Has Hudson City Lost Its Mojo? Part 1

Jun.16.11 | About: Hudson City (HCBK)
Over the past decade, Hudson City Bank (NASDAQ:HCBK) has been an outstanding dividend stock and a strong performer for patient, total-return investors. Consider this fact: For the first 10 years following its initial IPO in 1999, management paid out total cumulative dividends of $2.25, compared to an initial (split-adjusted) stock price of $1.56. In other words, you would have earned back all of your initial investment, as well as made an ~44% return on the initial investment, from the dividends alone.
Even the financial crisis that hobbled banking institutions, particularly those with large exposure to the residential mortgage market, did not seem to stop its growth. Hudson City Bancorp was the largest U.S. bank to forgo the capital purchase program of the Troubled Asset Relief Program, yet continued to achieve record net income in 2009 and then again in 2010.
Recent Problems
In recent quarters, however, the bank has struggled to grow net interest income and earnings have been under pressure. In the most recent earnings release, management reported a net loss of $555.7 million, compared to net income of $121.2 million in the fourth quarter of 2010. In addition, several Seeking Alpha contributors correctly predicted a potential dividend cut, which was confirmed in the most recent earnings release. And if that wasn’t enough to spook investors, the OTS issued a regulatory statement about interest rate risk, and the bank had to undergo a major restructuring of its balance sheet in order to help address these concerns.
As a result, the stock is now down -36% YTD and is well off its 52-week high of $13.48. In fact, Tuesday’s closing price of $8.15/share is actually 5% lower than it was in the midst of the crisis in March of 2009. Do the large losses and steep dividend cut reported in the most recent earnings report justify the pessimistic outlook reflected in the bank’s current stock price?
I believe there are three issues that investors should keep in mind when considering investing in Hudson City. First, although the bank reported a net loss this quarter, it was predominately due to a one-time charge related to its balance sheet restructuring. Second, the balance sheet restructuring that management undertook helped address regulator’s concerns by reducing interest rate risk. Third, the bank has a high quality loan portfolio, and its core operations are still strong. Combine these factors with the possibility of renewed earnings growth over the next year, and Hudson City starts to look attractive at this price.
Non-Recurring Losses
Hudson City reported a net loss of $555.7 million for Q1 2011, the first quarterly loss since its second stock offering in 2005. According to the earnings release, the balance sheet restructuring reduced after-tax earnings by $649.3 million, but operating earnings were still positive at $93.7 million, or $0.19 per diluted share. Although this is a significant decline from historical earnings (quarterly earnings ranged from $0.26 to $0.30 per share for the previous eight quarters), it is clear that the negative earnings reported this quarter are a result of the balance sheet restructuring, which is a one-time expense. Thus, the bank should once again report a positive net income next quarter.
Interest Rate Risk & Balance Sheet Restructuring
As a savings and loan holding company, Hudson City Bancorp is subject to the regulation and oversight of the Office of the Thrift of Supervision, an agency within the U.S. Treasury Department. In its March 2011 10-K report, the bank reported that it “expects to become subject to an informal regulatory enforcement action in the form of a memorandum of understanding” from the OTS.
The following day, both The Wall Street Journal and The New York Times reported on “regulatory enforcement action” and “excessive risk”. Several analysts also highlighted that interest-rate risk (the possibility that net interest margins compress and earnings become negative as interest rates rise) could be the bank’s Achilles’ heel. In order to address interest rate concerns, the bank restructured its balance sheet by paying off $12.5B in structured quarterly putable borrowings by selling $8.66 billion of its mortgage-backed securities portfolio and borrowing $5 billion of new shorter-term, fixed-rate funding.
The best way to understand a putable advance (or “borrowing”) is to think of it as a loan between a bank (Hudson City) and a Federal Home Loan Bank (FHLB) with two components. The first component is simply a loan that the FHLB provides to Hudson City. Hudson City pays interest to the FHLB, and uses the funding to issue mortgages to clients. The second component is Hudson City selling a put option to the FHLB that allows the FHLB to “put” the loan. In other words, the FHLB can request that Hudson City pay back the loan before the stated maturity date in the agreement, and the bank must comply. In exchange for including this option, Hudson City gets to borrow the money at a lower rate than it would for a normal loan.
The downside to this type of funding, however, is the potential interest rate risk and liquidity risk it adds to Hudson City’s balance sheets. For example, if interest rates increased significantly, the FHLB could terminate the loan and require Hudson City to repay the entire amount. The FHLB would then offer to replace the funding, but at the higher interest rate that loans are then being issued at. Thus, the borrowed portion of Hudson City’s funding would become more expensive, while the existing mortgage loans would still pay the low, fixed interest rate that they were issued at, and the bank’s net interest margin would be squeezed.
In part 2, I will address the quality of the bank’s mortgage loan portfolio and its ongoing core operations. I will also highlight the bank’s long term potential as well as some potential catalysts to unlock its value in the market.
Disclosure: I am long HCBK.