California isn't the best place to go looking for canaries -- unless they're metaphorical ones.

The state has one of the frothiest housing markets, and banks have been enablers. Investors looking for early warnings of trouble in the mortgage industry should give Downey Financial's numbers a look.

Two weeks ago, I wrote about the rising popularity of option adjustable-rate mortgages, especially in the land of Schwarzenegger. Option ARMs give borrowers the ability to make a minimum monthly payment that results in the balance of what's owed going up. Lots of people are doing that, seemingly oblivious to the risk: Interest rates are rising, and if housing prices fall, homeowners could end up unable to afford the monthly nut on a home they'd have to sell at a loss.

But, as I noted, investors haven't been able to gauge banks' exposure adequately because the disclosure generally is poor, though that problem has improved a bit recently. At Downey, disclosure is good; it's the exposure that's bad. A small Newport Beach, Calif., bank with a stock-market value of $2 billion, Downey writes option ARMs like Californian plumbers write screenplays.

Downey had a blockbuster second quarter. It reported earnings of $2.29 a share, beating estimates by a whopping 75 cents a share. The stock is down a notch since then, but it's up more than 30 percent for the year.

Other measures disclosed last week in quarterly SEC filings are more troubling.

To remind readers, if a borrower chooses to make that minimum monthly payment, a bank nevertheless books the entire monthly amount owed as earnings. That's noncash earnings, which is fine -- as long as the bank isn't allowing people to buy wildly overpriced homes they might not be able to afford as interest rates rise.

As of June 30, $12 billion, or 87 percent of Downey's ARMs are option ARMs. Its customers have racked up $72 million in additional balances on those mortgages by choosing to make minimum monthly payments. That's called negative amortization.

Right now, Downey's negative amortization is a mere 0.6 percent of its ARM portfolio. But that measure understates its significance. Its negative amortization balance is accelerating, from $51 million in the first quarter and $37 million in the fourth quarter of 2004.

These noncash earnings were 20 percent of Downey's earnings per share in the second quarter. If that trend continues, more than 40 percent of Downey's current-quarter earnings would be noncash. Analysts already expect earnings to decline to $1.79 a share in this quarter, so it would be a bigger slice of a smaller pie.

In other words, the bank's earnings are being increasingly driven by sales of a product to inherently risky customers. Downey Finance Chief Tom Prince says concerns about option ARMs are exaggerated and that his bank previously has had even more exposure to them without problems. "I'm not particularly concerned about it," he says.

So far, the bank has had little problem selling off option ARMs into the secondary market. But the company has cautioned that profit margins on those sales are likely to go down.

Since Downey has been disclosing negative amortization figures for a while, we can see what the customer patterns are. They don't bode well. Banks argue that these loans are appropriate for customers who want flexibility or who have variable salaries, like salespeople who work for high, but unpredictable, commissions and bonuses.

That should mean, then, that rising interest rates wouldn't necessarily lead to an increase in people choosing to make minimum payments. Yet the percentage of payments by Downey customers that are big enough to make their principal go down is falling (as a portion of the loans).

Why? Probably because some customers are only repaying their mortgages by refinancing their homes, not when they get paid that big bonus. With mortgage rates unlikely to head down soon and housing prices potentially stalling, customers aren't going to get that chance much anymore. Those bonuses better be pretty good.

The Office of the Comptroller of the Currency is looking broadly at ARM practices. Regulators there would be even more concerned if a bank's capital were at risk. At Downey, there's no sign of that for now. Negative amortization represents 6 percent of the bank's equity. But that could be 9 percent at the end of this quarter, based on recent trends.

This canary is looking a bit peaked.