UPDATE 1-Option ARM specialist Downey Financial may fail

NEW YORK, Nov 10 (Reuters) - Downey Financial Corp DSL.N, one of the largest specialists in "option" adjustable-rate mortgages, said on Monday its survival was in doubt because it may fail to raise enough capital to satisfy its regulators.

In its quarterly report filed with the U.S. Securities and Exchange Commission, Downey said there was “substantial doubt” about its ability and that of its banking unit “to continue as going concerns for a reasonable period of time.”

The Newport Beach, California-based lender agreed with the federal Office of Thrift Supervision on Sept. 5 to raise new capital by the year-end and to provide an alternative strategy to ensure it could operate safely if it did not.

While Downey said it bolstered capital by selling some real estate assets, it added that “in the current economic environment, there was a significant risk” it will not have enough capital at year end.

Option ARMs let borrowers pay less than the interest and principal due each month. The loans are now considered among the riskiest offered during the recent housing boom and have left many borrowers owing more than their homes are worth.

If Downey were to fail, it would join 19 other U.S. lenders to do so this year. The largest of these, Washington Mutual Inc WAMUQ.PK and IndyMac Bancorp Inc IDMCQ.PK, both had large option ARM operations.

Downey has overhauled top management, stopped making mortgage loans through brokers and scaled bank its retail mortgage business after credit losses soared.

The company lost $547.7 million, or $19.64 per share, in the first nine months of this year. As of Sept 30, it was not collecting payments on $2 billion, or 15.7 percent, of its $12.8 billion of assets. That ratio of nonperforming assets was up from 2.9 percent a year earlier.

Wachovia Corp WB.N, the biggest option ARM provider, agreed to sell itself to Wells Fargo & Co WFC.N after regulators pushed it to find a buyer and avoid its own possible bankruptcy.

Downey shares closed on Monday down 4 cents at $1.45 on the New York Stock Exchange. They have fallen 97 percent from their 52-week high of $43.08 set last Nov 30. (Reporting by Jonathan Stempel; Editing by Andre Grenon)