Never in his wildest dreams did Ron Hermance, Jr., expect to become a national media darling, held up in such publications as Newsweek and The New York Times as exhibit No. 1 that yes, in fact, bankers can make money in this environment - in the mortgage business, no less - by sticking to their knitting. In those stories, Hermance's Hudson City Bancorp comes across as a modern-day iteration of George Bailey's building and loan - an old-style thrift that has thrived amid two years of industry turmoil by simply taking deposits, making solid housing loans and holding them on its books.
"I was naive. I thought everybody was doing it this way," says the 60-year-old Hermance, who has worked the past 20 years for $52 billion-asset Hudson City, since 2002 as CEO. "Our approach has always been, 'do what you do well and don't worry about what the other guy is doing.' I guess it's like my grandfather used to say: 'If we all thought the same way, we all would have married your grandmother.' ...I like telling the story, because America needs to see what the basics look like and how you can get rewarded for them."
In addition to running one of the nation's most successful banking companies of 2008, he sits on the board of New York's Federal Home Loan Bank and is a regular on CNBC and the speaking circuit. In December, he was part of a Washington Press Club panel that discussed the future of the mortgage business. "The picture that's painted is of a sleepy, fly-by-the-seat-of-his-pants thrift guy," says James Abbott, an analyst with FBR Capital Markets. "Ron Hermance has a Bloomberg screen on his desk. He's constantly looking up data and has a very good handle on the economy. ...He's very shrewd."
Shrewd enough to have stayed away from subprime, alt-A, option ARMs and other toxic mortgage products during housing's boom times, and to have stuck close to home. Hudson City makes two primary types of loans - 30-year, fixed-rate conforming and jumbos - only in its core markets, underwrites them by hand, and holds onto them. Of nearly 82,000 mortgage loans on its books in November, just 388 were 90 days or more past-due. Net charge-offs in the third quarter were less than two basis points of the portfolio. Yes, that's 0.02 percent.
Shrewd enough that last spring, when commodity prices were soaring and inflation looked like a serious threat, Hermance publicly predicted that the Federal Reserve would cut rates and went shorter on his funding. "People looked at him like he was growing a second head," Abbott recalls, "but he was totally right."
Shrewd enough to grasp that, after credit quality, the most important thing a bank or thrift can do for the bottom line is control costs. Hudson City has 128 branches in New Jersey, New York and Connecticut, but just 1,400 employees. A typical branch employs seven workers, all with one chief purpose: serving deposit customers. Customers seeking loans are referred to headquarters, where a centralized underwriting staff works. The company's efficiency ratio: 19.2 percent, among the lowest anywhere.
And shrewd enough to understand that both Hudson City's success and its recent celebrity are as much about being in the right place at the right time as they are about the operating model. Indeed, the biggest near-term risk is that the strong New York area housing market that has played so well into Hermance's hands could falter, pushing up losses and eating into profits.
In the third quarter, Hudson City reported earnings of $121.9 million - a record tally, up 64 percent from a year earlier. During the first 11 months of the year, its share price rose 11.2 percent, while the Keefe Bruyette & Woods Bank Index fell 44.6 percent. Matthew Kelley, an analyst with Sterne Agee in Portland, ME, predicts per-share earnings growth of about 30 percent in 2009, powered by strong loan growth and growing spreads. Throw in strong capital levels-9.24 percent of assets - and "investors like this story," Kelley says.
If this were merely a tale of performance and operating models, then Hudson City wouldn't be getting such a disproportionate share of attention. One untold story of the crisis is that 41.6 percent of all institutions grew profits during the third quarter, according to the FDIC. Nearly 100 publicly traded banking companies' share prices at the end of November were higher than at the beginning of the year, according to an analysis done for U.S. Banker by SNL Financial. Hudson City is the largest of those, but ranked just 50th on the list. The winners include a disproportionate number of thrifts, including $8 billion-asset Capitol Federal Financial in Topeka, KS, and Cleveland-based TFS Financial, at $11 billion in assets, which, like Hudson City, specialize in mortgages.
What makes Hudson City a good story for the New York-centric media is location. The company's Paramus, NJ, headquarters lies within eyeshot of Wall Street's carnage, providing just the kind of juxtaposition the press loves. While it seems that most of the financial services giants in the City have failed or gotten bailouts related to bad housing loans, Hudson City - which does nothing but housing loans - plugs merrily along, generating record profits with a simple, throwback strategy. As USA Today opined in a September editorial about Hermance, "In these complex financial times, it's good to know there's still a place for old-fashioned common sense."
The attention has been good for Hermance, a native of upstate New York, who was dubbed "America's smartest banker" by one publication. In the fall, he received "some notes and emails from older folks wondering why I didn't run for president," he confides with a chuckle. It's also been very good for Hudson City, which has cashed in on the publicity. Now the nation's largest thrift, it originated more than $7 billion of mortgage loans through November, its highest volume ever, and has a "constant $1 billion" in the pipeline, Hermance says. It also added $2.1 billion in deposits during the first three quarters, and tacked on another $500 million in October, capitalizing on customers' desire for safety.
"They've been very promotional, taking advantage of the attention," Kelley notes. "They realize now is the time to grow market share and the balance sheet, when competition is less and customers are seeking safety."
The company traces its history to 1868, when a group of local immigrant leaders in the old City of Hudson, a predecessor to today's Jersey City, got together to launch a savings and loan. Hermance has a picture of the founders, laying the cornerstone for the original building, on his wall. "One was a farmer, one was a lawyer, one was a shepherd," he explains. "It was more like a cooperative. ...I keep looking at that picture and saying, 'You've got to be true to your foundations.'"
In an environment fraught with troubles inspired by CDOs, SIVs and other complex financial instruments, Hermance's way of doing business harkens back to a simpler time. Hudson City leverages its low cost structure to pay up for deposits. Ninety-six percent of its deposits are interest-bearing. Among the recent offerings: four percent on a five-month CD, 3.5 percent on a money-market account and a checking account that pays three percent. Hudson City has branches in nine of the 50 wealthiest counties in the country, and averages $140 million in deposits per-outlet. It also recently launched an Internet bank. Unlike many banks, deposits are not viewed as a big source of fees. If an account is overdrawn, Hermance says, "we'll make a call and say, 'If you get in by 2 p.m., we won't charge you."
It then uses that funding - combined with hefty doses of Home Loan Bank advances and "street repo" money borrowed from large banks that take securities (all agency-issued) as collateral - to originate 30-year-fixed conforming and jumbo mortgages at competitive rates. The loans - most leads come from "introducing brokers" who get a one percent commission for steering customers Hudson City's way - are all underwritten by hand, with a keen eye for credit histories and "the likelihood the borrower will remain employed." The company doesn't use FICO scores, which Hermance calls "the worst indicator you can use," because they offer little insight into a borrower's future.
The primary criterion - the one that Hermance says, above all, keeps defaults so low-is extraordinarily high loan-to-value ratios. The average LTV on the company's portfolio is 61 percent, and no one loan's LTV is greater than 80 percent. That gives Hudson City plenty of equity should it need to foreclose, and serves as a powerful disincentive for borrowers who might consider walking away from their loans. "It's a pretty simple business proposition we offer people," says COO Denis Salamone. "You give us a lot of equity, and we give you a good rate."
It holds those loans - Hudson City does no securitization - and buys similar mortgages from other companies, including the likes of Citigroup and Bank of America, underwriting them with equal vigor. "Everyone else underwrites to sell," Hermance says. "We don't sell to Fannie Mae and Freddie Mac. We retain everything in portfolio."
"They stick to the basics and don't take excessive risks," says Rick Maples, head of the financial institutions group at Stifel Nicolaus, a St. Louis investment bank that helped convert Hudson City from mutual to public ownership in 1999. "Most of the companies in trouble have two things working against them: leverage and bad underwriting practices. These guys kept their discipline, and now they stick out and shine."
Other banks and thrifts are following similar paths, but not many have the same market dynamics. The liquidity crisis that began in late 2007 shut down virtually all securitization activity for non-conforming loans, including jumbos. Lenders began ramping up their portfolio lending capabilities, but "you don't just flip a switch and do that," says Guy Cecala, publisher of the newsletter Inside Mortgage Finance. Indeed, knowing they have to hold onto loans, as opposed to selling them to investors, has forced banks to overhaul underwriting standards and other practices - a lengthy exercise. "When you're holding onto the loans yourself, the math is different. You've got to decide how much risk you want to take," Cecala says.
As a result, competition for jumbo loans all-but vanished, and rivals that remained active, including Wells Fargo, boosted rates sharply. Quite suddenly, Hudson City was left in the enviable position of being able to cherry-pick jumbo borrowers in a New York metro market filled with lots of high-priced homes and plenty of wealthy people - many of them, ironically, from Wall Street. One reason the LTV is so low, Salamone says, is that many customers purchase $3 million homes, but only take out a $1 million mortgage because there's no tax break above that, financing the rest with pocket change. "We have a lot of Wall Street clients who only borrow 30 percent of their house," he says. Fully 66 percent of the loan portfolio is in jumbo mortgages.
To be sure, Hudson City's model isn't perfect. Its net interest margin is a relatively meek 2.08 percent. Hermance professes little concern, asserting that the combination of loan quality, low costs and sheer volume more than make up for any deficiency. "If you're looking for a $400,000 house and you only have five percent to put down, then you're not getting a loan from them," Cecala says. Others wonder how a bank that caters to the wealthy follows through on its CRA requirements. "This is not a model most consumer groups would support," Cecala says. (Company officials say they meet CRA obligations through loan purchases.)
That Hermance has benefited by lending to Wall Street folks while rejecting their business practices is perhaps the most ironic twist of all. The bank also has benefitted by operating in market where housing prices have held up relatively well. While housing prices in other big-buck markets, such as southwest Florida, Los Angeles, Las Vegas and Phoenix, have plummeted by 25 percent or more over the past year, the New York area's home prices declined a modest 7.3 percent for the year that ended in October, according to the S&P/Case-Shiller Home Price Index.
"Hudson City has been fortunate," Abbott says. Its success "hasn't really had anything to do with the company, per se, other than deciding not to go outside of its core footprint. Had they been in California or Florida with the same strategy, their performance would be nowhere near where it is today. The real story is that they've been good enough to be in a good location."
The question is, will that change? Abbott notes that housing prices in the New York metro area recently stood at nine times average household incomes - historically high, and only a bit below the 10 times incomes California boasted at its housing peak. Financial firms, the engine of the local economy, shed 153,105 jobs in 2007, and had laid off more than 220,000 jobs by the end of November, according to Challenger, Gray & Christmas. In November, Citigroup alone announced plans to reduce its payroll by 52,000; JPMorgan Chase is slashing 21 percent of acquiree Wamu's workforce. While the pain will be spread around the globe, New York will feel the brunt of it.
"Every firm on Wall Street is laying off people," Abbott says. "The big bulge-bracket firms are cutting. The hedge fund community has been decimated - they're redeeming and liquidating and going out of business. And there's a multiplier effect: for every Wall Street job that's lost, the governor's office says three other jobs in the area go. ...Those are Hudson City's customers."
A softening job market seems destined to lead to further drops in housing prices, which leads to one inevitable question: Despite its best efforts, might Hudson City yet be undone by the Wall Street mess it's worked so studiously to avoid? Hermance says no. Prices might fall, he argues, but with the high LTVs on its loans, Hudson City should be fine. "Even if you triple that seven percent [home price] drop to 20 percent, I'd still have a 75 percent loan-to-value," he says.
Kelley of Keefe Bruyette predicts the bank's provisioning expenses will jump to $49 million in 2009, from $18 million in 2008. But that's a relative pittance, and he expects just seven basis points of loan charge-offs in 2009. Capital levels are projected to fall to 8.3 percent - still comfortably in the well-capitalized range - and spreads should widen.
The biggest challenge could be growth. The company plans to move into western Pennsylvania soon, and will likely face diminished competition, but "if the turnover of property slows, then there's not as much opportunity to lend," Salamone says. As Abbott of FBR Capital Markets puts it: "At the end of the day, no bank - no matter how good the management or what it does - can sidestep its local economy."
