California Lender Finds a Way to Survive

First Federal Bank of California is a picture of contrasts. Its parent company, FirstFed Financial, just reported a loss...again...for the second quarter, this time for $46 million. The ratio of non-performing assets to all assets—a key metric used to measure a bank's health—is over 10 percent. It is operating under a cease and desist order barring it from making new loans.

One year ago, as Indymac collapsed, FirstFed was on analyst Dick Bove's list of the banks that might be the next to fall. Over the following months, the stock went from around $24 to $.05.

One year later, FirstFed is still around, perhaps the last option-ARM lender in Southern California that hasn't been taken over the the FDIC.

• Slideshow: The Largest Bank Failures of 2009

"All of our clients were panicking because they thought that everyone was going to turn into Indymac," says Chairman and CEO Babette Heimbuch. She let me into the bank's headquarters in the Playa Vista area of Los Angeles, where they recently moved from their long-time offices in Santa Monica. The rent in Santa Monica was twice as much.

"We've always been a very low-expense company," she tells me in an office with bare white walls. "This is a company where...Post-it notes are not allowed."

Heimbuch joined the bank 27 years ago as CFO. She seems confident in the face of potential disaster that she can keep FirstFed afloat. There are some signs she may succeed. The amount of loans which are 90 days late has plummeted to $109 million in the June quarter, down from $232 million in the previous quarter, and $208 million a year ago. The bank has modified nearly $1 billion in mortgages out of a $6 billion portfolio.

Heimbuch says the bank has worked through one-third of its troubled residential mortgage portfolio, and she believes that, somehow, they'll get through the rest by the end of this month. That's a tall order. But the clock is ticking. The bank needs to work through all of its loans and modify where it can, then private investors will recapitalize it, and only then will regulators let the bank begin making new loans again.

How has the bank lasted even this long?

"We cut back on our lending at the end of 2005," Heimbuch says, long before rival banks stopped making risky home loans. "People said, 'What's the matter with you, why aren't you lending?' Everyone was making money, but we thought that the market had gotten a little crazy."

Unfortunately, the damage had been done. Heimbuch says FirstFed discovered that early, too. As Countrywide signaled the beginning of the end in August 2007 by drawing down its credit line, Heimbuch says she realized, "the loans in California were going to have serious trouble, and we needed to get out ahead of that."

In December of that year, her bank began proactively reaching out to all of its residential mortgage customers to see if it was possible to fix their loans.

"We haven't made borrowers go delinquent before we would modify their loans," she says.

Video: Part of CNBC's interview with homeowner Thomas Dowd.

As a result, the bank has fewer delinquent loans than the national average for banks, and four out of five of the modified loans are being paid on time. That means one out of five is redefaulting, but that is also below the national average.

"I actually started my own business at the beginning of the year," says homeowner Thomas Dowd, who approached First Federal Bank of California to modify his $480,000 mortgage. "Initially I was declined because I was going to be self-employed without any steady income. Then, in July, I got a call from (bank) President Jim Giraldin."

Dowd says the bank president set up a meeting to go over the loan and gave him three options to choose from.

"I thought it was a joke, the president calling me," he says. It wasn't. Dowd's adjustable mortgage at 5.9 percent has been converted into a fixed loan at 4.9 percent. "My payments went down $800 a month."

The bank hasn't taken any TARP money, and it's not bound by many of the constraints of government programs in modifying mortgages. Most of the modifications are to interest rates or the length of the loan, not a reduction in principal, "because if you're the type of person that's going to live in (the home) for 30 years...I'd like my money back," Heimbuch says.

Video: See the interview with FirstFed Chairman and CEO Babette Heimbuch.

But the clock is ticking. Heimbuch has been holding the FDIC at bay by showing how well the modification program is working.

"The other thing that I've been saying to them is 'You know, guys, if you want the lowest cost solution for our bank, it's to let us raise capital, it's to let us finish and raise capital, because then you won't lose a dime. She says the bank has private investors out there ready to recapitalize the firm after it gets through its loan portfolio.

"If we can get through this last group of mods, which we are doing very aggressively, in the next couple months, an investor will be able to look at us and say, 'We understand how much money we're putting in and what's at risk.'"

And only after it's been recapitalized will regulators let First Federal Bank of California begin making loans. How much longer can the bank hold on? When will the danger zone have passed? "We're hoping to raise capital by September. If it can't be done by September, it needs to be done by year end. So if we're here at year end, it's passed."