Hudson City Bank 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 $52.45 billion in assets (2011Q1) and operates 130 locations in the New York metro area or surrounding counties. Hudson City got through the sub-prime crisis in 2008 unscathed but not the current low interest rate environment.
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 and as such they were forced to restructure their balance sheet in the first quarter of 2011. This issue likely contributes to the low valuation of the stock. Third, Hudson City is having trouble finding a way to grow its loan portfolio because of the continued interference of Fannie and Freddie in the mortgage market. This third issue is likely the biggest risk HCBK faces.
Loan PortfolioNonperforming Loans
As of the first quarter 2011 Hudson City had $886 million (or 2.92% of total loans) of nonperforming loans (NPLs) but took charge offs of only $21.3 million and has loan loss provisions of only $40 million (reduced this quarter from $45 million). 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.
Hudson City’s 1-4 family first mortgage and FHA/VA loan portfolio makes up 98.2% 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 71.2% of its loans in the NY Metro Area as of March 31, 2011Q1. According to the S&P/Case-Shiller home price index, there has been a 23% price decline in that area from the peak in June 2006 until January 2011. This compares to a 31% decline in the 20-area metro composite. Since April 2009 price declines in the NY Metro have been getting weaker and weaker. However, home prices may have further to fall according to some experts, including Robert Shiller himself. 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. In fact in some quarters the company has booked gains on the sale of foreclosed real estate.
The most important thing Hudson City has to protect itself from loan losses is excess capital. As of March 31, 2011 Hudson City had leverage (core) capital of 8.12% which is well above the 5% definition for well capitalized and 4% adequacy ratio. Hudson City also had risk based capital of 19.66% 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. However in the current environment HCBK is having trouble growing its loan portfolio.
Net Interest Margin and Balance Sheet RestructuringLow Net Interest Margin
Hudson City’s Net Interest Margin (NIM) is one of its greatest risks. The Net Interest Margin (NIM) 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 2011Q1 Hudson City had a net interest margin of 1.72%. 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 (now President) 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 efficiency ratio of 26% as of the first quarter of 2011. This means that it costs Hudson City 26 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.
The Federal Reserve has continued to keep interest rates low and this has had a negative impact on HCBK. During the low interest rate environment HCBK’s NIM has steadily declined. Last March HCBK’s NIM was at 2.2%, which is already considered low. One year later by March 2011 the NIM had fallen to 1.72%. Because of this Hudson City was forced to restructure its balance sheet.
Hudson City had financed itself through certain types of borrowings that early last decade when interest rates were higher. Generally the interest it paid on those borrowings was fixed. However Hudson City’s investment portfolio contained securities whose yields dropped as interest rates fell. HCBK also saw prepayments on its mortgage portfolio rise meaning it needed to reinvest those funds as well. Hudson City essentially could not find enough investments that yielded substantially higher than its borrowing cost so it was forced to restructured its funding and take a large loss in 2011Q1. Reasons for the slow growth and lack of investment opportunities will be discussed in the next section.
A link to the press release with information on the balance sheet restructuring is here.
Slowing Growth and Government Interference in Mortgage MarketSlowing Growth
“Furthermore, in light of the current economic environment, where interest rate levels are artificially low and GSEs are actively purchasing loans, there is very little opportunity for residential mortgage portfolio lenders, like Hudson City, to profitably add to our loan portfolio and to continue our recent growth strategy.”
n From the 2010 Letter to Shareholders
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%. In 2010 the bank barely grew as the loan portfolio only increased 1.5%. The bank then started shrinking. In the first quarter of 2011 as assets dropped 14.3%. Growth has turned negative for two reasons.
Lack of Qualified Borrowers
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. High unemployment, slow economic growth, and falling home prices have greatly reduced the demand for new lending.
Continued Involvement of GSEs in the Mortgage Market
Fannie Mae and Freddie Mac continue to offer insurance for loans at what is generally viewed as below market rates and have accounted for more than 90% of mortgage production in 2010. This has the affect of crowding traditional thrifts such as Hudson City out of the market and making it difficult to grow their loan portfolio.
Lack of qualified borrowers and the involvement of GSEs is perhaps the biggest risk as Hudson City traditional method of growing assets is no longer viable and it must find a new business model.
As of March 31, 2011 Hudson City had a book value of $9.58, and a Tangible Book Value of $9.26. The stock currently yields 3.8% (after the recent dividend cut). With Hudson City currently trading in the mid $8 range it would seem at first blush that HCBK would be an attractive investment.
Since it is Hudson City’s asset growth that is of most concern we will lay out three different scenarios using an asset based valuation methodology. Hudson City has seen its return on assets drop from a high of 1.36% in 2002 to .8% as of last quarter. Historically Hudson City’s return on assets has averaged around 1%.
Current Market Cap: $4.4B
2014-2016 Assets: 50B, Return on Assets (ROA) .75% = $375M in net income
$375M times 10x multiple = $3.75B market cap
$3.75B market cap in 2014: -5% CAGR on your investment at today’s price ($4.4B or roughly $8.5/sh)
$3.75B market cap in 2016: -3% CAGR
2014-2016 Assets: 56B, ROA .85% = $476M in net income
$476M times 12x multiple = $5.712B market cap
$5.712B market cap in 2014: 9% CAGR
$5.712B market cap in 2016: 5% CAGR
2014-2016 Assets: 62.5B*, ROA 1%** = $531M in net income
$531M times 14x multiple = $7.434B market cap
$7.434B market cap in 2014: 19% CAGR
$7.434B market cap in 2016: 11% CAGR
*Valueline estimate: Hudson City’s total assets were $61 million in 2010 but now stand at $52 billion, so this scenario assumes higher growth for the next few years.
Using an asset based model we can see that we need to use some aggressive assumptions in order to make HCBK shares look attractive and provide a satisfactory rate of return for an investor at today’s prices.
SummaryAlthough Hudson City Bank looks cheap its old pre-2008 business model has essentially died because of government policy. HCBK now is being forced to find a new way to do business. Because of the forced change in its business model HCBK faces a very uncertain future. Even though its valuation currently may look attractive I believe the continued threats of long term government intervention in the financial markets, specifically keeping short term interest rates low and keeping the price of mortgage insurance low, do not make HCBK a good investment. Indeed, the Fed has shown no signs of raising rates and no concrete plans to reduce the role of Fannie and Freddie in the mortgage market have been presented.
It would be wise to hold off on investing in HCBK until management informs shareholders of its strategy to grow the bank going forward. At that point investors can better judge the likelihood of success. Furthermore while shares do hold some upside, there is very little downside protection as aggressive growth assumptions are needed to realize a good return.