Hudson City Bancorp: Takeout Winner (Update 1)

Updated with regulatory news, market close information and comment from Deutsche Bank analyst Matt O'Connor.

NEW YORK ( TheStreet) -- Hudson City Bancorp ( HCBK) was the big afternoon winner among large financial services companies on Monday, with shares rising 16% to close at $7.45.

Hudson City's shares popped after the troubled Paramus, N.J., lender agreed to be acquired by M&T Bank ( MTB) for $3.7 billion in cash and stock, or $7.22 a share.

The deal price represents a 12% premium over Hudson City's Friday closing price of $6.44, offering shareholder a way forward, after Hudson City's long-term leverage strategy of increasing wholesale borrowings and investing in mortgage-backed securities backfired.

Hudson City has undergone two recent and painful balance sheet restructurings, the first of which was forced by the Office of Thrift Supervision.

Following a first-quarter 2011 restructuring that included a charge of $649.3 million to prepay $12.5 billion in higher-cost borrowing, the company prepaid another $4.3 billion in borrowings during the fourth quarter of last year, resulting in $440.7 million in charges.

Despite the balance sheet overhaul, Hudson City's second-quarter net interest margin -- the difference between a bank's average yield on loans and investments and its average cost for deposits and wholesale borrowings -- was a stubbornly low 2.12%, declining from 2.15% in the first quarter, and 2.14% in the second quarter of 2011. With long-term rates continuing to see downward pressure, especially for Hudson City's bread-and-butter mortgage lending business, the margin pressure was bound to continue.

Hudson City Bancorp reported second-quarter earnings of $72.3 million, or 15 cents a share, for mediocre return on average assets of 0.66% and a return on average equity of 6.19%.

Hudson City CEO Ronald Hermance said that "Hudson City recently embarked on a diversification of our product lines and our balance sheet," and that "as we combine Hudson City's attractive retail network with M&T's full service commercial banking suite, our stakeholders will participate in the growth of one of the nation's strongest and most successful banking franchises." After the merger is completed, Hermance will remain as a board member for the combined holding company and its main banking subsidiary.

Hudson City has $43.6 billion in assets, with 135 branches, with 97 branches in New Jersey, 29 in New York, and nine in Fairfield County, Conn. M&T has $80.8 billion in total assets, and plans to "repay approximately $13 billion of Hudson City's long-term borrowings by liquidating its comparably sized investment portfolio," after the merger is completed. M&T -- headquartered in Buffalo, N.Y. -- will add $25 billion in deposits and $28 billion in loans, from the acquisition.

M&T also said that the merger with Hudson City will be "accretive to the combined company's capital ratios, capital generation and tangible book value per share, as well as its GAAP and operating earnings per share."

During a conference call with analysts, M&T CFO Rene Jones said that for the combined companies "The pro forma tier 1 common ratio is estimated to improve by roughly 30 to 40 basis points compared to M&T's stand-alone levels that we would have experienced had we not announced the transaction with an estimated range of 8.25% to 8.50% at closing. This is some 115 to 135 basis points above the level in existence at the end of the most recent quarter ended the 6-30-2012."

Jones went on to say that "the transaction is immediately accretive in 2013 with a high-single-digit EPS accretion by 2014 and it provides an above 18% IRR."

M&T Bank CEO Robert Wilmers said "as a thrift, Hudson City focused primarily on deposits and mortgages. M&T will build on Hudson City's loyal customer base to create a comprehensive community banking franchise that provides a full range of checking and savings accounts, debit and credit cards, home equity loans and other lending options, plus small business and commercial banking services and our premier wealth management and corporate trust solutions through Wilmington Trust," which M&T acquired in May 2011.

Shareholders of M&T were obviously pleased at the prospect of making such a large acquisition at 80% of Hudson City's reported June 30 tangible book value of $9.08, while avoiding a dilutive common equity raise. M&T's shares rose 5% to close at $89.82.

Deutsche Bank analyst Matt O'Connor has a "Hold" rating on M&T, but said that "It's tough to find many negatives -- other than one could argue for a lower valuation for the combined company vs. MTB stand alone given the lower quality earnings mix at HCBK and a bigger combined company (which may be tougher to grow and under more regulatory scrutiny)."

M&T has been quite the innovator when it comes to avoiding the dilution of common shareholders. The company owes $230 million in bailout money provided through the Troubled Assets Relief Program, or TARP, in December 2008, in addition to $151.5 million for TARP assistance provided to Provident Bancshares before that company was acquired by M&T in May 2009.

The U.S. Treasury on Aug. 17 completed a public offering of the $381.5 million in M&T TARP preferred shares held by the government. The preferred shares have a 5.00% coupon, which is scheduled to rise to 9.00% in February 2014 for the remaining $230 of the bank's original TARP bailout, with the coupon on the $151.5 million in assistance originally provided to Provident Bancshares rising to 9.00% in November 2013.

M&T on Aug. 20 made proposed an innovative amendment under which the dividend rate on all of the former TARP preferred shares will rise to 6.375% on November 15, 2013. The amendment needs to be approved by common shareholders, who will be sure to do so, since it will reduce the possibility of a dilutive common equity raise. The amendment also needs to be approved by the new preferred shareholders, who are likely to give the plan the nod, because 6.375% is a decent rate in the current environment, especially when the issuer is a strong, consistent earner like M&T.

If M&T's preferred shareholders approve the lower rate increase, M&T won't redeem the preferred share until November 15, 2008. Otherwise, the company will probably redeem the shares in 2013, leaving the investors to pursue dividend income elsewhere. The big icing on the cake for M&T is that the former TARP preferred shares qualify as regulatory Tier 1 capital.

In other financial industry news, the Federal Reserve, Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency announced that they were "considering changes to the implementation timeline for the annual company-run stress test requirements required by the Dodd-Frank Wall Street Reform and Consumer Protection Act," to "delay implementation until September 2013 for bank holding companies, state member banks, and savings and loan holding companies with between $10 billion and $50 billion in total consolidated assets."

Banks with over $50 billion in assets are already required to participate in regulator-run annual stress tests.

The broad indexes ended mixed on Monday, as investors looked ahead to the economic summit in Jackson Hole, Wyo., this weekend, which will feature presentations by Federal Reserve Chairman Ben Bernanke and European Central Bank president Mario Draghi.

The KBW Bank Index ( I:BKX) was flat for the day, closing at 47.17, with 17 of the 24 index components showing declines.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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