The Hudson City Flood Gates Open (NYSE: BAC) (NASDAQ:HCBK)

NEW YORK - Forbes magazine named Hudson City Bancorp (HCBK) one of the best banks in the United States in 2007 and 2008 and said it would be one of the best companies to hold during a recession. However HCBK has declined nearly 50% from October 2008 and the problems appear to be growing. In fact it may be one of the worst worst recession stocks.

HCBK business model is founded on the belief that they are a pure and simple bank.

"Our industry-leading efficiency ratio enables us to execute our simple business model and provide a strong value proposition for our customers. We do not try to be 'all things to all people.'"

HCBK prides itself on lending money to consumers and instead of reselling the loan to another party it keeps this loan on their books for the duration of the loan. The idea is that the quality of the borrower is high and that they offer a low loan to value proposition ensuring safety for the bank. Loan to value is a ratio that determines the amount a bank lends out in relation to the total value of a home. The lower the loan is, in relation to the value the higher likelihood the borrower won't default. Intuitively it is because the borrower is likely in a better financial position if he had paid a higher down payment for his home and second of all he has less incentive to leave a mortgage if his loan to value ratio is low. (A further explanation is at the bottom)

HCBK reported disappointing 4Q net income of $121 million or 25 cents a share. This amount beat analyst estimates, only in terms of accounting chicanery. The company sold available for sale (AFS) investments that due to accounting intricacies are realized when they go up in value but are not reported on the income statement until they are sold. Thus if a company has assets of $2 in AFS investments and liabilities of $0, they have equity of $2. If the AFS investment goes to $3 they now have assets of $3 and they still have liabilities of $0 but the equity is now $3. However the income statement would show the company made $0 profit. Now let us say the company sold that investment, they would now report $1 profit on the income statement but the balance sheet remains unchanged, hence there is no change in the company's economic value. This accounting policy is to be eliminated by 2014. Without these gains HCBK reported 12 cents of profit or $60 million substantially down from $137 million in organic profit in Q4 last year.

The next problem is that HCBK is not the pure company that everyone thinks. HCBK has 135 branches and the company has $60 billion of assets. Century Bancorp, a small bank located in Boston has 23 branches but has $2 billion of assets, meaning HCBK has very few branches for a bank of its size. This means that HCBK is doing something else on the side to justify its size.

Let us explain, HCBK business model outside its traditional model is very strange. The first red flag is that HCBK has borrowed funds from the Federal Home Loan Bank near $30 billion. It uses these funds to originate loans but also to buy mortgage backed securities (MBS) which yields are above its borrowings causing gains but a low net interest margin. However, because of the recession the yields on the mortgage backed securities have dropped causing in some cases borrowing to be above new mortgage backed securities yields which is impacting profitability. In Q4 the company received $240 million from interest and dividends from MBS's but they paid $300 million for borrowed funds. In 2006 the company received $654 million and paid out $565 in interest payments on their borrowed funds. This made up 1/3 of HCBK's net earnings in 2006. Also it should be pointed out that borrowed funds also go to other loan originations so the amount of profit as a percentage of earnings in 2006 may have been even higher. It is also important to point out that HCBK may not have had a loss in 2010 if a high proportion of these borrowed funds went to traditional loan originations. However it is important to note that Mortgage Backed Securities and investment securities make up $28 billion in assets and borrowed funds make of $29 billion, meaning that they could get rid of their MBS business with borrowed funds.

Since the interest rate spread has changed HCBK no longer makes a profit on this segment of their business. The next problem is the borrowings have increased in value due to the present value of bonds rising when interest rates drop causing a fair value equity hole on their balance sheet which is not reported. Though this event is unlikely to cause a liquidity problem, it is a concern in terms of value. HCBK would need to sell its MBS investments if their borrowings are called which would cause an equity drop of approximately $2 billion.

The next dirty part of HCBK's business is that they claim to be a pure originator of loans but they are not. HCBK actually buys some of their loans from other financial institutions to supplement loan origination. In Q4 2010, Ron Hermance the CEO of HCBK said

"Our loan purchase activity has significantly declined as the GSEs (Government Sponsored Enterprises, like Fannie Mae) have been actively purchasing loans as part of their efforts to keep mortgage rates low to support the housing market during the recent economic recession. As a result, the sellers from whom we have historically purchased loans are selling many of their loans to the GSEs. We expect that the amount of loan purchases will continue to be at reduced levels for the near-term."

HCBK business model is to purchase loans loans from six to eight of the largest nationwide mortgage producers. and HCBK says " our wholesale loan purchase program is an important component of our strategy to grow our residential loan portfolio, and complements our retail loan origination production by enabling us to diversify assets outside our local market area, thus providing a safeguard against economic trends that might affect one particular area of the nation.

Yet HCBK claims "We do not try to be “all things to all people.” Rather, we offer some of the best deposit yields, lowest fees, and competitive mortgage rates in the New York metropolitan area.

The company is not being honest it is buying loans from all over the country and it is implying that it only has loans in the New York metropolitan area. The problem is that they are now having trouble purchasing these loans because banks such as Wells Fargo will now sell loans to GSE's instead of HCBK since GSE's offer better prices. This has caused loan growth to stagnate and decline for HCBK.

The next problem for HCBK is that nonperforming loans (NPL) continue to increase. NPL's increased to $871 million from $838 million in Q3. The growth has continued and now nonperforming loans to total loans is 2.73%. Bank of America is now at 3.48% and aren't they supposed to be the ones with all the problems. The second issue is that HCBK has very little in their allowance for loan losses to cover this. Bank of America has set aside $42 billion to cover $32 billion of nonperforming loans. HCBK has set aside $236 million to cover $917 million of nonperforming assets. It is important to note that nonperforming assets does not mean that the value of a nonperforming assets are zero thus a company will usually provide less provisions as compared to actual nonperfomring loans. However, HCBK's provisions are appallingly low.

To see the full HCBK report and our recommendation on the stock click here.

*Loan to value -if there were a loan of $150,000 and the value of a home was $150,000 the loan to value would be 150,000 to 150,000 or 1. Now lets say the down payment on the home was $40,000 so the loan would be $110,000 to the value of a home being $150,000. Meaning the higher the down payment on a home the safer the borrower should be and the lower risk a company has. Therefore the lower LTV ratio in theory the safer the loan.