Nov. 21 (Bloomberg) -- Downey Financial Corp., the California thrift crippled by bad mortgages, and smaller PFF Bank & Trust were closed by regulators today and taken over by U.S. Bancorp at an estimated cost to the FDIC of $2.1 billion.

U.S. Bancorp acquired the lenders in a deal brokered by the Federal Deposit Insurance Corp. Downey’s liabilities may cost the agency’s Deposit Insurance Fund about $1.4 billion, and losses related to PFF may reach $700 million, according to a statement outlining the takeover.

Closure yesterday of the two southern California thrifts and Community Bank of Loganville, Georgia, added to the highest total of bank failures since 1993. The collapses of Washington Mutual Inc. and IndyMac Bancorp Inc. were among the biggest in history. IndyMac’s failure cost the FDIC $8.9 billion.

Downey Financial, based in Newport Beach, California, lost about $680 million on mortgages in the past five quarters. The lender is the last of the five biggest sellers of option adjustable-rate mortgages to fail or be sold. Those loans, which let borrowers defer part of the monthly payment and add it to the principal, leave banks vulnerable to defaults when housing prices fall because the size of the mortgage can rise beyond the value of the property.

Bad Loans

Loans no longer collecting interest surged to 15.7 percent of assets from 2.9 percent a year ago, Downey said Oct. 22, in reporting an $81.1 million third-quarter loss. At the end of the previous period, Downey held $6.9 billion in option ARMs.

“With the deterioration in the economy and especially the California economy, it suggests even more losses are coming” in Downey’s portfolio, said James Barth, former chief economist at the Office of Thrift Supervision and professor of finance at Auburn University in Alabama, in an interview before the takeover was announced.

Housing prices in California declined by 41 percent in September, the 12th straight monthly fall, the California Association of Realtors said in October. In its annual housing forecast, the group said home prices in the state will drop another 6 percent next year.

For Minneapolis-based U.S. Bancorp, the takeovers add approximately $12.8 billion of assets and $11.3 billion of liabilities, including $9.7 billion of deposits belonging to Downey, the bank said in a statement. It will assume $3.7 billion in assets and $3.5 billion of liabilities, including $2.4 billion of deposits, from Rancho Cucamonga, California-based PFF.

Assuming Losses

The bank also agreed to assume the first $1.6 billion of any losses on the acquired assets. Any excess losses will be shared with the FDIC, U.S. Bancorp said.

The acquisitions more than double U.S. Bancorp’s share of deposits and number of branches in certain Southern California markets, including the Los Angeles area, the company said. It gains 170 Downey Savings & Loan branches in California and five in Arizona, along with 38 PFF Bank & Trust branches in Southern California.

Downey was fourth in option-ARMs ahead of IndyMac and behind Wachovia Corp., Washington Mutual and Countrywide Financial Corp., now part of Bank of America Corp.

Washington Mutual became the biggest U.S. bank to fail on Sept. 25, when regulators sold the Seattle-based lender’s deposits to JPMorgan Chase & Co. Wachovia agreed in October to be bought by Wells Fargo & Co.

Downey named Charles Rinehart chief executive officer on Sept. 22 to help orchestrate a rebound. Rinehart, 61, assumed the duties of Thomas Prince, who was interim CEO since July when Daniel Rosenthal stepped down.

Family-Run

Co-founder Maurice L. McAlister stepped down as chairman the same day Rosenthal -- his son-in-law -- lost his job. His daughter Cheryl E. Olson retired as vice chairman in December 2007. McAlister had helped run the bank for 50 years after establishing the business with Gerald H. McQuarrie, who died in 1992, according to the company.

Downey Savings and Loan opened its doors in 1957 with an office in Downey, Los Angeles County. The mortgage lender said Nov. 10 it might be seized because it probably couldn’t comply with an OTS order to raise capital by the end of the year.

To contact the reporter on this story: Ari Levy in San Francisco at alevy5@bloomberg.net; Finbarr Flynn in Tokyo at fflynn3@bloomberg.net

Last Updated: November 22, 2008 01:37 EST