Dividend Cut Among Prices Hudson City May Pay to Deleverage

Two big questions face Hudson City Bancorp as it copes with a surprising wrist-slap from regulators: How much will it cost the well-regarded thrift to appease its overseers, and is the Paramus, N.J., lender's unusually rich dividend threatened?

The short answer to both, according to market watchers: Complying with the pending enforcement action from the Office of Thrift Supervision will be expensive. And the future looks grim for that 15-cent-a-quarter dividend, a payout that until now had confirmed everything that Hudson City had done before the crisis — sticking to safe bets on giant New York-area home mortgages while other big banks chased subprime borrowers.

What galls some investors and analysts since the probable enforcement action came to light Wednesday is that Hudson City still has not really done anything different. Its bread-and-butter banking model is essentially the same as it was before and after the collapse, they say. What's changed is that the drawn-out economic recovery and tighter scrutiny of big banks is exposing a weakness in its approach — a leveraged balance sheet. In other words, a lot of securities investments and borrowed funds, items that can create a lot of interest rate risk.

Right now Hudson City's risk level — because of the size and unusual structure of its balance sheet — is making increasingly aggressive regulators nervous. A memorandum of understanding that Hudson City said it expects to receive from the OTS means it will most likely have to spend plenty of money to rein in that risk by shrinking its $60 billion-asset balance sheet. Just how, and by how much, isn't known yet.

"They're a victim of circumstances," said Charles C. Carnevale, co-founder and chief investment officer of EDMP Inc. in Lutz, Fla. "They're kind of caught up in the wave of regulation, if you will."

In the past, regulators have been comfortable with the way Hudson City has managed its interest rate risk because it tends to make loans that don't lose money. But that doesn't exempt it from the stark new realities facing all banks: People aren't borrowing, which squeezes profits, and regulators are implementing tougher compliance standards for banks like Hudson City deemed a potential threat to the economy under the Dodd-Frank Act.

Hudson City isn't really a threat to the economy, according to David W. Darst, an analyst with Guggenheim Securities LLC. He said the economy — and government — are the threat to Hudson City. It has had to compete harder on new loans since the government-sponsored enterprises increased the limits on the size of mortgages they will purchase, he said. It has also had to compete with the agencies to purchase jumbo mortgages made by others, a market that Hudson City has used to grow assets.

"It's very hard for them to originate and put assets on the books today," Darst said.

But what is more certain is that the company will have to restructure its funding base because other circumstances have complicated its interest rate exposure. Hudson City has managed that exposure by using deposits to fund securities investments and borrowed funds to fund loans, he said. Tepid loan demand coupled with a bottoming out of interest rates upset that balance.

Last year many borrowers paid off their 30-year mortgages to refinance at lower rates, which shortened the maturation timetable of its $30 billion of loans. But rates and maturities on its $30 billion in borrowings — evenly divided between repurchase agreements and advances from the Federal Home Loan Bank of New York — haven't moved.

Yields on its $30 billion of securities have been plummeting, too. That has created a negative spread between what it's paying to borrow money and how much it is earning from securities.

The end result is that the company is under pressure from regulators to deleverage.

What that means for the future of Hudson City won't be clear until the enforcement action becomes official and it announces how it plans to come into compliance.

Matt Clark, an analyst with Keefe, Bruyette & Woods Inc., said the price of compliance could be steep as it sells securities — most likely some of its $21 billion of mortgage bonds — while paying hefty prepayment fees to reduce borrowings.

By his math it would cost Hudson City about $1.3 billion to reduce its balance sheet by $20 billion, a speculative number that he used to illustrate how much deleveraging might cost.

"It does clearly put the dividend at risk in our view," he said. "While we have expected a dividend cut it could also be completely eliminated in the short term."

Touching the dividend would be a setback for Hudson City, one of the few large banks that never cut its dividend during the downturn. He said Hudson City has a difficult choice that comes down to whether to absorb a good amount of short-term pain that could result in better profits down the line by reducing its reliance on borrowed funds.

Matthew Kelley, an analyst with Sterne Agee & Leach Inc., said more than Hudson City's future dividend is at stake. So are its ambitions to grow as the economy recovers and demand for home loans picks up. And that is ironic, he said, because Hudson City has been one of the soundest players in that market. The government needs banks like Hudson City to keep loans flowing if it intends to scale back its support of the mortgage market, he said.

"My view is this is going to be a much smaller bank over the next several years," Kelley said. "Their business model is in question. If the government is trying to help foster a private mortgage market, Hudson City was at the leading edge of that pack. Now they're in the penalty box." He and other industry experts said Hudson City's problems with regulators are unique for a company its size. Other big thrifts that rely on borrowed funds, like New York Community Bancorp, have more flexibility managing their interest rate risk because their loans mature faster rate than Hudson City's. Hudson City makes 30-year mortgages. New York Community makes mortgages on apartment buildings and the loans roll over every three to six years.

Hudson City's shares closed up 22 cents, or 2.22%, to $10.14 on Thursday after falling 9% Wednesday.