A single-minded focus on the credit card industry gives Capital One (COF) a very unique business model compared to the country’s biggest banking groups, who are either extremely diversified in their financial services offerings like JPMorgan Chase (JPM) and Bank of America (BAC), or are focused on the traditional loans-and-deposits model like Wells Fargo (WFC) and U.S. Bancorp (USB). The credit card business model has a lot of potential simply because card loans demand the highest interest rates among all retail loans offered by banks. Net interest margins on credit cards for banks are normally twice or three times the figure for other retail loans like auto or student loans.
But then, there really is no such thing as a free lunch. The high returns come with a higher risk due to the short term, unsecured nature of credit card loans. And card loans are often the first to go bad when the economy shows signs of slowing down. However, the bigger problem for a bank’s credit card business is when there is an increase in loan losses gauged through charge-off rates despite there being an improvement in the overall economic condition for a period. And this is the situation Capital One is currently facing.
The table below summarizes the credit card charge-off rates for each of the banks we named above in the last nine quarters. The data has been compiled using figures reported by individual banks as a part of their quarterly announcements.
|Q1 2011||Q2 2011||Q3 2011||Q4 2011||Q1 2012||Q2 2012||Q3 2012||Q4 2012||Q1 2013|
|Bank of America||7.78%||7.08%||6.24%||4.72%||5.45%||5.08%||4.51%||4.14%||4.12%|
Quite notably, Capital One has reported the highest credit card charge-off rates among these banks in each of the last two quarters. It must be mentioned here that as a part of its Q3 2012 earnings release, the bank did give a heads up to higher charge-off figures in the future, holding the less stringent lending practices by the acquired HSBC (HBC) card business responsible for an overall reduction in the quality of its loan portfolio. (Q3 2012 Earnings Press Release, Capital One Press Releases, Oct 18 2012)
But side-by-side comparison of charge-off figures in Q1 2013 shows a bad sign. Capital One’s card loan charge-offs increased 13 basis points (0.13%) over the period, even as other banks (except for Wells Fargo) reported slightly lower charge-offs. As for Wells Fargo, its card business forms a substantially smaller part of its total business compared to Capital One; to put things in perspective, Capital One’s average outstanding card loans for the first quarter was $83 billion, whereas for Wells Fargo this figure was $24 billion.
So why are we so concerned about Capital One’s higher charge-off figures? The answer is simple: because of the bank’s dependence on the card business to generate a bulk of its value. Higher charge-off figures would mean the bank has to set aside higher provisions to cover these losses over subsequent quarters. The impact of higher provisions on the bank’s share price can be easily understood by making changes to the chart below.
To explore one such scenario, suppose Capital One is forced to set aside 5% of its loan size as provisions each year in the future – similar to what it did in 2012. In this case, the bank’s share price will lose nearly 12% of its value compared to our current estimate of $58 to reach just above $51. Capital One will really need to work hard to fix the quality of its card loan portfolio going forward if it wants to avoid this huge downside to its value.
Disclosure: No positions.