Hudson City - Bank on better values.
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Office of the Chairman

As we look back at the past year, it is difficult to find the silver lining in the clouds that overshadowed our industry and economy in 2011. Unemployment remained high, economic growth was anemic, the housing markets were weak and economic conditions in Europe threatened the economic recovery in the United States. While these factors have continued into 2012, we know that at some point the clouds will clear and we believe the prospects for Hudson City will improve.

The “cure” for the ills of the past economic cycle included the Federal Reserve’s policy of keeping interest rates “low for long” to spur the economy and the U.S government-sponsored enterprises (the “GSEs”) pushing mortgage rates to an all-time low in an attempt to support the housing markets. These actions, while intended to stimulate the economy and the housing markets, had an adverse effect on Hudson City. As a portfolio lender, we take great pains to ensure the quality of the mortgage loans we originate. As a result, while the recent economic cycle took its toll on our industry, the credit losses that plagued many other institutions did not affect Hudson City to the same extent. However, as interest rates remained at historic lows, mortgage customers refinanced their loans to the low market rates. In addition, mortgage-related securities that we hold on our balance sheet also experienced elevated prepayment levels. This caused the yields we earn on our interest-earning assets to decrease which resulted in a decrease in our net interest margin and net income and the prospect of continued declines with the continuation of the prevailing low market rate environment.

We responded by restructuring our balance sheet in the first quarter of 2011 to reduce the amount of higher-cost borrowings. As part of that restructuring, we extinguished $12.5 billion of structured borrowings, $5.0 billion of which were replaced with short-term borrowings at current market rates. Interest rates remained historically low during 2011, and we continued to experience increased levels of prepayments on our loans and securities portfolios, resulting in elevated levels of liquidity. Low market interest rates limited our options to redeploy these funds profitably since the yields available on mortgage-related assets were at historical lows and we did not believe it would be prudent to put such long-term assets on our balance sheet. As we considered the alternative uses of the excess liquidity, we looked at the opportunities for Hudson City beyond the near term and avoided strategies that bolstered only short-term earnings, such as investing in riskier assets to earn a higher yield. Instead, we used the excess cash on our balance sheet to extinguish an additional $4.3 billion of our longer-term borrowings during the fourth quarter of 2011.

Our actions during the past year were designed to strengthen our balance sheet for the future and improve our net interest margins. We decreased the size of the balance sheet by 26% to $45.4 billion and reduced our borrowings 49.2% to $15.1 billion. Our Tier 1 leverage capital ratio increased from 7.95% at December 31, 2010, to 8.83% at December 31, 2011, and we anticipate that our net interest margin will improve in 2012 from what we otherwise would have experienced. These actions required that we incur the loss on the extinguishment of borrowings in the first and fourth quarters of 2011, which, after taxes, totaled $1.1 billion. As a result, we reported a net loss for 2011 of $736.0 million. However, our underlying core business operations are performing in accordance with our expectations.

We believe that our balance sheet, while smaller, is stronger as a result of the actions we took in 2011. Economic conditions appear to be improving although at a very slow pace and housing markets seem to be stabilizing. However, the economy has a long road to recovery as economic growth is weak and jobs creation is lackluster. Significant forces such as inventory levels and foreclosures in process continue to weigh on the housing markets.

Despite all of this, we believe that the future holds opportunities for Hudson City to grow and therefore we will continue to prepare our Company for the eventual economic recovery. While we remain a residential real estate lender, the “new normal” will require us to diversify our asset base and develop additional mortgage lending distribution channels.

We continue to respond to the requirements of our new regulators, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency. The Dodd-Frank Wall Street Reform and Consumer Protection Act has spawned a myriad of regulations and regulatory oversight that far surpass anything in our memory. This new environment requires enhanced risk management functions, policies and procedures. We put many of these in place during 2011.

We made great strides in 2011 to meet the challenges of 2012 head-on. We decreased the size of our balance sheet, reduced our levels of interest rate risk, increased our Tier 1 leverage capital ratio, increased staffing levels and created an Enterprise Risk Management department. All of these steps should prepare us to grow our business when economic conditions make growth both prudent and profitable. While it is difficult to find the silver lining in a cloudy 2011, we are starting 2012 with a stronger balance sheet, enhanced risk management capabilities, strong regulatory capital and the focus to meet the challenges of the “new normal.” We believe that to see the silver lining requires a longer-term view in order to discern the possibilities for Hudson City. It is this long-term perspective that saw Hudson City through the many economic cycles and challenges over the past 144 years and which we believe will benefit Hudson City’s customers and shareholders when the clouds finally clear.
Ron Hermance Signature   Denis Salamone Signature

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