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Downey Financial Wins $374 Million Tax Refund Fight

October 8, 2013 | By Peg Brickley peg.brickley@wsj.com | online.wsj.com

Bondholders of Downey Financial Corp. won big Tuesday when a bankruptcy judge said the former home lender, not the Federal Deposit Insurance Corp., has top claim on a $374 million tax refund.

The ruling from Judge Christopher Sontchi means the FDIC gets an unsecured claim in Downey Financial's bankruptcy and must share the refund with investors in $200 million worth of bonds issued by the bank-holding company.

The FDIC is overseeing the liquidation of Downey Financial's bank unit, Downey Savings & Loan, in a proceeding separate from the parent company's bankruptcy.

The agency argued it was entitled to the tax refund, which was generated by massive losses in the collapse of the housing market.

Judge Sontchi ruled otherwise, finding that the FDIC-controlled bank is a creditor in its parent's bankruptcy case.

"We believe the decision is extremely well-reasoned and we're obviously very pleased with it," said Schulte Roth & Zabel LLP's Alan Glickman , attorney for Wilmington Trust Co., indenture trustee for the $200 million bond issue. The FDIC, through spokesman David Barr, declined to comment, citing "active litigation."

Downey's 2008 losses ran to more than $1 billion, the consequence of a long run of issuing "option" adjustable-rate mortgages, which ultimately soured, leaving many borrowers owing much more than their homes were worth.

Regulators shut down and seized the bank, sending the parent into bankruptcy. The tax refund was the ultimate prize for both, the largest asset left as the legacy of Downey's run of risky lending.

Downey Financial's fight against the FDIC drained most of the available cash, and sent the bankruptcy trustee to hedge funds that had invested in the parent company's debt for aid.

In exchange for providing Downey a $12 million litigation war chest, investors including Halcyon Loan Trading won the right to collect a large chunk of the tax refund assuming the bankruptcy trustee trumps the FDIC.

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