Hudson City Stays Neutral

We have recently reiterated our Neutral recommendation on Hudson City Bancorp Inc. (HCBK - Analyst Report). The decision follows our detailed analysis of the company’s fundamentals in light of the current economic environment and the recent strategic efforts to offload debt.

Hudson  City’s  third-quarter  2011  operating  earnings  came  in  at  17 cents  per  share,  missing  the  Zacks Consensus Estimate of 18 cents as well as the year-ago quarter’s earnings of 25 cents per share. The company reported  an operating  income  of  $84.2  million  compared  with  $124.6  million  in  the  prior-year quarter.

Hudson  City’s  operating  earnings  were  primarily  affected  by  lower  interest  and  dividend  income,  substantial decrease  in non-interest  income  and  increased non-interest  expense, which  were partly offset by lower interest expense and reduced provision for loan losses.

Recently,  Hudson  City  has  completed  its  balance  sheet  restructuring,  which  has  substantially reduced  higher-cost  structured  borrowings  and  is  projected  to  increase  net  interest  income  in  the coming quarters as interest expenses decrease.

The company paid off $4.3 billion debt as part of its effort to restructure the balance sheet. The company expects restructuring transactions to have no effect on regulatory capital ratios, but boost the net interest margin by as much as 20 basis points for the first quarter of 2012 from the third quarter 2011 level of 1.97%.

Similar restructuring efforts led to an improvement in the net interest margin in the second quarter of 2011. We believe that such efforts would support the company’s growth strategy and enable it to compete in the residential mortgage marketplace going forward.

HudsonCityinvests primarily in mortgage-backed securities issued by Ginnie Mae, Fannie Mae (FNMA - Snapshot Report) and Freddie Mac (FMCC - Analyst Report). The company also invests in other securities issued by government-sponsored enterprises (GSEs).

Recent market proceedings and the United States government’s participation in both mortgage markets, through GSEs, and the maintenance of low market interest rates, resulted in an environment that has made its balance sheet less responsive to the existing market conditions.

In an extensive low interest rate environment, Hudson City has hastened prepayment on mortgage-related assets, which resulted in reinvestment in these instruments at the current low market interest rates. These lower-yielding assets and higher-cost borrowings, which did not re-price during this extended low rate environment, have resulted in interest rate risk and margin compression concerns for the company.

Consequently, the company’s calls of securities in its investment portfolio and mortgage pre-payments have provided it with excess liquidity. However, with expectations that the normal interest rate environment will not return until 2013 coupled with the regulatory atmosphere, the company has lesser choice for redeploying this excess liquidity. Therefore, Hudson City found it appropriate to reduce its higher-cost debt.

Though the restructuring effort is encouraging, the upfront costs associated with it cannot be ignored either. Hudson City’s first-quarter 2011 results were significantly impacted by the balance sheet restructuring transaction and resulted in the company reporting a loss in the quarter.

The recently announced restructuring, Hudson City, is also projected to have a negative impact of about $440.7 million or 89 cents per share on fourth-quarter after-tax earnings, and consequently result in a loss. While its dividend strategy was impacted last time and the company slashed the quarterly dividend from 15 cents to 8 cents per share, this time its dividend strategy is likely to remain untouched.

However, this debt pay off is a strategic fit for Hudson City. Further, the company's strong business model, solid capital position and conservative underwriting will boost its financial position. Yet, unfavorable interest rate environment, sluggish economic recovery and uncertainty surrounding the new and anticipated regulations are the primary headwinds.

HudsonCityis scheduled to report its fourth quarter and full year earnings results before the market opens on January 25, 2012. According to the Zacks Consensus Estimate, the company is expected to report a loss of 74 cents in the fourth quarter.

HudsonCitycurrently retains its Zacks #2 Rank, which translates into a short-term ‘Buy’ rating. However, considering the fundamentals, we have reaffirmed our long-term Neutral recommendation on the stock.

Read the full analyst report on HCBK

Read the full analyst report on FMCC

Read the full analyst report on FNMA