Capital One Financial Corporation (NYSE:COF)
Q2 2009 Earnings Call
July 23, 2009 17:00 pm ET
Jeff Norris – IR
Richard Fairbank – President & CEO
Gary Perlin – CFO
Craig Maurer - Caylon Securities
Unspecified Analyst – Ladenburg FSG
Christopher Brendler - Stifel Nicolaus & Company
Steven Wharton - JPMorgan
Joe Mack - Meredith Whitney Advisory Group
Henry Coffey - Sterne Agee & Leach
Moshe Orenbuch - Credit Suisse
Bruce Harting - Barclays Capital
John Stilmar - SunTrust Robinson Humphrey
Andrew Wessel - JP Morgan
Brian Foran - Goldman Sachs
Sanjay Sakjrani - Keefe Bruyette & Woods
Ken Bruce - Banc of America
Robert Napoli - Piper Jaffrey & Co.
Good day everyone and welcome to the Capital One second quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Jeff Norris, Managing Vice President of Investor Relations. Sir, you may begin.
Welcome everyone to Capital One’s second quarter 2009 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log onto Capital One’s website at www.capitalone.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our second 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. Richard 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 the actual results to differ materially from those described in forward-looking statements. For more information on these factors please see the section entitled Risk Factors in our Annual and Quarterly reports filed with the SEC and accessible at the Capital One website and also the forward-looking statements section in the earnings release presentation.
Now I will turn the call over to Mr. Perlin.
Thanks Jeff and good afternoon to everyone listening to the call tonight. I’ll begin on slide three, in the second quarter Capital One earned $224 million or $0.53 per share prior to impacts from the government’s preferred share investment. After including a $462 million accounting impact of the June redemption of the shares, and $38 million dollars in preferred dividend payments in the quarter deposited $0.53 per share becomes a loss of $0.65 per share available to common shareholders.
These quarterly results also include a pre-tax expense of $80 million for the FDIC special assessment partially offset by a pre-tax gain of $65 million from the sale of MasterCard stock. Performance in second quarter continuing operations primarily reflects the economic environment, and our actions to manage the company through the downturn.
Revenue increased $418 million in the quarter driven largely by two factors, first our margins improved. This improvement was driven primarily by reducing our funding costs through better pricing and managing the mix of our liabilities to bring down our weighted average funding costs by 36 basis points. More on funding costs in a moment.
And second we posted a full quarter of Chevy Chase Bank revenues. Let me point out that while Chevy Chase Bank’s results remain in the other category in the segment reporting supplemental tables we’ve also included a specific schedule in the tables to outline its results for the quarter.
Chevy Chase Bank will be merged into Capital One NA on July 30 and the results will be integrated into our existing business segments in the third quarter. While they didn’t materially impact the quarter over quarter revenue change, we also recognized a negative $127 million valuation adjustment to our retained securitization interests and suppressed $572 million in fees assessed but deemed uncollectible in the second quarter.
About half of the valuation adjustment was driven by an increase in the amount of subordinated asset backed notes we retained in conjunction with the issuance of new public ABS in the quarter. And the other half of the valuation adjustment was driven by an increase in the size of spread accounts as we slipped just below our three month average 4.5% BBB trigger in the common securitization trust.
The overall improvement in revenue was partially offset by an increase in non-interest expense which resulted primarily from a full quarter of Chevy Chase Bank expenses and the FDIC special assessment. Provision expense was down $228 million quarter over quarter with an expected modest increase in charge-offs more than offset by the swing from a $124 million allowance build in the first quarter to a $166 million allowance release in the second quarter.
US card more than accounted for the entire allowance release in the second quarter where $1.9 billion of reported loan contraction led to $183 million release in that business despite the fact that we maintained card coverage ratios. The $68 million build in the local banking segment driven mostly by worsening credit trends in commercial was mostly offset by the $61 million release in auto to reflect both improving charge-off trends and declining loan balances.
As we turn to slide four I’ll discuss how the changes to our allowance have impacted our coverage ratios. For the total company our allowance as a percentage of reported loans remained flat in sequential quarters at 4.8%, up 143 basis points from the year go quarter. In the second quarter we maintained our increased our ratio of allowance to both reported loans and reported delinquencies in nearly all of our businesses as we anticipate higher losses than today’s levels.
The loan exception was a slight decline in coverage in auto finance which experienced a full quarter’s worth of improving charge-offs. With a coverage ration of allowance to reported delinquencies at historical highs for our unsecured lending businesses, our allowance anticipates a full 12 months of losses that are higher than today’s levels.
Let’s turn to slide five where we see that both cost and revenue margins improved in the quarter. On the revenue side we saw significant improvement in both our net interest and revenue margins. Our NIM improvement of 30 basis points was driven by a reduction in our cost of funds.
Despite the continued mix shift of assets from loans to lower yielding investment securities we managed to maintain a stable weighted average asset yield allowing the cost of funds improvement to fully benefit NIM. Its also worth noting that this 30 basis point improvement is actually understated as a full quarter of the lower yielding Chevy Chase Bank portfolio decreased NIM by about 10 basis points quarter over quarter.
In addition to the factors driving up NIM revenue margin improved as gains from the sale of securities from our investment portfolio and of shares in MasterCard were accompanied by an increase in gross interchange income stemming from 10% higher purchase volume in the quarter.
We continue to aggressively manage our costs bringing down our efficiency ratio even while absorbing a full quarter of the historically higher efficiency ratio of Chevy Chase Bank, the FDIC special assessment and ongoing integration expenses. Looking ahead while our efficiency ratio may fluctuate as a result of these integration expenses and potential swings in revenue we remain committed to driving run rate efficiencies over time.
Since our results will continue to be influenced by the composition of the balance sheet I’ll discuss our asset mix and funding in more detail on slide six. Our strong and flexible balance sheet continue to reflect both a secular shift from the strategic choices we’ve made especially the transformation of our funding mix as well as cyclical trends caused by the current economic environment. Especially the impact of lower rates and reduced demand for loans. Average earning assets increased by approximately $5 billion in the quarter more than entirely accounted for by the effect of a full quarter of Chevy Chase Bank loans. Excluding Chevy Chase Bank loans average managed loan balances in legacy segments declined by about $4 billion despite about $5 billion of new originations.
Several factors caused loan balances to fall in the quarter including the run off of over $2 billion in loans related to businesses we repositioned or exited several quarters ago, such as auto and installment loans. In addition rising charge-offs, low purchase volumes, particularly in revolving card businesses, weak loan demand, and normal attrition also contributed to the decline in loan balances.
Our average securities portfolio grew by approximately $3 billion in the second quarter and now represents 20% of our earning assets up from 18% in the first quarter. While lower yields on the securities we purchased in the quarter led to an overall yield on the investment portfolio the weighted average yield on all earning assets remained stable because of margin expansion in our loan book.
I’ll provide more color on the securities portfolio in a moment and Richard will speak to loan margins later. On the liability side we rolled approximately $4 billion of securitization maturities in the quarter including the issuance of $1.5 billion of new public securities marking our return as an ABS issuer as spreads tightened to the best levels in a year. We also accessed the capital markets for $1 billion of senior notes and $1.5 billion of subordinated bank debt, both deals done without government backing.
As we’ve noted before Capital One has not had to rely on any of the government programs created to aid capital market access like TALF or TLGP. As a result of these moves our funding mix remains stable in sequential quarters. The full quarter effect of Chevy Chase Bank increased average deposits by approximately $7 billion although period end deposits were down $4 billion as we allowed higher cost deposits to run off in the face of the contracting loan book.
As a result or ending period loan to deposit ratio remained stable. Our actions significantly reduced our average interest bearing deposit costs from 2.51% to 2.08% which drove down our overall cost of funds by 36 basis points to 2.40%. As we turn to slide seven, I’ll provide a more detailed view of our investment portfolio.
This portfolio continues to be a source of both strength and flexibility for Capital One. The quarter end investment portfolio grew by a billion in the quarter. We continue to believe it is not only prudent to maintain excess liquidity given today’s market uncertainty but also that we can generate attractive risk adjusted returns while doing so.
While lower yields on the securities we purchased in the quarter brought down the yield on the investment portfolio by 22 basis points to 4.40% the rally in the fixed income market in the quarter enabled us to recognize some modest gains from sales of securities as well as improve the unrealized loss position by $316 million.
In fact our unrealized loss position has improved by approximately $800 million since the beginning of this year. Although securities are currently generating attractive returns we expect that when attractive lending opportunities present themselves in the future we will be able to finance those opportunities without the need for us to raise additional capital by reducing the size of our investment portfolio.
I’ll discuss capital in more detail on slide eight. Our TCE ratio improved by 90 basis points in the quarter to a healthy 5.7% driven by our $1.5 billion common equity raise in May and the $6 billion decrease in our tangible managed assets. Redeeming the government’s $3.55 billion in preferred shares reduced our Tier 1 ratio by approximately 300 basis points in the quarter. However our period end Tier 1 ratio was only down 170 basis points to 9.7% as our common equity raise in May along with a reduction in risk weighted assets partially offset the return of the government’s investment.
Our Tier 1 ratio now stands at 9.7% or 370 basis points above the regulators well capitalized threshold. We know that many of you like we are paying close attention to prospective impact on issuer balance sheets of the consolidation of securitization assets required by FAS 166 and 167 currently scheduled to take place in early 2010.
It would be an understatement to say that there are many uncertainties as to how this would effect regulated financial institutions because of the implementation options available to issuers under the accounting standards, recent notices from the FAS B about their intention to move even further towards fair value accounting for all loans and the absence of relevant rules by banking regulators.
As for Capital One we’re hard at work planning for each of the many alternative outcomes. Given the range of potential changes in accounting, its important to true back to the ways in which we assure our capacity to absorb expected and unexpected losses. The most important of these are maintaining an appropriate allowance for expected losses and managing capital to a healthy TCE ratio.
The TCE calculation is blind to on or off balance sheet treatment of assets in the denominator. And the numerator includes only common equity. Under scenarios in which we might build additional allowance as a result of the consolidation, this could reduce the TCE numerator. But such an accounting change if it happened would simply move resources to absorb future losses from one part of our balance sheet retained earnings, to a different part of our balance sheet, the loss allowance.
Thus these accounting events whenever and however applied, do not effect our true economic earnings power, our risk position or our capacity to bear that risk. That’s why were confident that an accounting change in and of itself would not require us to add to our common equity. Unlike TCE regulatory capital calculations are more complex and subject to change.
Our ratio of Tier 1 capital to risk weighted assets and similar regulatory ratios are strong and as you can see on slide eight comprised of very high quality capital. They’ve been validated by our supervisors as evidenced in our S cap results and our recent redemption of the TARP preferred shares.
We still value however the flexibility provided by strong regulatory capital ratios especially in uncertain times like these. Therefore we’ve recently strengthened our regulatory capital base with $1.5 billion of subordinated debt and will continue to look at similar opportunities as appropriate.
Turning to slide nine I’ll touch on the financial performance of our other category before turning the call over to Richard. We experienced a $40 million loss in the other category in the second quarter, an $86 million improvement from the prior quarter. There were a number of largely offsetting items, strong revenue from our treasury, and a modest profit from Chevy Chase Bank were more than offset by the FDIC special assessment, losses from the Greenpoint HELOC portfolio and restructuring costs.
I’ll now turn the call over to Richard to discuss the performance of our national lending and local banking businesses.
Thanks Gary, our US card business posted $168 million in profits in the second quarter. The primary driver of US card profits in the second quarter was lower provision expense as the pretax allowance release of $183 million more than offset rising charge-offs. As Gary described the allowance release in US card was entirely driven by the decline in reported loan balances.
The allowance as a percentage of reported loans was flat and the allowance as a percentage of reported delinquencies actually increased. US card net interest income improved as a result of lower funding costs and the modest improvement in finance charge revenue from the revenue enhancement actions we took earlier this year.
The improvements in net interest income were offset by a decline in non interest income as we continue to see consumers behaving defensively in the current economic environment, spending less, exercising caution to avoid fees and working hard to remain current. Revenue margin for the second quarter improved to 14.5%. We continue to expect that US card revenue margin will increase in the second half of 2009.
We anticipate that revenue margin will be above 15% in each of the last two quarters of 2009. For the full year however we now expect the average revenue margin will be a bit below 15% as revenue improvements will be partially offset by the effects of defensive consumer behavior and early implementation of some aspects of the new card law that we expect to complete later this year.
The international businesses posted net income of $5 million in the second quarter. We have been retrenching in the UK business for some time now and we’ve been cautious in Canada in an anticipation of the credit worsening that began in the first half of 2009. As a result local currency international loan volumes have been declining. The dollar increase in international loan volumes in the second quarter resulted entirely from foreign exchange impacts.
Capital One auto finance delivered net income of $97 million in the second quarter. Second quarter net income was helped in part by a $60 million pretax allowance release driven by declining loan balances and better than expected credit performance. Our 2008 origination vintages are delivering strong results. We’ve been able to originate loans with lower LTVs to customers with higher FICO scores.
At the same time we’ve been able to improve pricing and margins in the current competitive environment. As a result we expect that the 2008 originations will yield above hurdle risk adjusted returns and their performance to date is tracking at or above our expectations. Although auto finance results through the first half of 2009 are encouraging we remain cautious.
By definition the seasonal elements of strong first half credit performance will not persist so we don’t expect this level of profitability to be our run rate for the remainder of 2009. It is uncertain how long we’ll continue to benefit from rising used vehicle prices and recoveries. And the continued strength in the economy and the auto industry create continuing uncertainty about the near-term results of our auto business.
The local business essentially broke even in the second quarter despite cyclically high provision expense. Pre provision pretax earnings increased as a revenue improvement outpaced the modest increase in non interest expenses. The revenue increase in the quarter resulted from favorable loan and deposit pricing, higher average deposit balances and improving deposit mix.
Provision expense remains elevated at this point in the cycle but declined from the sequential quarter as the allowance build in the second quarter was lower than the allowance build in the first quarter. Our local banking allowance coverage ratio as a percentage of reported loans increased.
Slide 10 shows credit performance in our national lending businesses. Economic deterioration continued during the second quarter although the pace of deterioration was partially offset by seasonal tailwinds and our ongoing efforts to aggressively manage credit risk. As a result delinquency and charge-off rates increased across most of our national lending businesses although the pace of deterioration slowed. In fact we saw modest improvements in our US card delinquency rate and our auto finance charge-off rate.
US card charge-off rate increased to 9.2% for the second quarter. About 45 basis points of the second quarter charge-off rate resulted from declining balances and about 10 basis points resulted from implementing the OCC minimum payment policies. The second quarter charge-off rate also includes an offsetting positive impact of 35 basis points from a change in our bankruptcy recognition process that we noted in our monthly credit 8-K filings during the quarter.
While our internal guidelines require bankrupt accounts to be charged off within 30 days our practice had been to charge-off customer accounts within two to three days of receiving notification of bankruptcy. Due in part to an increase in the volume of bankruptcies we have extended our processing window to improve the efficiency and accuracy of bankruptcy related charge-off recognition.
The new process remains within Capital One’s internal guidelines as well as regulatory guidelines that bankrupt accounts must be charged off within 60 days of notifications. This was a one time impact limited to the months of April and May. It has now run its course and the June monthly credit results were not effected. Without this processing change second quarter charge-off rate would have been 9.6%.
The US card delinquency rate improved modestly to 4.8% at the end of the quarter. Second quarter charge-off and delinquency trends were generally consistent with expected seasonal patterns and in line with the expectations we articulated last quarter. We expect further increase in US card charge-off rates through 2009 as the economy continues to weaken.
We also expect that our US card charge-off rate will deteriorate at a faster pace then the broader economy as a result of denominator effects and our implementation of OCC minimum payment requirements. While many credit card issuers have experienced declining loan balances in the current environment we expect that our denominator will decline more than the industry in the second half of 2009 as the result of installment loans running off.
As we’ve discussed over the past couple of quarters our US card business includes about $9.3 billion in installment loans down from about $10.6 billion at the end of the first quarter. We essentially stopped originating installment loans late last year so the portfolio will continue to shrink as the outstanding loans amortize.
Installment loans account for just 14% of US card loan balances but we expect that run off of installment loans will drive about a third of the expected denominator effect. Combining both revolving card and installment loans we expect the denominator effect to increase third quarter charge-off rates by about 40 basis points for the US card business.
As we 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 continue to analyze test sale data to refine and update our estimates of the expected impacts of implementing OCC minimum payment policies.
We now expect the OCC minimum payment impact to drive around 80 basis points of charge-off rate in the third quarter and 20 basis points in the fourth quarter and into 2010. Taken together we expect the denominator effect, the OCC minimum payment effect and the absence of the bankruptcy processing benefit will result in about 150 basis points of higher US card charge-off rate in the third quarter before any charge-off rate effects from continuing economic deterioration or seasonality.
Switching from quarterly to monthly charge-off rate we expect that OCC minimum payment effects will be significant in each month of the third quarter beginning with June to establish a baseline we estimate that the June monthly managed charge-off rate for US card included about 20 basis points from the OCC minimum payment effects.
We estimate that this impact will be about 120 basis points in July, 80 basis points in August, and 50 basis points in September. Credit trends in the international business reflect increasing economic deterioration in the UK and Canada. While the Canadian portfolio has been relatively stable for several quarters, the Canadian economy and credit trends continued to show signs of weakness in the second quarter.
Auto finance charge-off rate continued to improve in the second quarter driven by several factors. Charge-offs exhibited expected seasonal improvements in the second quarter. Used car prices have been improving for several months resulting in lower charge-off severity. And our investments in auto finance collections and recovery operations are paying off. We realized improvements in charge-off rate even though the denominator declined by nearly $800 million as a result of our actions to retrench and reposition the business in late 2007.
Auto finance delinquency rate increased modestly from the sequential quarter following expected seasonal patterns. We expect auto finance charge-offs and delinquencies to increase in the second half of 2009 in line with expected seasonal patterns, continuing economic deterioration and uncertainty about the sustainability of favorable used vehicle prices.
Before moving on to commercial credit, I’ll update our economic outlook. Unemployment and home prices have been and continue to be the economic variables with greatest on our credit results. We now expect unemployment rate to increase to around 10.3% by the end of 2009, up from our estimate of about 9.6% last quarter.
Our prior assumption for home prices was for the Case-Shiller 20 City index to fall by around 39% peak to trough. We now expect a modestly worse peak to trough decline of around 42%. To date this index has declined by about 31% from its peak. Slide 11 summarizes credit performance in our local banking business. Charge-offs in non performing loans as percentage of managed loans both increase in our local banking business in the second quarter.
The increased resulted from continuing economic stress in the Metro New York City market and to a lesser degree in Louisiana and Texas. In our commercial lending portfolio the increase in non performing loans and charge-offs was primarily driven by our middle market portfolio and the construction segment of our commercial real estate business. While non performers and charge-offs in our construction portfolio have been elevated for the last three quarters, non performers and charge-offs in our middle market portfolio had been increasing only modestly until this quarter.
The recession which hit construction and consumer portfolios some time ago has finally started to have its impact on our middle market portfolio. In the consumer portfolio residential mortgage non performers and charge-offs increased in the quarter as home prices continued to fall. Let me pull up and spend a few minutes providing more detail in what’s in our commercial lending portfolio.
Our largest portfolio is commercial and multifamily real estate at $13.6 billion, 81% of this portfolio is in the New York Metro area. Most of this is permanent loans for multifamily, office and retail real estate. Construction lending comprises only $2.3 billion or a little under 10% of our overall commercial lending business and less then half of that is for sale residential construction. This is far less than what you would find at most other large banks. In our CRE business we are a relationship based cash flow lender. We underwrite to in place cash flows and not to aspirational rent increases. As a result our average debt service coverage ratios remained strong average 1.7x.
And our average LTV at origination is about 60%. To date the CRE portfolio has performed better than industry averages. Our non performers and charge-offs have nevertheless been rising but the deterioration is primarily concentrated in the construction sector. We expect credit losses to remain elevated for the balance of the recession. We also expect that our CRE portfolio will continue to outperform the industry as a whole for several reasons.
We had disciplined lending standards, and relationship oriented approach. We have a relatively small exposure to construction lending and a relatively large exposure to New York City multifamily. Because of rent controls and supply limitations New York City multifamily has been relatively resilient to recession. Our second largest portfolio is middle market at $9.8 billion. These are typically C&I loans made to private middle market companies.
Approximately half of the portfolio is in Louisiana and Texas and a third is located in the New York Metro area. Our portfolio is diverse with less than 10% of the portfolio in any single industry. We expect that continuing economic deterioration will drive further increases in middle market non performers and charge-offs although we expect that the portfolio will continue to outperform the industry average for several reasons.
Our lending strategy focuses on hard asset collateral coverage and proven cash flows. We have steered clear of more risky loan products such as enterprise value lending and broadly syndicated loan participations. And we follow a relationship driven strategy that focuses on borrowers with whom we have had long and deep relationships. We believe that the continuing recession will drive further increases in non performers and charge-offs across our commercial lending businesses but we also believe that our conservative underwriting, relationship driven strategy and favorable portfolio mix within commercial lending result in a commercial lending portfolio that is well positioned to weather this recession.
And compared to most large banks, commercial loans are a much smaller percentage of our total company managed loans. Beyond the commercial lending business you can see credit trends in other parts of our local banking business in the second quarter press release tables. Small ticket commercial real estate lending was part of the Greenpoint mortgage origination business we shut in August 2007.
Although we are no longer originating these types of loans we still have a $2.5 billion portfolio of loans on our books. It’s a weak portfolio and we’re working it out. The significant rise in non performers is the result of the long and involved work out process due to the nature of the collateral, the fact that the court system is clogged, and the simple fact that delinquency rates are rising.
Similar to residential mortgage this causes significant accumulation of non performers prior to foreclosure. We are increasing the resources dedicated to this portfolio which will help us resolve bad loans faster but we expect non performers to remain elevated for the foreseeable future. The increase in charge-offs is a function of more loans going to foreclosure combined with falling collateral values.
We expect further worsening in the credit performance of this portfolio and have incorporated these expectations in setting the loan loss allowance in our local banking business. Our small business lending portfolio includes about $4.6 billion in loans to small businesses in our local banking markets. Similar to our middle market business our strategy is to focus on borrowers with whom we have broad based banking relationships.
We have seen a moderate increase in non performers and charge-offs as expected at this point in the economic cycle and we expect that this portfolio will continue to show elevated non performers and charge-offs for the balance of the recession. Our consumer lending portfolio in local banking is comprised primarily of residential first mortgages and branch based home equity loans.
The mortgages in this portfolio are high FICO low LTV and relatively well seasoned. The home equity loans are entirely within our branch footprint and are mostly first liens. As I mentioned earlier residential mortgage non performers and charge-offs increased as home prices continue to fall. Credit trends for branch based home equity and other consumer were relatively stable in the second quarter.
The local banking consumer lending portfolio does not include the Chevy Chase Bank mortgages or the run off portfolio of Greenpoint HELOC. Both of these portfolios are held in the other category. Turning to slide 12 I’ll discuss a key piece of news from the second quarter of 2009, the passage and signing of the new law on credit card industry practices. As you’d expect we’re very hard at work analyzing testing and developing new strategies to anticipate and respond to the new law and the new credit card market it will create.
Based on our work thus far we can draw several high level conclusions. We believe the new credit card industry law will profoundly change the structure and competitive landscape of the entire credit card industry. We expect that the new law will lead to a constriction in credit and a reduction in the resilience of the industry.
With respect to revenues we believe all issuers will see a significant redistribution of where credit card revenue comes from. There will be a shift away from penalty fees, penalty repricing and the use of practices like double cycle billing and payment allocation. Instead the economics will be imbedded in clearly disclosed headline prices like annual percentage rates and annual fees.
In our view that’s really at the heart of the new law. As a result of this redistribution of the revenue model, its likely that long zero percent teasers which relied on aggressive penalty repricing can make the economics work will essentially disappear. We expect that teaser offers will continue but they are likely to look more like they did in the 1990’s when teasers were generally for shorter periods of time with higher go to rates.
Relative to the industry we believe our US card business will be less exposed to most aspects of the new law because we never relied on practices like aggressive penalty repricing, universal default or double cycle billing. We do expect to see a redistribution of where credit card revenues come from in our US card business but in aggregate we believe the revenue model will remain largely in tact over time.
We expect the returns in our card business to diminish modestly from pre recession levels but to remain very attractive and well above hurdle rates. The timing of implementing these changes coincides with the great recession. Managing our business to both weather the recession and respond to the coming changes in the credit card industry creates risks and potential profitability pressures in the short-term.
But in the long-term we believe the new law and the marketing competitive environment it will create could open up opportunities and be a net benefit for Capital One. Slide 13 shows the trends in credit card industry use of zero percent long teasers on the left and trends in Capital One market share on the right.
We believe that the up front underwriting and pricing for risk has always been one of our most enduring and powerful competitive advantages. The widespread use by our competitors of some of the soon to be banned industry practices diminish the power of that advantage. One example of this was the industry practice of using aggressive penalty repricing and payment allocation in conjunction with very long zero percent balance transfer teaser offers. These graphs show that the rise of zero percent long teasers coincides with the leveling off of Capital One’s market share gains.
You may recall our quarterly earnings call from this era on which I consistently spoke about the unattractiveness of the prime revolver segment of the credit card market. We felt that the market clearing headline price of zero combined with heavy use of aggressive penalty repricing and payment allocation was not a sustainable business practice even the vast majority of the industry direct mail included these types of offers, we mostly stayed on the sidelines.
Now that the new law has effectively ended these practices we expect we’ll be able to re enter parts of the credit card market like prime revolver. After the new law is implemented, many industry practices will be cleaned up and the playing field will be level. We believe this environment will play to our strengths including up front underwriting and pricing for risk, resilient and low cost deposit funding, continuing opportunities for efficiency improvement, and a leading brand.
The new law will clearly drive significant change. It creates risks and uncertainties particularly in the near-term when we’ll face both the recession and the transition to the new environment. In the long-term we expect the restriction of credit, returns that are somewhat lower but still very attractive and potential opportunities because of the more level playing field and more sustainable customer practices.
All in all if we had the choice between today’s status quo or the new law we’d definitely choose the new law. I’ll close tonight on slide 14, second quarter and near-term results remain under significant pressure at this point in the cycle and 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.
We’ve tightened underwriting standards across the board. We’ve retrenched and repositioned the auto lending business and we’ve exited the least resilient businesses like nation lending, installment loans and small ticket commercial real estate. We’ve maintained our increased focus on collections with earlier entry, higher intensity, and new tools. Even as we’ve invested in increased collections, we’ve made great progress on our efforts to reduce our cost structure and improve operating efficiency to enhance our long-term competitive position and build resilience to rising credit costs.
And we’re taking action to maintain and improve our margins by optimizing the mix of our earning assets and liabilities. Collectively these actions put us in a better position to manage the company through the downturn for the benefit of shareholders. They also influence the second quarter results. In particular the effects of shrinking loan balances are apparent in many of the results Gary and I have discussed today.
Declining balances impact both the optics and the substance of our second quarter and near-term results. An example of optics is the divergence between dollar trends and rate trends for metrics like delinquencies, charge-offs and margins. An example of substance is the income statement benefit of allowance releases that are possible even as we continue to build our coverage for future losses.
Against the backdrop of economic worsening and volatile markets our strong and transparent balance sheet remains a source of strength in these turbulent times. Allowance coverage ratios remain high, funding and liquidity remain rock solid, and our TCE ratio at the end of the second quarter was 5.7%, an improvement of about 90 basis points from the prior quarter.
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 time as capital markets funding and wholesale deposits mature and we replace them with lower cost local banking deposits.
And when the cycle eventually turns and opportunities for profitable and resilient loan growth emerge we expect that we’ll be able to grow loans by rotating our earning assets from investment securities back into new loan growth. One of the keys to successfully weathering this storm is getting to the other side with our valuable franchises in tact.
Despite the declining loan balances we still believe that our businesses continue to have more than sufficient scale and that our core national lending and local banking businesses are still very valuable franchises. Despite significant economic challenges and legislative uncertainty we believe that we remain well positioned to weather the storm, deliver shareholder value over the cycle and achieve our vision of combining great local banking franchises with a sustainably high return credit card business.
Now Gary and I will be happy to answer your questions.
(Operator Instructions) Your first question comes from the line of Craig Maurer - Caylon Securities
Craig Maurer - Caylon Securities
First I was hoping you could clarify your thoughts on credit losses and there’s so much noise in the actual rate I was hoping you could discuss what your thoughts are regarding the trend in actual dollar losses.
I guess a quarter or two ago we got out of the business of giving forward guidance on dollar losses just because of all the uncertainty that is out there. That said the dollar losses have actually been coming in pretty consistent with our expectations. Basically what’s happening, with respect to our view of future credit losses, the economy is in many ways worsened a little more than our expectations and our own credit performance has actually come in a little bit better than expectation.
So in some ways there are offsetting so our view of dollar losses has been pretty steady over time. The big thing we want to stress is that when you’re looking at loss rates which is what most of the cross calibration among players has in it that I think for a lot of players and even more so for Capital One the denominator effect is going to become actually possibly the most significant impact even in an environment where we still see credit worsening gradually over time.
Craig Maurer - Caylon Securities
One of the differentiators of Capital One it seemed to me is your low exposure to C&I lending especially considering what the expectations are for that segment can you just discuss what your long-term thoughts are regarding exposure to commercial credit.
We have of the major banks in the United States we have the smallest percentage of our portfolio in commercial lending and I think probably a representative portion of that is in C&I lending. Our view is that commercial in the long run is a good diversifier relative to our, the flipside of our small exposure in the commercial is of course a larger than most other banks exposure on the consumer side.
So long run we think that a very conservatively managed commercial business both C&I and local commercial real estate will I think lower the overall charge-off rate of the company and be an important form of diversification. That said we’re not in any rush to get to that destination. Our commercial lending business is generally flat these days with respect to loans, our loan volumes even as on the consumer side leveraging the inherent sort of faster run off that happens in the consumer side we in fact have been shrinking.
Your next question comes from the line of Unspecified Analyst – Ladenburg FSG
Unspecified Analyst – Ladenburg FSG
It sounds like some of the early stage delinquency improvement that you have noted and others have noted as well, it sounds like you’re not predicting that that will translate into much in the way of improvement in the charge-offs at least over the foreseeable future, could you talk about why that would be, is it because those early stage improvements are driven by factors other than improving underlying credit.
Yes, so when we talk about early stage delinquencies, let me make a few points here first of all kind of the conventional wisdom of how credit works in a card business is consumers enter the first stage of delinquency and then of course make their way through the six buckets to charge-offs and when there is in improvement it will show up in lower entry into these buckets and that will six months later make its way into lower charge-offs.
The by far the most important relative to that conventional view that we have seen in this downturn and continued to see it in the second quarter was the entry into the first bucket of delinquency, that’s the bucket that you don’t even see in the 30 plus delinquency. That is strikingly the rate of entry into that bucket is strikingly down. For example at Capital One the proportion of our card holders entering that first bucket relative to a year ago is actually down like 11%.
And that’s certainly, this is the phenomenon we think of sort of changed behavior by consumers that the people who have the means to do it I think are just being extra careful to avoid going into delinquency to avoid going over limit and other things as well and that’s had the revenue impacts we talk about.
So up until this last quarter we saw the very stubborn effect of very low flow into the first bucket and then frankly degrading flow across the rest of the buckets and so even as the first the roll rate with respect to the first bucket was declining all the other roll rates were rising and this is this phenomenon we talked about the increasing slope of the roll rate curve which created a sour spot of fewer revenues and worse charge-offs.
The only thing that I do want to flag here is that in portions of the card business there is a small and again I say a small effect where we’ve now seen some benefits of the early buckets making their way through the next couple of buckets. This is a small effect. We don’t think it indicates any really important green shoots in the credit performance of consumers but at least relative to the alternative it’s a slight positive.
But mostly I think what the second quarter is about is really about seasonal benefits, I think some benefits from the stimulus direct cash to consumers’ pocket stimulus and collectively a slightly better than expected credit performance.
Your next question comes from the line of Christopher Brendler - Stifel Nicolaus & Company
Christopher Brendler - Stifel Nicolaus & Company
I was if you could just talk a little bit about the card act, you mentioned some early implementation that may happen this year, just talk a little bit about that and then sort of more broadly it seems like the biggest impact at least immediately to Capital One is the over limit fee opt in, can you talk about some of your strategies there to offset that. How aggressive will you be in trying to get consumers to opt in, do you have any pricing strategies that may offset that, care you quantify your limits.
The card law of course all the conversation everybody has about the card law is sort of the policy impact. Behind that the not very extensively talked about thing is just the breathtaking kind of logistics and executional challenges associated with just such a comprehensive set of changes. There are for Capital One about 200,000 IT hours that we’re going to need to put in to achieve compliance on things like statement design, delivery date, things like this.
There are massive changes in communications with customers, statements to account in recoveries, and so these costs are many tens of millions for Capital One but of course other than a lot of hard work by very talented people that’s something that we certainly expect to do. With respect to on the policy side, as we have said we believe we are less effected from the vast majority of the things that are in the card legislation because of our lower credit lines we do think there’s more impact on us on the over limit side.
But I think that what we would expect there, even that impact is moderating because ironically the whole phenomenon of changed behaviors that we’re seeing during this recession actually lowers the size of the impact sort of ironically on Capital One. But with respect to over limits we’re extensively conducting testing right now on OL opt in. I think its our expectation where the industry is probably going to go is probably some blend of lower fees and that will help achieve higher opt in rates.
So we’re still testing it and we’ll go from there.
Christopher Brendler - Stifel Nicolaus & Company
As I look back at Capital One’s success in the card business it seems to me that a lot of your success has been using a very steep slope on the risk based pricing. You were able to offer really aggressive rates and sort of invented the whole super prime segment by forecasting which customers would not only experience good credit trends but if they got into trouble you had the ability to reprice so you could offer the 4 9 fixed rate card back in 2003 or 2004 and in the sub prime business you had a very low price up front in sub prime at 12.9 I think was a prevailing offer, that’s kind of changed with the new law. The price based strategy that you were so good at over the years I think really becomes a challenge now and my thinking is maybe that Cap One in the card business may benefit from a level playing field but also without the ability to reprice it seems like you just joined the rest of the pack and have to offer more prime like offers, more middle of the pack type rates. What do you think about that.
I think that I’d probably take the precise opposite of the description that you make. I would point to the difference between the 90’s and the 2000’s, those decades. In the 90’s Capital One came out with very aggressive pricing to an industry that had pretty entrenched higher pricing. We differentiated ourselves on very careful underwriting repricing, well in that decade and this decade has not been about something that you do to consumers soon after you book them but rather something that one saves for extreme circumstances like the economic shock that we’re going through.
So what you described that was the characterization of this decade has been the exact thing that has troubled us with respect to the competitive environment. Using very low prices not so much driven by very discriminating underwriting but rather low prices that come from being able to have such steep slope of in many cases almost immediate a trigger based repricing and that enables players to, it doesn’t put such a premium on up front underwriting, its more about just marketing these kind of products.
This is where for years you’ve seen in our vocal conversations to everyone who will listen we have been so concerned about the impact on the industry, on consumers, and on in a sense the sustainability of franchises in the context of this. What I am saying is going to happen going forward is a return more I think get your head around the way the 90’s was without the rapid industry growth in credit cards that corresponded with the 90’s.
But it was about up front underwriting if you were going to go for it with an aggressive price you really needed to back it up with solid underwriting and to your comment that there will be no repricing in the future, I want to clarify there, its not that there will be no repricing, there will be no retroactive repricing of existing balances. The law is explicit about allowing forward repricing for new balances so the impact of any repricing that happens in the future would be something that would play out over a much longer period of time.
And when I talk about resilience vis-a-vie repricing therefore what I’ve said is is one is counting on repricing to lead to significant revenue impacts right when a shock to the system comes, forward repricing the new form of repricing post this legislation that is going to have fairly muted impact. And this is going to get back to I think a really good healthy competitive business the way it was in the 90’s and we are really looking forward to it.
Your next question comes from the line of Steven Wharton - JPMorgan
Steven Wharton - JPMorgan
I just wanted to follow-up on the allowance in the US card business, so based on your revised unemployment forecast factoring in the elements you mentioned in the third and the fourth quarter from the OCC changes and such, I guess your basically telling us the charge-off rate is going to go up north of 10% US card and I just want to make sure that the allowance that you’ve established today and it actually went down a little bit of course sequentially factors in that higher loss outlook.
You have obviously heard us correctly with respect to our outlook and let me just remind you the decrease in the allowance with respect to the card business is entirely driven by volume. So if our loan balances had stayed the same we would have been building allowance in order to improve our coverage ratios. And just take a look at the increase in coverage ratios both in, particularly with respect to delinquencies, it does actually comport with the notion of higher losses in the quarters to come.
But again its all about the volume in terms of this quarter’s allowance release. Just take a look at the coverage ratios.
Steven Wharton - JPMorgan
So the OCC law changes don’t have any impact on those delinquency rates.
When we look out both at expected losses from delinquencies that are already going through the buckets and when we take a look at the back six months because again we allow for 12 months of expected losses we include in our loss forecasting losses from wherever they come including the effect of OCC [min] pay and I think Richard went through that in pretty good detail about how much of our expected losses are going to come from that but they will definitely be covered in the allowance.
Your next question comes from the line of Joe Mack - Meredith Whitney Advisory Group
Joe Mack - Meredith Whitney Advisory Group
I just had a quick question regarding your unused card commitments or your open to buy from the data you’ve put out we’ve seen that you’ve reduced your lines maybe a little bit less aggressively then some of your peers and I was wondering given the regulatory restrictions and the negative revisions in your economic outlook did that change how you look at your unused lines going forward.
Yes I think the TARP disclosure data was actually very interesting with respect to open to buy Capital One was among the least, we restricted open to buy less than I think a lot of other players did. I think it’s a reflection more of the line setting strategy that we’ve had over time. General conservatism with respect to credit lines. And its also one thing that lowering lines doesn’t have the same beneficial effect on credit that not having them as high in the first place does.
So there’s some negative selection associated with doing it which is why we have been cautious but still we have done some line reduction. Do the new regulations, will that effect our view about our open to buy, I would say I don’t think it would be that material of an impact to us.
Your next question comes from the line of Henry Coffey - Sterne Agee & Leach
Henry Coffey - Sterne Agee & Leach
The hardest thing to get our hands around has been the expected impact of 166, 167, if its being done at book value obviously you’ll have to put in the full 12 months of reserves, can you give us some sense of what sort of numbers we should be using to try to quantify that impact.
If you think its confusing for you, you should be sitting in our seat. These things keep changing as we go along. Listen regardless of how consolidation takes place under the new accounting guidelines the one thing that’s quite clear is you add to the denominator all of the off balance sheet assets which we show in our managed financial reports and which we include in our TCE ratio.
When it comes to the numerator, you’re right, if you bring it back at book value then you do have to post an allowance and that allowance we believe as with the implementation of all new accounting standards would probably run through retained earnings rather than through the P&L. The size of that allowance is something that will be based on our outlook at the time and the size of the book at the time.
I’m sure just taking a look at our current book of securitized assets and our current coverage ratio you can calculate what that would be but again we’re talking about how much of our current retained earnings would migrate through the income statement and the balance sheet into allowance. It will still be there, it’ll just be in a different place. Now whether or not these assets will come back on balance sheet at book value, is something that we are still studying.
Issuers have the option to elect either book value or fair value. FAS B has come out recently with some new statements that suggests that all loans may be moving towards fair value with valuation adjustments going through other comprehensive income so exactly where we’re going to be when we get to the implementation date, kind of hard to say but you’ve got it right when it comes to the book value approach.
Henry Coffey - Sterne Agee & Leach
One of your competitors actually disclosed the expected impact based on book value, are you likely going to be doing the same think in your 10-Q.
No, again I think if you want to calculate what the impact would be I think you can do it with the information that we give you. I just remind you that GAAP does not lead you to do that today but its going to be based on balances at the time of implementation and will also be based on the election that the issuer makes. But we’ll be sure when the time comes to give you full and complete disclosure.
Your next question comes from the line of Moshe Orenbuch - Credit Suisse
Moshe Orenbuch - Credit Suisse
I wanted to go back to the question that related to the issue of how you’ll fair long-term from a competitive standpoint under the new environment and looking at your slide 13 wouldn’t another interpretation of the industry behavior there just be that the industry was willing to take sub par returns in the hopes of getting them at a later date and I guess its not clear to my why you wouldn’t assume that same sort of behavior would persist in an environment under the new legislation once the banking industry had a little bit healthier earning stream particularly when you think about the fact that most of your big competitor in the business have cards 15% to 20% of their earnings as opposed to some significantly larger number.
Its certainly, it’s a great question because one of the things that I’ve certainly learned over the years about lending its not just about what we think about a business the attractiveness is so driven by the behavior of competitors. I actually believe that our competitors have been mostly economically rational over the last decade. I think that frankly a lot of the irrationality I saw in the last 20 years in the card business related to smaller players who ended up flaming out.
I think the generally our card competitors are fairly sophisticated, I think they view their card business as a very important part of the franchise but as you say also their whole company doesn’t depend on it. But I think, our issue with what has happened over the last 10 years is less about the economics of doing what has been going on its really about the impact on the franchise and the customer franchise.
And I think actually if you look at the returns of the card business our competitors’ card business until this very, very severe downturn during a lot of this period of time they’ve made quite decent returns. So I don’t want to get too far on the other side of your argument because I worry greatly about how the industry will respond here and I think the, a very important indicator is to look at what happens to go to rates.
Because in a world where repricing cannot be something that sort of happens overnight kind of thing and any repricing would be in the form of very muted and ultimately forward repricing, the go to rate becomes a very, very important destination in a way that it really used to be in the 90’s and wasn’t necessarily during this period of time.
And if we look at the great work that you did that we always with great interest look at your analysis of the mail monitor data that comes in one thing I immediately go look at is what’s happening to go to rates and they, go to rates from your own analysis here if I can read your analysis back to you, the go to purchase APR has been generally over the last maybe since sort of late last year its gone from 11.5 to 12.40 so its gone up about 90 basis points but if you adjust for prime sort of go to minus prime, has actually gone up from about 7% to about 9.15.
So the sort of effective economic price in the card business as reflected in go to rates is slowly going up. Its certainly not in my opinion hasn’t arrived at a destination that would I think cover the risk of this business but I think that will be a key indicator to look for.
Your next question comes from the line of Bruce Harting - Barclays Capital
Bruce Harting - Barclays Capital
Just a follow-up to Steve Wharton’s question, so the decline in the provision is due to volume, are you saying that loan’s outstanding in the card business will continue to fall and then a follow-up question would be same methodology to local banking and auto, in other words are you expecting, it looks like from the managed balance sheet statistics you had a pretty sharp drop in total assets at the very end of the quarter so should we model continued decline in assets, you both speak very quickly, I can’t write as fast as you speak, you might have covered it but in terms of getting a handle on the allowance connection to where you go with total assets given that you said the important thing will be the denominator effect.
Let’s start with the card allowance and the dynamics there and then talk a little bit about the likely trend of loan balances going forward. So within the card book we had a kind of a steady level of decline in reported balances over the course of the quarter with coverage ratios about stable relative to loans going up relative to delinquencies. All in all the lower level of balances leads to an allowance release but let me be very clear that there is not factor in the allowance for an expectation of what balances will do in the future.
So this is not a change in our outlook for the future, it is simply the recognized decline in the balances to date on a reported basis so that’s what’s going in on the card book right now. Again for the rest of the allowance remember there was a build of about $60, $65 million in the bank. Most of that is commercial, that’s largely raising the level of coverage ratio that’s not really being driven by volume and that was more or less offset by the decline in the auto allowance which was really a combination of both better credit and therefore lower coverage ratios as well as lower volumes.
Now going forward looking at loan balances overall, and Richard mentioned a couple of these items, but just to kind of remember, when you take a look at some natural run off in our portfolio, our installment loan business we’re not originating there. Those are rolling off at about a billion dollars every quarter, you see that in the US card segment. Auto loans given our current level of originations versus how much amortization we have, those are declining anywhere between sort of $700, $800 million a quarter.
If you take a look at the residential mortgage holdings in our local banking segment, those are legacy loans, very well seasoned, mostly brought on from Northfork, those balances are running off at more or less $500, $600 million a quarter. So you’ve got the effect of those three businesses, just give you a starting point which is well over $2 billion of shrinkage during the quarter and then in card, because of the factors that Richard and I both talked to which is the impact of lower loan demand, the impact of just higher charge-offs, there are a number of factors that are causing a shrinkage in card loans which is more of a cyclical factor rather than a secular factor having to do with our choice about whether to be in or out of a business and to what extent.
So we start off with shrinkage and then on top of that certainly in the current economic situation we’d expect to see card balances continue to shrink. And so you can expect to see that going forward wherever we happen to be at the end of the quarter is going to drive our allowance but the allowance in and of itself at any given point in time is not looking forward to what future balances may be.
Bruce Harting - Barclays Capital
And was the local banking, was that the rationale for local banking provisioning dropping as well, that the loan balance dropped at the end of the quarter.
No, again the provisioning was lower in the second quarter than it was in the first quarter but there was still a build in the second quarter even though volume didn’t go up. So effectively what you had in the second quarter in the banking segment was simply a reflection of the degrading credit environment particularly in commercial.
Your next question comes from the line of John Stilmar - SunTrust Robinson Humphrey
John Stilmar - SunTrust Robinson Humphrey
Not to retread on the topic of the card act, but one question I have about the industry as you go forward and the repricing or the ability and flexibility with regards to manage a customer, certainly its going to be limited for a card, does that give rebirth to the installment lending business something that you’ve been in and out of over the life of Capital One by virtue of the fact that the product itself in installment loans defines the terms and is more programmatic in its features relative to a credit card where it seems that the consumer has a lot more of the choice rather than the lender.
Its an interesting question, count me skeptical on this causing that much of a change vis-a-vie the installment loan business. The credit card is a remarkable product that, I’ve always loved for so many years and what I like about it, mostly persists here but the fact that there is a transaction product and a borrowing product wrapped into a single product is a very special and unique utility for a customer.
The ability to manage that product on a continuing basis is still largely in tact after the card act because a lot of the management relates to dynamic line management and there is also just the ability to do many customized offers and to take advantage of the continued rich information that we see with the customer and therefore to dynamically respond to that. And the repricing is now going to be constrained to more to forward repricing but that’s okay so long as you’re not counting on a very immediate revenue change in the event of a shock to the system like a downturn.
Installment loans and we’re living it right now, installment loans you just sit there and watch, its like watching paint dry because there’s really not much you can do about it. They entire product is sort of frozen and in fact the relationship with the customer is mostly not there. So I think the credit card will continue to be a fabulous cornerstone product and frankly if I look around our company where we have the best businesses is where there’s the intersection of transactional business and broader financial opportunities.
That’s in credit cards, that’s in the checking account relationships with the consumer and its in the cash management and broader commercial relationships that we enjoy. And you look wherever you see cornerstone gateway transactional relationships you tend to see that’s where a lot of the exceptional returns in banking are.
John Stilmar - SunTrust Robinson Humphrey
My follow-up question has to do with operating leverage from here, it seems like if you ex out some of the bank where you saw a lot of improvement was in the non interest expense in US card. Where should we think about operating leverage from here for the business. Clearly the balance sheet will continue to shrink, how should we think about it on a dollars versus a relative proportion to balances on the whole as well as specifically in US card.
Its hard to pinpoint exactly where the operating leverage is going to go. Some of the decline in operating expenses in the card business are simply going to be a reduction in variable costs especially when volume is down. But there’s some real improvements in efficiency in that business as well which we’ve seen kind of play through as you’ve seen and we expect we’re going to see it there.
On the banking side again we’ve had a certainly a higher efficiency ratio then in our card business although its much closer in line with other banks. We are going through still today a rather significant amount of integration. We are going to be integrating Chevy Chase Bank. We’re just kind of through the integration of our other banks and we’re really trying to make sure that we have a truly sustainable and scalable banking model for the long run.
We didn’t inherit that from any one of our banks because none of them was as big as we are now so we got a little catching up to do and I think we’ve got some investments there to make to make sure we can serve our customers and build bigger scale.
I think operating leverage is going to be an important part of value delivery from Capital One over time. I think you’re going to see it at different paces in our different business lines but I think if you take a look at where we’ve come over the course of the last couple of years and our commitment to continue going there, I think you will see operating efficiency as an important hallmark of where we go over the long run.
Your next question comes from the line of Andrew Wessel - JP Morgan
Andrew Wessel - JP Morgan
I guess my main question is just kind of more strategic long-term, looking at the balance sheet and the securities portfolio that continues to grow and you mentioned lower loan demand and the fact that you’re going to be shrinking the credit card portfolio pretty aggressively in the back half of this year, what should we think about 2010, 2011 looking out in terms of where you expect asset growth to really come from and this kind of ties in, the card act and how you think about competition going forward for I guess those borrower dollars as everybody kind of moves up the credit curve. Really is Capital One going to look much more like a regional bank, [inaudible] sized credit card company or do you expect that to come back in time.
I think that Capital One is going to look like it does now. The defining thing will be when the economy turns so until the economy turns what you’ll see at Capital One because we take from an origination point of view we look at the economy and you know how bearish we get on things like that and then for our underwriting we overlay worse, a lot more worsening on top of the economy that’s already worsening so you’ll see generally continued shrinkage across our consumer businesses.
You won’t see that on the banking side because they don’t lend themselves to on the bank commercial side it doesn’t really lend itself to shrinking and the interesting phenomenon here is that this shrinking is just another element in the resilience of a thing like the credit card business and it helps preserve capital and so on.
But so that is, from now until kind of the inflection point, that’s the world that you’ll see at Capital One. I believe that the best part of the credit cycle based on a lot of experience, experience being on the back side of the last two recessions, I think the best part comes from that inflection point for a fairly extended period out after that where you have the competitive supply has been the most reduced, you kind of hit an inflection where from a consumer point of view, adverse selection that tends to dominate the credit performance as you’re sliding down in the cycle tends to flip over to relatively more positive selection.
Credit people have taken over every institution in a sense so it is the most conservative time. In this case you also have the overlay of a huge amount of investment by the country in addressing the practices that otherwise would haunt us about growing more aggressively in something like the card business so I think that a lot of planets are going to align at that time.
Now to take advantage of it we’ve got to make sure we got on the wheels on the bus, that we’re not in a capital deficit kind of situation that we’re frankly robustly prepared to take advantage of it and a lot of our focus right now is just making sure that the company weathers this storm very sure footedly, so that we can be in a position to take advantage of this on the other side.
I’m pretty optimistic about that. I think we all should take Moshe’s challenge to heart though. There is so much of a change in the US card business that how the competitors and the timing with which the competition adjusts to the kind of new pricing levels for new originations will also I think have a sizable impact.
But the destination for Capital One I think is Capital One is going to be a successful, significant local banking business in combinations of local markets but powered by a national credit card business that I think will allow us to generate exceptional returns and that’s been our model for a long time and I think its going to be on display on the other side of this downturn.
Just adding on to that for a second, thinking about it a little more short-term I think our securities investment portfolio is unlikely to grow dramatically from where its at. We’re very comfortable with where we are right now. Maybe the opportunities won’t be quite as compelling as we’ve seen in the past but with a contraction in loan balances I think what you might see is the investment portfolio staying more or less perhaps loan balances going down and so the percentage of the balance sheet that’s in the investment portfolio might go up for a short period of time but again the investment portfolio is there as Richard just said to make sure that we have the capital and funding to flip over to loans when that opportunity comes.
So I think you might expect that over the next period of time.
Your next question comes from the line of Brian Foran - Goldman Sachs
Brian Foran - Goldman Sachs
On the delinquency terms, I guess the seasonal impact is quantifiable, have you run any tests on the stimulus impact to help us understand the way we measure it it was about 20 basis points better this quarter then you would expect seasonally roughly for you and the industry so of that 20 basis points how much may have come from the stimulus and how much just might be the consumer getting a little better.
We have done a lot of analysis of the impact of stimulus on credit behavior. The way we have done this is to go back to prior times where things like cash rebates where it was identifiable as to what consumers got it at what time. And what we have done is to, we have gone back and traced the stimulus’s that were given by month and we can absolutely visibly see an effect on consumer delinquencies and that effect actually makes its way through to charge-offs.
Its also an effect that not surprisingly sort of goes away after the stimulus goes away. So what, with the stimulus that is going on right now, it is not identifiable as clearly per customer so we’re more extrapolating from the old effects where we had better data to sort of now magnitude. So for example in the first half of this year direct government payments to consumers including tax refunds, social security checks, things like that were about $140 billion higher than for the same period in 2008.
And when we then kind of estimate the size of that impact compared to prior stimulus checks we believe that there, that an important part of what seems to be better about credit right now is attributable to this. There’s a lot of estimation involved here but its one thing that gives us caution about kind of declaring a turn or even really the full kind of leveling off of things.
So I think that we should all be cautious about that. There’s another effect also going on right now that’s not government stimulus but it’s the equivalent of that with respect to consumers which is what’s happening with respect to energy prices versus like a year ago. Now the government stimulus which was $140 billion over the prior period for the first half of the year, for the second half we calculate that’s going to be around $100 billion higher.
So this stimulus is going to last. Even if it is the case that the stimulus is causing a good part of this better than expected performance this is still real in the sense it will make its way into charge-offs. It just may not herald quite as significant a turn in the economy as people might otherwise think.
Brian Foran - Goldman Sachs
There’s been a lot of questions about the long-term and obviously the card act is important but just in the near-term provision dollars are down two quarters in a row, revenue is inflected, the balances are shrinking but you sound pretty bullish on the revenue margin, the preferred dividend is going away, isn’t there some room for optimism about the relative change of near-term net income results or what am I missing in that equation.
You’ve got to fill in all the blanks and you’ve got, certainly you’ve got clarity on the what’s going away in terms of some of the coupon payments but I think that you also have to keep in mind that while provision expense was positively impacted by the allowance release this quarter net charge-offs went up and seasonally we should expect to, that we’re not going to get much relief on that score certainly with where we are in the year and where we are in the cycle.
Richard talked about some of the challenges in terms of a fee so I think when you put it all together we think our results are reflective of a combination of what you’re seeing in the economy along with the actions that we’ve taken taking advantage certainly of the lower rates and improving our funding costs. We think that’s going to stick around for awhile. Richard talked about the overall margins in the business but the counter veiling factor there will be volume.
So just a lot of offsetting factors. This is a very difficult time to call the future. Probably feels a little better than last year in terms of direction where everything kind of seemed to be pointing down. Now that we’re down, we got arrows pointing all sorts of different ways but we feel confident that we can manage through it with all the tools that we have at our hands.
I think that there’s certainly a number of things that are going on that we feel very good about. Just to put a few cautionary comments in here, the worsening of unemployment and to a small extent HPA as well, that is worsening faster than ours and many people’s expectations and frankly the credit performance that we’ve observing at Capital One is a little bit at odds with the pretty breathtaking amount of degradation that’s actually occurred in some of the economic variables.
And so for one thing that suggests that there’s more than unusual uncertainty. I’ve always said also that its very clear that unemployment and credit performance are very correlated whether you’re looking at past downturns or whether you’re looking cross sectionally across MSAs with respect to this downturn. What didn’t matter for most of the ride but now starts to matter quite a bit more is actually the timing of which comes first in a sense, a credit turn or an unemployment turn.
And one possible explanation for better credit performance then would be warranted by the economic numbers could be some indication that consumers with their own credit behavior actually front run potentially lagging indicators like unemployment. So those are some thoughts we have on both sides of that discussion. The other thing I’m starting to increasingly believe is even as it becomes more plausible that we’re getting near a peak I think in some ways a lot of the government actions and things that have happened in this economy may have traded magnitude for length and I’m getting a growing belief that we may be looking at extended, even as we reach a peak sort of extended challenges.
So to the extent that we don’t have a peak prior bad recessions have had a sharp peak followed by a sharp decline in unemployment. This may be more of a plateau and that would create obviously a pretty sluggish recovery for all of us.
Your next question comes from the line of Sanjay Sakjrani - Keefe Bruyette & Woods
Sanjay Sakjrani - Keefe Bruyette & Woods
As it relates to the reserves is there any reason why securitized loans would decline with declining balances this year.
Again what you saw, let’s just take a look at what happened in the second quarter which was we had about $4 billion worth of securitizations maturing. We rolled those $4 billion either through public issues or conduits but the overall volume in the business went down so there was a higher percentage of our book was securitized but I think the big driver of where we’re going to end up is really going to be a result of what happens in terms of just the managed loan volume itself.
Sanjay Sakjrani - Keefe Bruyette & Woods
And then on the trusts, we’ve been looking at the excess spreads [degradate], and one of the questions I wonder is do you anticipate providing subordination like your peers have and the only reason I ask is because of the implications to write cap ratios.
We’re a very long standing and active participant in the capital markets. We’re an issuer of fixed income securities, we’re also a big investor securities so whenever there are either downgrades or threats of downgrades including those that we don’t agree with, we take it pretty seriously especially if that causes investors to take a loss, realized or unrealized and even when we’re fully confident the securities will be money good as we are.
So I’d say right now that although the excess spread in our trust has come down, somewhat and we dipped just below that 4.5% three month average level at which we start to trap a little cash which we now have, the strong actions that Richard described about what we’re doing in our business, improving revenue margins, aggressive loss mitigation efforts, they’re designed to bolster the performance of the trust and for now we’re going to wait and see how those things kind of play through.
Remember we just issued $1.5 billion of new [inaudible] AAA card back securities in the quarter at spreads in the very low 100 ranges, hundreds of basis points inside of where secondary paper was just a few months ago. As you say pretty obvious to us that other issuers with less robust performance and less structural enhancement in their securities has stepped in to provide additional support to their trusts and now we’re seeing that those moves may not even prove sustainable in terms of assuring a particular ratings outcome.
Well I’d rather not speculate on the specific motives of issuers who have taken extraordinary actions with respect to their trust, in general I assume they were concerned with liquidity or the strength of their balance sheets which caused them to step in and those are things around which we have a great deal of confidence. And we’ll maintain the strength of our balance sheet, we’ll watch how our business performs, how our securities perform, we’ll see how the world changes, when we get consolidation of asset backs and in the meantime we’ll continue to take whatever steps we feel are appropriate in light of market developments.
We’ll be aware of what others are doing but we’ll do what’s best for all of our stakeholders.
Your next question comes from the line of Ken Bruce - Banc of America
Ken Bruce - Banc of America
We’ve had somewhat of an ongoing dialogue as to the performance of credit cards relative to other assets and we continue to see mortgage related assets in particular deteriorate and I was wondering if you had any update to any analysis that you performed where your customers are making choice decisions to pay back credit card relative to other debts.
Yes, we have, for example we have told you over time about our examination of our card holders who are 90 plus days delinquent on their credit cards and what’s happening with respect to them, typically we have found the somewhat striking finding that about two thirds of our US card customers who were so delinquent on their mortgages remained current on their credit cards.
As of May the last time I looked at this this figure was 72% so the, it may be less of a comment about how much people are really holding up on their card payments as much as it is on how they’re not holding up on their mortgage payment but we certainly have seen that. I think we’ve seen inferential evidence that auto in the payment hierarchy has done pretty well as I often joke, people still have to drive to their job interviews but we have seen some behavior that has really been quite striking.
It is almost the reverse of this steepening slope of roll rates that we have in the card business where consumers seem to be so earnest to try to do anything they can to pay back their card debts that we’ve actually seen some fairly positive things happening that we infer are telling us something about the payment hierarchy on the, with respect to auto.
The other thing I would say is that we always also track what is the performance of overall on a credit business the relationship between mortgage holders and non mortgage holders overall and there has been a very sizable gap for years to the positive with respect to mortgage holders. That gap still exists but that gap continues to close so that it is actually plausible for credit cards overall that actually these things are going to touch each other by the time we get to the end of this downturn.
And that gap is steadily closing over the last, and continuing over the last six months. So what a lot of this says to me is just the pressures from mortgage are just extraordinary. Consumers knowing that their options for other debt like auto and credit cards are not going to be very plentiful, are really doing everything that they can to pay their debt and if you then kind of go back to the prior commentary about the stimulus effect and the possibly slightly better than expected credit performance these days that we’re seeing, I think it could be a manifestation of consumers in their choice with their lives, they’re really tightening up, increasing savings rates, doing a lot of things to be very, very careful and a beneficiary, a modest beneficiary of this has been the providers of unsecured and auto loans.
Ken Bruce - Banc of America
And I think the last time we spoke the, you might have felt a little bit more optimistic in terms of getting to an inflection point in one of the inflection points in the auto business are you able to confirm that at this point or how do you feel generally speaking in terms of your ability to grow in the auto side. It sounds pretty clearly that the credit card is probably still a [persona non grata] in terms of growth.
I think the auto business is certainly is, and to any of us to who look at it and I’m sure to you as an investor, it sort of continues to provide pleasant surprises to us. In some ways its partly I think because everything that could go wrong in auto has kind of gone wrong and so particularly with respect to probably the biggest single driver of why auto, the industry I think has done better lately is just the substantial rise in used car prices after all the crashes, the massive decline in the past.
So the, we are benefited at Capital One by very, very good performance in our post 2007 vintages where we really pulled back to the highest ground and did the restructuring of auto that we’ve talked about. So and the other benefit auto has and frankly so does credit card but maybe just a little stronger in auto is the revenue benefit that comes from so many competitor exits.
So as we look at an inflection point its not just about when is the economy turning, its really when do the economics of a particular business turn where the, in looking at the economy, vintage results, the positive or negative selection that one is getting with respect to applicants, competitive environment and pricing. So this is an individual analysis. We’re not ready to declare that yet in auto but its probably the one that has, shows a bit more promise there.
Your final question comes from the line of Robert Napoli - Piper Jaffrey & Co.
Robert Napoli - Piper Jaffrey & Co.
Obviously with two calls going on I don’t think somebody asked this question but did you give any color on the level of over limit fees that you currently are generating and what you feel the effect of the legislation would be on that.
Yes we talked a bit about it before but we don’t give out that segmentation of revenue data but the level of over limit fees has actually been declining solidly through this cycle, whether that’s permanent or temporary I don’t know and may be slightly academic but just as consumers have been a lot more careful with their management of their credit we’re doing a lot of testing of over limit opt in and things like that.
Certainly there will be some impact on Capital One with respect to our over limit revenue but I think overall what is really happening in the business is a redistribution of where revenue comes from and more and more away from penalty fees and more toward APRs and in some cases annual fees and so I think to us we’re more focused on the net effect of the redistribution of revenue in the near-term and the longer-term and I think we feel quite bullish about that.
Robert Napoli - Piper Jaffrey & Co.
American Express is talking about charge-offs declining in the back half of the year, I think they’re the first ones to say that and is that, do you think, are you seeing better performance out of California and Florida, why do you think they’re charge-offs are declining and your are not. You both have similar denominator effects.
I can’t speak for American Express. We have the very substantial OCC minimum payment effect that we itemized in the early part of this call that it will be a third quarter effect but additionally we have in our reported card business we also have our installment loan business that’s in pure run off mode and that also, that plus continuing declines in the size of the card business are causing a substantial denominator effect. So we’re not even close to having credit, and also you have seasonality which makes losses higher in the second half of the year. So we’re not, its not even a close call as to whether the collective impact of those effects is going to offset by such dramatically improving credit that you’d actually have the loss rate go down.
So you can expect our loss rate to be going up.
Thanks everyone for joining us on the conference call tonight and thank you for your interest in Capital One. The Investor Relations team will be here this evening to answer any further questions you may have. Have a good evening.
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