When last we left our subject, Puerto Rico-based mortgage lender Doral Financial (NYSE:DRL), I suggested that investors should exercise caution with this stock for two reasons: the nature of the company's portfolio and its vulnerability to a rising/flattening yield curve.

At the time, the stock was at $44 a share. Today, it's half that price -- what we used to call "a split the hard way" when I was an analyst.

What led to such a steep fall? Analysts and investors began poking around the company's structure and pricing assumptions, and they didn't feel comfortable with what they found. A wave of downgrades ensued and the stock got hit hard.

The center of angst concerns the company's interest-only (IO) strips -- a highly interest-sensitive security that is created when the company sells its "non-conforming" mortgages to other financial institutions. In particular, there is concern that the company has been too aggressive in valuing these instruments and that further impairments/write-downs may be coming. Not only would impairments hurt the company's reported profits, but they would also impact the company's capital structure -- making it less robust than it currently appears.

Investors may remember that Doral recorded a $97.5 million impairment on its IO strips in the fourth quarter (due to interest rate increases) and a total of $131 million in impairment for all of 2004. Should the Fed continue to hike rates, it's reasonable to expect that further impairments could ensue -- and that would hurt earnings.

There is also concern about the sustainability of Doral's gain-on-sale margins -- the money that the company makes from selling off its mortgages. The creation of IO strips is a large component of gain-on-sale and, as the yield curve flattens, mathematically, there almost has to be a decline in the margin generated by creating IO strips.

But that's not to say that Doral is entirely helpless here. This bank controls about 45% of the Puerto Rican mortgage market, competing with firms like First BanCorp (NYSE:FBP) and Santander BanCorp (NYSE:SBP), and the company does have at least some ability to raise pricing on non-conforming loans and dictate terms on loan sales.

So, it's something of a stand-off between buyers and sellers, with Doral's margin hanging in the balance. While I am not about to doubt Doral's strength in the Puerto Rican market, I just don't believe that it can win this fight indefinitely. As a result, I would expect to see at least some weakness in the gain-on-sales margin.

To its credit, the company's management is responding to these issues. Management has announced that it may sell some of those IO strips that are causing such controversy. While this could remove some risk from the balance sheet, it might also give investors a peak at whether management's valuation assumptions are in fact aggressive. Doral management also seems to be increasing its hedging activities, an action that should moderate the need for future impairments if rates continue to rise.

So what does the future now hold for Doral and its shareholders? Let me be clear about one thing: This a company whose management has a solid performance track record. What investors should realize, though, is that this is a time of transition for the company and management must reposition the business to deal with the realities of a rising interest rate environment. So while Doral had "easy sledding" when rates were falling, it's time now to trudge back up the mountain and reload that sled.

Present valuations certainly look cheap -- a trailing P/E of only 5.5, a dividend yield of 3.2%, and a return on assets of 3.7% -- but concerns still linger. Should further impairments become necessary and should the company's margin decline, earnings will obviously be hurt and those now-attractive ratios could deteriorate.

Investors who can accept the risk involved today (not to mention read and understand the company's discussion of IO strips in the 10-K) will probably come out okay in the long run, but those who don't know the difference between IO, IPOs, and C-3PO would do well to wait on the sidelines until the dust settles.

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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares). The Fool has a disclosure policy.