Good day everyone and welcome to the Capital One First Quarter 2009 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question-and-answer period. (Operator Instructions). Thank you.
I would now like to turn the call over to Mr. Jeff Norris, Managing Vice President of Investor Relations. Sir, you may begin.
Thank you very much, Jamie and welcome everyone to Capital One’s first quarter 2009 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One’s website at CapitalOne.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our fourth quarter 2009 results.
With me today are Mr. Richard Fairbank, Capital One’s Chairman and Chief Executive Officer and Mr. Gary Perlin, Capital One’s Chief Financial Officer and Principal Accounting Officer. Rich and Gary will walk you through this presentation. To access a copy of the presentation and the press release, please go to Capital One’s website, click on investors then click on quarterly earnings release.
Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information whether as a result of new information, future events or otherwise.
Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors please see the section titled 'forward-looking information' in the earnings release presentation and the risk factors section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.
Now I will turn the call over to Mr. Fairbank. Rich?
Thank you, Jeff. And good evening everyone. I will begin on slide 3. Capital One posted a net loss from operations of $87 million or a negative $0.39 per share. Total company net loss for the quarter was $112 million or negative $0.45 per share. Continuing economic deterioration through the first quarter was the biggest driver of our quarterly result. While first quarter and near-term results remain under significant pressure at this point in the cycle. We continue to make tough decisions and take the actions that we believe will put our company in the best possible position to weather the storm and create shareholder value over the cycle.
The results we are reporting today reflect the decisions and actions we took in the first quarter. Charge-offs increased across our lending businesses with exception of our auto finance business. I will discuss credit performance in just a moment.
In the first quarter, we took several actions to further fortify the company and build future earnings power. For example, we continued to increase our capacity to absorb future credit losses by adding a $124 million to our allowance for loan losses increasing our coverage ratio to 4.8%. We made choices to ship the mix of the earnings assets and liabilities on our balance sheet. We made these choices to further strengthen our position to weather the storm and to create sources of long-term value, but these choices also impacted revenues, margins and balance sheet metrics in the quarter.
We added $14 billion in deposits with our acquisition of Chevy Chase Bank. With strong and growing access to local banking deposits; we were able to increase our funding from core deposits and allow higher cost wholesale deposits to run off as they matured in the quarter.
The combination of adding Chevy Chase deposits and optimizing across our deposit channels resulted in net deposit growth of about $12 billion to $121 billion at the end of the quarter. We saw unprecedented opportunities to generate revenues by purchasing investment securities at attractive levels. So we grew our portfolio of high quality investment securities to $36 billion. And we originated billions of dollars in new loans while maintaining disciplined underwriting standard. Loan originations were more than offset by falling purchase volumes and loan demand by the run-off of loans related to businesses we repositioned or exceeded several quarters ago, as well as by normal attrition and of course by rising charge-offs. Our loan-to-deposit ratio has improved from 1.7 to 1 a year ago to 1.2 to 1 at the end of the first quarter.
First quarter pre-provision, pre-tax earnings were relatively stable compared to the fourth quarter at 2008. Revenue declined due to a combination of factors related to the weakening economy and choices we made about the mix of our loans and earnings assets. Revenue declines were mostly offset by improvements in non-interest expense that resulted primarily from our actions to improve operating efficiency and because we saw limited opportunities for new marketing in the current environment.
Against the back drop of economic worsening and volatile markets, our strong and transparent balance sheet remains a source of strength in these turbulent times. Despite higher charge-offs, further additions to our allowance and the completion of our acquisition of Chevy Chase Bank, our tangible common equity to total managed assets or TCE ratio at the end of the first quarter was 4.8%, an improvement of 20 basis points from a pro-forma level of 4.6% at the end of last year, but the strength of our balance sheet is not just about weathering the storm, we also expect our balance sheet to generate shareholder value as we emerge from the storm. Our balance sheet can contribute to higher margins over the time as capital markets funding and wholesale deposits mature and we replace them with lower costs, local banking deposits. And when the cycle eventually turns and opportunities for profitable and resilient loan growth emerge, we will be able to grow loans without the need to raise additional capital by rotating our earning assets from investment securities back into new loan growth.
I will discuss credit performance and the profitability of our businesses on slide 4. Economic deterioration continued at a rapid pace during the first quarter driving increasing delinquency and charge-off rates across most of our lending businesses. US card charge-off rate increased to 8.4% for the first quarter above the 8.1% charge-off rate expectation we articulated a quarter ago. Expected seasonal increases in bankruptcies and declining loan balances resulted in higher charge-off rates compared to the fourth quarter of 2008. The increase in charge-off rates beyond our expectations resulted from several factors related to the pace of economic deterioration in the quarter. Bankruptcies were higher than expected increasing charge-offs directly without impacting delinquency rates.
Recoveries on already charged-off debt were lower than expected. We also observed an acceleration of later stage delinquency balances flowing to charge-off in the quarter. For context, recall that when we articulated our expectations last January, the unemployment rate was 7.2% and we assumed it would increase to about 8.7% by the end of 2009. The unemployment rate has already deteriorated to 8.5% and is expected to move beyond 8.7% well before year-end.
Even though our US card charge-off rate was higher than the expectation we had last quarter, delinquencies in charge-offs were a bit better than we would have expected given the actual economic worsening we have seen in the quarter.
Our US card business posted just over $2 million in profits in the first quarter. Profits of about $50 million in our revolving card businesses were mostly offset by a $48 million net loss in the installment loan businesses.
As we discussed last quarter, our US card business includes about $11 billion in installment loan. Installment loan performance has been significantly worse than that of our credit card businesses. We essentially stopped originating installments loans late last year, so the portfolio will continue to shrink as the outstanding loans amortize.
We expect the drag on US card profits to continue as the installment loans continue to run off. We expect further increases in US card charge-off rates through 2009 as the economy continues to weaken. It is likely that our US card charge-off rate will increase at a faster pace than the broader economy as a result of the denominator effect and our implementation of OCC minimum payment requirements.
While many credit card issuers will see declining loan balances in the current environment. We expect that our denominator will decline even more than the industry as a result of installment loans running off. While installment loans account for just 15% of US card loan balances, we expect that run off installment loan will drive about a third of the expected denominator effect.
We expect the total denominator effect to increase second quarter charge off rate by about 50 basis points. As we have discussed in prior quarters, we are the only major credit card issuer implementing OCC minimum payment policies now as we were not regulated by the OCC when the policies were put in place several years ago in a wholly different credit environment. We have been analyzing test cell data to estimate the expected impacts of implementing OCC minimum payment policies. Based on three months of additional data and test cell results, the size of expected OCC minimum payment impacts has not changed although the expected timing has shifted a bit.
We had previously estimated that implementing OCC minimum payment policies could add 10 basis points to the US card charge-off rate in the first quarter and 50 basis points to the charge-off rate in subsequent quarters in 2009 before curing somewhat in 2010.
We now expect the impact to be around 20 basis of charge-off increase in the second quarter, 80 basis points in the third quarter, and 50 basis points in the fourth quarter. We continue to expect some curing of the OCC minimum payment impact in 2010.
Taken together, we expect denominator and OCC minimum payment effects will result in about 70 basis points from higher US card charge offs in the second quarter before any charge off rate increases from continuing economic deterioration. We expect monthly US card charge-off rate to cross 10% in the next couple of months.
Credit trends in the international businesses reflect increasing economic deterioration in the UK and Canada. While the Canadian portfolio had been relatively stable for several quarters, the Canadian economy and credit trends began to show signs of weakness in the first quarter.
We have been retrenching the UK business for some time now and we have been cautious in Canada in anticipation of the credit worsening that began in the first quarter. As a result, international loan volumes have been declining. The international businesses posted net income of $2 million in the first quarter.
Auto finance credit trends improved in the first quarter driven by several factors. Charge offs and delinquencies exhibited expected seasonal improvements in the first quarter. Used car prices and recovery values have been improving for several months resulting in lower charge offs severity.
Our investments in auto finance collections and recovery operations are paying off and our 2008 origination vintages continue to out-perform our expectations. We have been able to originate loans with lower LTVs to customers with higher FICO scores. At the same time we have been able to improve pricing and margins in the current competitive environment. As a result, we expect that the 2008 originations will yield adequate risk adjusted returns through cycle and their performance to date is tracking at or above our expectations.
We realized improvements in charge off rates even though the denominator declined by more then $800 million as a result of our actions to retrench and reposition the auto business in late 2007.
Capital One auto finance delivered net income of $71 million in the first quarter. Although the first quarter auto finance results are encouraging, we remain cautious. By definition, the seasonal elements to strong first quarter credit performance will not persist. So do not expect this level of profitability to read our run rate for the remainder of 2009. It is uncertain how long we will continue to benefit from rising used vehicle prices and recoveries and the continued strength of the economy in the auto industry creating increasing uncertainty about the near term result of the auto business.
Local banking business, non-performing loans as a percentage of managed loans increased while charge off rates decreased in the quarter. The increase in non-performing loans percentages resulted from continuing economic stress in the metro New York City market and to a lesser degree in Louisiana and Texas.
In our commercial portfolio, the increase in non-performing loans was concentrated in wholesale residential construction loans. Construction lending comprises only $2.4 billion and less than half of that is fore say residential construction.
The rest of the commercial portfolio continues to perform relatively well. In the consumer portfolio, continuing economic pressures on the residential mortgages drove the increase in non-performing loans. The increase in non performing mortgage loans was exacerbated by our decision to suspend foreclosure actions in anticipation of the announcement of the administration’s mortgage modification program.
The improvement in first quarter local banking charge off rate was driven by the fact that we took several sizeable charge offs related to specific loans in our construction portfolio in the fourth quarter of 2008 as well as the reduction in residential mortgage foreclosures I just mentioned. The local banking business posted a net loss of $36 million in the quarter. Provision expense remains elevated in the current economic environment and local banking revenues declined as a result of falling interest rates.
While falling interest rates benefit loan margins, they hurt deposit margins because we can not reprised demand deposits that already pay no interest. These interest rate impact pressure revenues in our local banking business because it has nearly twice as many deposits as loans.
Before moving on to loan deposit volumes, I will update our economic outlook. Unemployment and home prices have been and continue to be the economic variables with the greatest impact on our credit result. We now expect unemployment rate to increase to around 9.6% by the end of 2009. Our prior assumption for home prices was for the Case-Shiller 20 City Index to fall by around 37% peak to draw.
We now expect a modestly worse peak to drop decline of around 39%. Based on economic deterioration in the first quarter and recalibrated economic assumptions, we believe that managed charge off dollars in 2009 will be higher than the $8.6 billion outlook for 2009 that we articulated last quarter.
We chosen not to specifically update our outlook for manages charge-offs given significant uncertainty in the economy. I will discuss loan and deposit volumes on slide 5.
While we originated several billion dollars of new loans and added $9.5 billion of Chevy Chase loans in the first quarter ending loan balances grew by only $3.4 billion. Several factors had a negative impact on ending loan balances in the first quarter.
These factors include falling purchase volumes and loan demand, the run off of loans related to the businesses we repositioned or exceeded several quarters ago. Normal attrition and rising charge offs. Together these factors more than offset loan originations in the first quarter before the addition of Chevy Chase loans.
Consumers and businesses are behaving defensively and rationally in the current economic environment. For example, credit card purchase volumes fell by 14% from the fourth quarter of 2008 and 12% from the first quarter of 2008.
Since credit card loan balances typically begin as purchases, defensive spending behavior effectively reduces credit card loan demand. Demand from credit worthy borrowers for other type of consumer and commercial loans was also weak in this first quarter.
In 2009, we expect continuing weakness in loan demand from credit worthy customers as the customer behaviors we observed in the first quarter continue in the current economic environment.
We also expect the other factors that offset first quarter originations will continue driving a decline in managed loans for the full year. We expect that the decline in earning assets will be more modest resulting in a mix shift from loans to high quality investment securities back by mortgage and consumer loan.
Total deposits grew to $121 billion including the addition of $14 billion in Chevy Chase deposits. Deposits in our local banking business grew by $176 million. With declining loan balances in the addition of Chevy Chase’s deposits we shifted our local banking focus from growing deposits to optimizing our deposit strategy. We maintain disciplined pricing and focused our efforts on the deposit segment that drive the most profitable and enduring customer relationships.
Continuing deposit growth opportunities across our local banking franchises now including Chevy Chase reduced our appetite for wholesale deposits. Maturing CDs resulted in a modest reduction in wholesale deposits in the quarter. Over the long term, we expect deposits to benefit earnings as maturing capital markets and wholesale deposit funding is replaced by lower cost local banking deposits.
Slide 6, summarizes margin trends, revenue margins declined 62 basis points in the quarter to 8.03%. In turn falling revenue margin was the primary driver of the $221 million decline in revenues in the first quarter. Trends in US card revenues and revenue margin had the biggest impact on total company revenues.
Credit and consumer behavior impact contributed to the decreasing revenue margin in our US card business. As I just mentioned, we see consumers behaving defensively in the current economic environment, spending less, exercising caution to avoid fees and working hard to remain current.
While defensive consumer behavior is a benefit to credit performance all else equal, it also reduces fee revenues. Falling purchase volumes in the quarter reduced interchanged fee revenues.
Early-stage delinquencies declined in the quarter as fewer borrowers moved from being current on their payments to the first delinquency buckets. The bucket we call 1 to 29 days late. As a result, we assess fewer late fees.
We also observed a decline in the number of customer attempts to go over their credit limit. As a result, we assessed fewer over limit fee. While early-stage delinquencies improved in the quarter, later-stage delinquencies increased. And the rate at which delinquent customers flowed through to charge-off, accelerated in the quarter. With higher late-stage delinquencies the amount of finance charge and fee revenue deemed uncollectible increases, and we don't recognize revenue on finance charges and fees we don't expect to collect.
So in the first quarter of 2009 build, but unrecognized fee revenue remained elevated at $540 million. This compares to $591 million in the fourth quarter of 2008 and $408 million in the year-ago quarter.
We first observed this phenomenon of a steeper flow rate curve and the resulting revenue drawn out during the first half of 2008. Deteriorating credit trends also drove the write-down of our retained interest in securitization trust.
At the end of the first quarter, the remaining value of retained interest in our IO strip was down to just $13 million. We expect the first quarter to be the low point for US card revenue margin in 2009.
During the first quarter, we took several actions to enhance future revenue. We expect that second quarter revenue margins will begin to benefit from these moves with more sizable increases in US card revenue margin in the second half of the year. We expect full year US card revenue margin will be around 15%, a bit below the full year 2008 revenue margin of 15.5%. In addition to credit and consumer behavior impacts, changes in the mix of earning assets reduced revenue and net interest margin.
The primary mix shifts with the addition of the lower yielding Chevy Chase loan portfolio and the continuing shift from loans to investment securities. The negative impact to net interest margin was partially offset by favorable moves in the prime LIBOR spread during the first quarter, and our continued efforts to mange our interest rate risk position, so net interest margin declined a modest 15 basis points.
As you can see on slide 7, our efficiency ratio for the first quarter improved to 46.3%. First quarter non-interest expense declined about $200 million as a result of our continuing efforts to achieve operating efficiency improvements and lower marketing expense in the current economic environment.
These favorable trends were partially offset by the decline in revenue I just discussed. Going forward, we will continue to benefit from our ongoing efforts to reduce costs and improve operating efficiency, including the synergies from the Chevy Chase acquisitions. We also expect that we will continue to find fewer opportunities to effectively invest our marketing dollars, while the economy continues to deteriorate and loan demand remains weak.
We expect several factors to offset these underlying improvement trends in the non-interest expense and to create quarter-to-quarter variability in non-interest expense and the efficiency ratio. Collections and recoveries expense will increase as we maintain an increased collections intensity in the current economic environment.
Integrating Chevy Chase will add one-time deal and integration cost as well as ongoing Chevy Chase operating expenses, and the FDIC special assessment of deposit insurance premiums is expected to increase non-interest expense in the second quarter.
Slide 8, summarizes a pre-provision pretax view of earnings. Pre-provision pretax earnings were just under $2 billion as the decline in revenue was largely offset by improvements in non-interest expense. Despite significant economic and credit headwinds, each of our national lending businesses posted a modest profit for the quarter. The modest quarterly loss in local banking was more than offset by national lending profits. Credit impacts drove the operating loss for the total company.
As you can see on the first slide, first quarter revenues were pressured by credit-driven I/O strip write-down and revenue suppression. And provision expense remained very high as a result of rising charge-offs and further allowance build in the first quarter. At this point in the cycle, we expect provision expense will continue to be the largest single determinant of our overall result.
And with that I will turn it over to Gary.
Thanks, Rich, and good afternoon to everyone listening on the call. Rich has walked you through the primary drivers of our income statement, which reflect not only the current economic environment, but also the ongoing de-risking of our balance sheet.
We are confident this strengthens our ability to confront near-term economic challenges, while positioning us to deliver long-term value when the storm begins to abate. Allow me to begin by discussing the near term de-risking.
As Rich discussed a moment ago, we built our allowance by a further $124 million in the quarter. And our allowance now stands at $4.6 billion to protect us against expected future principal losses in on balance sheet loans.
You will note that while our reported net charge-off rate increased by 20 basis points in the quarter, our allowance as a percentage of reported loans was up 36 basis points in the quarter to 4.84% as we continue to reserve for anticipated future higher losses.
This percentage does not include approximately $9.5 billion of Chevy Chase Bank loans that were added to the balance sheet in the quarter after those loans were fair valued to reflect anticipated losses, and therefore do not carry an associated allowance.
Within each of our national lending businesses, we increased the coverage ratio of allowance to reported delinquencies to historically high levels as increases in bankruptcies, degradation and recoveries and worsening of late stage flow rates have lead to an assumption that a greater proportion of delinquent balances will eventually charge-off.
Our US card allowance is now equal to two times the level of reported delinquencies. Also the credit pressures, Rich described earlier, have led us to increase our allowance coverage ratio in the banking segment by nearly 30% from a 110 basis point to 140 basis points.
As you are all well aware, these increases to our coverage ratios are bringing forward anticipated future losses for on balance sheet loans. Future allowance levels of course will be driven by the size of our reported loan portfolio and assumptions of about future losses.
It's for this reason, we believe, that our balance sheet is well-fortified to protect against near-term risks, while positioning us to perform when the cycle begins to turn. Another aspect of balance sheet strength is the low risk and steady performance of our investment portfolio, which I will discuss on slide 10.
Our $36 billion investment portfolio performed well in the quarter as we accelerated, much of our planned purchases for the year into the first quarter, to take advantage of highly attractive opportunities in the agency MBS and consumer ABS sectors.
This approach appears to have been the right one as fixed income spreads narrowed materially through the course of the quarter, largely in response to government actions. Quarter-end spreads were in substantially relatively to year end, so we saw a $498 million improvement in our unrealized loss position from last quarter with the net unrealized loss now standing at $615 million.
It's worth reminding you that the related $526 million improvement in OCI does not impact the income statement, and I would also like to highlight that we did not adjust our valuation methodology to use mark-to-model allowed under recently issued accounting guidance. In these highly uncertain times, we believe it is prudent to continue to invest in highly liquid low risks securities to ensure we have ample liquidity to fund our business.
And while investing in low risk securities inhibits the leveraging of our portfolio to reap high risk gains, we avoid many of the pitfalls experienced by others of having to realize significant unexpected losses when outsized best don't work out. On the subject of unexpected losses, let's move on to a discussion of capital, which underpins all the risks on our balance sheet.
Looking at slide 11. On a pro forma basis, our TCE ratio improved by 20 basis points in the first quarter primarily due to the improvement in OCI and the pro forma shrinkage of the balance sheet.
While our announced intention in early March to reduce our quarterly dividend to $0.05 per share has not yet affected the balance sheet, our future capital ratios will benefit from that dividend reduction.
As expected, our TCE ratio fell by approximately 100 basis points upon closing of the Chevy Chase acquisition. Please recall that the purchase accounting for Chevy Chase Bank marks the first application of FAS 141(NYSE:R), which requires all acquisitions after January 1 of this year to mark the entire portfolio for both credit and interest rates at the time of closing.
The credit mark on the Chevy Chase loan portfolio turned out to be a couple hundred million dollars higher than originally estimated. This was offset by a more positive interest rate mark. We have included a schedule in the supplemental tables to size the currently estimated impact of the acquisition in the quarter. And intend to provide in future quarter a lens for recognizing the impact of purchase accounting on our results.
Our capital ratios continue to be meaningfully above regulatory well capitalized minimums. Our tier 1 risk-based capital ratio is estimated to be around 11.4% in the first quarter, up approximately 10 basis points from the pro forma prior quarter. Without the preferred stock and warrants issued to the US treasury under the TARP Capital Purchase Program, that ratio would be about 8.5% or approximately 250 basis points above the well capitalized threshold.
As we continue to build allowance in anticipation of higher expected losses, conservatively manage our investment portfolio to avoid large unexpected losses and having fair valued the entire Chevy Chase Bank loan portfolio, we are very comfortable with the cushion provided by our current levels of capital. At this point in the cycle it is only prudent to assume that economic headwinds may continue to create short-term earnings pressure. However, we believe that disciplined growth and the active management of our balance sheet will enable us to maintain healthy capital ratios and position us to perform well through the cycle.
I will discuss our balance sheet management philosophy in greater detail beginning on slide 12. Deposits continue to increase as a percentage of our funding as disciplined growth in our existing channels has been supplemented with the addition of Chevy Chase Bank deposits.
Our ending loan to deposit ratio improved from 1.68 to 1.24 from just one year-ago. This deposit expansion continues to decrease our reliance on wholesale funding providing us with tremendous flexibility to choose from a variety of funding vehicles to optimize cost. To evidence this point, you will note that our weighted average cost of funds decreased 139 basis points from the year ago quarter, while the decline in overall funding rates certainly provided a tail wind in our efforts to reduce funding cost, you will note that a large driver of the overall decline is from the change in liability mix. In fact, if you compare the annualized funding cost from the first quarter of this year versus what the annualized funding cost would have been had the liability mix of the year-ago quarter stayed the same, we are saving approximately $240 million a year. And it’s worth noting because marginal wholesale funding costs would have been relatively high in the first quarter, that savings estimate is likely understated.
In addition, our funding flexibility has enabled us to be entirely self reliant. We have chosen not to participate in any government assisted funding programs such as TLGP, CPFF or TALF as we have cheaper all-in options at our disposal. We fully expect that we will maintain access to attractively priced funding necessary to support lending consistent with the demands of creditworthy borrowers and our own prudent lending standards. We will constantly use the most economical way to fund our business and I fully expect that cheaper retail deposits will continue to replace expensive wholesale funding as it matures overtime further improving our funding costs.
Let me now move to the left hand side of the balance sheet, to discuss our migration to lower risk assets. As you can see on slide 13, our investment portfolio continues to become a greater portion of our earning assets, having increased from approximately 12% a year ago to 18% today. As I mentioned when describing the portfolio in detail, we continue to take advantage of attractive securities investment opportunities in the quarter to replace lower yielding assets expected to mature over the coming quarters.
While we saw many investment opportunities that exceed the marginal returns on many lending opportunities given the current environment, the 4.62% average yield for the total investment portfolio is as you would expect less than the 9.44% average return on our portfolio of loans held for investment. While we are confident that we have made the right decisions in building our strong liquidity positions and in the marginal investments we are pursuing, growing investment portfolio certainly brings down the weighted average yield of our total assets.
However, given the confidence we have in our funding profile as marginal lending opportunities become more attractive, we believe the migration to a more typical asset mix will provide a meaningful financial tailwind. To put this prospective asset shift into perspective, if we were to assume we returned to a 12% investment portfolio mix by increasing our loans by 6 percentage points at our current average yield, we would experience an annual increase in revenue of approximately $500 million a year without the need to raise capital to support the loan growth. Our plan is to eventually shrink the investment portfolio back to its historical share of earning assets by taking advantage of attractive lending opportunities when the environment turns.
However, if we don’t see a sufficient amount of attractive risk adjusted lending opportunities to fully swap out our investment portfolio assets, we also have the choice to bring down the size of the investment portfolio and further bolster our capital ratios. We would shrink the investment portfolio back down to achieve a 12% proportion of total earning assets. Our TCE ratio would increase by approximately 30 basis points. Although, we believe it is not prudent to take action against either one of these options today due to the current economic environment suffice it to say that this optionality has a great deal of strategic and economic value.
Turning to slide 14, I would like to conclude and pull all of these pieces together. We continue to manage the company to confront short-term pressures while delivering long-term value. And we believe the best way to address both of these goals simultaneously is to maintain a strong and resilient balance sheet. To confront these short-term economic pressures, we continue to build our allowance to stay well in front of the possible future degradation in credit. We also are conservatively managing our investment portfolio to ensure we have ample liquidity while avoiding taking outsized risk to reap unsustainable trading gains.
And we continue to manage our capital to levels well in excess of any regulatory minimums even assuming a worsening environment. As we think about the future, we are confident that the de-risking of the balance sheet will provide both strategic and economic long-term value.
We are building a deposit franchise with a strong customer value proposition and disciplined pricing affording us a great deal of funding flexibility while building enduring relationships with our consumer and commercial customers.
In addition to bringing down our overall funding costs, these deposits provide the ability to grow a resilient investment portfolio. The capital which supports this portfolio can then be reallocated to higher yielding loans when the opportunity arises. So, while we remain cautious about near-term economic challenges, we are confident that our balance sheet will not only provide the stability to get us through the storm but also the power to generate value when the storm evades.
With that, Rich and I welcome your questions.
(Operator Instructions). We will take our first question from Brian Foran with Goldman Sachs.
Brian Foran - Goldman Sachs
Hi, good afternoon guys. When you talked about removing guidance for the rest of the year in terms of losses, I guess is the uncertainty around the unemployment forecast because you gave one but everyone I guess realized is obviously there is a wide range of variability around that spot forecast, or is the uncertainty more around the relationship between charge-offs on unemployment and you are just not sure if it will kind of stay a roughly one to one relationship or is it a little bit of both?
Brian, we really work hard to try to see how we can give the best window into our business for our investors. And we have taken various forms of kind of getting out on a whim just a little bit with different ways of forecasting here and for example giving the we went through the six month window in our credit card business as uncertainty kind of grew we sort of went through the three month window into that thing. We are a little bit struck by I mean I was surprised by, but still it's noteworthy that the most near-term kind of baking in the window, baking in the oven. Part of our forecast to credit card business still was even that forecast turned out to be off somewhat by virtue of things around the edges that really weren’t so much in the oven.
And we then looked at all the competitors and they were out of the outlook business. And then finally kind of to your point, we are kind at a striking point right now where unemployment in many ways is sort of raging and it’s a bad direction.
You have got other data sort of starting to show even some positive signs and so all in all we just felt that maybe we are better served just trying to give you a window into how our business works and maybe at this point not sort of be in the 12 month outlook business. If people insisted on a follow up question I can certainly talk about the relationship between credit card and the unemployment, credit card charge off unemployment which bottom line we don’t see any reason to believe that that relationship has changed.
Brian Foran - Goldman Sachs
Yes I guess that was going to my follow-up question, I mean when we look at some of the markets where we do have 11% and 12% unemployment around the country and you drill into your portfolio by state is I mean I guess what you are saying is that relationship is holding and it’s just a fact of having really higher unemployment in those states.
Let me give you kind of a fairly robust answer to this thing because it’s very important to I think you anyone who is trying to assess the card business, we are junkies about trying to gather everything we can from economic variables and how they drive our credit card charge offs. And what we have Bryan in our universe of data available to us is when I often called the two humps of the camel we have got there the 90-91 down turn have got the early in this decade downturn and there if you look kind of by eye ball. This thing that we commonly call the one-to-one relationship between card charge offs and unemployment where sort of unemployment if it goes up a 100 basis points card charge offs go sort of directionally up a 100 basis points.
Our best read of that is that relationship is somewhat less than one-to-one, in other words card charge off should go somewhat less than 100 basis points. But anyway there is a pretty close relationship there and also credit worsening is tended to be a lead indicator relative to unemployment.
Then one of the benefits of this downturn, Brian, is we have a very rich database of cross sectional MSA data that we can use. And also what's relevant about this one is this is this downturn. It's not yesterday's downturn it is today's downturn. And so as what we have done is cross sectionaly modeled MSAs and exposed it to as many economic variables as we can. Some of the data is limited. What you are stuck by is that both HPA and again unemployment tend to be the key drivers. We have found from the, even in the most stressed boom and bust stage.
Generally, the kind of relationships that we by eye ballsaw in the last two downturns are still the same. Generally that there is somewhat less than the one-to-one relationship with unemployment, but it kind of turns out by the time you are done with HPA to in a sense sort of average out to one-to-one.
So that -- we have a phenomena right now I guess you have seen this quarter you had -- there is big surge in unemployment in kind of as we said. We did not see our credit metrics in the very moment, sort of be as responsive as they might have been through this but we do not necessarily see any evidence of a change for that.
We have also looked for interactive effects, Brian, between unemployment and HPAs sort of the context the thing that says well if they are both bad is the interaction of those something a lot worse. We see small interactive effects but not anything that really changes sort of the fundamental relationships we have seen.
So I would say that what you operated in your assumptions up to this point, we do not see too much that would change that. What we did go out of our way in the upfront talking points there was to say with respect to the credit card charge-off rate, because of the denominator effect most importantly and to some extent to the OCC minimum payment policy. You will essentially see, I think, our charge off rate exceed the normal relationship but that's not a substantive point about the economy that’s really more just a point about our metrics.
Next question please.
We will go next to Craig Maurer with CLSA.
Craig Maurer - CLSA
Hi good afternoon. Couple of questions, first regarding the international card portfolio I was hoping you could go into a little more detail regarding the trends you are seeing separately in Canada and the UK.
Yes, let me start with the UK, if we adjust for debt sales, the UK losses are higher than a year ago. And most of that increase is from higher contractual charge-off and but also insolvencies have been trending up recently after being pretty flat for 2008 insolvencies are essentially the UK equivalent of bankruptcy.
As we look at the UK environment, certainly the economic environment looks pretty troubled there, consumer indebtedness remains at record levels, house prices are declining rapidly, unemployment is rising and it’s a worrisome environment. There is one potential benefit that's bigger in the UK than in the US. And that is the lower interest rate may help homeowners more in the UK because the majority of them have variable rate mortgages, we have not seen this effect and nor are we counting on it.
So we expect further credit worsening in the UK business and we are in very much hunker down mode, we have even stopped doing pretty much stopped doing teaser rate marketing in the UK, we are very much in hunker down mode and there is, you will see foreseeable future, steady sort of decline in that portfolio.
In Canada, Canada has been kind of the one part of our world that has seemed to, as ostensibly not be suffering a lot of the issues that the rest of the world is suffering and we have just in our underwriting assumed that it will behave the way the US and the UK have gone. And our point here in our conversation today about this quarter is we have started to see the economic measures jump up somewhat in Canada and our own losses in the Canadian portfolio went up about 74 basis points as I recall in the business.
So, for Canada it still for us a very profitable business but we are underwriting assuming Canada ends up going the direction of the UK and the US. But at this point it’s still performing at quite higher level.
Craig Maurer - CLSA
Okay. And if we can continue on the card theme for a minute, looking at your purchase volume in quarter, down 12% year-on-year, you certainly outperformed some of your large bank competitors despite the fact you have 15% contraction in the account base. So I was hoping you could talk a little bit about spending per active account?
Well basically our purchase volume, you are right, declined at 12% year-over-year about half of this decline, Craig, is due to a reduction in active accounts on file and the rest is driven by the economic environment. So, what we have seen in our purchases per active account is they appear to have stabilized the levels about 6% lower than a year-ago and this is consistent with overall decline in retail sales and consumer spending.
Next question please.
We’ll go next to David Hochstim with Buckingham Research.
David Hochstim - Buckingham Research
Thanks I wonder if you could just clarify what you are saying we could expect in terms of expense changes. I'm trying to relate the expense outlook to what seems to be further declines in revenues or I guess an improving margin offset by lower balances and then rising credit cards would suggest that first quarter earnings might be among the better quarters this year. I'm just wondering what I might be missing?
Hi David let me just focus exclusively here on the question what we might see in a way of non-interest expense. As Richard said, we experienced some good improvements in efficiency in the first quarter, this started a couple of years ago as you know and we are continuing to make good strides in efficiency, in all of our businesses, there have been some near-term elevations coming from things such as the intensity of our recovery and collections efforts. But by and large we have been benefiting quite substantially from the improvement in efficiency. As we look particularly at the next quarter, remember that we have a couple of things that you should keep an eye out for. The first is that the expected special assessment in terms of what's coming out of the FDIC will be affecting Capital One like all banks.
If that hits, it's likely to hit all at once here in the second quarter. We also will, as we rapidly start to integrate Chevy Chase, remember that their efficiency ratio was substantially higher than that for Capital One as a whole and that's going to have an effect for a while to come.
Those expenses are a little bit exaggerated, certainly in the first quarter. As we have indicated, the expenses related to the deal under new FAS 141(R), they all have to be expensed rather than going to goodwill. And so you saw some elevated level of expenses in Chevy Chase, and you will probably see some integration expenses coming through over the course of the next couple of quarters.
Of course, we are rapidly trying to make that integration work and move quickly towards getting some of those synergies. But I think the biggest two drivers of any movement away from the improvement trend at least in the next quarter would be the FDIC assessment and the impact of Chevy Chase going forward towards the end of the year, we are going to try to make sure that we continue too see the benefit of our efficiency efforts.
David Hochstim - Buckingham Research
Can you give us an idea how big those two things are?
Well, I would really not suggest what the FDIC assessment is going to be, that obviously has not yet been determined. And there is quite a wide range you know what the size of our deposit book is, so you can probably figure out that the range there could be from tens of million to a couple of hundred million.
And with respect to Chevy Chase, run rate of expenses there, prior to our being able to get the start to realize the synergies, which again, we are going to try and do pretty quickly, run rate of somewhere at or just around $150 million a quarter. Again, that maybe higher or lower based on the level of integration expense and the speed of achieving the synergies, but certainly after a couple of quarters we are going to start to try and make sure those synergies are showing through.
Next question, please?
We will go next to Andrew Wessel with JP Morgan.
Andrew Wessel - JP Morgan
Hi, thanks for taking my call. One question I have is on card re-pricing, just kind of taking the average spreads that you recorded against prime. During the quarter, over the last few quarters it looked like prices moved up a bit, but then over the last three quarters it's kind of stalled. Could you talk about just what you are doing and re-pricing the portfolio out of the Fed mandate rule changes?
Andrew, I think like all banks, we continue to manage our portfolio dynamically across all of the metrics. I think some players moved earlier with respect to a number of things. Our various efforts on account management will be more manifest. In the second half of the year, you will start to see some impact in the second quarter and more significant impact in the third and fourth quarter.
But that was part of the conversation where by the time we are done, if you pull up on the whole year that's where I gave the indication on the overall revenue margin, which will be just modestly lower than last year, full year, over year.
Andrew Wessel - JP Morgan
Great, thank you very much.
Thank you, Andrew.
Next question, please?
We will go next to Don Fandetti with Citi.
Don Fandetti - Citi
Hi, just a quick question on the FAS 140 changes. Any changing sort of your thought process on potential for a delay, and are you okay in terms of capital, how the regulators will look at that?
Hey, Don. It's Gary, and we of course keep a very close eye on what's happening and lot of mixed signals coming out on FAS 140. Of course the meeting that was scheduled through for this month with the FASB has been delayed, so we will just have to wait and see what happens.
But overall as we approach FAS 140, my watch for the year is that it's a change in accounting. It's not a change in our economic position. The accounting impact could of course be quite significant, but that will depend a lot on a bunch of things starting with timing, and so given the percent of our portfolio that is off balance and how much of that is declining quarter-over-quarter, the impact of FAS 140 when in its 140(R) when it commences likely to decline overtime.
Secondly, the nature of the accounting guidance is going to be extremely important as to how we bring those off balance sheet securities and assets back onto our balance sheet could have a material impact on a short-term impact on the bottom line.
And certainly from a capital perspective, as you say, Don, look we mostly managed our business with tangible common equity ratio as our guide. We have always had managed assets in the denominator, so from a capital standpoint, we have always been blind to whether or not assets are on or off balance sheet, so we are confident that our level of capital would be appropriate regardless of the accounting change.
Obviously, we will have to wait and see what FASB does and what the regulatory outcome might be, but even if we take the very worst outcome on every dimension of timing and structure, and regulatory response and so forth. I'll simply repeat what I said before, which is that would not require us to raise common equity or really any other form of Tier 1 capital even without target.
Don Fandetti - Citi
Okay, thank you.
Next question, please?
We will go next to Bob Napoli with Piper Jaffray.
Bob Napoli - Piper Jaffray
Thank you and good afternoon. Rich, I was just wondering if you could give any thoughts around the meetings going on in Washington DC later this week.
Yes. Good afternoon, Bob. The meeting, Thursday at the Whitehouse is the working session, what was basically set up as a working session among the executives who manage the credit card businesses at various banks to work with treasury and administration officials.
And we appreciate the opportunity to participate in Thursday's meeting and welcome the constructive dialogue, including now that the President apparently is going to attend this as well.
Ryan Schneider, our President of US card business will be there, representing Capital One. Fair access to credit is an issue of great importance, both to banks and the consumers. And Bob, you know the importance that we place on that so we are really looking forward to an open exchange of views. And I think that it's really important if the various parties can really get a common set of understandings and also understand the impact of choices and for a possible development on the regulatory environment and legislative environment, so that's what the meeting is about.
Bob Napoli - Piper Jaffray
Okay, thank you. The follow-up question just on the credit side. Capital One has not historically sold charge offs, is that you suggested I think maybe you did sell some in the UK. Are you doing anything different from managing the credit loss perspective, both on selling charge-offs, maybe on increasing use of deferrals things, two different items, but if you could touch on your intent to sell charge-offs, which is something you historically have not done. And if the level of deferrals are increasing, which I think it's also something that you, Capital One has generally been a light user of deferrals in the past.
Yes, Bob charge-off debt, we have been probably relative to most of the industry a pretty light user of debt sales. I think there are few folks in the industry who got rather used to some of the benefits that came from a large continuing flow of debt sales.
We try to not sort of get that dependency, but also really most importantly just look to debt sales as a sort of NPV based calculation to see when can someone else do it effectively for better economics than we can manage it. And debt sale is also a good way to manage to the capacity of in-house recoveries, where there can be capacity constraints sometimes in a worsening credit environment.
So that's how we look at debt sales. We are glad, we have not had a big dependency on it because the debt sales market has really kind of declined. Interestingly, it held up last year. So over the past year, we have seen our liquidation rates decline by 20% to 40% depending on the segment of the credit card business.
And it was sort of striking to us that the debt sale market sort of hung in there for most of last year, in terms of its pricing but it really kind of the bottom fell out of it in the first quarter, and so we don’t have much in a way of plans for debt sales. For the re-age policies which should be the industry term for some of the extension that you are talking about, Bob, for us we are inline with the industry and this has not changed and it is pretty tightly regulated by the OCC.
Next question please.
We will go next to Sanjay Sakhrani with KBW.
Sanjay Sakhrani - KBW
Hi, thanks, by my math, I think the dividends on the preferred were about $64 million this quarter, I mean, is that a quarterly run rate we should use for the rest of the year?
Sanjay Sakhrani - KBW
Okay, great. And then just a follow-up on the broader question on the regulatory proposal as they have been outlined, could you help us think about the economic impact if they are implemented in July of 2010 versus if they were implemented earlier than that date? Thanks.
Okay. First of all the big issue in the debate about the implementation of the federal reserve rules which are commonly called Reg AA or UDAP rules. The big debate I am sure, as you know relates to the ability to implement any earlier than the proposed date. So, all the issuers ourselves including are scrambling to do a very substantial amount if kind of technology and operational changes associated with the sweeping proposals. So it’s a very important issue to us in fact that the time is very important just in terms of literally the ability to pull it off,
The impact of this if it comes earlier, I suppose it will bring forward some changes that otherwise I think have always said will sort of be in the card, no pun intended for the industry over the course of next year. But I do want to say that the sort of account management changes some of the revenue moves that the various issuers have done make it -- I think that is going to mute some of the near-term immediate impact of that otherwise you would have seen when July of next year came along, but I think that the big question is how much of the industry is going to adapt its pricing relative to these changes and the most important issue is what happens on the front end, so let me give you an example here and this is the thing I am watching so closely.
Given that retroactive re-pricing of existing balances will not be allowed post the implementation of this, it means that, and because of the very, very low rate of amortization of these cards effectively, while it's a slight overstatement, credit card issuers will be stuck with the rate that they have for revolvers for the foreseeable future. And so I think the industry is addressing that with respect to their existing files over the course of these months, but for new originations, the thing to watch is the go-to rate because while the industry can use teasers and even teaser down from the go-to rates in the future, the go-to rate will be the defining rate that determines the long-term resilience we are going to have in the business.
When I look at the go to rates that the industry is competing with right now, it doesn’t look like it nearly covers the kind of long-term. It's not at the levels that you would need for long-term resilience, frankly go-to rates if you look at mail monitor data have actually been declining over the last number of months, very slightly declining but so have interest rates. If you adjust it for interest rates, they have actually gone up about 150 basis points which is good news but it is still well below where the go-to rates need to go to. So, I suggest all of you take, all of us. We certainly are very closely looking at that metric in terms of as a predictor of the future resilience in the card business.
Next question please.
We will go next to Chris Brendler with Stifel Nicolaus.
Chris Brendler - Stifel Nicolaus
Hi, good evening. Can you talk about the reserve level in US card business relative to the installment loan business? At 9.5%, is that (inaudible) a large portion of that, because if 9.5% in US card business that would be a pretty significant impact if you had a reserve at that kind of level, anywhere close to that kind of level on your off-balance sheet loan if FAS-140 were to go through. Thanks.
Chris, it's Gary, we don’t disclose the allowance in individual, parts of the various portfolios, I would say that again with the installment loan portfolio, we have been seeing a rising level of allowance because of the increasing loss rates. But remember that there is a countervailing effect coming from the impact of the reduction in the outstandings in the ILs. Remember also that the ILs are entirely or almost exclusively on balance sheet already, so they are not going to have an effect there. As far as FAS 140 goes, Chris, the impact to the allowance is going to be dependent on what the loss outlook is at the time and in terms of the impact of that loss allowance build at the time that we bring everything back on balance sheet. There may or may not be many countervailing factors depending on the way in which we bring those other things back onto balance sheet. So, again it's all accounting and we will certainly walk our way through it if and when we need to.
Chris Brendler - Stifel Nicolaus
That answer won't make any sense, I think if US card at 9.5% reserving on balance sheet or installment loan is driving that level of reserve, because if it is 9.5% that's a huge number for the US card?
Well, again the 9.5% allowance for reported loans in the US card segment covers both card, the revolving card as well as installment loans. If you take a look at the loss rate that we are experiencing on a managed basis and that's externally reported US card segment that was at 9.3% in March. You don’t remember as well that there is not necessarily an equal amount of credit card assets across the credit spectrum that are on the reported balance sheet for which there is allowance versus that which is securitized. And so again I think the closeness of the coverage ratio to the reported loss rate, should at least suggest that we are in the right ballpark exactly which product is contributing what amount is going to change overtime.
Next question please.
We will go next to Bruce Harting with Barclays Capital.
Bruce Harting - Barclays Capital
Yes, your cost of deposits has dropped nicely along with other core deposit funded banks and if you could just go back to the discussion you had on loan shrinkage or reconciliation, I think I heard you say that you are planning to shrink the US card business but the installment loans will be a bigger part of that shrinkage. Could you just clarify in terms of that and I am just trying to connect with when we see the monthly trust data coming out in the next few months. The denominator effect that you are talking about, 50 basis points higher in the second quarter from denominator and shrinkage of loans that ties into my question, then the OCC minimum payment 20 basis point impact. So just from those two, that’s a 70 basis point impact that we will see coming through the monthly 8-K data. Is that correct? And then just on that loan question, I hate to go with too many of these tangents, but if you are going to have shrinkage in loan as you said but you are going to keep, I think I heard you say you are going to keep earning assets kind of flattish, just wondering what the rationale is for that and why not go ahead and shrink earning assets, as well to get the tangible equity up. Thank you.
You suggested there is a bunch of different comments and questions there. Let me just start with a couple of facts to make sure that we are all on the same page here. So, although the installment loans as unsecured consumer credit on an national basis are included in our reported US card segment. There are no installment loans in our credit card master trust. The only thing in the master trust would be consumer in small business card. So, the effect of the shrinkage in the IO portfolio is not going to have any impact at all on the card master trust. So let me just stop right there. Maybe get a better view here Bruce on how I can take that forward for you.
Bruce, I am sorry, could you ask the question again. I am not we got it all.
Bruce Harting - Barclays Capital
Sort of two parts, I am just trying to get the overall logic or thinking behind, what's your philosophy right now with regard to asset liability management you have got a great funding source in your deposits. It just seems like it would be good time to shrink overall earning assets? So that’s one question and get the margin up and take advantage of the deposits and get the loan to deposit ratio down a little bit. And then the other part of that is you have made some comments about just trying to tie into your monthly data that I know apart from the trust now you are showing total managed charge offs right?
So just trying to get a sense of how quickly we are going to see those credit numbers develop from the denominator effect and then get to that 10% charge off number you are talking about? So two I was not clear, one question on this charge off and credit numbers as they evolve in the next few months and then another question on funding philosophy and why not shrink the earning asset as well as the loans? Thanks.
Okay. Bruce I would take both of those in order. In terms of the overall earning assets, as Rich indicated, if not for the acquisition of Chevy Chase, we would have shrunk overall earning assets in the quarter. Obviously there has been a shrinkage in the loan book coming largely from what Rich described which is the charge offs the run offs as well as the, as a reduced demand purchase falling in the like.
We had a couple of billion dollars of securities in our investment portfolio roll off in the first quarter. However, knowing that we have another $6 billion of investment securities rolling for the balance of the year, given what we saw largely in the first couple of weeks of January with agency mortgage backs at incredibly attractive levels, and a lot of consumer ABS which we know extremely well at very attractive levels. We chose to reinvest the proceeds of the roll off of some of our investment securities and also some of the deposits we were taking in.
We chose to invest those in our investment portfolio in the first quarter effectively to anticipate the roll off over the next three quarters of lower yielding investment securities, but certainly as we go through the course of the rest of the year having in a sense pre invested some of those proceeds you are likely to see a decline in the level of investment assets and therefore if we have shrinkage in loans and along with some mild shrinkage in the investment portfolio you could well see precisely what you would predict given our strong balance sheet, our strong funding sources which is shrinkage in overall earning assets. The timing is more or less our response to what we perceive to be the right kind of market opportunities.
With respect to the shrinkage and how it plays through into the monthly data, again as I indicated, remember ILs are not in the common trust and what you are going to see in the trust data is less a matter of the denominator effect, you will see some of the OCC min pay affect that Rich described. And you will tend to see that with a slight lag because of the way trust accounting works, that’s on the downside on the credit side. On the upside, what Rich described in the way of revenue moves that are going to benefit the overall card business, you will also see that come through into the trust as well.
Bruce let me just make one small clarification also, just to be precise here. We ourselves also are talking about two slightly different things and we talk about the monthly managed and then sort of the quarterly impact of this denominator effect. So the quarterly impact on the US card managed loss rate, this is the denominator, the 50 basis points denominator effect on average for the Q2 quarter and the OCC min pay effect on average 20 basis points for the second quarter. The monthly -- we also said the monthly managed numbers will -- that charge off rate will across 10% over the next couple of months. So that’s a monthly number, the others in average there, sligh differences in the effect per month, I just want to make that point.
And before we move on the next question Bruce, the thing that’s driving the monthly managed rate to cross 10% in the next couple of months is a combination of economic worsening the denominator impact and the OCC min pay impact. Next question please?
We'll go next to Moshe Orenbuch with Credit Suisse.
Moshe Orenbuch - Credit Suisse
Thanks, I guess, I understand not wanting to give guidance on charge offs but given the way your reserve is established, how should we think about the reserve addition both this quarter and in subsequent quarters relative to what you might be expecting for an increase in losses from your balance sheet portfolio?
Happy to take that question Moshe. Look, the allowance build in this quarter entirely consistent with the assumptions that Rich gave of significant further economic deterioration. You see that in this quarter alone with the reduction in loan balances, the increase in the allowance not only are we increasing our allowance but we are increasing our coverage ratios, both the allowance to reported loans and in the national lending businesses, the allowance to delinquencies.
The factors that drive allowance are often hard to predict, but I can tell for the first quarter just looking back here, that there were two factors that really accounted for the relative size of this quarter’s allowance in relation to the degree of experience and expected economic weakness that we are seeing and expect to see in the labor market.
The first I believe, Rich indicated that our own results in the quarter were generally in-line with the expectations we had when we set the allowance at the end of the fourth quarter. despite the fact that the economy overall had degraded more sharply than we would have expected at that same time and so again we're going to constantly be calibrating to make sure we have the right kind of the expected loss rate for any given move in the economy.
The second effect is that although our overall credit during the quarter was more or less as expected. It was differentially better in auto. I think that’s pretty clear from the numbers, and auto is entirely on balance sheet and that’s going to have a relatively helpful effect when it comes to allowance. It was differentially worse in card as Rich described and because that’s not on balance sheet that’s not going to drive the allowance overall.
So what I would say is that our first quarter allowance build, it still reflects a pessimistic outlook, certainly more pessimistic than the one on which the fourth quarter allowance was built. But it's one that recognizes a wide range of outcomes for the next twelve months.
I think as we go forward what we are going to have to do, is take a look at the potentially offsetting effects of, if there is a potential for further degradation in the outlook that will tend to push things up. But if the balances of loans are shrinking, that’s going to have a depressive effect on the allowance and is really going to be the relationship between those two that you see. And I think based on my conversations with so many of our investors and analysts. When they look back at the very large allowance build we had at the end of the fourth quarter, remember that the step change in the outlook that took place. All of the indicators pointing in the same direction at the end of the fourth quarter, although things have degraded; they have been a steady degradation this quarter.
We have seen our performance pretty steady and we see mixed signals on what’s coming on in the future and I think when you put all these things together, you can kind of understand how we came up with this quarters' allowance.
Moshe Orenbuch - Credit Suisse
Okay just a follow-up question, the contribution from Chevy Chase, I mean how should we think about the progression from this point forward, second quarter through the balance of the year?
Taking the question here, quickly Moshe, we showed you for this quarter and this quarter only as we often do. The impact of the acquisition in the quarter that happens and shows up as in any other category it will be rolled into our local banking segments starting in the second quarter. Remember the huge effects on the accounting results is coming from FAS 141(R), so you had truly elevated expenses all to do with the integration with the deal itself showing through in the first quarter that won't necessarily be there for very long.
The other thing that will change quite dramatically is, Chevy Chase not unlike many local and regional institutions tend to have an asset-sensitivity on their balance sheet, which given the very sharp decline in short-term interest rates over the last several months, really hurts their performance in the first quarter.
As we now have consolidated the management of the assets and liabilities, we are going to transform that into a more liability-sensitive position, which will allow us to benefit more from those Chevy Chase deposits.
And again, hopefully we will be able to demonstrate the ability to get some of the synergies pretty quickly as well. So clearly we are going to look for an improving impact from Chevy Chase as we go through the course of the year, and you will see that and we will talk about it showing up in the local banking segment, including some unique effects of purchase accounting, because of the new standard. And when we get there, we will break it out so you can see it.
Next question, please?
We will go next to Bill Carcache with Fox-Pitt.
Bill Carcache - Fox-Pitt
Hello, I have a couple of questions relating to your trust. First is the entire $118 million decline in the fair value of the I/O strips that you mentioned in your release, driven by the decline in the excess spread that we have been seeing in the trust.
And given that the value of the I/O strip has fallen so much, which we expect to happen in the non-interest income line item next quarter if losses are going to continue to rise and also what's the maximum cash trapping that would occur if your average excess spread falls below 4.5%?
And along the same lines, what are the key trigger points, what this cash trapping do to their earnings in book value, and finally would you provide support for the trust as excess spreads continue to fall, thanks.
Okay, Bill. That was four or five questions, I'll do these, because they are all about the same subject, we will count that. Okay, so let’s just start with the impairment of the I/O strip, I believe Rich indicated the impact, about $120 million leaving the balance of just $10 million or $20 million less, so needless to say when that no longer has any value attributed to it.
It can't, it can’t go down any further. That's not to say that you won't see some impact on our P&L should there be continued degradation in the trust that would come from two sources. The first would come from a reduced valuation of any of the trust interest that we have retained on our balance sheet.
Also, if there is cash trapping, which we will get through in a moment, we have to discount that and that can also have an impact on income, so we may continue to see some impact on non-interest income.
I would tend to doubt that we would see anything close to the kind of impact that we have seen in last couple of quarters in the I/O strip, but just when the I/O goes away, I don't want you to expect that you might not see any non-interest income impact from what's going on in credit, which takes us to the trust, so just a couple of facts, Bill, to make sure everyone's level set.
For the Class C, that means the BBB securities in our master trust, we start trapping cash when the three month average excess spread goes below 4.5%, the three month average excess spread at the end of March was 6.23% or about one or three quarters percent higher than the trigger.
So we are not trapping cash in relationship to that Class C at the present time. Of course we have seen a very marked degradation in excess spread over the course of the quarter, down to just over 4.8% in March.
And looking back at prior year trends, April trust data, which you are going to see released in middle of May, would typically be the seasonal low point for both yield and excess spread in the trust, so I think it would be prudent to expect to see a further seasonal decline next month.
Now, as Rich discussed a little bit earlier. In order to support the strength of our business, we have taken a number of moves on the revenue side, which will become obvious starting in the second quarter and probably more markedly in the second half of the year. And although those moves were taken simply for good business reasons, they will tend to benefit the trust.
And we think that although they make sure it's a little bit of a lag, because how trust accounting works those actions will return the trust to a healthier position relative to recent new-term performance.
Finally in terms of the amount of cash trapping, again, that will depend on what the excess spread level is, we are not there yet. If and when we were to get there, it will fluctuate quite a bit and we may trap cash and we may release depending on what's going on at any particular point in times.
In terms of the financial statement impact, our cash trapping, there could be an impact or, would be an impact on earnings if we were to be there. As I suggested earlier, a spread account established in order to trap the cash is discounted at a rate that is kind of commensurate with the risk associated with other kinds of receivables retained interest, and so we could see an impact on non-interest income for those periods of time when cash is trapped, of course it then gets released and it could easily have an offsetting impact on non-interest income.
The only other impact of cash trapping is really on the regulatory capital impact, because the excess spread that's trapped and the account is considered at risk from a regulatory capital standpoint, and we back out capital by holding dollar-for-dollar capital against it from a regulatory standpoint.
And when we do any of our stress tests, we assume that our trusts are going to perform more or less like the rest of our balance sheet. And under those scenarios, where the trust might be in a position of trapping cash, our judgment about the adequacy and the resiliency of our capital takes into account the prospective hit that would come from that kind of situation.
Again that is not necessarily once and forever, because that we expect that cash that gets trapped at some point in time gets released. But certainly in the short run, we want to be prepared for every eventuality. I hope that covered the landscape for you.
Next question please.
We will go next to Scott Valentin with FBR Capital Markets.
Scott Valentin - FBR Capital Markets
Good evening. Thanks for taking my question. Just a real quick question on the bank, net charge-offs were down in the quarter, but non-performing assets were up quite a bit and looking to provision expense did not really increase that much. And I was hoping maybe you can reconcile the thought process behind the provision expense versus the non-performing assets and maybe just don't see that much than even better losses in those estimate and provide little more color about the New York market and what you are seeing in the loan categories?
Sure, Scott. It's Gary. Let me take the first part of your question, and I will hand it up to Rich to give you some color as to what we are seeing in the New York market or any of the others.
Remember, there is a real seasonality to what goes on in the provision for the banks. So if you go back to the fourth quarter, you would have seen a relatively elevated level of charge-offs. These are very lumpy kinds of things as we do our review of the portfolio and move things to charge-off, we tend to see that. We've risen in the fourth quarter, you clear out a lot of the NPLs as we get into the first quarter.
Again, we are going to reassess on a quarterly basis, loan-by-loan everything that happens with the overall level of performance in the markets, not surprising that you would see a decline in the level of charge-offs, but an increase in the level of NPLs.
And so if you saw the fourth quarter allowance build, that was really drawn on the basis of the economic degradation as that continues, it's not surprising to see a level of provision that's more or less the same.
The only other thing I will remind you about in our local banking segment, and it's broken out in the table, so you can see it is there is a one-off portfolio, it is called the small ticket commercial real estate portfolio. Those were loans that were originated by deal to our GreenPoint mortgage for sale into the secondary market, which we ended up having to hold when the secondary market pretty much shutdown.
Remember that a lot of the overall bank statistics are going to be driven, by that one-off portfolio. But I think to really understand the quality of the commercial book I will hand it over to Rich, and I would look at that separately.
Okay Scott, it’s not lost on any of us that just all the bad news that seems to keep coming out with respect to jobs, particularly high paying jobs in the New York area. The city has lost about 87,000 jobs from what we can gather here and is projected to loose I mean another 150,000 jobs if the recession plays out as the projection by the Office of Management and Budget.
I think that one very good thing is that New York entered this downturn in much better shape than in past recession. In the early 90s when New York got sort of creamed on the commercial side, they started with a big oversupply of office and residential real estate. This is not the case today and one reason for that is by-product of September 11. So in our portfolio, New York portfolio is still performing really quite well and I think that there is one exception to that which is the fore sale construction portfolio which I talked about in our talking points, but quickly dividing this up, we have got the multi-family business. It’s about $5.4 billion and this multi-family segment which is apartment rentals has historically been very resilient to economic downturns and I think we expect the same this time around.
About 70% of our multi-family properties are subject to government mandated rent restrictions and it provides a level of stability I think that doesn’t exist in other markets in America. So that one is probably the very best performing, the one we are the most optimistic about.
Now our office portfolio is largely composed really of Class B and C properties and located throughout the five [borrows] and they have a really quite diverse tenant base and we have stayed away from some of the biggest signature kind of office buildings, I think are a little more challenged at this point.
We have over the years, and this is a great heritage from John Kenneth and John Wilson. The underwriting standards for this portfolio are rigorously and uncompromisingly based on in-place cash flows, they don’t bet on the come with respect to rent rate escalation, there were relatively low LTVs in the structure and so far this is performing pretty well.
Our retail portfolio is composed mostly of sort of neighborhood and community centers that are grocery anchored in particular and the grocery anchored retail centers tend in these downturns to be doing a little bit better. So that’s working pretty well.
The construction portfolio again is a big exception for that, the most important thing about that is just relatively small. And I mentioned the fore sale construction properties, they are under significant pressure, but I think we have tried to be pretty disciplined in working through our portfolio to identify those that are weak.
On the C&I side, we are really pretty well diversified across many industries and middle market borrowers and this is also performing really quite solidly. So, we are going to watch very closely the developments in New York. It's obviously no matter how good the numbers can be, it's obvious that New York has a long way to go in this downturn. And I think New York itself and we with our underwriting at least start in a pretty good place as we weather it could be big storm in New York.
Scott Valentin - FBR Capital Markets
Thanks very much.
Next question, please.
We will go next to John Stilmar with SunTrust Robinson Humphrey.
John Stilmar - SunTrust Robinson Humphrey
Good evening, gentlemen. Quick question with regard to the balance sheet, clearly your strategy of favoring liquidity and preserving the ability to allocate capital to different businesses, it seems to be very evident, but can you put some fence post in around your guidance of flat earning assets. First of all is it managed flat earnings assets or reported?
And secondly can you talk about the dichotomy between the actual core commercial lending book, consumer lending book and then the liquidity portfolio and roughly what we can expect for dynamics over that over the next 12 months as sort of your base case or fairway assumptions right now?
Sure, John. It's Gary. Just with respect to your first question, the flattish earning asset is on average managed basis with Chevy Chase. With respect to the dynamics going forward, again I think we would expect that this may or may not be the high watermark for the percentage of our portfolio that's in investment securities, if not we are probably pretty close to it based on the opportunities that we see in the market. So I would expect to see that portfolio starting to come down.
The question that’s tough to answer is when we will see the loan portfolio grow net of all of the attrition and the charge-offs and so forth. And that's really going to be dependant more on the economy. So, I guess just looking forward, things stay more or less as they are. You could see a little bit of shrinkage most of that you would see it coming from both investments and loans, unless we see opportunities surprisingly show up on either side.
Longer-term I think you will continue to see shrinkage in the investment portfolio but certainly we would expect to see some growth in the loan portfolio. I wish I could give you the dates on which all of that is going to happen, but I need a crystal ball that’s a lot better than the one that I have right now.
John Stilmar - SunTrust Robinson Humphrey
Perfectly I understand, and than I hate to bring up the securitization trust again and it’s nothing regarding accounting, but one of the things that we have noticed over the past couple of months, there has been at least a divergence between the managed statistics, credit statistics and the trust statistics, it has always been a little bit lower, but that difference has become more amplified or the difference has become greater. Can you help me think through what some of those reasons may be and how should we think about that as we are looking forward and gauging future credit expectations given some of the details you have provided in the trust?
I can give a couple of hints, they wont always work John, but in your own mind if you see things coming out differently than you expect, first thing you should keep in mind is the managed US cards statistics that you see every month include all of our unsecured nationally originated consumer loans that includes IL’s. And so you are going to see that affecting what’s going on in the managed but that doesn’t necessarily affect the trust.
Secondly, amongst lag under normal circumstances usually doesn’t create a lot of disconnect, but given the speed with which things are happening both on the credit side and maybe on the revenue side, just having a lag of a month or so in the trust could also have an impact.
And then finally just remember that the trust and the managed book are not exactly a mirror image of each other and so we can have slightly different performance on the balance sheet versus of. And then finally on the balance sheet, you are going to have more of a denominator effect as well. So ask yourself all of those questions and I am sure you will ask our IR team the same questions, those are the ones you should be asking.
Next question please.
We'll go next to Richard Shane with Jefferies & Company.
Richard Shane - Jefferies & Company
Hi, guys. Thanks for taking my question. You guys provided guidance on January 20th and let's assume you had pretty good outlook into what was going on for the month of January at that point. When you look at what happened in February in March and in April, where was the break point, where was the point where you said what a loss guidance, our credit guidance needs to be revised, I don’t mean this from you have an obligation to go and update that, but what happened during the quarter. Are things continuing to get worse or just where was the breakpoint?
Richard, I don't know if I really used it, the word breakpoint, but when we give guidance about our credit card business charge offs, it's really based on this what I called what's baking in the oven which is basically driven by delinquencies and roll rates from one delinquency bucket to another. And the final charge-off numbers of course include recoveries and they include bankruptcies. So bankruptcies just kind of come in a sense sort of out of the blue and they don't even march through the bucket so too with recovery. Relative to our own forecast, the three things that deviated precisely from our forecast were bankruptcies which came in higher and they again don't go through the oven.
Recoveries which came in lower and don't go through the oven and then also late bucket roll rates increased somewhat also and that sort of, yes it is part of the oven but it's in the later part of that. But that's how the number ended up being 30 basis points higher for the quarter. And of course at the same time so that was kind of from a metrics point of view. At the same time of course Richard unemployment was massively accelerating during the quarter.
So it is both the case that we said we exceeded our own internal estimates with respect to the card business. But I think it's also the case that the sort of electrifying increases in unemployment have not thus far been associated with electrifying increases in some of the credit numbers.
Richard Shane - Jefferies & Company
Got it and that's actually a very helpful answer, because I think what it suggests is that it was somewhat linear. The follow-up to that is, you saw three, let's ignore unemployment for a second, you saw three anomalous events within your portfolio. You guy's have an enormous amount of data and you are very good at mining that. Historically, the anomalies that you saw, the spike in bankruptcies, the deterioration of late phase BK roll rates, and the deterioration of recoveries, is that a sign that things are getting worse or is that a sign that the problems are starting to burn out, where does that occur in the credit cycle?
Richard I don't even think these things arise to be called really anomalous events. I mean this world has so many, so much uncertainty around there. When we try to guide you with what's baking in the oven, it is still an imprecise thing, I don't think any of us would characterize the developments in BK role rates or recoveries to be anything more than just in a sense worsening, the thing that probably most has our attention in the quarter really are none of these things, it’s really the very significant increase in unemployment rate.
So, and if you also, but if you also go back and just sort of track how all the contributors to losses that have gone sort of contractuals, bankruptcies and recoveries, the one that's most strikingly degrading overtime is bankruptcies and recoveries is probably, and recoveries moving closure with then to contractuals but a little bit worse. So it is just an example though despite all of our good efforts to try to carefully forecast the stuff, it’s just a reminder at the end of the day that this is an imprecise science, but I wouldn't get too carried away with the anomalous nature of these events.
Next question please?
We will take our final question for the evening from Ken Bruce with Banc of America/Merrill Lynch.
Ken Bruce - Banc of America/Merrill Lynch
Thank you, good evening and I appreciate for taking the time to answer the questions. We discussed the nature of the installment loans, I was hopping you might be able to provide some qualitative information about what is in that portfolio, I know you said in the past there were high FICO, that higher indebtedness borrowers, can you provide any additional clarity as to what's in that installment loan book why it's performing as bad as it is, what's your, if you are concerned with the broader consumer revolving portfolio will begin to demonstrate similar trends please?
Yes, Ken, these loans went mostly to high FICO customers, a lot of them fairly super prime customers, but the key thing is they tended to be relatively more indebted customers than in our card business. And that's why they've proven to be ultimately more vulnerable in this downturn.
Now, it's not that in doing the installment loan business we sought more indebted people, it's really the nature of the selection that happens with respect to this product. People attracted people who had very good credit records but had higher indebtedness and this has always been something that we've been very cautious about frankly across our whole business, it's a key reason we've had a relatively low mix on the revolver side and of more indebted folks.
But here is an example probably within our portfolio, example of the part of our business that's attracted relatively more the higher indebted folks here. However, there is another thing about this Ken, that is really charge-off math and that is that the relative growth of the installment loan business was a fair amount higher over the last probably in the '07 - '08 time period than the credit card business which really didn't basically grow at all. So, in the installment loan business started off a much smaller base. So, you have just the math of more recent vintages here that is also really affecting the metrics. We have certainly found with respect to, it's almost the universal thing one finds across all the credits businesses.
The vintages that you originated right at the penultimate days before the downturn, those tend to be performing the worse and that has a lot higher mix in our installment loan business, and we’re probably less than the average card company to have that kind of mix in our card business.
Then finally the installment loan metrics have a big denominator effect because we’re basically shutting down the originations of these things. So, all those are conspiring to give this effect, but we are junkies about analyzing where you get positive and negative selection in credit.
This is one of the wonderful and awful things about lending. It is not like actuarial prediction of things in the insurance base. This is about things that the intersection of supply and demand, and it's all about whether you attract positive or negative selection.
One thing that I’ve always liked about the credit card business is that it attracts people who are not solely there just for a loan. They are into product by being a combination of a transactional product and an occasional or opportunistic borrowing product.
It tends to have better selection sometimes with respect to credit and also a better opportunity for revenue, and a greater resilience for things we’ve talked about. So, that’s the (inaudible) again.
Ken Bruce - Banc of America/Merrill Lynch
Okay. And when you walked in on Thursday to this working session with the administration, are you at all concerned that they are going to be pulling the credit card industry to be more lenient on credit and doing something that are frankly counterproductive given the economic cycle?
Well, I don’t know if we really know quiet what to expect from the meeting on Thursday, but as a macro point, we are very concerned about the highly politicized environment right now. One thing about the credit card business, this is a very complicated business that has witnessed the fact that the regulators in doing Reg AA, UDAP rules to basically two years, 65,000 comment letters and what feels I am sure to them like lifetimes to pull together the consumer issues and the safety and soundness issues in a very, very thoughtful set of rules.
And now we sort of enter the political environment and the intersection of a lot of controversy about credit card practices at the very same time of course of the big downturn. I think this is high stakes environment and the most important thing is to get past the rhetoric to focus on really what's going on in the business, what is already being achieved by the federal reserve rules that haven’t even been implemented yet.
And also to understand the consequences of what may happen with respect to consumer credit availability by virtue of some of the ideas that have been proposed in Congress. So, this is a high stakes time for card companies, it's the high stakes time for I think for what happens with respect to the consumer credit availability and we look forward to a good conversation on that.
That concludes our earning call for this evening. Thank you very much for joining us on the conference call tonight, and thank you for your continuing interest in Capital One. Now the investor relations staff will be here this evening to answer any further questions you may have. Have a good evening.
That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.
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