Markets & Finance

Hudson City: Small Bank, Big Promise


Its conservative lending policies have helped maintain credit quality, and it has enough capital to pick up bargains from the subprime mess

From Standard & Poor's Equity ResearchThe recent turmoil in mortgage markets and the reduction in volume by many lenders due to capital restraints presents an opportunity, in our opinion, for Hudson City Bancorp (HCBK; recent price, $15) to increase its market share. Hudson's strong capital base gives the company the liquidity to take advantage of today's favorable mortgage spreads, i.e. the difference between the interest rates the company pays on the funds it has available to lend, and the interest rates it can charge borrowers.

In addition, we look for the company to take advantage of mispriced mortgage-backed securities by adding high-quality holdings to its existing securities portfolio at attractive prices. All told, we view Hudson's valuation as compelling and our recommendation is 5 STARS (strong buy).

Company Overview

Hudson, through its wholly owned thrift, Hudson City Savings Bank, has roughly $40 billion in assets and 111 branches in the New York metropolitan area, most of them located in New Jersey. About two years ago, the company reorganized from a two-tier mutual holding company to a stock holding company. The company originates and purchases mortgage loans and also purchases mortgage-backed securities and investment securities to supplement its mortgage loans.

With relatively little fee income (about 1% of revenue), the company relies heavily on net interest income to generate profits. Mortgage loans held for investment represent approximately 54% of Hudson's earning assets; the balance is in securities either held for investment or for sale. About 60% of the company's funding is through borrowing; the balance comes from deposits. Hudson relies heavily on more costly certificates of deposit.

Hudson's loan portfolio, which totaled about $22 billion as of June 30, 2007, consists primarily of one-family to four-family residential mortgage loans. Approximately 82% of these loans are fixed rate, which tend to have lower delinquency rates than adjustable-rate mortgages. The company services all loans it originates, which we believe helps the company retain customers for future loans. Hudson's loan-to-value ratio totals roughly 65%, below the industry norm. This, plus what we view as its conservative lending philosophy, puts the company near the top of the spectrum in terms of credit quality, compared to its peers.

The company has used a significant portion of its capital over the last year for share repurchases. Specifically, Hudson has purchased about 60 million shares over the last six quarters, more than 10% of its current share base. The buybacks have helped boost per share earnings. We believe the rate of share buybacks will slow in the coming quarters as the company will likely use more of its capital to originate and purchase mortgages now that the lending environment for the company has turned more favorable.

The recent shakeout in the mortgage industry has resulted in fewer lenders, which has increased the spreads on new mortgages, especially for nonconforming loans (above $417,000). Also, the recent cut in the Fed funds rate target to 4.75% from 5.25% should lower the company's funding costs, resulting in a further widening of spreads. The company also purchases mortgage-backed securities backed by government-sponsored enterprises (GSEs) for its investment portfolio. The recent disruption in the mortgage markets has provided attractive buying opportunities, in our view, as even high-quality securities have fallen in price. We look for Hudson to add to its holdings at attractive yields.

Company and Industry Outlook

The mortgage industry has undergone significant changes over the last six months. After peaking in mid-2006, home prices have declined for most of 2007, and home sales are down as well. Refinancing is also on the decline, as not only has the spread narrowed between fixed and adjustable-rate mortgages, but many borrowers willing to refinance have been unable to qualify for new mortgages. This is because lending standards have become stricter, with many lenders eliminating loans that have underperformed, including piggyback loans and no-documentation loans.

We look for total mortgage originations to decline about 15% in 2007 and to be down another 14% in 2008. Meanwhile, many lenders have gone out of business in 2007, particularly those that relied heavily on warehouse lending (instead of deposits) and sold their loans to the secondary market. With delinquencies and defaults on the rise, and liquidity a major concern, many lenders that remain in business have been forced to scale back volume.

Against this backdrop for the industry, we think that lenders with excess capital, that do not rely on the secondary market and that are not weighed down with a loan portfolio that needs to be significantly written down, are well positioned. We believe that Hudson is one of those lenders.

Excess Capital: As of June 30, 2007, Hudson had a 27.5% risk-based capital ratio, far above the 10% required for a well-capitalized company. Additionally, the company has no preferred debt outstanding, which could be issued if it needed to boost its capital level further. Also, Hudson currently has about $3 billion of additional Federal Home Loan Bank advances it could tap into to add to capital. Finally, the company has a strong deposit base which it is looking to expand by adding new retail outlets and accumulating deposits over the Internet.

Secondary Market: The company originates and purchases loans that it adds to its own loan portfolio. It does not sell loans to the secondary market to generate income.

Credit Quality: The company has one of the highest-quality loan portfolios among it peers. Net charge-offs of bad loans totaled only $76,000 in 2006, and $36,000 so far this year, only a fraction of its total loans of $20.5 billion. Meanwhile, nonperforming loans (for which principal and interest payments are not being received) totaled 0.18% of average loans in the second quarter of 2007, up only 2 basis points from the previous year. Although allowances were only 0.14% of average loans (below peers), we are not concerned given the company's low level of charge-offs. All in all, we look for net charge-offs to total $1.5 million in 2007 and $4 million in 2008, still only a small fraction of its loan portfolio.

We believe the company will use its excess capital to take advantage of attractive spreads that have materialized in the mortgage market due to a dearth of lenders, especially as it applies to nonconforming loans. Spreads should even be more attractive with the recent cut in the Fed funds rate by 50 basis points, to 4.75%. As a result, we look for the company to boost its loan origination volume and increase the purchase of loans held in its mortgage portfolio.

Meanwhile, the secondary market for mortgage-backed securities is still illiquid. We look for the company to take advantage of these conditions and add to its mortgage-backed securities portfolio by buying GSE-backed paper. Our projections call for average earning assets to grow 25% in 2007 and 2008, with a net interest margin of 1.72% in 2007, increasing to 1.85% in 2008.

Finally, we believe that the company is well positioned for a lower interest-rate environment. As an example, and based on Hudson's sensitivity analysis performed at the end of the 2007 second quarter, management says a 100-basis-point reduction in interest rates (of which 50% was accomplished with the Sept. 18 Fed easing) would increase net interest income by roughly 3%. The company's positioning for a declining interest rate environment is also reflected, in our view, by gap analysis which shows that $11 billion of liabilities come due in the next six months versus $4 billion of assets. We note, however, that a 200-basis-point reduction in interest rates would reduce net interest income by 3.3%, largely due to a pickup in mortgage prepayment speeds.

Valuation

The stock recently traded at 17.3 times our 2008 EPS estimate of 89 cents. We look for earnings to grow at an approximate 18% rate over the next five years and 25% over the next three years.

Given that Hudson completed its second-step conversion in June, 2005, we believe it is more appropriate to value the company as a multiple of tangible book value. Based on this metric, the stock currently trades at 1.69 times its tangible book value of $9.06 as of June 30, 2007. We note that the median tangible book value of the company's peers is 1.85. Our 12-month target price of $17 applies a 1.8 times multiple to our 2008 tangible book value estimate of $9.35, which assumes that the company's income will grow by roughly $600 million from today's level and that shares will total some 490 million at the end of 2008.

Corporate Governance

We believe Hudson's corporate governance policies are sound. A supermajority of board members (greater than 75%) are independent outsiders. The full board of directors is elected annually. We are also encouraged that both the nominating and competition committees are comprised completely of independent, outside directors. The compensation committee consists solely of independent outside directors and has met in the past year.

The primary negative factor, in our view, is that the positions of chairman of the board and chief executive officer are combined. In general, we believe a nonaffiliated chairman better serves the interest of shareholders. Additionally, the board is authorized to increase or decrease the size of the board without shareholder approval. New directors added to the board to fill vacancies may not be up for shareholder election at the next annual meeting.

Investment Risks

Risks to our recommendation and target price, in our view, include an inversion of the yield curve, which would lower Hudson's net interest margin. Increased competition from other mortgage lenders would result in lower loan volume and the likely narrowing of margins. A sizable increase of the GSE's conforming loan limits (currently $417,000) could also hurt margins. We also note that there is credit risk, in that an extended downturn in housing prices, and an increase in unemployment rates, especially in the Northeast, could deteriorate the value of Hudson's loan and securities portfolio.


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