Moody's Harshes M&T's Deal Mellow: Street Whispers

Corrected to show that while M&T's common shareholders need to approve the amendment to the former TARP preferred shares, the U.S. Treasury approved the amendment before the public offering, so the new preferred shareholders will not be voting on the preferred dividend rate of 6.375%, effective on November 15, 2013.

NEW YORK ( TheStreet) -- Moody's is trying to crash a bank merger party.

Following a very positive equity market reaction to a merger deal between M&T Bank Corp. ( BBT) of Buffalo, N.Y., and Hudson City Bancorp of Paramus, N.J., Moody's Investor Service late on Monday placed M&T and its subsidiaries on review for a possible credit rating downgrade.

Moody's said its review would "primarily focus on the credit profile of Hudson City, an unrated thrift holding company, and the integration challenges that it presents," as "the acquisition of Hudson City will substantially heighten M&T's exposure to residential mortgages through the addition of its $28 billion portfolio." The ratings agency said it "will analyze the acquired residential mortgage portfolio for potential losses versus M&T's estimated credit mark of 1.5% and its overall capital position."

Moody's currently has a senior debt rating of A3 for M&T, while main subsidiary Manufacturers & Traders Trust Co. has a bank financial strength rating of C+ and a baseline credit assessment of a2.

M&T early on Monday announced that it would acquire Hudson City for $3.7 billion in cash or stock, or $7.22 a share. This represented a 12% premium from Friday's closing price of $6.44, and Hudson City's shares rose 16% on Monday, to close at $7.45. M&T was up 5%, closing at $89.82.

Despite Moody's concern about Hudson City's credit quality, the thrift's big problem -- which eventually led to the sale -- has been a narrowing net interest margin, as the company struggled to disengage from its long-term leverage strategy of investing wholesale borrowings into mortgage-backed securities. 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.

Hudson City remained profitable on a core basis, with second-quarter earnings of $72.3 million, or 15 cents a share, for a mediocre return on average assets of 0.66% and a return on average equity of 6.19%. With mortgage loan rates continuing to decline, the second-quarter net interest margin was a low 2.12%, declining from 2.15% in the first quarter, and 2.14% in the second quarter of 2011.

Taking a look at Hudson City's credit quality, since Moody's is questioning "M&T's estimated credit mark of 1.5%" on the acquired mortgage loans, Hudson City's June numbers make the case that M&T is being conservative in its loss estimate.

Hudson City reported $1.1 billion in total nonperforming loans as of June 30, or 3.88% of total loans. While that would appear to be a high number on the surface, Hudson City has had a very low rate of annualized net charge-offs (loan losses less recoveries) to average loans, ranging from 0.25% to 0.30% over the past five quarters. That is a key figure, and quite a low loss rate.

Another thing to keep in mind is that Hudson City's New Jersey and New York market footprint was less affected by the real estate bubble and collapse than other areas of the country. Considering Hudson City's low loss track record and the much smaller home price collapse in its market footprint, it would appear that M&T would have to really mess up Hudson City's loss mitigation efforts in order to see a 1.5% loss rate on the acquired mortgages.

Besides, the Office of the Comptroller of the Currency -- now the primary regulator of Hudson City's main subsidiary, Hudson City Savings Bank, after taking over from the old Office of Thrift Supervision -- is known for taking a particularly strict view on identifying problem credits and recognizing loan losses.

Moody's also said it would "consider M&T's capital management plans post-acquisition," as the acquiring bank's "capital position has traditionally been managed to lower levels than similarly-rated peers," which "has been a credit challenge especially considering M&T's sizable concentration in commercial real estate."

That's an interesting position for Moody's to take, because M&T said on Monday that the merger would 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."

M&T has also taken an innovative step to reduce its cost of capital and avoiding dilution of its 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 proposed an 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 M&T's common shareholders, who will be sure to do so, since it will reduce the possibility of a dilutive common equity raise. The amendment was approved by the Treasury before the public offering, so the new preferred shareholders will not be voting.

If M&T's common 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. The big icing on the cake for M&T is that the former TARP preferred shares qualify as regulatory Tier 1 capital.

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

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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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