Are Hudson City Bancorp's Limited Documentation Loans in Trouble?

| About: Hudson City (HCBK)

Hudson City Bancorp (Nasdaq:HCBK) recently informed their shareholders in their 2010 10-K, as filed with the SEC on 3/1/2011, that they expect to become a subject of an informal regulatory enforcement action in the form of a memorandum of understanding (“MOU”) with the Office of Thrift Supervision ("OTS"), a regulatory agency.

This event prompted us to research and examine Hudson's disclosures and SEC filings.

From Hudson's filing, the reason for the enforcement is their "interest rate risk position", "funding concentration in structured borrowings", and "certain regulatory compliance matters". Further, in the same 10-K filing, Hudson City Bancorp claims that "according to the exclusions defined in the "Expanded Guidance for Subprime Lending Programs (.pdf)" (the "Expanded Guidance"), issued on January 31, 2001", they are a "prime lender."

Hudson City Bancorp states the following in their 10-k filing:

Five specific criteria, which are not intended to be exhaustive and are not meant to define specific parameters for all sub-prime borrowers and may not match all markets or institutionsspecific sub-prime definitions, are set forth, including having a Fair Isaac Corporation (“FICO”) score of 660 or below. Based upon the definition and exclusions described above, we are a prime lender.

In the next sentence, they state the following regarding their "prime" status:

However, as we are a portfolio lender, we review all data contained in borrower credit reports and do not base our underwriting decisions solely on FICO scores and do not record FICO scores on our mortgage loan system.

In addition to a FICO score above 660, the list of borrower credit criteria used in determining whether a loan is "prime" or "subprime", as suggested by the OTS in the "Expanded Guidance for Subprime Lending Programs" contains, but is not limited to, the following:

  • Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months.
  • Judgment, foreclosure, repossession or a charge-off in the last 24 months.
  • Bankruptcy in the last 5 years.
  • Debt service-to-income ratio of 50% or greater, or otherwise limited ability to cover family living expenses after deducting total monthly debt service requirements from monthly income.

Hudson's statement that they record FICO scores on their mortgage system raises a fundamental question about Hudson's operations: How does Hudson track the change in their borrowers' creditworthiness, which is reflected in the trend of their FICO scores, when Hudson does not record and manage the borrowers' FICO scores at the loan origination stage? While FICO scores are not the only determinant of credit quality, they are a baseline and a starting point in modern credit analysis. Hudson's practice of not recording and keeping track of borrowers' FICO scores is, in our opinion, very unusual and troubling.

Further, the OTS requirements are since 2001, and may be outdated and inadequate for measuring and analyzing credit quality in the current lending environment. For example, Freddie Mac (OTCQB:FMCC) disclosed (.pdf) that their Alt-A loans, traditionally some of the riskiest loans, had an average score of 719 as of 12/31/2010. Ocean First (Nasdaq: OCFC), another jumbo lender in the New York/New Jersey area, reported that as of December 31st 2010, the average FICO score on their loans was 746. In addition, on February 15th 2011, Redwood Trust offered a securitized jumbo loan portfolio originated by First Republic Bank (NYSE: FRC) and PFF Mortgage Corporation (NYSE: PHH), which carried a weighted average FICO score of 775.

Only 4.66% of the loans were issued to borrowers with FICO scores between 700-720, and 79% of all loans were issued to borrowers with FICO scores between 741 and 800. It is worth noting that 100% of the securitized loans were issued with at least one year of borrower's income fully verified. Based on the above evidence, we conclude that Hudson's use of a FICO level of 660 may be outdated in the current lending environment. We hope that Hudson's management would offer similar schedules of their borrowers' FICO scores, but per their statement, the FICO scores are not recorded or available.

The additional requirements, especially the debt service-to-income ratio, are important for Hudson City Bancorp, yet Hudson does not discuss them in the 10-K filing. Hudson states in the 10-K that they offer limited documentation loans. Further, Hudson allows up to 10% of their wholesale loan purchases to be limited documentation loans, but Hudson admits that they do not track those loans on their "mortgage loan system." As of December 31, 2010, of the $30.92 billion in total loans, the bank had "$3.38 billion of originated amortizing limited documentation loans and $938.8 million of originated limited documentation interest-only loans," for a total of $4.32 billion in limited documentation loans.

By definition, Hudson City Bancorp does not know the borrowers' income levels at the point of loan origination of these loans. More importantly, Hudson City Bancorp is unaware of their borrowers' current income levels and the current debt service-to-income ratios. This translates to $4.32 billion, or 14% of all loans, worth of potentially subprime loans on Hudson City Bancorp's books. In perspective, $4.32 billion is approximately 88% of Hudson's $4.9 billion in equity, as defined by the market capitalization at the time of writing this article.

The increase in the volume of non-performing loans are a proof of the deterioration in their borrowers' creditworthiness. This trend is summarized in their 10-K filing as: "Non-performing loans totaled $871.3 million at December 31, 2010, as compared to $627.7 million at December 31, 2009", which is a 38.8% increase, year over year. These figures, however, are for loans "on which the accrual of income has been discontinued and loans that are contractually past due 90 days or more but have not been classified as non-accrual", i.e. considered uncollectable, as of 12/31/2010. The more revealing figure is the total of past due loans - $1.48 billion - as presented on page 69 of the 10-K Exhibit 13.1. This amount is 4.8% of the $30.92 billion in total loans, and 30% of Hudson's market capitalization. The distribution of the past due loans is as follows:

30-59 Days past due: $418 Million
60-89 Days past due: $193 Million
90+ Days past due: $871 Million

This distribution shows that borrowers who are over 90+ days past due represent a significant 58% of the total past due loans. Also, an increasing number of new borrowers are becoming past due, as depicted by the fact that the loans 30-59 days past due are more than 2 times greater in volume than the loans in the next delinquency stage, and represent 28% of the total past due loans.

The credit deterioration brings us to the behavioral effects the declining real estate market and the omnipresent defaults can have on borrowers. As evidenced by the turmoil in real estate related financial derivatives, the correlation calculations used in determining expected loan default rates were proven to be wrong. What these models did not take into account was the fact that the likelihood of a borrower defaulting on a loan increased significantly if the borrower was in proximity, physical or social, to other defaulting borrowers.

We believe that this contagion effect is reflected in, and is reinforcing the increases in non-performing loans on Hudson's books, as described in the previous paragraphs. We do not believe that Hudson City Bancorp has any control over the contagion effect. From a purely macroeconomic perspective, we agree with the company's statement that the regional unemployment rate and the falling housing prices contribute to the increasing trend in loan delinquencies.

So is Hudson City Bancorp a prime lender? Hudson's use of the FICO score of 660 or greater in order to label itself a "prime lender" is, in our opinion, outdated considering the credit quality of other comparable loans. This practice, combined with Hudson's issuing 14% of all loans without full documentation and purchasing wholesale-originated limited documentation loans, is not, in our opinion, a paragon of prime lending. However, labeling the bank one way or another is irrelevant.

Analyzing the bank's loans and their characteristics is what's relevant, and that is what we have done in this article. We encourage all interested parties, including analysts, counterparties and shareholders to analyze and scrutinize the facts in Hudson's 10-K filing. We believe that the investors have so far reacted to the news that the company may be required by the OTS to stop paying its dividend, and is subject to regulatory action by the OTS. We do not believe that investors have priced Hudson's volume of limited documentation loans, the trend and volume of their non-performing loans and the potential for significant future charge-off as a result of these facts.

Disclosure: I am short HCBK.

Additional disclosure: We own put options on HCBK stock.