62.0  million at December 31, 1996,
compared to $97.2 million at December 31, 1995 and $65.6 million at December 31,
1994. The decline in non-performing assets was spread throughout most categories
but  primarily  reflected the return to accrual  status of one large  commercial
real estate loan secured by a Northern California shopping center totaling $28.0
million which had been placed on non-accrual  status during the first quarter of
1995 when the borrower declared bankruptcy.  Downey and the borrower agreed to a
restructure  of the loan which was approved by the  bankruptcy  court in January
1996  and the  borrower  has  since  performed  according  to the  terms  of the
restructure.  The  effective  yield on this loan bears a market rate of interest
and is,  therefore,  not considered a troubled debt  restructure.  Of the total,
real estate  acquired in  settlement  of loans,  net of  allowances  and covered
assets,  represented  $16.1  million at  December  31,  1996,  compared to $18.9
million at December 31, 1995 and $13.6 million at December 31, 1994.




                                       40
<PAGE>



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

<TABLE>
<CAPTION>
                                                                                             December 31,
                                                                    ---------------------------------------------------------------
(Dollars in Thousands)                                               1996          1995          1994          1993          1992
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                 <C>           <C>           <C>           <C>           <C>    
Non-accrual loans:
   One-to-four unit residential ..............................      $22,885       $25,587       $24,012       $30,784       $28,229
   Other .....................................................       22,136        52,754        28,025        25,445        34,524
-----------------------------------------------------------------------------------------------------------------------------------

     Total non-accrual loans .................................       45,021        78,341        52,037        56,229        62,753
Real estate acquired in settlement of loans, net (1) .........       16,078        18,854        13,558        13,364         4,757
Repossessed automobiles ......................................          928          --            --            --            --
-----------------------------------------------------------------------------------------------------------------------------------

Gross non-performing assets ..................................      $62,027       $97,195       $65,595       $69,593       $67,510
===================================================================================================================================

Allowance for loan losses (2):
   Amount ....................................................      $30,094       $27,943       $25,650       $26,835       $28,425
   As a percentage of non-performing loans ...................       66.84%        35.67%        49.29%        47.72%        45.30%
Non-performing assets as a percentage of total assets ........        1.19          2.09          1.41          2.01          1.94
===================================================================================================================================
</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 44.

     All of Downey's non-performing assets at December 31, 1996, 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  1996,  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, 1996,
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, 1996,  non-accrual
loans  aggregating  $3.6 million were less than 90 days  delinquent  relative to
their  contractual  terms.  Additional loans  aggregating $20.9 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 the  collateral  securing the loan.  Impaired  loans exclude large
groups of smaller balance homogeneous loans that are



                                       41
<PAGE>




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, 1996, the recorded
investment  in loans for which  impairment  has been  recognized  totaled  $46.7
million,  compared to $45.4  million at December  31, 1995 (all of which were on
non-accrual  status).  The total  allowance for losses related to such loans was
$4.4 million at December 31,  1996,  and $5.3 million at December 31, 1995.  For
further  information  regarding  impaired loans,  see Note 6 of the Notes to the
Consolidated Financial Statements on page 66.

     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, 1996 and 1995.

     Real  Estate  Acquired in  Settlement  of Loans.  Real  estate  acquired in
settlement of loans consists of real estate acquired through foreclosure or deed
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 either 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,  1996,  $5.8  million of  Downey's  loans were
delinquent  60-89 days and $19.6 million were delinquent 90 or more days.  These
amounts are down from $7.3  million and $60.8  million at December  31, 1995 and
$9.5 million and $23.1  million at December 31, 1994.  The decrease in the 90 or
more days category  during 1996 is primarily  attributable to the restructure of
one large commercial real estate loan with a carrying value of $28.0 million.




                                       42
<PAGE>



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

<TABLE>
<CAPTION>
                                                                              December 31,
                                               -------------------------------------------------------------------------------------
                                                                 1996                                       1995
                                               ----------------------------------------    -----------------------------------------
                                               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 .......................    $14,717    $ 5,502    $18,549    $38,768    $14,047    $ 6,645    $22,303    $42,995
   Five or more units ......................       --         --         --         --           89       --          447        536
Commercial .................................       --         --         --         --         --         --       30,675     30,675
Construction ...............................       --         --         --         --         --         --         --         --
Land .......................................       --         --          566        566       --         --        6,516      6,516
------------------------------------------------------------------------------------------------------------------------------------
   Total real estate loans .................     14,717      5,502     19,115     39,334     14,136      6,645     59,941     80,722
Non-mortgage:
   Commercial ..............................       --         --         --         --         --         --          115        115
   Consumer:
     Automobile ............................      2,080        328        274      2,682        667        249        540      1,456
     Other consumer ........................        158         15        181        354        257        410        170        837
------------------------------------------------------------------------------------------------------------------------------------
     Total loans ...........................    $16,955    $ 5,845    $19,570    $42,370    $15,060    $ 7,304    $60,766    $83,130
====================================================================================================================================
   Delinquencies as a percentage of total
     loans .................................      0.36%      0.12%      0.41%      0.90%      0.36%      0.18%      1.46%      1.99%
====================================================================================================================================

<CAPTION>
                                                                  1994                                        1993
                                               -----------------------------------------    ----------------------------------------
<S>                                             <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>    
Loans secured by real estate:
Residential:
   One-to-four units .......................    $15,306    $ 9,273    $20,584    $45,163    $15,058    $ 5,565    $29,160    $49,783
   Five or more units ......................       --         --          149        149         58        205        183        446
Commercial .................................       --         --        1,139      1,139       --         --       20,882     20,882
Construction ...............................       --         --         --         --         --         --         --         --
Land .......................................       --         --          836        836       --         --         --         --
------------------------------------------------------------------------------------------------------------------------------------
   Total real estate loans .................     15,306      9,273     22,708     47,287     15,116      5,770     50,225     71,111
Non-mortgage:
   Commercial ..............................       --         --         --         --         --         --         --         --
   Consumer:
     Automobile ............................         22         12         24         58         39          7        131        177
     Other consumer ........................        291        171        334        796        635        249        479      1,363
------------------------------------------------------------------------------------------------------------------------------------
     Total loans ...........................    $15,619    $ 9,456    $23,066    $48,141    $15,790    $ 6,026    $50,835    $72,651
====================================================================================================================================
   Delinquencies as a percentage of total
     loans .................................      0.37%      0.23%      0.55%      1.15%      0.54%      0.21%      1.74%      2.49%
====================================================================================================================================

<CAPTION>
                                                               1992                    
                                               -----------------------------------------
<S>                                             <C>        <C>        <C>        <C>    
Loans secured by real estate:
Residential:
   One-to-four units .......................    $15,245    $ 6,280    $24,816    $46,341
   Five or more units ......................        457       --        1,417      1,874
Commercial .................................       --         --       22,900     22,900
Construction ...............................       --         --        4,104      4,104
Land .......................................       --         --         --         --
----------------------------------------------------------------------------------------
   Total real estate loans .................     15,702      6,280     53,237     75,219
Non-mortgage:
   Commercial ..............................       --         --         --         --
   Consumer:
     Automobile ............................         62         42         55        159
     Other consumer ........................        247         18        219        484
----------------------------------------------------------------------------------------
     Total loans ...........................    $16,011    $ 6,340    $53,511    $75,862
========================================================================================
   Delinquencies as a percentage of total
     loans .................................      0.58%      0.23%      1.93%      2.74%
========================================================================================
</TABLE>
(1)  All 90 day or greater  delinquencies are on non-accrual status and reported
     as part of non-performing assets.





                                       43
<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 57.

     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,  Senior Internal Asset Review Officer,  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



                                       44
<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
single family residential assets in excess of $750,000 and all non-single family
residential assets in excess of $500,000,  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 $9.1 million in 1996, down $0.2
million from 1995. The provision for loan losses  exceeded net loan  charge-offs
by $2.2  million  resulting in an increase in the  allowance  for loan losses to
$30.1 million at December 31, 1996. This increase reflected the growth in single
family  residential  and  automobile  loans.  Included in the  current  year-end
allowance of $30.1 million was $29.2 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)                              1996             1995             1994            1993             1992
----------------------------------------------------------------------------------------------------------------------
<S>                                      <C>              <C>              <C>              <C>              <C>     
Balance at beginning of period ....      $ 27,943         $ 25,650         $ 26,835         $ 28,425         $ 22,889
Provision .........................         9,137            9,293            4,211            1,085            8,729
Charge-offs .......................        (7,660)          (8,017)          (5,511)          (2,675)          (4,478)
Recoveries ........................           674            1,017              115               22              159
Transfers .........................          --               --               --                (22)           1,126
----------------------------------------------------------------------------------------------------------------------

Balance at end of period ..........      $ 30,094         $ 27,943         $ 25,650         $ 26,835         $ 28,425
======================================================================================================================
</TABLE>

     Net loan  charge-offs  were $7.0  million in 1996,  the same as 1995 but up
from $5.4 million in 1994. Net charge-offs related to automobile loans increased
$1.4 million as a result of the increased level of that portfolio. That increase
was offset by declines in most other loan  categories,  particularly  commercial
real estate. Charge-offs,  net of recoveries, by category of loan are as follows
for the years indicated.

<TABLE>
<CAPTION>
(Dollars in Thousands)                                                    1996         1995         1994         1993        1992
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>          <C>          <C>          <C>         <C>     
Loans secured by real estate:
    One-to-four unit residential (1) ...............................    $ 4,982      $ 5,165      $ 4,051      $ 1,431     $  (115)
    Five or more unit residential ..................................        102          469          264          320         978
    Commercial .....................................................       (250)         807          959          617       3,254
    Land ...........................................................       --              4         --           --          --
Non-mortgage:
    Commercial .....................................................        115         (152)         (52)        --          --
    Consumer and other:
      Automobile ...................................................      1,791          398            9           51          39
      Other Consumer ...............................................        246          309          165          234         163
-----------------------------------------------------------------------------------------------------------------------------------
      Total net loan charge-offs ...................................    $ 6,986      $ 7,000      $ 5,396      $ 2,653     $ 4,319
===================================================================================================================================
Net loan charge-offs as a percentage of average loans and
    mortgage-backed securities held to maturity ....................       0.16%        0.17%        0.16%        0.09%       0.16%
===================================================================================================================================
</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.





                                       45
<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, 1996               December 31, 1995                 December 31, 1994
                               -------------------------------- -------------------------------- -----------------------------------
                                             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 .....    $13,241    $4,046,448    0.33%    $12,254   $3,656,512    0.34%    $12,404 (1)    $3,688,280    0.34%
    Five or more units ....        517        56,907    0.91         895       57,321    1.56         978            63,782    1.53
   Commercial .............      6,956       260,609    2.67       8,443      269,234    3.14       6,800           293,036    2.32
   Construction ...........        773        66,651    1.16         335       28,593    1.17         131            11,367    1.15
   Land ...................        466        21,177    2.20         986       23,216    4.25         876            11,204    7.82
Commercial non-mortgage:
    Secured ...............         96         9,610    1.00           3          250    1.00           2               225    1.00
    Unsecured .............        140        12,526    1.12         256       12,614    2.03         470            12,750    3.69
Consumer and other
    Automobile ............      4,303       202,186    2.13         849       56,127    1.51          42             3,028    1.39
    Other consumer ........        802        47,281    1.70       1,122       50,945    2.20       1,094            53,241    2.05
Other .....................       --            --       --         --           --       --           53            39,143    0.14
Not specifically allocated       2,800          --       --        2,800         --       --        2,800 (1)          --       -- 
------------------------------------------------------------------------------------------------------------------------------------
    Total loans held for
      investment and 
      mortgage-backed
      securities held to
      maturity ............    $30,094    $4,723,395    0.64%    $27,943   $4,154,812    0.67%    $25,650        $4,176,056    0.61%
====================================================================================================================================

<CAPTION>
                                      December 31, 1993                December 31, 1992
                               -------------------------------- --------------------------------
<S>                            <C>        <C>           <C>      <C>       <C>           <C>  
Loans secured by real estate:
   Residential:
    One-to-four units .....    $ 7,598    $2,376,586    0.32%    $ 6,093   $2,265,132    0.27%
    Five or more units ....      1,052        73,505    1.43         941       70,086    1.34
   Commercial .............     10,537       339,602    3.10      10,685      262,890    4.06
   Construction ...........        372        37,180    1.00       3,716       82,186    4.52
   Land ...................        622        13,251    4.69         864       17,294    5.00
Commercial non-mortgage:
    Secured ...............        180           253   71.15         330        1,395   23.66
    Unsecured .............        159         7,976    1.99          30       19,397    0.15
Consumer and other
    Automobile ............         53         3,274    1.62          92        4,577    2.01
    Other consumer ........      1,362        48,580    2.80         774       42,915    1.80
Other .....................       --          51,060     --         --         49,339     -- 
Not specifically allocated       4,900          --       --        4,900         --       -- 
------------------------------------------------------------------------------------------------
    Total loans held for
      investment and 
      mortgage-backed
      securities held to
      maturity ............    $26,835    $2,951,267    0.91%    $28,425   $2,815,211    1.01%
================================================================================================
</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  the year,  $1.2
     million  in loss  provision  was  recorded  to  further  increase  the loss
     allowance associated with the Northridge earthquake.





                                       46
<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 $3.3 million and $2.9 million provision  reductions in
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 1996 amounted to $1.0 million related to
the sale of one Arizona property held for development.

<TABLE>
<CAPTION>
(In Thousands)                                  1996            1995             1994             1993             1992
--------------------------------------------------------------------------------------------------------------------------
<S>                                          <C>              <C>              <C>              <C>              <C>     
Balance at beginning of period ......        $ 34,338         $ 37,198         $ 38,674         $ 34,921         $ 33,811
Provision (reduction) ...............          (3,306)          (2,916)          (1,400)           4,128            6,772
Charge-offs .........................          (1,035)            --                (76)            (355)          (4,567)
Recoveries ..........................              74               56             --               --                 31
Transfers ...........................            --               --               --                (20)          (1,126)
--------------------------------------------------------------------------------------------------------------------------

Balance at end of period ............        $ 30,071         $ 34,338         $ 37,198         $ 38,674         $ 34,921
==========================================================================================================================
</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)                                 1996            1995            1994            1993            1992
---------------------------------------------------------------------------------------------------------------------
<S>                                          <C>             <C>             <C>             <C>             <C>    
Balance at beginning of period ......        $ 1,217         $   743         $   747         $   255         $   335
Provision (reduction) ...............          1,658           2,498           2,035           1,360             (16)
Charge-offs .........................         (1,797)         (2,024)         (2,039)           (890)            (64)
Recoveries ..........................           --              --              --              --              --
Transfers ...........................           --              --              --                22            --
---------------------------------------------------------------------------------------------------------------------

Balance at end of period ............        $ 1,078         $ 1,217         $   743         $   747         $   255
=====================================================================================================================
</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 $832.7 million
for 1996,  compared to $538.2 million in 1995.  These  repayments were more than
offset by new loan  originations and purchases for portfolio of $1.4 billion and
$588.2 million, respectively.

     During 1996,  Downey  experienced a net deposit  inflow of $382.9  million,
primarily in certificates of deposit and regular passbooks. Aggregate borrowings
increased $175.2 million to meet loan funding demands.

     Downey  expects  to meet its 1997  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, 1996, Downey had
commitments to fund loans amounting to $144.1  million,  undrawn lines of credit
of $72.6  million and loans in process of $40.5  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  is 5%. At December  31,  1996,  the Bank's  ratio was 5.26%
compared to 5.03% and 5.69% at December 31, 1995 and 1994, respectively.





                                       47
<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,  1996.  The core and tangible
capital  ratios were 6.56% and the  risk-based  capital ratio was 12.66%.  These
levels are down from  comparable  ratios of 6.86% and 13.56%,  respectively,  at
December 31, 1995, but continue to exceed the "well capitalized" standards of 5%
for core and tangible and 10% for risk-based,  as defined by regulation.  During
1996, the amount of the Bank's non-includable investment in real estate required
to be deducted from regulatory  capital declined by $8.9 million  primarily as a
result of DSL Service  Company having  obtained  third party  financing to repay
Bank advances.


<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 ................................   $ 382,932             $ 382,932             $ 382,932
Adjustments:
  Deductions:
     Investment in subsidiary, primarily real estate      (43,657)              (43,657)              (43,657)
     Non-supervisory goodwill .......................      (5,583)               (5,583)               (5,583)
     Core deposit premium ...........................        (513)                 (513)                 (513)
     Non-permitted mortgage servicing rights ........        (117)                 (117)                 (117)
  Additions:
     Unrealized loss on securities available for sale       1,559                 1,559                 1,559
     General loss allowance - Investment in DSL .....       2,300                 2,300                 2,300
     Loan and lease general valuation allowances (1)         --                    --                  29,158
---------------------------------------------------------------------------------------------------------------------------

Regulatory capital ..................................     336,921    6.56%      336,921    6.56%      366,079    12.66%
Well capitalized requirement ........................      76,988    1.50 (2)   256,627    5.00       289,220    10.00  (3)
---------------------------------------------------------------------------------------------------------------------------

Excess ..............................................   $ 259,933    5.06%    $  80,294    1.56%    $  76,859     2.66%
===========================================================================================================================
</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 11.65%.

     As mentioned in "Investments in Real Estate and Joint Ventures" on page 33,
DSL Service Company completed an all cash sale of four shopping centers from one
joint  partnership  relationship  pursuant to an  agreement  between DSL Service
Company  and its joint  venture  partner.  This  transaction  produced  net cash
proceeds  of  approximately  $11  million  which  were used to reduce the Bank's
investment  in DSL Service  Company,  thereby  improving  the Bank's  regulatory
capital position to support future growth.  If that reduction had occurred as of
year-end 1996,  the Bank's  tangible and core capital ratio would have increased
to 6.77% from 6.56% and the  risk-based  capital  ratio would have  increased to
12.99% from 12.66%.

CURRENT ACCOUNTING ISSUES

     In June 1996, the Financial  Accounting Standards Board issued Statement of
Financial  Accounting Standards No. 125, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities" ("SFAS 125").

     SFAS 125 provides  accounting  and  reporting  standards  for transfers and
servicing  of  financial  assets  and  extinguishments  of  liabilities.   Those
standards are based on consistent application of a financial-components approach
that  focuses on control.  Under that  approach,  after a transfer of  financial
assets,  an entity recognizes the financial and servicing assets it controls and
the liabilities it has incurred,  derecognizes financial assets when control has
been  surrendered,  and  derecognizes  liabilities when  extinguished.  SFAS 125
provides consistent  standards for distinguishing  transfers of financial assets
that are sales from transfers that are secured borrowings.

     SFAS 125 requires that liabilities and derivatives  incurred or obtained by
transferors as part of a transfer of financial  assets be initially  measured at
fair value,  if  practicable.  It also requires that servicing  assets and other
retained  interests  in the  transferred  assets be measured by  allocating  the
previous  carrying  amount  between  the  assets  sold,  if  any,  and  retained
interests,  if any,  based  on their  relative  fair  values  at the date of the
transfer.





                                       48
<PAGE>




     SFAS 125 included  specific  provisions  to deal with  servicing  assets or
liabilities.  These provisions retain the impairment and amortization approaches
that are contained in SFAS 122 but eliminates the distinction between normal and
excess servicing.

     SFAS 125 will be effective for  transactions  occurring  after December 31,
1996. It is not  anticipated  that the financial  impact of this  statement will
have a material effect on Downey.

SUBSEQUENT EVENT

     In January  1997,  DSL Service  Company  completed an all cash sale of four
California shopping centers from one joint partnership  relationship pursuant to
an agreement  between DSL Service  Company and its joint  venture  partner.  The
aggregate  assets  involved  totaled  $41.7  million of which $30.8  million was
financed  by  secured  notes  from the  Bank.  The sale  will  result  in Downey
recognizing  an after-tax  gain of  approximately  $2.5 million in first quarter
1997  results.  In addition,  this  transaction  produced  net cash  proceeds of
approximately $11 million which were used to reduce the Bank's investment in DSL
Service Company,  thereby  improving the Bank's  regulatory  capital position to
support  future  growth.  For  further  information   regarding  the  pro  forma
regulatory impact of this event see "Regulatory Capital Compliance" on page 48.





                                       49
<PAGE>




ITEM 8.       FINANCIAL STATEMENTS

                   Index to Consolidated Financial Statements

<TABLE>
<CAPTION>
                                                                          Page

    <S>                                                                    <C>
    Independent Auditors' Report.......................................... 51
    Consolidated Balance Sheets........................................... 52
    Consolidated Statements of Income..................................... 53
    Consolidated Statements of Stockholders' Equity....................... 54
    Consolidated Statements of Cash Flows................................. 55
    Notes to Consolidated Financial Statements............................ 57
</TABLE>




                                       50
<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, 1996 and 1995,  and the
related consolidated  statements of income,  stockholders' equity and cash flows
for each of the years in the three-year  period ended  December 31, 1996.  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, 1996 and 1995,  and the results of
their  operations  and their cash flows for each of the years in the  three-year
period ended December 31, 1996, in conformity with generally accepted accounting
principles.



/s/ KPMG Peat Marwick LLP

Los Angeles, California
January 16, 1997




                                       51
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES
                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                                               December 31,
                                                                                                       -----------------------------
(Dollars in Thousands, Except Per Share Data)                                                               1996             1995
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                                    <C>               <C>
ASSETS
Cash ............................................................................................      $    67,221       $    58,581
Federal funds ...................................................................................            6,038             7,249
------------------------------------------------------------------------------------------------------------------------------------
    Cash and cash equivalents ...................................................................           73,259            65,830
U.S. Treasury and agency obligations and other investment securities available for
    sale, at fair value .........................................................................          141,999           164,880
Municipal securities being held to maturity, at amortized cost (estimated market value
    of $6,975 at December 31, 1996 and $7,170 December 31, 1995) ................................            6,997             7,194
Loans held for sale, at the lower of cost or market .............................................           12,865            13,059
Mortgage-backed securities available for sale, at fair value ....................................           61,267            52,076
Loans receivable held for investment ............................................................        4,655,714         4,104,339
Investments in real estate and joint ventures ...................................................           46,498            42,320
Real estate acquired in settlement of loans .....................................................           16,078            18,854
Premises and equipment ..........................................................................           96,643            92,977
Federal Home Loan Bank stock, at cost ...........................................................           41,447            39,146
Other assets ....................................................................................           45,390            55,592
------------------------------------------------------------------------------------------------------------------------------------
                                                                                                       $ 5,198,157       $ 4,656,267
====================================================================================================================================

LIABILITIES AND STOCKHOLDERS' EQUITY
Savings deposits ................................................................................      $ 3,859,122       $ 3,493,207
Checking deposits ...............................................................................          313,980           297,014
------------------------------------------------------------------------------------------------------------------------------------
    Total deposits ..............................................................................        4,173,102         3,790,221
Mortgage-backed securities sold under agreements to repurchase ..................................             --              16,099
Federal Home Loan Bank advances .................................................................          386,883           220,715
Commercial paper ................................................................................          198,113           196,602
Other borrowings ................................................................................           10,349             2,802
Accounts payable and accrued liabilities ........................................................           28,357            37,032
Deferred income taxes ...........................................................................            9,782             8,724
------------------------------------------------------------------------------------------------------------------------------------
    Total liabilities ...........................................................................        4,806,586         4,272,195
------------------------------------------------------------------------------------------------------------------------------------

STOCKHOLDERS' EQUITY:
Common stock, par value of $0.01 per share; authorized 50,000,000 shares; outstanding
    25,459,079 shares in 1996 and 16,972,905 shares in 1995 .....................................              255               170
Additional paid-in capital ......................................................................           22,607            22,696
Unrealized gains (losses) on securities available for sale ......................................           (1,559)            3,495
Retained earnings ...............................................................................          370,268           357,711
------------------------------------------------------------------------------------------------------------------------------------
    Total stockholders' equity ..................................................................          391,571           384,072
------------------------------------------------------------------------------------------------------------------------------------

                                                                                                       $ 5,198,157       $ 4,656,267
====================================================================================================================================
</TABLE>


See accompanying notes to consolidated financial statements.




                                       52
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                        Consolidated Statements of Income

<TABLE>
<CAPTION>
                                                                                                 Years Ended December 31,
                                                                                    ------------------------------------------------
(Dollars in Thousands, Except Per Share Data)                                             1996            1995              1994
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>              <C>               <C>         
INTEREST INCOME:
   Loans receivable ...........................................................     $    329,746     $    300,098      $    212,503
   U.S. Treasury and agency securities ........................................            7,765           11,122             7,347
   Mortgage-backed securities .................................................            4,317            4,311             4,768
   Other investments ..........................................................            4,532            2,661             3,804
   Yield maintenance on covered assets, net ...................................             --                636               548
------------------------------------------------------------------------------------------------------------------------------------
       Total interest income ..................................................          346,360          318,828           228,970
------------------------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE:
   Deposits ...................................................................          184,402          180,859           109,995
   Borrowings .................................................................           27,363           33,379            12,606
------------------------------------------------------------------------------------------------------------------------------------
       Total interest expense .................................................          211,765          214,238           122,601
------------------------------------------------------------------------------------------------------------------------------------
   NET INTEREST INCOME ........................................................          134,595          104,590           106,369
   PROVISION FOR LOAN LOSSES ..................................................            9,137            9,293             4,211
------------------------------------------------------------------------------------------------------------------------------------
       Net interest income after provision for loan losses ....................          125,458           95,297           102,158
------------------------------------------------------------------------------------------------------------------------------------
OTHER INCOME, NET:
   Loan and deposit related fees ..............................................            7,435            5,546             5,310
   Real estate and joint ventures held for investment, net:
     Net gains on sales of wholly owned real estate ...........................              392            4,539               532
     Reduction of loss on real estate and joint ventures ......................            3,306            2,916             1,400
     Operations, net ..........................................................            4,543            3,737             7,598
   Secondary marketing activities:
     Loan servicing fees ......................................................            1,415            1,460             1,462
     Net gains on sales of loans and mortgage-backed securities ...............            1,543              266               114
   Net gains (losses) on sales of investment securities .......................            4,473              (15)             --
   (Provision for) reduction of loss on investment in lease residual ..........             --                207              (920)
   Other ......................................................................            2,092            1,943             2,241
------------------------------------------------------------------------------------------------------------------------------------
       Total other income, net ................................................           25,199           20,599            17,737
------------------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSE:
   Salaries and related costs .................................................           45,811           39,349            40,971
   Premises and equipment costs ...............................................           12,640           11,535            11,774
   SAIF insurance premiums and regulatory assessments .........................            8,949            9,024             7,565
   Professional fees ..........................................................            2,985            3,150             3,512
   Other general and administrative expense ...................................           16,075           11,412            11,744
------------------------------------------------------------------------------------------------------------------------------------
     Total general and administrative expense .................................           86,460           74,470            75,566
------------------------------------------------------------------------------------------------------------------------------------
   SAIF special assessment ....................................................           24,644             --                --
   Net operation of real estate acquired in settlement of loans ...............            2,567            4,206             3,595
   Amortization of excess of cost over fair value of net assets acquired ......              532              530               532
------------------------------------------------------------------------------------------------------------------------------------
       Total operating expense ................................................          114,203           79,206            79,693
------------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES ....................................................           36,454           36,690            40,202
Income taxes ..................................................................           15,750           15,597            16,670
------------------------------------------------------------------------------------------------------------------------------------
   NET INCOME .................................................................     $     20,704     $     21,093      $     23,532
====================================================================================================================================
PER SHARE INFORMATION:
NET INCOME ....................................................................     $       0.81     $       0.83      $       0.92
====================================================================================================================================
CASH DIVIDENDS PAID ...........................................................     $      0.320     $      0.305      $      0.305
====================================================================================================================================
Weighted average shares outstanding ...........................................       25,491,202       25,459,079        25,459,079
====================================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.




                                       53
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                 Consolidated Statements of Stockholders' Equity

              For the years ended December 31, 1996, 1995 and 1994

<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, 1993 .............................    $     162    $   3,720        $    --        $ 347,588     $ 351,470
Cash dividends, $0.305 per share ..........................         --           --               --           (7,759)       (7,759)
Unrealized loss on securities available for sale ..........         --           --             (1,056)          --          (1,056)
Net income ................................................         --           --               --           23,532        23,532
------------------------------------------------------------------------------------------------------------------------------------

Balances at December 31, 1994 .............................          162        3,720           (1,056)       363,361       366,187
Cash dividends, $0.305 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, $0.320 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
====================================================================================================================================
</TABLE>




















See accompanying notes to consolidated financial statements.




                                       54
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                      Consolidated Statements of Cash Flows


<TABLE>
<CAPTION>
                                                                                                   Years Ended December 31,
                                                                                          ------------------------------------------
(In Thousands)                                                                                1996           1995           1994
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                       <C>            <C>            <C>        
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income .........................................................................   $    20,704    $    21,093    $    23,532
   Adjustments  to  reconcile  net  income  to net cash  provided  by  operating
   activities:
    Depreciation and amortization .....................................................         8,279          7,390          7,068
    Provision for losses on loans, leases, real estate acquired in settlement
      of loans and investments in real estate and joint ventures ......................         7,533          8,693          5,765
    Net gains on sales of loans and mortgage-backed securities, investment
      securities, real estate and other assets ........................................        (6,827)        (4,799)        (2,517)
    Interest capitalized on loans (negative amortization) .............................        (9,388)        (2,600)        (2,728)
    Federal Home Loan Bank dividends ..................................................        (2,301)        (1,808)        (1,175)
   Net change in loans receivable - held for sale .....................................       (23,232)       (12,395)        13,479
   Other, net .........................................................................         2,477        (11,772)        18,632
------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities ..................................        (2,755)         3,802         62,056
------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Net proceeds from reduction of securities purchased under resale agreements ........          --             --          110,000
   Proceeds from:
    Maturities of U.S. Treasury and agency obligations ................................          --           30,000         14,000
    Sales of investment securities -  available for sale ..............................       189,541           --             --
    Sales of mortgage-backed securities -  available for sale .........................        31,385         21,372           --
    Sales of wholly owned real estate and real estate acquired in settlement of .......        10,337         45,393         27,645
    loans
   Purchase of:
    U.S. Treasury and agency obligations and other investment securities ..............      (170,455)       (42,089)       (65,000)
    Mortgage-backed securities -  available for sale ..................................       (30,073)          --          (51,138)
    Loans receivable -  held for investment ...........................................          (223)       (44,194)      (145,117)
   Loans receivable originated - held for investment (net of refinances of
    $90,824, $50,039, and $91,839 during 1996, 1995 and 1994, respectively) ...........    (1,309,663)      (493,955)    (1,685,836)
   Principal payments on loans receivable held for investment and mortgage-backed
    securities -  held to maturity and available for sale .............................       757,550        501,367        559,328
   Net change in undisbursed loan funds ...............................................        12,147         11,605          2,081
   Investments in real estate held for investment .....................................        (6,454)        (1,377)        (1,233)
   Other, net .........................................................................        (7,769)       (13,451)        (6,427)
------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) investing activities ..................................      (523,677)        14,671     (1,241,697)
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>



















See accompanying notes to consolidated financial statements.




                                       55
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                Consolidated Statements of Cash Flows (Continued)

<TABLE>
<CAPTION>
                                                                                                    Years Ended December 31,
                                                                                          ------------------------------------------
(In Thousands)                                                                                1996            1995          1994
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                       <C>            <C>            <C>        
CASH FLOWS FROM FINANCING ACTIVITIES:
   Deposits acquired from another financial institution ...............................   $      --      $      --      $     9,036
   Net increase in deposits ...........................................................       382,881        232,823        479,433
   Net decrease in securities sold under agreements to repurchase .....................       (16,099)          --             --
   Proceeds from Federal Home Loan Bank advances ......................................     1,018,700        844,800      6,066,600
   Repayments of Federal Home Loan Bank advances ......................................      (852,532)    (1,035,885)    (5,656,600)
   Net increase (decrease) in other borrowings ........................................         9,058        (47,473)       251,058
   Cash dividends .....................................................................        (8,147)        (7,759)        (7,759)
------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities ..................................       533,861        (13,494)     1,141,768
------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents ..................................         7,429          4,979        (37,873)
Cash and cash equivalents at beginning of year ........................................        65,830         60,851         98,724
------------------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ............................................   $    73,259    $    65,830    $    60,851
====================================================================================================================================
Supplemental  disclosure of cash flow  information:
  Cash paid during the period for:
    Interest ..........................................................................   $   212,482    $   215,696    $   118,402
    Income taxes ......................................................................        19,753         13,965          5,706
Supplemental disclosure of non-cash investing:
   U.S Treasury and agency obligations transferred from held to maturity to
    available for sale ................................................................          --          164,880           --
   Loans exchanged for mortgage-backed securities .....................................        26,452           --             --
   Mortgage-backed securities transferred from held to maturity to available for ......          --           33,555           --
   sale
   Real estate acquired in settlement of loans ........................................        27,367         36,991         38,879
   Loans to facilitate the sale of real estate acquired in settlement of loans ........        23,356         13,777         13,867
====================================================================================================================================
</TABLE>
























See accompanying notes to consolidated financial statements.




                                       56
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

                        December 31, 1996, 1995 and 1994


(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 or held for  trading
     mortgage-backed  securities portfolios,  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 AND  MORTGAGE-
       BACKED SECURITIES

     Downey has established  written guidelines and objectives for its investing
     activities. At the time of purchase



                                       57
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements


     of a  mortgage-backed  security  purchased  under  resale  agreement,  U.S.
     Treasury   and  agency   obligation,   other   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, 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 RECEIVABLE

     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



                                       58
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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
     its one-to-four family residential assets under $750,000 and all non-single
     family residential assets under $500,000 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 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.

     Statement  of  Financial  Accounting  Standards  No.  114,  "Accounting  by
     Creditors  for  Impairment  of a  Loan",  as  amended  in  October  1994 by
     Statement  of  Financial  Accounting  Standards  No.  118,  "Accounting  by
     Creditors for Impairment of a Loan - Income  Recognition and  Disclosures,"
     was adopted  January 1, 1995.  These  standards  require  that the value of
     impaired loans be established by discounting the expected future cash flows
     at the loan's effective  interest rate, or by the current observable market
     price or the fair value of its  collateral.  Downey  considers a loan to be
     impaired when,  based upon current  information and events,  Downey will be
     unable to collect all amounts due according to the contractual terms of the
     loan  agreement.  Many  factors  are  considered  in the  determination  of
     impairment. The measurement of collateral dependent impaired loans is based
     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



                                       59
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     income  when  the  related  mortgage  loan  payments  are  collected.  Loan
     servicing costs are charged to expense as incurred.

     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,
     1996,  Statement of Financial Accounting Standards No. 122, "Accounting for
     Mortgage  Servicing  Rights, an Amendment to FASB No. 65," ("SFAS 122"). In
     accordance  with SFAS 122, 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 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.

     REAL ESTATE

     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.

     REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS

     Real estate  acquired  through  foreclosure  is initially  recorded at fair
     value (net of an allowance for estimated



                                       60
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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  adopted  the  provisions  of  Statement  of  Financial   Accounting
     Standards No. 121,  "Accounting for the Impairment of Long-Lived Assets and
     for  Long-Lived  Assets  to Be  Disposed  Of," on  January  1,  1996.  This
     Statement   requires  that  long-lived  assets  and  certain   identifiable
     intangibles  be  reviewed  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. Adoption of this Statement did not
     have  a  material  impact  on  Downey's  financial  position,   results  of
     operations, or liquidity.

     MORTGAGE-BACKED SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

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



                                       61
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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 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

     Income per share is based on net income  divided  by the  weighted  average
     number of outstanding  shares and stock options,  deemed to be common stock
     equivalents,  to the extent they are  dilutive.  Prior  period  outstanding
     shares and stock options have been  adjusted for stock  dividends and stock
     splits.

     CURRENT ACCOUNTING PRONOUNCEMENTS

     In June 1996, the Financial  Accounting Standards Board issued Statement of
     Accounting  Standards No. 125,  "Accounting  for Transfers and Servicing of
     Financial Assets and Extinguishments of Liabilities" ("SFAS 125").

     SFAS 125 provides  accounting  and  reporting  standards  for transfers and
     servicing of financial  assets and  extinguishments  of liabilities.  Those
     standards are based on  consistent  application  of a  financial-components
     approach that focuses on control. Under that approach,  after a transfer of
     financial  assets,  an entity recognizes the financial and servicing assets
     it controls and the  liabilities  it has incurred,  derecognizes  financial
     assets when control has been surrendered, and derecognizes liabilities when
     extinguished.  SFAS 125 provides  consistent  standards for  distinguishing
     transfers  of  financial  assets  that are sales  from  transfers  that are
     secured borrowings.

     SFAS 125 requires that liabilities and derivatives  incurred or obtained by
     transferors as part of a transfer of financial assets be initially measured
     at fair value, if practicable.  It also requires that servicing  assets and
     other  retained   interests  in  the  transferred  assets  be  measured  by
     allocating  the previous  carrying  amount between the assets sold, if any,
     and retained interests,  if any, based on their relative fair values at the
     date of the transfer.

     SFAS 125 included  specific  provisions  to deal with  servicing  assets or
     liabilities.  These  provisions  retain  the  impairment  and  amortization
     approaches  that are contained in SFAS 122 but eliminates  the  distinction
     between normal and excess servicing.

     SFAS 125 will be effective for  transactions  occurring  after December 31,
     1996. It is  anticipated  that the financial  impact of this statement will
     not have a material effect on Downey.

(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 to be received are nontaxable under the Internal
     Revenue Code.



                                     


                                       62
<PAGE>


                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     During 1995 and 1994,  the  estimated  losses on covered  assets which were
     covered by the Butterfield  Assistance  Agreement totaled $12.9 million and
     $4.2 million, respectively. The yield maintenance on covered assets totaled
     $0.6  million  and $0.5  million  for 1995 and 1994,  respectively,  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.

     Now that all assets subject to the  Butterfield  Assistance  Agreement have
     been sold or repurchased by the FDIC, Downey and the FDIC are negotiating a
     termination of the Butterfield  Assistance  Agreement.  Such termination is
     anticipated during the first quarter of 1997.

(3)  U.S. TREASURY AND AGENCY OBLIGATIONS AVAILABLE FOR SALE

     On  December  29,  1995,  the Bank  transferred  U.S.  Treasury  and agency
     obligations  with an  amortized  cost of  $159.7  million  from the held to
     maturity portfolio to the available for sale portfolio.

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

<TABLE>
<CAPTION>
                                               Gross       Gross      Estimated
                                  Amortized  Unrealized  Unrealized     Market
     (In Thousands)                 Cost       Gains       Losses       Value
     --------------------------------------------------------------------------
     <S>                          <C>         <C>         <C>          <C>     
     December 31, 1996 ........   $145,025    $    317    $  3,343     $141,999
     ==========================================================================
     December 31, 1995 ........   $159,690    $  5,294    $    104     $164,880
     ==========================================================================
</TABLE>

     The amortized cost and estimated  market value of U.S.  Treasury and agency
     obligations  available  for  sale at  December  31,  1996,  by  contractual
     maturity, are shown below.

<TABLE>
<CAPTION>
                                                           Amortized     Market
     (In Thousands)                                           Cost        Value
     ---------------------------------------------------------------------------
     <S>                                                    <C>         <C>     
     Due in one year or less ...........................    $  9,998    $  9,997
     Due after one year through five years (1) .........     135,027     132,002
     ---------------------------------------------------------------------------
       Total ...........................................    $145,025    $141,999
     ===========================================================================
</TABLE>
     (1)  No investment matures beyond five years.

     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:

<TABLE>
<CAPTION>
     (In Thousands)                               1996        1995        1994
     ---------------------------------------------------------------------------
    <S>                                        <C>             <C>        <C>
     Proceeds ...........................      $ 191,179       $--        $--
     ===========================================================================
     Gross realized gains ...............      $   4,578       $--        $--
     ===========================================================================
     Gross realized losses ..............      $    (105)      $--        $--
     ===========================================================================
</TABLE>

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


                                       63
<PAGE>


                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     of $5.2 million, or $3.0 million net of income taxes, at December 31, 1995.

(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, 1996 or 1995.  The average  interest  rate and
     balance was 5.52% and $18.1 million,  respectively,  during 1996, and 5.93%
     and $3.0 million, respectively, during 1995. The maximum amount outstanding
     at any month-end  during 1996 and 1995 was $40.0 million and $10.0 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. There were no sales
     during 1994.

     MUNICIPAL SECURITIES

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

<TABLE>
<CAPTION>
                                                Gross        Gross     Estimated
                                  Amortized   Unrealized   Unrealized    Market
     (In Thousands)                  Cost       Gains        Losses      Value
     ---------------------------------------------------------------------------
     <S>                            <C>       <C>          <C>           <C>   
     December 31, 1996 .........    $6,997    $    --      $   22        $6,975
     ===========================================================================
     December 31, 1995 .........    $7,194    $    --      $   24        $7,170
     ===========================================================================
</TABLE>

     The  investment  at December  31, 1996 and 1995  represents  an  industrial
     revenue bond on which the interest  income is not subject to federal income
     taxes.





                                       64
<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:

<TABLE>
<CAPTION>
                                                       Gross        Gross     Estimated
                                         Amortized   Unrealized  Unrealized     Market
     (In Thousands)                        Cost        Gains       Losses       Value
     ----------------------------------------------------------------------------------
     <S>                                 <C>          <C>          <C>         <C>    
     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
     ==================================================================================
     December 31, 1995:
       GNMA certificates ..........      $13,808      $   599      $     1     $14,406
       FNMA certificates ..........          328           15         --           343
       Non-agency certificates ....       37,053          696          422      37,327
     ----------------------------------------------------------------------------------
         Total ....................      $51,189      $ 1,310      $   423     $52,076
     ==================================================================================
</TABLE>

     Net unrealized gains on mortgage-backed  securities available for sale were
     recognized in stockholders'  equity in the amount of $291,000,  or $166,000
     net of income  taxes,  at December  31, 1996.  At December  31,  1995,  net
     unrealized gains were recognized in  stockholders'  equity in the amount of
     $887,000, or $510,000 net of income taxes.

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

<TABLE>
<CAPTION>
     (In Thousands)                              1996        1995         1994
     ---------------------------------------------------------------------------
     <S>                                       <C>          <C>          <C>   
     Proceeds ...........................      $31,414      $21,463      $ --
     ===========================================================================
     Gross realized gains ...............      $   308      $  --        $ --
     ===========================================================================
     Gross realized losses ..............      $  --        $  --        $ --
     ===========================================================================
</TABLE>





                                       65
<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)                                          1996           1995
     ------------------------------------------------------------------------------
     <S>                                                 <C>            <C>        
     Held for investment:
        Loans secured by real estate:
          Residential:
             One-to-four units .......................   $ 4,046,448    $ 3,656,512
             Five or more units ......................        56,907         57,321
          Commercial real estate .....................       260,609        270,583
          Construction ...............................        66,651         28,593
          Land .......................................        21,177         21,867
          Commercial loans:
             Secured .................................         9,610            250
             Unsecured ...............................        12,526         12,614
          Consumer:
             Automobile ..............................       202,186         56,127
             Other consumer ..........................        47,281         50,945
     ------------------------------------------------------------------------------
                                                           4,723,395      4,154,812
        Less:
          Undisbursed loan funds .....................       (49,250)       (29,942)
          Net deferred costs and premiums ............        11,663          7,412
          Allowance for estimated losses .............       (30,094)       (27,943)
     ------------------------------------------------------------------------------
                Loans receivable held for investment .   $ 4,655,714    $ 4,104,339
     ==============================================================================
     Held for sale:
        Loans secured by residential one-to-four units   $    12,865    $    13,059
     ==============================================================================
</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, 1996 and 1995, the Bank had extended
     loans  to  certain  directors,  executive  officers  and  their  associates
     totaling $28.8 million and $29.7 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, 1996 and 1995.




                                       66
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

<TABLE>
<CAPTION>
     (In Thousands)                                        1996           1995
     ---------------------------------------------------------------------------
     <S>                                                <C>            <C>     
     Balance at beginning of period .................   $ 29,681       $ 28,360
     Additions ......................................       --            1,749
     Repayments .....................................       (846)          (428)
     ---------------------------------------------------------------------------
     Balance at end of period .......................   $ 28,835       $ 29,681
     ===========================================================================
</TABLE>


     A summary of activity in the allowance for loan losses for loans receivable
     held for investment during 1996, 1995 and 1994 follows:

<TABLE>
<CAPTION>
                                                  Real                               Other
     (In Thousands)                              Estate    Commercial  Automobile   Consumer     Total
     ----------------------------------------------------------------------------------------------------
     <S>                                        <C>         <C>         <C>         <C>         <C>     
     Balance at December 31, 1993 ...........   $ 25,081    $    339    $     53    $  1,362    $ 26,835
     Provision for (reduction of) loan losses      4,052          81          (2)       (103)      4,028
     Charge-offs ............................     (5,190)       --           (13)       (175)     (5,378)
     Recoveries .............................         46          52           4          10         112
     ----------------------------------------------------------------------------------------------------
     Balance at December 31, 1994 ...........     23,989         472          42       1,094      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 ...........     25,713         259         849       1,122      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 ...........   $ 24,753    $    236    $  4,303    $    802    $ 30,094
     ====================================================================================================
</TABLE>

     Charge-offs  represented  0.16%, 0.17% and 0.16% of average loans for 1996,
     1995 and 1994, respectively.

     All impaired loans at December 31, 1996 and 1995 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, 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
     ===============================================================================
     December 31, 1995:
         Loans with specific allowances .....   $34,149        $(1,223)      $32,926
         Loans without specific allowances ..    11,283           --          11,283
     -------------------------------------------------------------------------------
         Total impaired loans ...............   $45,432        $(1,223)      $44,209
     ===============================================================================
</TABLE>




                                       67
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     The average recorded investment in impaired loans during 1996 totaled $45.8
     million and $39.4 million in 1995.  During 1996, total interest  recognized
     on the impaired loan portfolio, on a cash basis, was $3.5 million, compared
     to $1.6 million in 1995.

     The combined  weighted  average interest yield on loans receivable held for
     investment  and sale was 7.77% and 7.67% as of December  31, 1996 and 1995,
     respectively,  and averaged  7.72%,  7.20% and 6.57% during 1996,  1995 and
     1994, respectively.

     The aggregate amount of non-accrual loans receivable that are contractually
     past due 90 days or more as to principal or  interest,  in the  foreclosure
     process,  restructured,  or upon which interest collection is doubtful were
     $45.0  million  and  $78.3  million  as of  December  31,  1996  and  1995,
     respectively.  There were no troubled debt restructurings on accrual status
     as of December 31, 1996 and 1995.

     Interest  on   non-accrual   loans   excluded  from  interest   income  was
     approximately $4.1 million for 1996, $6.1 million for 1995 and $4.3 million
     for 1994.

(7)  LOAN SERVICING

     Mortgage  loans  serviced for others are not  included in the  accompanying
     consolidated  statements  of  financial  condition.  The  unpaid  principal
     balances  of  mortgage  loans  serviced  for others was $576.0  million and
     $527.2 million at December 31, 1996 and 1995, respectively.

     Custodial escrow balances  maintained in connection with the foregoing loan
     servicing,  and  included in demand  deposits,  were $2.0  million and $2.8
     million at December 31, 1996 and 1995, respectively.

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

     During 1996,  a valuation  allowance  was  provided for mortgage  servicing
     rights.  Following is a summary of activity in the  allowance  for mortgage
     servicing rights in 1996.


<TABLE>
<CAPTION>
     (In Thousands)                                                        1996
     ---------------------------------------------------------------------------
     <S>                                                                   <C>
     Balance at beginning of period .............................          $--
     Additions .................................................            129
     Reductions ................................................            (28)
     ---------------------------------------------------------------------------
     Balance at end of period ..................................          $ 101
     ===========================================================================
</TABLE>





                                       68
<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)                                                     1996        1995
     --------------------------------------------------------------------------------------
     <S>                                                              <C>         <C>     
     Gross investments in real estate .............................   $ 66,745    $ 63,917
     Accumulated depreciation .....................................    (11,094)     (9,570)
     Allowance for estimated losses ...............................    (22,294)    (24,509)
     --------------------------------------------------------------------------------------
        Investments in real estate (1) ............................     33,357      29,838
     --------------------------------------------------------------------------------------
     Investments in and interest bearing advances to joint ventures     20,918      22,311
     Joint venture valuation allowance ............................     (7,777)     (9,829)
     --------------------------------------------------------------------------------------
          Investments in joint ventures ...........................     13,141      12,482
     --------------------------------------------------------------------------------------
          Total investments in real estate and joint ventures .....   $ 46,498    $ 42,320
     ======================================================================================
</TABLE>

     (1)  Includes  $0.6 million and $1.4 million at December 31, 1996 and 1995,
          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
     $27.6 million and general valuation allowances of $2.5 million, at December
     31, 1996:

<TABLE>
<CAPTION>
     (In Thousands)                                            California  Arizona    Other    Total
     --------------------------------------------------------------------------------------------------
     <S>                                                         <C>       <C>       <C>       <C>    
     Property Type:
        Shopping centers .....................................   $21,386   $18,408   $ 2,909   $42,703
        Office buildings .....................................       404      --        --         404
        Residential ..........................................     3,431      --        --       3,431
        Land .................................................     1,430       447       554     2,431
     --------------------------------------------------------------------------------------------------
          Total real estate before general valuation allowance   $26,651   $18,855   $ 3,463   $48,969
     ========================================================================================
                                                                                             ----------
     General valuation allowance .............................                                  (2,471)
     Net investment in real estate and joint ventures ........                                 $46,498
                                                                                             ==========
</TABLE>





                                       69
<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)                                                     1996        1995        1994
     -------------------------------------------------------------------------------------------------
     <S>                                                             <C>         <C>         <C>     
     Net gains on sales of real estate ...........................   $    392    $  4,539    $    532
     Rental operations:
       Rental income .............................................      4,649       5,837       6,305
       Costs and expenses ........................................     (2,232)     (2,126)     (1,798)
     -------------------------------------------------------------------------------------------------
          Net rental operations ..................................      2,417       3,711       4,507
     Joint venture operations:
       Equity in net income (loss) from joint ventures ...........         55      (1,676)      1,512
       Reduction of losses provided for by the DSL Service Company      2,043         831         634
     -------------------------------------------------------------------------------------------------
          Net joint venture operations ...........................      2,098        (845)      2,146
     Interest from joint venture loans ...........................      2,071       1,702       1,579
     Reduction of estimated losses on real estate ................      1,263       2,085         766
     -------------------------------------------------------------------------------------------------
          Total ..................................................   $  8,241    $ 11,192    $  9,530
     =================================================================================================
</TABLE>

     Activity  in the  allowance  for losses on real estate and  investments  in
     joint ventures for 1996, 1995 and 1994 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, 1993 ................   $  6,293     $  9,733       $ 11,334       $ 11,314     $ 38,674
     Provision for (reduction of) estimated losses       (120)      (1,640)           994           (634)      (1,400)
     Charge-offs .................................       --           --             --              (76)         (76)
     Recoveries ..................................       --           --             --             --           --
     -----------------------------------------------------------------------------------------------------------------
     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
     =================================================================================================================
</TABLE>





                                       70
<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)                                                   1996         1995
     -------------------------------------------------------------------------------------
     <S>                                                           <C>          <C>      
     ASSETS
     Cash ......................................................   $   1,778    $   2,624
     Projects under development ................................      13,039        3,075
     Completed projects ........................................      91,049      106,824
     Other assets ..............................................       6,310        9,247
     -------------------------------------------------------------------------------------
                                                                   $ 112,176    $ 121,770
     =====================================================================================
     LIABILITIES AND EQUITY
     Liabilities:
        Notes payable to the Bank ..............................   $  77,598    $  87,879
        Notes payable to others ................................      28,562       24,450
        Other ..................................................      11,152       10,020
     Equity (deficit):
        DSL Service Company ....................................      13,141       12,482
        Allowance for losses recorded by DSL Service Company (1)       7,777        9,829
        Other partners' (1) ....................................     (26,054)     (22,890)
     -------------------------------------------------------------------------------------
          Net deficit ..........................................      (5,136)        (579)
     -------------------------------------------------------------------------------------
                                                                   $ 112,176    $ 121,770
     =====================================================================================
</TABLE>
     (1)  The  aggregate  other  partners'  deficit of $26.1  million  and $22.9
          million at December 31, 1996 and 1995, 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  $7.8  million and $9.8 million at December 31, 1996 and 1995,
          respectively.  At December 31, 1996, 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 $26.1  million  and $22.9
          million at  December  31,  1996 and 1995,  respectively,  exceeds  the
          amount of  aforementioned  valuation  allowances  established  of $7.8
          million and $9.8 million at December 31, 1996 and 1995, respectively.




                                       71
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

          CONDENSED COMBINED STATEMENTS OF OPERATIONS - JOINT VENTURES

<TABLE>
<CAPTION>
     (In Thousands)                                          1996        1995        1994
     ---------------------------------------------------------------------------------------
     <S>                                                   <C>         <C>         <C>     
     Real estate sales:
        Sales ..........................................   $  2,901    $   --      $ 21,158
        Cost of sales ..................................     (1,401)       --       (17,294)
     ---------------------------------------------------------------------------------------
          Net profit on sales ..........................      1,500        --         3,864
     ---------------------------------------------------------------------------------------
     Rental operations:
        Rental income ..................................     13,674      16,587      16,749
        Operating expenses .............................     (1,781)     (3,574)     (2,487)
        Interest, depreciation and other expenses ......    (14,784)    (16,365)    (15,102)
     ---------------------------------------------------------------------------------------
          Net loss on rental operations ................     (2,891)     (3,352)       (840)
     ---------------------------------------------------------------------------------------
     Net income (loss) .................................     (1,391)     (3,352)      3,024
     Less other partners' share of net income (loss) ...     (1,446)     (1,676)      1,512
     ---------------------------------------------------------------------------------------
     DSL Service Company's share of net income (loss) ..         55      (1,676)      1,512
     Reduction of losses provided by DSL Service Company      2,043         831         634
     ---------------------------------------------------------------------------------------
     DSL Service Company's share of net income (loss) ..   $  2,098    $   (845)   $  2,146
     =======================================================================================
</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:

<TABLE>
<CAPTION>
                                                                December 31,
                                                           ---------------------
     (In Thousands)                                          1996        1995
     ---------------------------------------------------------------------------
     <S>                                                   <C>         <C>     
     Property Type
     Residential:
       One-to-four units ...............................   $ 12,690    $ 11,997
       Five or more units ..............................       --         2,226
     Commercial:
       Land ............................................        712         836
       Shopping centers ................................      3,754       5,012
     ---------------------------------------------------------------------------
                                                             17,156      20,071
     Allowance for estimated losses ....................     (1,078)     (1,217)
     ---------------------------------------------------------------------------
       Total real estate acquired in settlement of loans   $ 16,078    $ 18,854
     ===========================================================================
</TABLE>




                                       72
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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)                                                      1996       1995      1994
     -----------------------------------------------------------------------------------------------
     <S>                                                               <C>        <C>        <C>    
     Net (gains) losses on sales ...................................   $  (389)   $   (25)   $    44
     Net operating expense .........................................     1,298      1,733      1,516
     Provision for estimated losses ................................     1,658      2,498      2,035
     -----------------------------------------------------------------------------------------------
       Net operations of real estate acquired in settlement of loans   $ 2,567    $ 4,206    $ 3,595
     ===============================================================================================
</TABLE>

     Activity in the  allowance  for  estimated  losses on real estate  acquired
     through foreclosure for 1996, 1995 and 1994 is as follows:

<TABLE>
<CAPTION>
     (In Thousands)                                 1996       1995       1994
     ---------------------------------------------------------------------------
     <S>                                          <C>        <C>        <C>    
     Balance at beginning of period ...........   $ 1,217    $   743    $   747
     Provision ................................     1,658      2,498      2,035
     Charge-offs ..............................    (1,797)    (2,024)    (2,039)
     ---------------------------------------------------------------------------
     Balance at end of period .................   $ 1,078    $ 1,217    $   743
     ===========================================================================
</TABLE>

(10) PREMISES AND EQUIPMENT

     Premises and equipment are summarized as follows:

<TABLE>
<CAPTION>
                                                               December 31,
                                                         -----------------------
     (In Thousands)                                         1996         1995
     ---------------------------------------------------------------------------
     <S>                                                 <C>          <C>      
     Land ............................................   $  21,287    $  19,401
     Building and improvements .......................      84,612       81,732
     Furniture, fixtures and equipment ...............      39,828       35,979
     Construction in progress ........................          37          319
     Other ...........................................          91          122
     ---------------------------------------------------------------------------
                                                           145,855      137,553
     Accumulated depreciation and amortization .......     (49,212)     (44,576)
     ---------------------------------------------------------------------------
       Total premises and equipment ..................   $  96,643    $  92,977
     ===========================================================================
</TABLE>





                                       73
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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 $0.8  million in 1996 and $0.7  million  in 1995.  The
     following  table  summarizes   future  minimum  rental   commitments  under
     noncancelable leases.

<TABLE>
<CAPTION>
     (In Thousands)
     ---------------------------------------------------------------------------
     <S>                                                                  <C>   
     1997 .......................................................         $1,178
     1998 .......................................................          1,156
     1999 .......................................................            993
     2000 .......................................................            555
     2001 .......................................................            330
     Thereafter (1) .............................................              6
     ---------------------------------------------------------------------------
       Total future lease commitments                                     $4,218
     ===========================================================================
</TABLE>
     (1)  There are no lease commitments  beyond the year 2002 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, 1996
     financial data, was $41.9 million. The investment in FHLB stock amounted to
     $41.4   million  and  $39.1   million  at  December   31,  1996  and  1995,
     respectively.  The Bank received a $0.7 million stock dividend in the first
     quarter of 1997 thereby increasing the Bank's investment above the required
     amount.

(12) OTHER ASSETS

     Other assets are summarized as follows:

<TABLE>
<CAPTION>
                                                                                              December 31,
                                                                                            -----------------
     (In Thousands)                                                                           1996      1995
     --------------------------------------------------------------------------------------------------------
     <S>                                                                                    <C>       <C>    
     Accounts receivable:
       Due from FDIC under the Butterfield Assistance Agreement .........................   $  --     $12,165
     --------------------------------------------------------------------------------------------------------
       Other ............................................................................     2,465     4,462
     Accrued interest receivable:
       Loans ............................................................................    24,259    23,206
       Mortgage-backed securities .......................................................       356       314
       Investment securities ............................................................     2,186     3,177
     Prepaid expenses ...................................................................     7,261     4,515
     Excess of purchase price over fair value of assets acquired and liabilities assumed,     5,586     6,118
     net
     Core deposit premium ...............................................................       513       824
     Mortgage servicing rights ..........................................................     1,175       406
     Repossessed automobiles, net .......................................................       928      --
     Other ..............................................................................       661       405
     --------------------------------------------------------------------------------------------------------
       Total other assets ...............................................................   $45,390   $55,592
     ========================================================================================================
</TABLE>




                                       74
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(13) DEPOSITS

     Deposits are summarized as follows:

<TABLE>
<CAPTION>
                                                          December 31,
                                         ----------------------------------------------
                                                  1996                    1995
                                         ----------------------------------------------
                                         Weighted                Weighted
                                          Average                 Average
     (Dollars in Thousands)                Rate        Amount      Rate        Amount
     ----------------------------------------------------------------------------------
     <S>                                   <C>      <C>             <C>      <C>       
     Regular passbook ...............      2.90%    $  416,868      2.59%    $  387,986
     Money market accounts ..........      2.52        100,750      2.30        119,891
     Checking accounts ..............      0.74        313,980      0.76        297,014
     Certificates of deposit:
       Less than 3.00% ..............      2.65         39,061      2.82         57,786
       3.00-3.49 ....................      3.03            723      3.21          1,392
       3.50-3.99 ....................      3.99             79      3.75          7,781
       4.00-4.49 ....................      4.39         63,577      4.18         99,758
       4.50-4.99 ....................      4.87        186,576      4.88        262,065
       5.00-5.99 ....................      5.54      2,489,852      5.52      1,863,474
       6.00-6.99 ....................      6.17        536,307      6.46        596,803
       7.00 and greater .............      7.15         25,329      7.29         96,271
     ----------------------------------------------------------------------------------
        Total certificates of deposit      5.56      3,341,504      5.61      2,985,330
     ----------------------------------------------------------------------------------
        Total deposits ..............      4.86%    $4,173,102      4.81%    $3,790,221
     ==================================================================================
</TABLE>

     The  aggregate  amount  of jumbo  certificates  of  deposit  with a minimum
     denomination  of  $100,000  was  approximately  $791.6  million  and $693.9
     million at December 31, 1996 and 1995, respectively.

     At December 31, 1996,  scheduled  maturities of certificates of deposit are
     as follows:

<TABLE>
<CAPTION>
                                                         Weighted
     (Dollars in Thousands)                            Average Rate     Amount
     ---------------------------------------------------------------------------
     <S>                                                   <C>        <C>       
     1997 ...........................................      5.53%      $2,915,547
     1998 ...........................................      5.72          357,742
     1999 ...........................................      5.76           39,618
     2000 ...........................................      5.82           14,793
     2001 ...........................................      5.72           13,228
     Thereafter .....................................      5.76              576
     ---------------------------------------------------------------------------
     Total ..........................................      5.56%      $3,341,504
     ===========================================================================
</TABLE>

     The weighted  average cost of deposits  averaged  4.74%,  4.81%,  and 3.49%
     during 1996, 1995 and 1994, respectively.

     As of  December  31,  1996 and 1995,  public  funds of  approximately  $1.8
     million and $1.2 million,  respectively, are secured by mortgage loans with
     a  carrying  value  of   approximately   $2.6  million  and  $1.8  million,
     respectively.




                                       75
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Interest expense on deposits by type is summarized as follows:

<TABLE>
<CAPTION>
     (In Thousands)                                 1996       1995       1994
     ---------------------------------------------------------------------------
     <S>                                          <C>        <C>        <C>     
     Regular passbook .........................   $ 11,242   $  8,725   $  9,297
     Money Market accounts ....................      2,599      2,994      4,638
     Checking accounts ........................      2,246      2,309      2,519
     Certificate accounts .....................    168,315    166,831     93,541
     ---------------------------------------------------------------------------
       Total deposit interest expense .........   $184,402   $180,859   $109,995
     ===========================================================================
</TABLE>

     Accrued  interest on  deposits,  which is included in accounts  payable and
     accrued liabilities, was $2.3 million and $4.1 million at December 31, 1996
     and 1995, respectively.

(14) MORTGAGE-BACKED SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

     Mortgage-backed   securities  sold  under   agreements  to  repurchase  are
     summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1996      1995       1994
     --------------------------------------------------------------------------------------------
     <S>                                                           <C>        <C>        <C>    
     Balance at year end .......................................   $  --      $16,099    $53,946
     Average balance outstanding during the year ...............    11,761     36,676     32,441
     Maximum amount outstanding at any month-end during the year    70,015     52,547     59,720
     Weighted average interest rate during the year ............      5.19%      6.21%      5.18%
     Weighted average interest rate at year end ................       --        5.90       6.09
     Secured by:
        Mortgage-backed securities .............................   $  --      $17,342    $58,718
     ============================================================================================
</TABLE>

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

(15) FEDERAL HOME LOAN BANK ADVANCES

     FHLB advances are summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1996        1995        1994
     -----------------------------------------------------------------------------------------------
     <S>                                                           <C>         <C>         <C>     
     Balance at year end .......................................   $386,883    $220,715    $411,800
     Average balance outstanding during the year ...............    266,252     284,003     158,058
     Maximum amount outstanding at any month-end during the year    397,147     473,800     411,800
     Weighted average interest rate during the year ............       5.85%       6.30%       5.44%
     Weighted average interest rate at year end ................       5.80        6.07        6.41
     Secured by:
       Loans receivable ........................................   $345,463    $276,375    $557,948
       Mortgage-backed securities ..............................     31,651      10,523        --
       FHLB stock ..............................................     41,447      39,146      34,500
     ===============================================================================================
</TABLE>

     In addition to the collateral  securing  existing  advances,  Downey had an
     additional $1.1 billion in loans



                                       76
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     available as collateral for any future advances as of December 31, 1996.

     FHLB advances have the following maturities at December 31, 1996:

<TABLE>
<CAPTION>
     (In Thousands)
     -----------------------------------------------------------------------
     <S>                                                            <C>     
     1997 .......................................................   $312,067
     1998 .......................................................     42,973
     1999 .......................................................     15,686
     2000 .......................................................      9,963
     2001 .......................................................      3,394
     Thereafter .................................................      2,800 (1)
     -----------------------------------------------------------------------
     Total ......................................................   $386,883
     =======================================================================
</TABLE>
     (1)  Includes  a  $1.8  million   advance  which  carries  a   penalty-free
          prepayment  option  beginning  in April  1996  and  every  six  months
          thereafter.

(16) COMMERCIAL PAPER

     Commercial paper borrowings are summarized as follows:

<TABLE>
<CAPTION>
     (Dollars in Thousands)                                          1996        1995        1994
     -----------------------------------------------------------------------------------------------
     <S>                                                           <C>         <C>         <C>     
     Balance at year end .......................................   $198,113    $196,602    $197,839
     Average balance outstanding during the year ...............    174,739     191,313      25,177
     Maximum amount outstanding at any month-end during the year    198,113     198,341     197,839
     Weighted average interest rate during the year ............       5.74%       6.38%       5.90%
     Weighted average interest rate at end of year .............       5.45        5.56        6.00

     Secured by:
       FHLB Letter of Credit (1) ...............................   $200,000    $200,000    $200,000
     ===============================================================================================
</TABLE>
     (1)  This letter of credit is secured by loans receivable of $247 million.

     Commercial  paper  borrowings  at  December  31, 1996 bear  interest  rates
     ranging from 5.29% to 5.58% and mature within nine months of year end.

(17) OTHER BORROWINGS

     Other borrowings are summarized as follows:

<TABLE>
<CAPTION>
                                                                                 December 31,
                                                                               -----------------
     (Dollars In Thousands)                                                      1996     1995
     -------------------------------------------------------------------------------------------
     <S>                                                                       <C>       <C>    
     Long-term notes  payable to banks,  secured by real estate and mortgage
        loans with a carrying value of $13,585 at December 31, 1996, bearing
        interest
        rates from 7.50% to 9.21%  .........................................   $10,349   $ 2,802
     ===========================================================================================
</TABLE>




                                       77
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     Other borrowings have the following maturities at December 31, 1996:

<TABLE>
<CAPTION>
     (In Thousands)
     ---------------------------------------------------------------------------
     <S>                                                                 <C>    
     1997 ..........................................................     $   950
     1998 ..........................................................       1,031
     1999 ..........................................................       1,120
     2000 ..........................................................       1,216
     2001 ..........................................................       1,310
     Thereafter ....................................................       4,722
     ---------------------------------------------------------------------------
     Total .........................................................     $10,349
     ===========================================================================
</TABLE>

(18) INCOME TAXES

     Income taxes are summarized as follows:

<TABLE>
<CAPTION>
     (In Thousands)                                   1996      1995      1994
     ---------------------------------------------------------------------------
     <S>                                             <C>       <C>       <C>    
     Federal:  Current ...........................   $ 8,310   $11,538   $ 6,832
               Deferred ..........................     3,317        17     5,661
     ---------------------------------------------------------------------------
                                                     $11,627   $11,555   $12,493
     ===========================================================================
     State:    Current ...........................   $ 2,602   $ 2,144   $ 3,237
               Deferred ..........................     1,521     1,898       940
     ---------------------------------------------------------------------------
                                                     $ 4,123   $ 4,042   $ 4,177
     ===========================================================================
     Total:    Current ...........................   $10,912   $13,682   $10,069
               Deferred ..........................     4,838     1,915     6,601
     ---------------------------------------------------------------------------
                                                     $15,750   $15,597   $16,670
     ===========================================================================
</TABLE>

     Current income taxes payable were $0.6 million and $9.4 million at December
     31, 1996 and 1995, respectively.





                                       78
<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)                                                 1996       1995
     ----------------------------------------------------------------------------------
     <S>                                                          <C>         <C>     
     Deferred tax liabilities:
         Deferred loan fees ...................................   $ 22,049    $ 16,937
         Tax reserves in excess of base year ..................     22,652      19,161
         Equity in joint ventures .............................      2,250       4,741
         Installment sales ....................................      3,683       4,090
         Depreciation on premises and equipment ...............      1,012       3,395
         FHLB stock dividends .................................      4,777       3,277
         SAIF insurance premiums ..............................      2,544       1,978
         Equipment lease ......................................       --         1,876
         Capitalized interest .................................      1,730       1,283
         Bad debt charge-offs .................................      3,431        --
         Other deferred income items ..........................        118         560
         Accrual to cash adjustment ...........................        422        --
     ----------------------------------------------------------------------------------
                                                                    64,668      57,298
     ----------------------------------------------------------------------------------
     Deferred tax assets:
         Loan valuation allowances ............................    (35,004)    (30,053)
         Real estate and joint venture valuation allowances ...    (16,150)    (17,970)
         Unrealized gains (losses) on investment securities (1)     (1,177)      2,583
         Alternative minimum tax credit carryforward ..........       (734)     (1,481)
         California franchise tax .............................     (1,475)     (1,448)
         Other deferred deduction items .......................       (346)       (205)
     ----------------------------------------------------------------------------------
                                                                   (54,886)    (48,574)
     Deferred tax assets valuation allowance ..................       --          --
     ----------------------------------------------------------------------------------
     Net deferred tax liability ...............................   $  9,782    $  8,724
     ==================================================================================
</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.

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

<TABLE>
<CAPTION>
                                                              1996                 1995                 1994
                                                       -------------------------------------------------------------
     (Dollars in Thousands)                             Amount     Percent   Amount     Percent   Amount     Percent
     ---------------------------------------------------------------------------------------------------------------
     <S>                                               <C>           <C>    <C>           <C>    <C>           <C>  
     Expected statutory income taxes ...............   $ 12,759      35.0%  $ 12,842      35.0%  $ 14,071      35.0%
     California franchise tax, net of federal income
         tax benefit ...............................      2,680       7.4      2,640       7.2      2,715       6.8
     Increase (decrease) resulting from:
         Non-taxable federal financial assistance ..       --          --       (223)     (0.6)      (192)     (0.5)
         Interest on municipal bonds ...............       (103)     (0.3)       (21)     (0.1)      --          --
         Other .....................................        414       1.1        359       1.0         76       0.2
     ---------------------------------------------------------------------------------------------------------------
     Income taxes ..................................   $ 15,750      43.2%  $ 15,597      42.5%  $ 16,670      41.5%
     ===============================================================================================================
</TABLE>





                                       79
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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.  Downey  calculated its bad debt deduction
     for 1996 under the specific  charge-off  method.  In 1995 and 1994,  Downey
     claimed a bad debt  deduction  based upon the  percentage-of-taxable-income
     method.

     Downey  made  income  tax  payments,  net of  refunds,  amounting  to $19.8
     million,   $9.6  million,  and  $5.7  million  in  1996,  1995,  and  1994,
     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 income and state  franchise tax returns have
     been examined by the Internal Revenue Service and the California  Franchise
     Tax Board,  respectively,  for all prior years through 1989. Federal income
     tax returns for years 1990 through 1994 are  currently  under  examination.
     Downey  believes  it  has  established   appropriate  liabilities  for  any
     resulting deficiencies. State franchise tax returns for years subsequent to
     1989 remain open to review.

(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, 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>
     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)       (1)
     ======================================================================================================
</TABLE>
     (1)  Ratio is not specified under capital regulations.

     In part to resolve the disparity  between bank and thrift deposit insurance
     premiums  and  resulting  competitive  inequalities,  Congress  passed  the
     Economic Growth and Regulatory Paperwork Reduction Act of 1996 (the "Budget
     Act") on  September  30, 1996 which,  among other  things,  authorized  the
     recapitalization  of the Savings  Association  Insurance Fund ("SAIF").  To
     effect the  recapitalization,  SAIF member institutions,  such as the Bank,
     were  required  to pay a  one-time  special  assessment  equal to 0.657% of
     deposits based upon deposit levels as of March 31, 1995. For the Bank, this
     assessment  was equal to $24.6  million or, on an  after-tax  basis,  $14.0
     million or $0.55 per share. The charge for this assessment was reflected in
     the Bank's third  quarter 1996 results and was paid to the FDIC on November
     27, 1996.

     Capital Distributions

     The OTS rules impose certain  limitations  regarding stock  repurchases and
     redemptions, cash-out mergers and



                                       80
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     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  current  and  fully-phased-in  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, 1996,  the Bank had the  capacity to declare  dividends
     totaling $65.8 million under the "safe harbor" limitations.

     Stock Dividend

     On October 29, 1996, the Board of Directors declared a three-for-two  stock
     split  effected in the form of a dividend on Downey's  common stock payable
     on December 12, 1996 to  stockholders  of record on November 15, 1996.  The
     stock split resulted in the issuance of 8,486,167  shares and the par value
     of the stock remained at $0.01.  Common stock issued and additional paid-in
     capital as of December  31,  1996 have been  restated to reflect the split.
     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 393,750 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 1996, options to purchase 15,000 shares were granted under the LTIP,
     compared to 90,750 in 1995.

     Options  outstanding  under  the  LTIP at  December  31,  1996 and 1995 are
     summarized as follows:

<TABLE>
<CAPTION>
                                                          Outstanding Options
                                                        ------------------------
                                                        Number         Average
                                                          of            Option
                                                        Shares          Price
     ---------------------------------------------------------------------------
     <S>                                                <C>            <C>      
     December 31, 1994 .........................        259,875        $   13.75
     Options granted ...........................         90,750            14.71
     Options canceled and exercised ............        (23,625)           13.29
     ---------------------------------------------------------------------------
     December 31, 1995 .........................        327,000            14.05
     Options granted ...........................         15,000            17.00
     Options canceled and exercised ............        (30,750)           15.00
     ---------------------------------------------------------------------------
     December 31, 1996 .........................        311,250        $   14.14
     ===========================================================================
</TABLE>

     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.




                                       81
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     At December  31,  1996,  133,125  options  were  exercisable  at a weighted
     average option price per share of $13.91,  with 67,500 shares available for
     future  grants under the LTIP.  At December 31, 1995,  59,063  options were
     exercisable at a weighted average option price per share of $13.80.

     Effective  January 1, 1995,  Downey adopted the disclosure  requirements of
     SFAS 123,  but it was  determined  that it will  continue  to  measure  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 1996 and
     1995  consistent  with the provisions of SFAS 123,  Downey's net income and
     income per share would have been reduced to the pro forma amounts indicated
     below:

<TABLE>
<CAPTION>
     (In Thousands, Except Per Share Data)                    1996        1995
     ---------------------------------------------------------------------------
     <S>                                                     <C>         <C> 
     Net income:
         As reported ....................................    $20,704     $21,093
         Pro forma ......................................     20,673      20,092
     Income per share:
         As reported ....................................      $0.81       $0.83
         Pro forma ......................................       0.81        0.83
     ===========================================================================
</TABLE>

     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:

<TABLE>
<CAPTION>
                                                                 1996     1995
     ---------------------------------------------------------------------------
     <S>                                                         <C>      <C> 
     Expected life (years) ................................       3.79     3.74
     Interest rate ........................................       6.08%    5.60%
     Volatility ...........................................      24.58    24.92
     Dividend yield .......................................       1.88     2.17
     ===========================================================================
</TABLE>


(20) 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 $1.3
     million for 1996, compared to $1.2 million in 1995 and 1994, respectively.

     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
     $3.1  million,  $2.7  million,  and $4.2 million in 1996,  1995,  and 1994,
     respectively.





                                       82
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(21) 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.

     The following is a summary of commitments and contingent liabilities:

<TABLE>
<CAPTION>
                                                                          December 31,
                                                                      -------------------
     (In Thousands)                                                     1996       1995
     ------------------------------------------------------------------------------------
     <S>                                                              <C>        <C>     
     Commitments to originate loans and mortgage-backed securities:
          Fixed rate ..............................................   $ 12,339   $ 12,962
          Variable rate ...........................................    131,767     70,606
     Commitments to sell loans and mortgage-backed securities .....     12,353     14,305
     Unused lines of credit .......................................     72,646     72,068
     Loans in process .............................................     40,535     28,783
     ====================================================================================
</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, 1996, the extent
     of collateral supporting mortgage and other loans varied from 0% 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



                                       83
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     reduce   Downey's   interest  rate  risk  between   repricing   assets  and
     liabilities, At December 31, 1996, no swap contracts were outstanding.

(22) FAIR VALUE OF FINANCIAL INSTRUMENTS

     Statement of Financial  Accounting  Standards No. 107,  "Disclosures  about
     Fair Value of  Financial  Instruments"  ("SFAS  107"),  requires  Downey to
     disclose  estimated  values  for  its  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.

     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 defined by SFAS
     107 as the carrying  amounts  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.





                                       84
<PAGE>



                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     OFF-BALANCE SHEET FINANCIAL INSTRUMENTS

     The fair value of interest  rate swaps was derived  from dealer  quotations
     and represents the estimated  amount Downey would pay upon  terminating the
     contracts or agreements,  taking into consideration  current interest rates
     and the remaining  contract  term.  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  discounting  at market  rates the
     expected net servicing income from the portfolio.





                                       85
<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 31,1996             December 31,1995
                                                                      -------------------------   --------------------------
                                                                       Carrying      Estimated     Carrying     Estimated
     (In Thousands)                                                    Amount (1)    Fair Value    Amount (1)   Fair Value
     -----------------------------------------------------------------------------------------------------------------------
     <S>                                                              <C>           <C>           <C>           <C>        
     Assets:
     Cash .........................................................   $    67,221   $    67,221   $    58,581   $    58,581
     Federal funds ................................................         6,038         6,038         7,249         7,249
     U.S. Government and agency obligations and other
        investment securities available for sale ..................       141,999       141,999       164,880       164,880
     Municipal securities being held to maturity ..................         6,997         6,975         7,194         7,170
     Loans held for sale ..........................................        12,865        12,865        13,059        13,059
     Mortgage-backed securities available for sale ................        61,267        61,267        52,076        52,076
     Loans receivable held for investment: 
        Loans secured by real estate:
          Residential:
            Adjustable ............................................     3,910,895     3,888,656     3,522,719     3,604,287
            Fixed .................................................       186,402       194,029       182,089       192,676
          Other ...................................................       291,791       297,361       282,851       284,018
        Non-mortgage loans:
          Commercial ..............................................        21,796        21,807        11,460        11,582
          Consumer and other ......................................       244,830       245,333       105,220       110,191
        Interest-bearing advances to joint ventures ...............        57,563        57,563        55,340        55,340
     Liabilities:
     Deposits:
        Regular passbook ..........................................       416,868       416,868       387,986       387,986
        Checking accounts .........................................       313,980       313,980       297,014       297,014
        Money market accounts .....................................       100,750       100,750       119,891       119,891
        Certificates of deposit ...................................     3,341,504     3,351,342     2,985,330     2,997,950
     Borrowings ...................................................       595,345       596,346       436,218       437,275
     Off-Balance Sheet Instruments:
     Interest rate swap contracts .................................          --            --             N/A        (3,487)
     Commitments to sell loans and mortgage-backed
        securities ................................................        12,353        12,353        14,305        14,305
     Unused lines of credit .......................................        72,646        72,646        72,068        72,068
     Commitments to originate loans and mortgage-backed securities:
        Fixed rate ................................................        12,339        12,339        12,962        12,962
        Variable rate .............................................       131,767       131,767        70,606        70,606
     =======================================================================================================================
</TABLE>
     (1)  The carrying amount of loans is stated net of undisbursed  loan funds,
          unearned fees and discounts and allowances for losses.




                                       86
<PAGE>



(23) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

     Selected  quarterly  financial data are presented  below by quarter for the
     years ended December 31, 1996 and 1995.

<TABLE>
<CAPTION>
                                                December 31, September 30,    June 30,   March 31,
     (In Thousands, Except Per Share Data)         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 losses .........................     33,884        30,943         30,915     29,716
     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 .............   $   0.34      $  (0.25) (1)  $   0.31   $   0.41
     =============================================================================================
     Market range:
       High bid ..............................   $  19.63      $  16.83       $  16.00   $  16.00
       Low bid ...............................      16.67         13.50          13.50      13.75
       End of period .........................      19.63         16.83          14.58      15.67
     =============================================================================================

<CAPTION>
                                                December 31, September 30,    June 30,   March 31,
                                                   1995          1995           1995       1995
     ---------------------------------------------------------------------------------------------
     <S>                                         <C>           <C>            <C>        <C>     
     Total interest income ...................   $ 82,592      $ 82,590       $ 79,865   $ 73,781
     Total interest expense ..................     53,351        54,887         54,519     51,481
     ---------------------------------------------------------------------------------------------
       Net interest income ...................     29,241        27,703         25,346     22,300
     Provision for loan losses ...............      1,596         1,805          2,336      3,556
     ---------------------------------------------------------------------------------------------
       Net interest income after provision for
         loan losses .........................     27,645        25,898         23,010     18,744
     Total other income ......................      7,012         3,077          4,379      6,131
     Total operating expense .................     20,135        19,620         20,121     19,330
     ---------------------------------------------------------------------------------------------
     Income before income taxes ..............     14,522         9,355          7,268      5,545
     Income  taxes ...........................      6,197         3,980          3,085      2,335
     ---------------------------------------------------------------------------------------------
     Net income ..............................    $ 8,325       $ 5,375       $  4,183   $  3,210
     =============================================================================================
     Net income per share ....................    $  0.33       $  0.21       $   0.16   $   0.13
     =============================================================================================
     Market range:
       High bid ..............................    $ 16.03       $ 13.89       $  11.75   $  10.56
       Low bid ...............................      12.63         11.34          10.16       9.44
       End of period .........................      14.50         12.70          11.59      10.16
     =============================================================================================
</TABLE>
     (1)  Net income totaled $7.6 million or $0.30 per share before an after-tax
          charge of $14.0 million or $0.55 per share for a one-time charge for a
          government-mandated  industry-wide  assessment to all institutions who
          are insured by the Federal  Deposit  Insurance  Corporation as part of
          its Savings Association Insurance Fund.





                                       87
<PAGE>




                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

(24) 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 follow:

     CONDENSED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                December 31,
                                                           ---------------------
     (In Thousands)                                          1996         1995
     ---------------------------------------------------------------------------
     <S>                                                   <C>          <C>     
     ASSETS
     Cash ............................................     $   --       $     15
     Due from Bank - interest bearing ................        7,333        7,679
     Investment in subsidiaries:
       Bank ..........................................      382,932      375,406
       Downey Affiliated Insurance Agency ............          162          193
     Real estate held for investment .................          704          704
     Other assets ....................................          558          262
     ---------------------------------------------------------------------------
                                                           $391,689     $384,259
     ===========================================================================

     LIABILITIES AND STOCKHOLDERS' EQUITY
     Intercompany accounts payable ...................     $   --       $     20
     Accounts payable and accrued expenses ...........          118          167
     ---------------------------------------------------------------------------
       Total liabilities .............................          118          187
     ---------------------------------------------------------------------------
     Stockholders' Equity ............................      391,571      384,072
     ---------------------------------------------------------------------------
                                                           $391,689     $384,259
     ===========================================================================
</TABLE>




                                       88
<PAGE>





                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     CONDENSED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                                     Years Ended December 31,
                                                                                     ------------------------
     (In Thousands)                                                                       1996      1995
     --------------------------------------------------------------------------------------------------------
     <S>                                                                                 <C>         <C>    
     INCOME:
       Dividends from the Bank .......................................................   $ 8,406     $16,940
       Interest income ...............................................................       382         603
       Other income ..................................................................        82        --
     --------------------------------------------------------------------------------------------------------
                                                                                           8,870      17,543
     --------------------------------------------------------------------------------------------------------
     EXPENSE:
       Provision for losses on real estate ...........................................      --           171
       General and administrative expense ............................................       883         909
     --------------------------------------------------------------------------------------------------------
         Total expense ...............................................................       883       1,080
     --------------------------------------------------------------------------------------------------------
     INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED NET INCOME OF SUBSIDIARIES     7,987      16,463
     Income tax benefit ..............................................................       168         194
     --------------------------------------------------------------------------------------------------------
     INCOME BEFORE EQUITY IN UNDISTRIBUTED NET INCOME OF SUBSIDIARIES ................     8,155      16,657
     Equity in undistributed net income of subsidiaries ..............................    12,549       4,436
     --------------------------------------------------------------------------------------------------------
       NET INCOME ....................................................................   $20,704     $21,093
     ========================================================================================================
</TABLE>




                                       89
<PAGE>





                             DOWNEY FINANCIAL CORP.
                                AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

     CONDENSED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                   Years Ended December 31,
                                                                   ------------------------
     (In Thousands)                                                   1996        1995
     --------------------------------------------------------------------------------------
     <S>                                                            <C>           <C>     
     CASH FLOWS FROM OPERATING ACTIVITIES:
       Net income ...............................................   $ 20,704      $ 21,093
       Equity in undistributed net income of subsidiaries .......    (12,549)       (4,436)
       Provision for losses on real estate ......................       --             171
       Increase in other assets .................................       (296)         (262)
       Increase (decrease) in liabilities .......................        (69)          187
     --------------------------------------------------------------------------------------
         Net cash provided by operating activities ..............      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        346        (7,679)
       Purchase of real estate from subsidiary ..................       --            (900)
     --------------------------------------------------------------------------------------
         Net cash provided by (used for) investing activities ...        346        (8,979)
     --------------------------------------------------------------------------------------

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






                                       90
<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 23, 1997, 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 1996.
       None.
(c)  Exhibits.





                                       91
<PAGE>




<TABLE>
<CAPTION>
     Exhibit
     Number                           Description

     <S>       <C>                                                        
      3.1 (1)  Certificate of Incorporation of Downey Financial Corp.
      3.2 (2)  Articles of Incorporation of Downey Financial Corp.
      3.3 (2)  Bylaws of Downey Financial Corp.
     10.1 (2)  Downey Stock Purchase Plan Agreement, dated January 1, 1973.
     10.2 (2)  Downey  Employees'  Retirement and Savings Plan,  dated January 1,
               1978 (as amended August 1, 1993).
     10.4 (1)  Downey  Savings  and  Loan Association  1994 Long-Term  Incentive 
               Plan (as amended).
     10.5 (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.
     10.6 (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).
     10.7 (2)  Merger of  Butterfield  Savings and Loan  Association,  FSA, into
               Downey Savings and Loan Association, dated September 29, 1989.
     10.8 (2)  Founder  Retirement  Agreement  of  Maurice L.  McAlister,  dated
               December 21, 1989.
     10.9 (2)  Founder  Retirement  Agreement  of  Gerald  H.  McQuarrie,  dated
               December 21, 1989.
     10.11(2)  Director Retirement Benefits
     10.12(2)  Management Incentive Program 1992
     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     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.**     Subsidiaries
</TABLE>
 
(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.

     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





                                       92
<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 14, 1997

     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 14, 1997

   /s/ CHERYL E. JONES             Vice Chairman of the Board
-----------------------------
       Cheryl E. Jones                     Director               March 14, 1997

   /s/ JAMES W. LOKEY                   President and
-----------------------------
       James W. Lokey              Chief Executive Officer        March 14, 1997

  /s/ THOMAS E. PRINCE            Executive Vice President,
-----------------------------      Chief Financial Officer        March 14, 1997
      Thomas E. Prince            (Principal Financial and
                                     Accounting Officer)

   /s/ BRENT McQUARRIE                    Director                March 14, 1997
-----------------------------
       Brent McQuarrie                            

   /s/ DR. PAUL KOURI                      Director               March 14, 1997
-----------------------------
       Dr. Paul Kouri        

  /s/ LESTER C. SMULL                      Director               March 14, 1997
-----------------------------
      Lester C. Smull        

   /s/ DR. DENNIS J. AIGNER                Director               March 14, 1997
-----------------------------
       Dr. Dennis J. Aigner  

     /s/ SAM YELLEN                        Director               March 14, 1997
-----------------------------
         Sam Yellen          

                                       93