Sept 6 - The acquisition of New Jersey thrift Hudson City Bancorp by M&T Bank brings to light many of the financial challenges faced by U.S. thrifts as they struggle to cope with tougher regulation and depressed net interest margins (NIM) in a low-rate environment. Fitch expects other thrift institutions to consider various strategic options, including acquisitions by larger banks, to maximize shareholder returns. The number of U.S. thrifts had fallen to approximately 730 as of July 2011, just before the merger of the Office of Thrift Supervision (OTS) into the Office of the Comptroller of the Currency (OCC) - now designated as the principal thrift regulator. That number represents less than 10% of all U.S. financial institutions. The Hudson acquisition, priced at a 12% premium over the bank's Aug. 24 share price, followed a period of weak operating results in which Hudson's mortgage book came under increasing interest rate pressure, prepaying rapidly, while the bank's fixed-rate Federal Home Loan Bank (FHLB) borrowings limited funding flexibility. Nonetheless, in general, the bank's credit performance has been relatively steady. Although Hudson's non-performing loans (NPLs) have increased compared with historical averages, net chargeoffs (NCOs) have remained relatively low, peaking in 2010 at 31bp. Further weighing on Hudson was the fact that it was operating under a regulatory agreement, noting improvements to its interest rate risk-management function. These structural and systems enhancements could be costly and further pressure the bottom line. As the number of institutions continues to decline, pressures to consolidate are likely to grow, particularly given increased regulatory oversight, the impact of the Dodd-Frank legislation, tougher capital rules, weak organic growth prospects, and the low interest rate environment. As thrifts come under regulatory supervision by the OCC, they may confront tougher scrutiny on capital, liquidity, and interest rate risk management. They face requirements at the holding company level, which represents a significant change in the thrift charter. Thrifts are likely to face continuing problems in building capital given their concentration in mortgage lending and securities investments, which continue to experience declining yields due to low interest rates. Historically, thrifts have been limited to 20% of total loans derived from commercial lending, constraining their ability to diversify. Further, thrift banks in general have operated with a higher cost of funds, given the larger mix of CDs and wholesale borrowings versus traditional commercial banks. Heavier reliance on FHLB advances and noncore deposits as sources of funding, evident in the case of Hudson, may force the hands of many smaller thrifts. These banks face continuing NIM compression, as mortgage rates remain low and funding costs are above commercial bank peer averages. Some thrifts had changed charters prior to Dodd-Frank, including First Niagara Financial Group and People's United. A charter change could, in some cases, help thrifts diversify and perhaps draw more core deposits, lowering their funding costs. We expect more efforts to address strategic challenges through this approach, but fundamental competitive obstacles, such as NIM compression, low interest rates, and high funding costs, will not be overcome solely through charter changes.