Consolidation is a prominent feature in the banking field, with the number of banks in the United States falling by many thousands since 1980, to around 7,200 currently. That trend is set to continue with the pending takeover of Hudson City Bancorp (HCBK) by M&T Bank (MTB). The twist is that M&T’s offer is at a discount to book value, rather than a premium, as is usually the case.

M&T’s offer of cash and stock amounted to about 85 cents on the dollar for Hudson’s City’s net assets when it was made in late August. Since then, M&T’s stock has appreciated nicely, benefiting Hudson City’s shares, and bringing the value of the deal, the year’s biggest in banking, close to, but not quite, a full dollar-for-dollar exchange. Although takeovers are often made at premiums of as much as two times book value, and occasionally greater during industry boom periods, this one is set to take place at a modest discount, owing to the perception that Hudson City is damaged goods.

Hudson City Bancorp’s business model of focusing on single-family residential lending is now outdated. Most lenders have long since given up the focus on the single-family residential line in favor of higher-margined commercial business. But Hudson City made issuing jumbo mortgages nicely profitable by keeping overhead low and boosting volume, at least until the 2008-2009 Financial Crisis. At that point, the company was hurt both by a drop in industry volume and the collapse in interest rates. Years earlier, it turns out, Hudson City had locked in a large portion of its funding at around 4.0%. With mortgage rates falling to that level, or below, profits from home lending became seriously challenged.

Hudson City’s own internal study showed that it would need to hire 230 people over two or three years to build up its commercial lending business, with no guarantee of acceptable results. That put the sale of the thrift on the table. But Hudson City’s poor prospects put it in a weak bargaining position, leading to the below-book value offer. (Book value has greater relevance for financial stocks than for other sectors because underlying corporate assets tend to be highly liquid.)   

Another bidder could emerge for Hudson City, but it would be tough to outbid M&T, whose shares are among the most highly valued in banking. There would also be substantial breakup fees to contend with.

It remains to be seen whether this deal will provide a major spark marking another merger wave among banks and thrifts. It could well turn out that way, given the additional margin pressures likely to be felt following the Federal Reserve’s third round of quantitative easing, in which it plans to buy $40 billion of mortgage securities a month until the economy is producing more jobs. The Fed’s moves to lower long-term rates are hurting industry asset yields, and flattening interest rate spreads, as lenders have less room to lower borrowing costs that are already near a floor.

Inhibiting merger activity is the fact that shares of many lenders have not fully recovered from the damage suffered during the Financial Crisis. In the same way that homeowners are reluctant to sell at prices much less than their peak, bank executives are less eager to entertain offers notably below what their share prices once commanded. Even so, consolidation is almost inevitable. Most likely, it will be the midtier or regional lenders, including the likes of M&T, Toronto-Dominion Bank (TD.TO), and New York Community Bancorp (NYB) looking to bulk up through a purchase. Among thrifts, names often mentioned as potential sellers include Flushing Financial (FFIC) and Astoria Financial (AF). But much patience is required when taking positions on the basis of takeover speculation, since most companies are usually in no hurry to sell.

At the time of this article, the author did not have positions in any of the companies mentioned.