Has Hudson City Lost Its Mojo? Part 2

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 |  About: Hudson City Bancorp, Inc. (HCBK)
by: Mike Young
In part I of my review of Hudson City (NASDAQ:HCBK), I talked about the bank’s strong performance over the past decade and the problems that surfaced in its most recent earnings release – a net loss for the quarter and a significant dividend cut. I also discussed how the balance sheet restructuring resulted in non-recurring losses, as well as its impact on the bank’s interest rate risk. In part II, I will focus on the core operations and quality of the loan portfolio, and discuss whether or not Hudson City is still a good long-term investment.
Core Operations & Loan Portfolio Quality
Although GAAP earnings for the most recent quarter were negative, operating earnings -- which are adjusted to exclude nonrecurring transactions such as the debt restructuring and the sale of MBS holdings -- were still positive. The bank reported operating earnings of $93.7 million and diluted operating EPS of $0.19. This is a 24% decrease from the previous quarter, so clearly earnings are under pressure. However, the bank has $438 million incash and cash equivalents, a Tier 1 capital ratio of 8.12% (vs. 7.95% in December 31, 2010), and a total risk-based capital ratio of 19.66%. These capital ratios make Hudson City a “well capitalized” bank according to the FDIC standards of 6% and 10%, respectively.
Furthermore, management estimates the restructuring transaction could increase net interest margin by as much as 0.40% (current NIM is 1.72%), which would help to improve net income. So the bank is certainly not in danger of going out of business in the near term, and its core operation (generating interest income from its mortgage loan portfolio) is still intact.
It is also important to keep in mind the quality of Hudson City’s mortgage portfolio, which is the result of strict and consistent underwriting practices during both boom and bust markets. Approximately 96% of the total loan portfolio is 1-4 family first mortgages totaling $29.2B. Nonperforming loans (NPL) are still less than 3% of the total loan portfolio and the year-over-year change in delinquency rates has been steadily declining, suggesting that NPLs may be nearing a peak. This is consistent with the fact that 71.2% of the bank’s NPLs are located in the NYC metro area, where house prices have declined less than the national average (23% vs. 31%) and appear to be stabilizing.
Furthermore, loan loss provisions have dropped to $40M from $50M in the first quarter of 2010, and the average loan-to-value ratio for the total mortgage loan portfolio was 60.6% (at March 31), giving Hudson City an extra reserve to cushion any additional declines in housing prices.
Long Term Potential
Like most financial firms, Hudson City faces significant headwinds in the near-term from increased regulation and the rising cost of doing business, as well as interest rate risk from its balance sheet if borrowing costs increase. In addition, continued weakness in both the housing market and in employment could lead to further declines in home prices and an increase in delinquency and default rates that would also negatively impact Hudson City’s balance sheet and income.
However, given the large drop that has already occurred in the housing market, along with the bank’s underwriting standards and the quality of its current portfolio, Hudson City has limited business risk. I also believe the stock price already reflects an extremely negative outlook. The stock now trades lower than it did during the market lows in March of 2009, when investors feared the worst for the entire capital market system, and financial stocks in particular. For a long-term investor, the downside risk of buying the stock at current levels in pretty low.
On the other hand, I believe that Hudson City could have a lot of upside from here over the next three to five years through a combination of stock price appreciation and dividend yield/growth. Why do I say this? First, there has been an unprecedented level of government intervention in the mortgage market that is scheduled to stop over the next few months. The Federal Reserve Bank will be stopping its bond-buying program (“QE2”) at the end of June, and the government-sponsored enterprises (Fannie & Freddie) are scheduled to stop purchasing jumbo mortgages in October of this year, which should allow private capital to enter the mortgage markets again.
Second, interest rates are at multi-decade lows and will have to increase at some point due to simple mean reversion. The bank has already taken significant steps to reduce interest rate risk, and if management can continue to manage interest rate risk, rising mortgage rates will ultimately be a plus for the bank, allowing it to earn higher yields and increase its net interest margin.
Third, management has shown a commitment not only to growing revenue and earnings over time, but also to returning capital to shareholders through a publicly stated commitment to its dividend. During a period of rising interest rates and contracting price/earnings ratios, which we are likely to see in U.S. equities in the coming years, the market will reward companies that grow their dividends.
Thus, I believe Hudson City offers an excellent risk/reward opportunity for patient investors that are willing to invest for the long-term.
Disclosure: I am long HCBK.