Prime Bomb: Former Golden Child Hudson City Bancorp Sees Prime Delinquencies Skyrocket

Subtitle: Green Shoots Fried by the Prime Bomb!

Hudson City Bancorp (HCBK), fully recognized as the poster child for “safe” prime-only mortgage lending and whose CEO’s frequent media appearances usually come with heaping portions of high praise and accolades, appears now to be fully experiencing portfolio stress driven by the vicious combination of rising unemployment and falling home values.

Though Hermance appears to have succeeded in his goal of increasing confidence in his bank, its non-performing loan ratio, which has exploded dramatically jumping from .74% on December 31 2008 to 1.40% in Q2 2009, tells a different story.

So much for “pristine” credit quality…

Worse yet, while it appeared that Hermance and his team had been working tirelessly to keep the impact of their credit losses quiet in recent quarters (… with excessively low loan loss provisions and little guidance as to eroding credit quality), the latest results are too severe to massage.

Hudson City now holds over $430 million in delinquent loans forcing them to increase their loan loss provisions to $52.5 million, a stunning 954% year-over-year increase for the six months ended June 30.

Further, over the same period, net-charge offs jumped to $14.2 million, a 1083% increase over the $1.2 million reported for the first six months of 2008.

I’ve been arguing for the better part of two years that although the traditional media and apparently general consensus has focused on subprime and other “toxic” mortgage products as the source for the credit tumult, the historic deterioration would by no means be limited to these “bleeding edge” products.

Before this massive housing and general economic contraction is complete, I expect to see new records set for prime defaults, be they prime-Jumbo ARM loans, prime-Jumbo fixed rate loans, prime-conforming ARM loans or prime-conforming fixed rate loans… we will see historic defaults across the entire spectrum of mortgage products.

Although there is significant debate about the true drivers of mortgage default, most individuals in default cite unemployment as the cause while other key instigators are: risky or insufficient household financial planning (high consumer debt and low/no savings), low-equity stake and housing depreciation, and simply general recession.

The key point to consider though is that while all of these factors have contributed to creating environments of high mortgage default in the past, our current circumstances make these past periods look like walks in the park.

It’s important to understand that although Hudson City’s total first mortgage loan portfolio has a reasonable average loan-to-value ratio of 61%, the bank is still seeing a precipitous increase in loan defaults.

In fact, currently the average LTV of their non-performing loans (defaulted loans) is 69% so “prime” borrowers with 31% equity at the time of origination are now defaulting in steadily increasing numbers.

The following chart plots Hudson City Bancorp’s Non-Performing Loan Ratio (defaulted loans to total loan portfolio) since Q1 2004.

Notice that defaults have been on the rise since Q2 2006 while in Q2 2007 things really started to heat up.

click to enlarge

But how does the growth in defaults of the Hudson City Bancorp “prime” portfolio stack up compared to other well know default rates?

The Following charts compare the Hudson City default rate to that of Fannie Mae (FNM) and the MBAA foreclosure rate.

The top chart compares the normalized default rates since Q1 2004 while the lower two compare the same data since Q1 2007 in order to get a sense of the respective growth over these periods.

It’s important to keep in mind that although Hudson City is not experiencing the same ratio of defaults (Fannie Mae and the general MBAA rates are worse) the growth of prime defaults is comparable and, since Q1 2007, has even been substantially higher.

As for Hudson City loan loss provisions, as you can see from the following chart, the capital cushion is dwindling.

The key instigators in this growth of default is more than likely home price depreciation and unemployment both working together to bear down on “prime” homeowners as is shown by the following charts plotting the year-over-year percent change to the New York area S&P/Case-Shiller home price index against the Hudson City default ratio as well as the unemployment in New York and New Jersey since 2004.

I will continue to update this data in coming quarters in order to see how slumping home values and rising unemployment affect the performance of “prime” borrowers.

Disclosure: Not only am I currently short HCBK, I’m more certain now than ever before that we are seeing a precipitous decline of the prime mortgage holder.

Comments

[58robbo:]

puzzled how anyone with a ltv of 69% can default. it doesn't make any sense. unless their valuations are too high in which case the ltv would not be 69%. to think that there are people out there calling for a bottoming out of re prices.

Jul 22 06:52 AM

[John Preston:]

Good insights...finally...

Equity does not make monthly payments....jobs and income do...

While subprime and no docs loans make good fodder for the media and serve to drive mass angst, ultimately it was overlveraged income via the underwriting process by Fannie/Freddie (and other credit grantors) that crippled the borrowers....you cannot (and F/F did) commit 45%-60% of a homeowners gross income to the mortgage payment and not expect problems...

The myth of the "20% down payment is one of todays problems. The only security for a homeowners a solid job, is consistent monthly income and some cash reserves. The down payment is a non-factor...always has been...and always will be a secondary issue in underwriting...

ANY borrower whose income-to-debt ratio has gone up as a result of declining household income is in deep trouble....and down payments...and high credit scores...and even full doc processing cannot overcome the lack of income....

Hudson BC's CEO was pretty arragant on TV....telling us all that they went by the book and did things the "old fashioned way"...28/36 ratios/downpayments, etc. If Hudson really did this...follwed the old rules, and, keep in mind, F/F was allowing MUCH higher ratios within their AUS systems (over 60%).....what this is really saying that the problem is in the jobs and income...and for many, overlev eraging of income, which is where thisw mess first started....

Jul 22 09:16 AM

[FloridaBoy2:]

I heard the CEO state that second mortgages that are junior to the first mortgage held by Hudson are the reason for the increase in losses. The homeowners tapped additional 'equity' and are now underwater and walking away.

Jul 22 09:48 AM

[OptimizedPrime:]

As for Prime defaults, it's all about the Strategics: people are going to walk away even though they can afford the payments because they are hopelessly underwater and will be for a decade (i.e. far longer than the bad credit will last).

@John Preston -- I think that the "job risk factor", while a normal part of the home loan process, doesn't solve the problem here.

What SHOULD have been happening as home prices spiraled upward was that mortgage rates should have spiraled upward as well: the increased volatility increased the risk. This would have put a natural damper on the entire market and kept us out of this mess.

In other words, if you are giving somebody a loan on an asset that has consistently increased in value by 3% per year over a long time, you can put that into your model and envision a certain downside if that trend reversed itself. Then you would make sure your LTV covers you and that wouldn't be too much.

However, if you are loaning somebody money for an asset that has tripled in five years, you MUST assume you can lose all of that increase and put THAT into your models.

In the Bubble era, LTVs should have been at least 50%. Interest rates should have been double digits.

Then again if that happened, then there wouldn't have been a Bubble. Problem solved.


OP

Jul 22 05:22 PM

[Troyhector:]

As home prices fall and banks tighten lending standards, people with good, or prime, credit histories are falling behind on their payments for home loans, auto loans and credit cards at a quickening pace, according to industry data and economists.

The rise in prime delinquencies, while less severe than the one in the subprime market, nonetheless poses a threat to the battered housing market and weakening economy, which some specialists say is a sure sign that the housing market is not reviving.

Read More :www.housingnewslive.co...

Jul 23 03:48 PM

[bond investor:]

You should be long HCBK, not short. Its franchise is significantly undervalued. I think you make three four errors; it may be that you've thought of these things but just didn't include them in the article.

1. A loan portfolio has a "cure rate," in which *what's left* in the loan portfolio *after* certain loans are provisioned for and charged off is *healthier* than before. Hence projecting chargeoffs and provisioning to head upward indefinitely is not appropriate. In fact, many analysts looking at 3Q bank earnings thus far have concluded that the declines in loss reserves is a *positive*, not a negative, as it shows "what's left" in banks' loan portfolios has not needed as much provisioning as in prior quarters.

2. Your charts on delinquencies need more data series to do apples-to-apples comparisons. You compare HCBK's prime jumbo book to the FNM book of non-jumbo loans. I would be encouraged, not discouraged, that a portfolio of loans with a high original loan size was performing so well versus a portfolio of loans with average-to-low original loan size. While LTV is most important, we should be clear on the second-order effects, too, and you're not.

3. HCBK can easily earn its way through its loan losses. Its efficiency ratio is in the mid-20s, meaning that for every $1.00 in deposits, only about 25c goes to expenses. Contrast this to the bank sector average efficiency ratio in the low 60s. HCBK can keep offering better deposit rates and growing spread income. But you only focus on the loan book. More comprehensive analysis looks at the *future*, not just the present and past.

4. All stocks should be valued on both a relative and absolute basis. I agree that on an absolute basis, HCBK is facing some headwinds, but as 1-3 above explain, I think you are overplaying them. On a *relative* basis, HCBK is cheaper on a Price/Book basis to banks like WFC, with it Wachovia/Golden West option-ARM timebomb ticking inside its balance sheet. But perhaps you are also short WFC. If so, then we agree on something!

Disclosure: long HCBK, can't short specific stock like WFC 'cause all my money's in my IRA.

Jul 26 02:19 PM