Hudson City Bank (NASDAQ:HCBK) is a traditional savings bank based in Paramus, NJ. The bank’s core business consists of taking deposits and making primarily 1-4 family first mortgage loans, with a specialty in jumbo loans, in the New York metro area. The bank has $60B in assets and operates 130 locations in the New York metro area or surrounding counties. Hudson City got through the banking crisis in 2008 unscathed but still trades at a low price. It seems like it could be a good investment but first we need to examine some concerns about Hudson City and their business model.
I believe that there are three main issues that surround Hudson City, keeping the stock price low. First, the amount of nonperforming loans has been rising while loan charge-offs have remained relatively low. Most understand that Hudson City’s loan portfolio is very high quality, so this likely is not the reason the bank is trading at low multiples. I will discuss this issue, however, to provide some clarity. Second, Hudson City has a very low net interest margin—the difference between what they pay to borrow money and the interest they charge for loans. This issue likely contributes to the low valuation of the stock. Third, Hudson City may be having trouble finding enough credit worthy borrowers so that the bank can continue growing.
As of the 2010Q1 Hudson City had $744M of nonperforming loans but took charge offs of only $24M and has loan loss provisions of only $50M. To understand why loan charge offs and loan loss provisions have been small relative to nonperforming loans, we need to look first at the characteristics of Hudson City’s loan portfolio. For this article we will concentrate on Hudson City’s 1-4 family first mortgage loan portfolio, which makes up 97.9% of its total loan portfolio. I’ll refer to it hereafter as “the loan portfolio.” When originating loans or purchasing loans from other borrowers, Hudson City insists that loans have a low total Loan-to-Value (LTV) ratio. The LTV ratio is the amount of money loaned in relation to the value of an asset that is put up as collateral (a home in this case). For example, if a borrower purchased a $1,000,000 home and paid $400,000 down and borrowed $600,000, that loan would have a LTV ratio of 60%: the amount of the loan ($600,000) divided by the value of the asset ($1,000,000). With Hudson City, the average LTV ratio of the loan portfolio at the end of 2009 was 60.8%. The average LTV of nonperforming loans was 72%. This makes intuitive sense as the less equity a person has in their home the less incentive they have to continue to pay the mortgage.
Future Charge Offs
Hudson City had 74% of its loans in the NY Metro Area as of March 31, 2010. According to the S&P/Case-Shiller home price index, there has been a 21.02% price decline in that area from the peak in June 2006 until February 2010. This compares to a 30.2% decline in the 20-area metro composite. Since April 2009 price declines in the NY Metro have been getting weaker and weaker. While prices are close to stabilizing, they may have a bit further to drop. As we saw above, the LTV of Hudson portfolio is about 60% and the LTV of the nonperforming loans was about 72%. This means that Hudson can continue to see the amount of nonperforming loans rise, but because of the substantial equity cushion in its loan portfolio the bank likely will not have to realize proportional losses.
Low Net Interest Margin
Hudson City’s Net Interest Margin (NIM) is perhaps one of the greatest sources of controversy and confusion surrounding the bank. The Net Interest Margin is the difference between what a bank pays for its funding, be it borrowing or deposits, versus the rate at which it loans the money. NIM can be thought of as similar to the gross margin for nonfinancial companies.
As of 2010Q1 Hudson City had a net interest margin of 2.2%. According to the St. Louis Federal Reserve, as of March 3, 2010 the average net interest margin of banks with assets over $15B was 3.83%. This means that Hudson City’s NIM is substantially worse than average.
Why is Hudson City’s net interest margin so low? It is generally the result of how Hudson City has chosen to conduct business. The COO Denis Salamone summed it up concisely in US Banker: "It's a pretty simple business proposition we offer people, you give us a lot of equity, and we give you a good rate." As we saw in the previous section Hudson City has a very low LTV ratio for its portfolio. It has been able to do this in part by offering loans at lower rates than competitors thus leading to a lower net interest margin.
But net interest margin tells only part of the story. For a stable bank that derives most of its revenue from making loans, the efficiency ratio is the best measure of a bank’s profitability. When discussing banks that are rapidly growing or deriving a large portion of revenue from other non-banking sources, the efficiency ratio is not an effective of a measure.
The efficiency ratio can be thought of as the rough equivalent to the operating profit margin (actually the inverse of the operating margin) of a traditional company. With traditional companies, the gross margin takes into account only the cost of goods sold. The operating profit margin also takes into account selling, general, and administrative expenses. So the operating profit margin shows a better picture of how profitable the company is overall. Similarly, the efficiency ratio takes into account not only the net interest margin (by using net interest income in the calculation of the ratio) but also most of the other costs a bank incurs.
Hudson City had an industry leading efficiency ratio of 18.27% as of the first quarter of 2010. This means that it costs Hudson City 18 cents to generate $1 in profit. Hudson City, then, derives the bulk of its advantage not from expanding its NIM but from being as efficient as possible.
Vulnerability to Rising Interest Rates
Clearly Hudson City has made the best choice on how it conducts banking business from a profitability perspective. Taking in to account all costs (not just interest paid) Hudson City is far and away one of the leaders in profitability. But, it’s a little bit trickier than that. A narrow net interest margin, like Hudson City has, makes a bank very vulnerable to sudden and unexpected (slowly rising rates can be more easily dealt with) rising interest rates. Hudson City has primarily chosen to protect itself from rising interest rates in a few ways.
Hudson City has been extending the length of its borrowing to help lock in low rates. Currently 54% of funding is long term borrowing with a weighted average weight of 4.06%. But even so some of the funding will need to be rolled over and a higher interest rate environment could put a dent in their profit. Indeed when examining Hudson City’s interest rate sensitivity gaps the bank has a negative gap for the greater than five years time period. This means that if interest rates were to rise then net interest income would fall. It is important to note that this gap is for assets and liabilities five years in the future, all other interest rate gaps save the less than six month bucket are positive. The company has also made recent strides in reducing its vulnerability to suddenly rising rates. A year ago a one year incremental increase of two percentage points in interest rates would have lead to a 1.66% decrease in interest income. As of the latest 10Q the funding structure changes have reduced that to a .92% potential drop in interest income.
Adjustable Interest Rates
Hudson City also has a significant number of adjustable rate loans. Approximately 50% of mortgage loans are adjustable rate (May 19th, 2010 Barclay’s investor presentation). While these adjustable rate loans can help preserve Hudson City’s net interest margin in a rising interest rate environment the real question is if the adjustable rates are raised how many borrowers will be unable or unwilling to make the new higher payments. Given the credit risk and demographic characteristics of Hudson City’s borrowers they should be able to weather an increase in payments better than many other loan portfolios might.
The most important thing Hudson City has to protect itself from interest rate shocks is excess capital. As of December 31, 2009 Hudson City had tangible capital of $4.5B with a ratio of 7.59% which is well above the adequacy ratio of 1.5%, there is no definition for well-capitalized. Hudson City had leverage (core) capital of $4.5B with a ratio of 7.59% which is well above the 5% definition for well capitalized and 4% adequacy ratio. Hudson City also had $4.7B in risk based capital with a ratio of 21.02% which is well above the adequacy level of 8% and the well-capitalized level of 10%. In a rising interest rate environment Hudson City can put this excess capital to work at higher interest rates and thus mitigate some of the effects that rising rates would have. This excess capital will likely be the most important thing in protecting Hudson City’s profitability in a rising interest rate environment. And as much as Wall Street hates seeing companies keep money lying around it may turn out to be a shrewd choice several years down the road.
From 2005 to 2008 Hudson City had grown their loan portfolio by over 20% each year. In 2009 the growth rate slowed to 7.75%. Additionally management has made comments about it being a tough environment to find customers wanting loans who meet the banks qualifications or loans available for purchase that meet the banks standards.
Hudson City currently trades at very cheap prices with a Price to Tangible Book ratio of 1.24 and sports a dividend yield of around 4.75%. As I pointed out above Hudson City has a very low interest rate loan portfolio so we would expect that it would trade at low price to book levels because the value of the book (the interest paid) is low. Of course if you believe Hudson City is well positioned for a rising interest rate environment or rising interest rates are less of a threat than people imagine than the price to book ratio should be higher and Hudson City is undervalued.
Another way to think about whether or not Hudson City is a good investment is to look at the dividend yield and attempt to answer the question of whether or not Hudson City can continue to pay their dividend and increase them at an attractive rate. When thinking about the valuation this way I think it makes the issue much clearer. Clearly Hudson City has a very attractive loan portfolio from a credit risk perspective. With the amount of excess capital Hudson City has and its funding structure it should be OK if interest rates were to rise suddenly. The lack of high demand for Hudson City’s primary product, jumbo home loans to borrowers with good credit, is another red flag. While I would expect to demand to remain weak there should still be enough to support at least a moderately increasing dividend. And if interest rates were to rise it would likely mean that the economy is recovering and demand for loans is stronger.
While you can tell the conclusion I have come to from my position disclosure it is important that anyone considering an investment in Hudson City have a thorough understanding of their business model and some of the unique risks they face. This article should be a starting point for your own research and not considered a comprehensive examination of Hudson City.
Disclosure: Long HCBK