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My grandfather used to say, though never to me directly, that "banking is like sex. When it's good, it's great. And when it's bad, it's still pretty good."
While the financial crisis may have led the average investor to question this -- 454 banks have been seized by regulators since the beginning of 2008 -- the industry is back on its feet and growing again -- albeit at a less frenetic pace than before. In its most recent quarterly banking profile, for instance, the FDIC noted that the industry's first-quarter aggregate net income of $35.3 billion is the highest it's been since the second quarter of 2007.
Yet many banks are still trading for fractions of book value. While the average savings and loan institution is selling for an 11% discount, mega-money center banks like Bank of America and Citigroup are trading for less than half of their book value. In this environment, it's become exceedingly important for investors in financial stocks to be able to separate the winners from the losers. And to do this appropriately, one must look under the proverbial hood.
In this series, I examine six of the most important metrics to assess the quality of a bank's operations. The current bank under the microscope is Hudson City Bancorp (Nasdaq: HCBK ) , a midsize consumer-focused lender with $43 billion in assets and branches throughout the New York metropolitan and surrounding areas.
Hudson City Bancorp
|Capital ratio||9.4%*||approx. 8%|
|Net interest rate margin||2.12%||>= 3.5%|
|Provision for loan losses (as a % of net interest income)||11.1%||<= 5%|
|Net noninterest expense (as a % of net interest income)||35.9%||<= 33%|
|Allowance for loan loss/non-performing loans||26.3%||>= 100%|
|Return on equity (TTM)||(2.7%)||>= 15%|
|Price-to-book ratio||0.71||approx. 1.0|
Sources: Hudson City Bancorp's Q2 2012 10-Q and Yahoo! Finance. *Hudson City Bancorp's 10-Q doesn't disclose its tier 1 common capital ratio. The ratio used is the leverage ratio.
I don't mean to telegraph where I'm going with this, but let's just say there's a reason Hudson City's shares trade for a 30% discount to book value.
To start at the top, Hudson City's balance sheet reveals an operation that's made a number of critical errors. Until the Federal Reserve recently required it to do so, for instance, the bank didn't focus on deposits, using other and significantly more expensive means to finance its holdings. Of its nearly $39 billion in liabilities, only 64% of them are deposits, and virtually all of these are high-priced time deposits as opposed to non-interest-bearing demand deposits such as checking accounts. This has resulted in a cost of funds that's nearly four times the industry average.
In addition, Hudson City has concentrated exclusively on either mortgages or mortgage-backed securities. The impact of this strategy has been twofold. First, it's missed out on higher interest-bearing commercial loans -- not to mention the non-interest-bearing commercial deposits that generally accompany these -- which, in turn, has contributed to Hudson City's anemic 2.12% interest rate margin compared to the industry average of 3.5%. And second, it's left the lender reeling from bad housing bets.
Hudson City's strategic errors are further magnified by its income statement. As you can see above, a full 11% of its already paltry net interest income is consumed by loan loss provisions related to its mortgage portfolio. And more of these are likely to come given the fact that 3.9% of its total loans are classified as nonperforming while only 1% are currently provisioned for in its allowance for credit losses. A further 36% is offset by noninterest expenses such as rent and salaries, among other things, as the bank has evidently been unable to use fees and assessments to mitigate overhead. These mistakes have added up to a negative 2.7% return on equity over the trailing 12 months.
Is Hudson City nevertheless a buy?
Investors may still be tempted by the fact that Hudson City's shares trade for 70% of book value. If you're one of these, however, I suggest that you exercise restraint.
The institution has a poor track record -- treating the vehicle more like a hedge fund or mortgage real estate investment trust than a bank -- evidenced by its failures to cultivate a solid deposit base and commercial banking operation. As a result, they're now operating under the strict terms of memorandums of understanding with both the Federal Reserve and the Office of the Comptroller of the Currency. Although these memorandums are ostensibly moving Hudson City closer to operating like a traditional bank, there's little evidence that its present leadership will know what to do if and when it completes this transition.
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