The "Pure" Banks Practices Earnings Management (NASDAQ: HCBK)

PARAMUS - The bank which prides itself on its simple business model has been caught by the whirlwind of the financial crisis and has resorted to accounting gimmicks to sustain profitability.

Hudson City Bancorp one of the 20 largest banks in the U.S. and the largest thrift in the United States reported earnings of 25 cents or $121 million. A thrift institution is essentially a bank which only deals with mortgages and deposits. This simpler business model allows thrifts to have very low expenses which enhances profitability but it also limits growth. As consumers cannot use the bank as a one stop shop for their finances.

HCBK's Q4 profit though was covered in accounting gimmicks. Available for Sale Investments which are likely to be eliminated by 2014 made up half of HCBK's gains. The problems with AFS investments is that if one buys a stock at $10 and it rises to $11 the next day he has made $1 dollar. However if it was an AFS investment the company would not show a profit on the income statement until the security is sold. Hence AFS investments can lead to earnings management and manipulation. HCBK sold these investments in Q4 which resulted in income statement gains but the gains had been achieved quarters ago and adds no economic value to the business.

HCBK continued to struggle with nonperforming loans as they continued to rise as most banks have begun to see loan quality improve. The company has also provided a very small amount for loan losses compared to nonperforming loans.

Perhaps the biggest problem for HCBK is that "unprecedented level of the U.S. government-sponsored enterprises (the “GSEs”) involvement in the mortgage market have impacted our ability to grow our loan portfolio as the GSEs were involved in over 90% of U.S. mortgage production.”

HCBK's business model like Fannie Mae and other GSE's, would buy loans from banks and earn a low and safe rate of return. However now GSE's are buying most of the loans which has caused loan demand to drop for HCBK. Interest Income dropped 14% for HCBK compared to last years quarter.

The company expects softer demand to continue into 2011. Since the Q4 report, HCBK shares have lost 14% of their value.

To see the full HCBK report click here.