Capital One Financial Corp. (NYSE:COF)
Q1 2010 Earnings Call
April 22, 2010 5:00 PM ET
Jeff Norris – Managing Vice President, Investor Relations
Richard Fairbank – Chairman and CEO
Gary Perlin – CFO and Principal Accounting Officer
Bruce Harting - Barclays Capital
Sanjay Sakhrani – KBW
Matthew Kelley - Morgan Stanley
Joe Mack - Meredith Whitney Advisory Group
Chris Brendler - Stifel Nicolaus
Yanni Koulouriotis - Buckingham Research
Stephen Wharton - JP Morgan
Henry Coffey - Sterne Agee
John Stilmar – SunTrust
Mike Taiano - Sandler O’Neill
Moshe Orenbuch - Credit Suisse
Welcome to the Capital One First Quarter 2010 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question-and-answer period. (Operator Instructions).
Thank you. I would now like to turn the call over to Mr. Jeff Norris, Managing Vice President of Investor Relations. Sir, you may begin.
Thank you very much, Jay. Welcome everybody to Capital One’s first quarter 2010 earnings conference call. As usual we’re webcasting live over the internet. To access the call on the internet, please log on to Capital One’s website at capitalone.com, and follow the links from there.
In addition to the press release and financials, we’ve included a presentation summarizing our first quarter 2010 results. With me today are Mr. Richard Fairbank, Capital One’s Chairman and Chief Executive Officer; and Mr. Gary Perlin, Capital One’s Chief Financial Officer and Principal Accounting Officer. Rich and Gary will walk you through the presentation.
To access a copy of the presentation and the press release, please go to Capital One’s website, click on Investors and 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 materials speak only as of the particular date or dates indicated in the materials.
Capital One does not undertake any obligation to update or revise any of this information whether as a result of new information, future events, or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements.
For more information on those factors, please see the section titled Forward Looking Information in the earnings release presentation and the Risk Factor section in our annual and quarterly reports, which are accessible at the Capital One’s website and filed with the SEC.
Now, I’ll turn the call over to Mr. Perlin. Gary?
Thanks, Jeff, and good afternoon to everyone listening in on the call this afternoon. Let me go straight to the income statement on slide three of the presentation. Capital One earned $636 million, or $1.40 per share in the first quarter, up $0.57 per share or 70% from the prior quarter, as modestly improved pre-provision earnings were bolstered by lower expenses.
Total revenue declined $79 million, or 1.8%, as an improvement in margin, partially offset a 2.9% decline in average loans. The margin benefited from a 17 basis point improvement in cost of funds. Loan yields were also up slightly in the quarter despite somewhat lower fees, as both were positively affected by higher collectability.
Despite the slight decline in revenue, pre-provision earnings were up modestly, as a $100 million reduction in our non-interest expenses more than offset the lower revenue. The largest contributor to the better quarter-over-quarter performance was the $369 million decrease in provision expense.
Total charge-offs in the quarter fell $170 million, as a lower charge-offs in our commercial, auto finance and retail banking businesses, more than offset a slight decrease in domestic card charge-offs.
We released $566 million of allowance through provision expense in the first quarter, after posting an allowance build a $4.3 billion to retained earnings on January 1st in line with new accounting standards. More on the impact of FAS 167 and the drivers of the allowance in a moment.
Several other items impacted income in the quarter. First, we sold mortgage I/O bonds that were acquired through the purchase of Chevy Chase Bank, resulting in the deconsolidation of $1.5 billion of loans and a net P&L gain of $127 million.
We also recognized a net gain on securities of $65 million as we rebalanced a portion of our agency mortgage bank securities portfolio.
Lastly we realized a $50 million benefit to tax expense in the quarter, resulting from settlements during the quarter. These gains were partially offset by a $224 million cost associated with our rep and warranty exposure, about half of which is related to the run-off GreenPoint mortgage portfolio and therefore is in discontinued operations.
Let’s turn to the balance sheet on slide four. Total lending assets declined by $11 billion in the quarter. Our domestic card portfolio was down $4 billion in the quarter, driven by $1.5 billion in charge-offs, $1 billion of run-off in our installment loan portfolio, as well as expected seasonal pay downs and revolving credit.
The installment loan portfolio will continue to pressure card growth metrics, as we expect approximately $2 billion more to run-off over the remainder of 2010.
The commercial banking portfolio remained largely flat versus fourth quarter levels, but we expect to see modest growth in this portfolio over the remainder of 2010, as good lending opportunities are beginning to emerge in our markets.
On the consumer bank side, the nearly $2 billion decline in first quarter assets, is primarily driven by two trends I mentioned on last quarter’s call. First, in our auto finance business, our decision to pull back on origination volume in early 2008 is continuing to reduce the level of outstandings, although we’re now beginning to approach the point at which new originations will equal the run-off of prior originations.
Auto assets were down $700 million in the first quarter and we continue to expect ending loans will be down approximately $2 billion at year-end 2010 versus the end of 2009.
The second factor pressuring consumer bank outstandings is that our mortgage portfolio largely remains in run-off mode with a $900 million declined in assets in the first quarter. The decline in other assets in the quarter is related to FAS 167 as we reclassified securitization receivables to cash, more on FAS 167 in a minute.
Our $38 billion securities portfolio shrank slightly in the first quarter, as the non-agency book continued to run-off. The portfolio continues to perform well and our total unrealized gain increased $191 million in the quarter and now stands at an unrealized gain position of $482 million, even after booking net gains of $65 million.
Between the run-off of our installment loan portfolio and declining consumer loans in both auto and mortgage, we continue to expect these businesses will drive over $7 billion of loan shrinkage over the course of 2010, with $2.6 billion of debt declined already occurring during the first quarter.
While our other lending business may see net growth this year, despite elevated levels of charge-offs, we still believe our total ending loan balances will decline by mid single digits in terms of percentage or taking into account the shrinkage we experienced in 2009, a high single-digit percentage decline in average loan balances year-over-year.
Now to the liability side of the balance sheet, securitization liability was down sharply, as conduit pay downs and others maturities totaled about $9 billion in this quarter. By year-end 2010, securitization is expected to be down another $11 billion, representing a 43% decline from year-end 2009.
Funding costs decline in the quarter by 17 basis points due to favorable market rates and continued leveraging of our commercial and consumer banking platforms to swap into lower priced deposits.
While on the subject of balance sheet composition, its worth highlighting that the implementation of FAS 167 has largely eliminated the distinction between our managed and reported balance sheet caused by securitized assets. I’ll briefly discuss this consolidation in greater detail on slide five.
On January 1st, we brought $48 billion of previously off balance sheet loans, the vast majority of which were securitized domestic card loans onto our balance sheet as we implemented FAS 167.
In line with the consolidation of these loans, we built about $4.3 billion in allowance, resulting in a $3 billion after-tax impact to retained earnings and the creation of a $1.6 billion deferred tax asset. So while our ending fourth quarter allowance stood at $4.1 billion, we begin the first quarter with an allowance balance of $8.4 billion.
It’s worth noting that this initial allowance build ran through retained earnings rather than through the income statement. However, the allowance release for the first quarter as well any future changes to the allowance balance will run through the P&L.
Turning to slide six, I’ll discuss the change in first quarter allowance in greater detail. We released $566 million from our allowance in the quarter, driven largely by the domestic card business. There were three main drivers of the allowance release in card.
First, we continue to believe that the first quarter will be the high watermark for card losses, so swapping of the first quarter of 2010 for the first quarter of 2011 drives down our allowance needs.
The second driver of the release is our moderating credit outlook for the remainder of 2010, compared to what we were projecting at the end of last quarter. And finally, the $5 billion of lower period end assets requires lower allowance, all else being equal.
It’s important to note that the absolute level of this quarter’s card allowance release was materially impacted by the addition of allowance coverage for the nearly two thirds of card assets that were previously off balance sheet and historically did not carry an allowance. Had we not consolidated under FAS 167, the card allowance release would have been approximately $290 million this quarter.
Similar to the improvement in underlying trends we’ve observed in the card business, we continue to see strong credit performance in auto. This performance, coupled with the approximately $700 million reduction in outstandings led to a $142 million release in for that business.
Unlike our consumer lending businesses, we continue to see an upward trend of non-performing loans in commercial and as a result, we built $130 million of additional allowance.
All told, despite the $566 million allowance release, we ended the first quarter with an allowance balance of $7.8 billion or nearly 6% coverage on our $130 billion loan portfolio.
Given the historically high levels of coverage and underlying business and economic trends, it’s reasonable to assume their total allowance levels will likely continue to decline over the course of the rest of the year.
Turning to slide seven, I’ll discuss our overall risk bearing capacity. Our ratio of tangible common equity to tangible managed assets in the quarter increased 70 basis points to 5.5% versus the fourth quarter pro forma ratio of 4.8%.
The increase in TCE was driven by strong earnings in the first quarter, as well as the $11 billion decline in managed assets. Coupling this level of TCE with the allowance built under FAS 167, our total risk bearing capacity now stands at 9.7% of our total assets. We expect earnings and a smaller balance sheet to further increase our TCE ratio over the course of the year.
Given the timing and nature of implementation rules for FAS 167, I indicated last quarter that the trends in TCE and Tier 1 ratios will diverge in 2010 and early 2011. You’ll see that happening in the first quarter results. Despite the fundamentally positive trends, that helps TCE, our Tier 1 ratio decreased to 9.6% in the quarter, down 30 basis points from Q4 2009 pro forma levels.
The numerator of the Tier 1 ratio already declined in line with the a large allowance caused by FAS 167 and is now also being affected by the disallowance of some related deferred tax assets. With consolidation phase in guidance now established, we know that the risk weighted denominator will increase through the first quarter of 2011. Actually, some of the impact was accelerated into the first quarter in line with the reduced level of off balance sheet securitizations I mentioned earlier.
In any event, our Tier 1 ratios are and will continue to remain comfortably above well-capitalized levels. And because regulatory capital ratios are more pro cyclical, as loss levels normalize, our Tier 1 ratio should more than proportionately follow the fundamental upward trajectory of TCE.
While there remains a fair amount of uncertainty about the future of bank capital requirements overall, I’m confident that our balance sheet strength and flexibility position us extremely well to grow profitably.
With that, I’ll hand it over to Rich to talk about our financial performance and outlook in greater detail. Rich?
Thanks, Gary. I’ll begin on slide eight with a look at our margins. Net interest margin increased to 7.1% in the first quarter, driven by a 17 basis point improvement in the cost of funds and a 3 basis point improvement in asset yields. Several factors drove the improvement in funding costs.
Our funding mix shifted from higher cost wholesale sources to consumer and commercial banking deposits. Within our banking businesses, our mix shifted from higher cost con deposits to lower costs and more relationship driven liquid saving and transaction accounts. And favorable interest rates and disciplined pricing drove a decrease in the deposit interest expense.
Two offsetting forces drove a modest increase in asset yield. Our asset mix shifted from loans to investment securities, which resulted in modest downward pressure on yields. The effects of this mix shift were more than offset by strong revenue margin in our domestic card business.
First quarter domestic card revenue margin remained elevated largely as a result of better than expected credit results and lower than expected attrition of higher yielding loans. The same credit results and outlook that contributed to the allowance release in the quarter had a parallel favorable impact on revenue.
Actual credit results were favorable to our prior expectations, driving a more favorable assessment of the collectibility of finance charges and fees that were previously billed but not recognized as revenue. This allowed us to recognize some of these previously billed fees as revenue in the first quarter and to recognize a larger portion of first quarter fee billings as well.
First quarter non-interest income declined. Over limit fee revenues declined as a result of the February 22nd implementation of Card Act Regulations. Interchange revenue also declined seasonally in the quarter.
Last quarter, we said that we expected the quarterly domestic card revenue margin to decrease somewhere – to decrease somewhat in the first quarter on its way to settling in the mid 15% range for subsequent quarters of 2010.
However, better than expected credit results, the resulting improvement in the collectability of revenue and lower than expected attrition have kept that margin at elevated levels.
As we’ve seen over the last several quarters, domestic card revenue margin for any specific quarter is subject to considerable uncertainty from Credit Trends, seasonality and consumer and competitive responses to the Card Act. But as these forces play out by the end of 2010 or early 2011, we still expect that the quarterly domestic card revenue margin will decline over the next few quarters.
The credit related benefit to revenue we experienced in the first quarter is likely to diminish because we’re able to recognize more of the finance charges and fees we billed in the first quarter will have a smaller backlog of first quarter billings that could be recognized in future quarters as credit improves.
Beginning in the second quarter, we’ll experience and additional modest decline in over limit fee revenue resulting from the February 22nd implementation of Card Act regulations.
It is still too early to precisely quantify the expected impact of the proposed reasonable and proportional fee regulations because we don’t yet know the final rules. But we do know that they are set to be implemented on August 22nd. That means that the third quarter will include a half quarter revenue impact from the regulations and that the fourth quarter include a full quarter impact. We’ll need to see more specifics at the rule making process continues through the common period and revisions in the spring and summer.
Last quarter we cited these revelations as a risk and we’re now incorporating a range of potential outcomes into our expectations for domestic card quarterly revenue margins. By the end of 2010 or early in 2011, we expect that quarterly domestic card revenue margin will be around 15%, which is a level consistent with very healthy overall returns for the card business.
Slide nine shows a history of the overall economics of our domestic card business. With all the noise surrounding the Card Act, revenue margin trends and uncertainty about the future of the card business, we believe that a look at this history provides a helpful context for our expectation of the future economics of the business.
Over the last six years, changes in the components of domestic card ROA have generally offset each other preserving strong ROA. The only exception over the last six years was, of course, the great recession.
While ROA declined over this period, the graph shows that this was the result of elevated provision expense that could not be fully offset with revenue or expense levers. The graph also shows that our domestic card business remained profitable throughout the worst credit cycle in generations.
Looking forward, we expect revenue margin to decline for the next several quarters to around 15% by early 2011, as I just discussed. Overtime, margins may experience further modest decline as credit improves.
We expect non-interest expense as a percentage of loans to increase in a near-term largely as a result of the declining loans in the denominator and the expected increase in marketing expense.
We expect that marketing will ramp back toward more normal levels over the next several quarters. The pace and extent of that ramp will depend upon consumer demand and the competitive landscape. We expect increased marketing and improved charge-offs will result in modest growth in our revolving card balances over the remainder of 2010.
But we expect that domestic card loan balances, the overall segment will be relatively flat for the remaining quarters of 2010 as growth in revolving cards is offset by elevated charge-offs in the continuing run-off of installment loans.
One issue of particular importance is equilibrium pricing in the industry following the Card Act. Pricing for new customers has been increasing gradually. We’re watching industry pricing trends carefully, as they are bellwether for the long-term health of the card industry. Go to APRs have risen about 300 basis points over the last year and have edged into the mid teens in the last few months.
We believe industry pricing needs to continue to increase to provide appropriate resiliency for new originations since post the Card Act there is less pricing resilience of APRs and there was in the past.
Overtime, we expect that higher marketing expenses will be partially offset by a decline in operating expenses. We expect operating expense as a percentage of loans to decline as improving credit allows us to reduce collections intensity and as balances begin to rebuild.
We expect provision expense to decline over the next several quarters. We believe that credit losses peaked in the first quarter of 2010. We expect modest improvement in charge-offs beginning in the second quarter of 2010. And as Gary discussed, we continue to see the potential for significant allowance releases in the domestic card business.
As a result of these revenue and expense trends, it’s likely that pre-provision earnings as a percentage of loans will decline through 2010 and perhaps into early 2011. But we expect that this decline will be partially offset by the expected improvement in provision expense.
All these components of ROA will almost certainly move over time as a result of market conditions, competitor moves and consumer behavior. But history has shown that they often move in ways that naturally offset.
We’ve been able to manage multiple levers to be delivered solid levers pre-provision and bottom line ROA as the industry and the economy have gone through enormous changes.
In the long-term, we still believe that the overall economics of the domestic card business are very attractive. We’d expect that growth and returns will lag marketing investments as they always have, but with healthy ROA and the return to loan growth, we expect the domestic card business will still be the most attractive consumer lending business in banking and that it will continue to deliver returns that are well above hurdle over the cycle.
Slide 10 shows credit results for our consumer lending businesses. Domestic charge-off rate increased to 10.5% for the first quarter of 2010, driven by declining loan balances and a temporary increase in charge-offs as last year’s pricing actions flowed through the charge-offs.
The charge-off increase was smaller than expected due to favorable bankruptcy trends and favorable performance in late stage delinquencies. The 30 plus delinquency rate improved nearly 50 basis points to 5.3% at the end of the quarter. Expected seasonal trends and the diminishing impact of last year’s pricing actions drove the improvement.
Based on first quarter charge-off and delinquency results, we now believe that the first quarter is likely to be the peak for both dollar charge-offs and charge-off rate in domestic card.
While we believe Q1 is the peak, we expect only modest improvement in second quarter, as seasonal improvements are offset by continuing declines in loan balance. We expect continuing modest improvement in charge-offs in the second half of 2010.
We expect modest growth in consumer cards to offset installment loan run-off reducing the denominator effect. And although it’s still early, in recent months we’ve seen further signs of stabilization and even some modest improvements in labor and housing markets.
International charge-offs and delinquency trends remain stable to slightly improving. We’ve been retrenching the U.K. business for some time now and we’ve been cautious in Canada. First quarter credit results reflect this cautious stance, as well as the fact that unemployment is improving in Canada and appears to be stabilizing in the U.K. Stronger that performs grow first quarter profits of a $117 million in our international card business.
Charge-offs for the mortgage portfolio were relatively stable. Early delinquencies improved, but non-performing foreclosure inventories continued to increase due to a very slow resolution process. Modifications add several months to the process and local jurisdictions face growing foreclosure backlog that further slow resolution. Overall our portfolio continues to perform better than industry averages.
Our mortgage portfolio includes the challenged Chevy Chase portfolio that we acquired in 2009. Chevy Chase portfolio is protected by the credit mark we took at acquisition. This portfolio continues to perform in line with our expectations and we remain comfortable with the mark.
Auto finance charge-off rate and delinquency rate both improved in the first quarter. The improvements resulted from expected seasonal patterns, the strong performance of recent origination vintages and the stabilizing economic and auction price trends. These factors were partially offset by the impact of declining loan balances.
Favorable consumer credit performance and credit outlook were key drivers of strong profitability in our credit card and consumer banking businesses in the first quarter.
Slide 11 shows credit performance in our commercial banking business. In the first quarter, commercial banking charge-off rate declined from elevated charge-off levels in the fourth quarter of 2009. We charged off fewer loans in the first quarter and we experienced lower severities on the loans we charged off.
Non-performing asset rate increased modestly in the quarter, but the pace of the deterioration was slower than we’ve seen the last several quarters. The pressure on non-performing asset rate and charge-off rate remains concentrated in our commercial and multifamily real estate business, about 70% of which is located in metro New York City. Within this portfolio the source of deterioration has shifted from the relatively small construction portfolio to loans related to New York City office buildings.
Sequential quarter charge-off comparisons were also impacted by actions we took in the fourth quarter on our small ticket CRE portfolio, which continues to run-off after we stopped originating these loans over two years ago.
Last quarter, we charged off a portfolio non-performing small ticket CRE loans as we sold them in the distressed debt market. Selling non-performers is an ongoing part of our workout strategy for the small ticket CRE portfolio. The timing of such sales depends upon investor appetite and market conditions and the volume of loan sales was much smaller in the first quarter. Credit performance in the middle market portfolio remained relatively stable.
Overall, we expect non-performers and charge-offs will continue to deteriorate in our commercial business but the pace of deterioration is slowing. It appears that the worst of the commercial credit cycle may be behind us.
We continue to believe that our commercial banking loan portfolio is well positioned to weather this downturn in commercial real estate. We have a favorable loan mix with a relatively small exposure to construction lending and our relatively small exposure to construction lending is a key reason that the absolute level of our CRE charge-off rate is lower than many other banks.
We also have relatively large exposure to New York City multifamily, which has been resilient to the recession because of rent controls and supply limitations. We have disciplined lending standards and we underwrite to in place cash flows and rents. And compared to most large banks, commercial loans are much smaller percentage of our total company managed loans.
I’ll conclude this afternoon on slide 12. We’ve worked for years to position our company to be resilient and we’re demonstrating that resilience through the most challenging economic cycle we’ve seen in generations.
We’ve delivered relatively resilient profitability through the downturn. We maintained the strength and flexibility of our balance sheet. We built strong and stable liquidity through careful management of our balance sheet and the growing deposits with disciplined pricings.
We maintained healthy allowance coverage ratios throughout the downturn and we maintained sufficient capital to address both the recession and the FAS 166 and 167 accounting changes. We’re now on the path to delivering normalized earnings.
Over the next several quarters, we expect the quarterly margins will decline to more normal levels driven by the expected decline in domestic card revenue margin, I described earlier, as well as the stabilization of funding costs. We expect the loans will continue to decline over the next few quarters before finding a bottom at the end of 2010 or early in 2011.
Continuing run-off of businesses we exited or repositioned earlier in the recession will drive loan declines even as some of our businesses begin to grow sooner and we expect that expenses will increase over this timeframe as marketing expense will ramp toward more normal historical levels and we make investments in banking infrastructure to support future growth.
The competition of these expected trends will result in lower quarterly pre-provision earnings in 2011. We expect that declining pre-provision expense will cushion the bottom line impact of falling pre-provision earnings. Actually we expect the decline in provision expense will cushion the bottom line of falling pre-provision earnings. We expect continuing improvement in charge-offs and the domination of declining loan balances and improving credit trends create the potential for significant allowance releases as well.
As we move past the early part of 2011, we believe that our path to normalized earnings will become more apparent in our quarterly results. We expect pre-provision earnings to establish a positive trend over the course of 2011. We remain well-positioned to deliver significant shareholder value over the long-term.
In our commercial and consumer banking businesses, we have great market positions and some of the best local markets in the country. We can grow commercial relationships in loans as the commercial credit cycle improves. We can continue to grow deposits with disciplined pricing and as we complete our investments in infrastructure, we expect our cost structure and bottom line profitability will improve overtime.
Our domestic card business has delivered industry-leading profitability and returns through cycles, including the most significant recession in generations. We believe that our domestic card business is well position to compete on a new level playing fields that’s created because the Card Act prohibits widely used industry practices, which we never relied on, like aggressive single infraction penalty re-pricing.
As a result, we expect that we’ll be able to essentially restart the marketing of similar products to similar customer segments that we were doing before we pulled back during the recession.
The credit card business has always been characterized by significant near-term marketing investments followed by a long-term payoff with very attractive risk adjusted returns.
Margins may moderate modestly overtime as charge-offs normalize, but we’re confident that returns will remained well above hurdle rate over cycles. We expect that returns will be more sustainable long-term with competitive practices cleaned up by the Card Act and as we’ve said before, we believe that the domestic card market and competitive environment following the implementation of the card law will play to our strengths.
Our balance sheet is emerging from the dual challenges of recession and the FAS 166, 167 accounting change with its resilience intact. As Gary described earlier, our balance sheet strength and flexibility put us in a strong position to grow profitably and to sustain above hurdle returns over the long-term.
Now Gary and I will be happy to answer your questions. Jeff?
Thank you, Rich. We’ll now start the Q&A session. As a courtesy to other investors and analysts who may wish to answer a question, please limit yourself to one question plus a single follow-up question. If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Jay, please start the Q&A session.
Our first question comes from Bruce Harting with Barclays Capital.
Bruce Harting - Barclays Capital
Thank you. I wasn’t clear on, Gary, good discussion on all the loan, excuse me, moving parts. But would you mind going over again between all the loan forecasts you gave, exactly how much shrinkage from year-end ‘09 to year-end ‘010, you’re going to see and if you could do it by segment that would be helpful.
But I just wasn’t clear on what the absolute shrinkage would be given that looks like mortgage credit is in run-off, installment is in run-off and maybe you can comment on international again? Sorry for not getting all that the first time.
That’s fine, Bruce, happy to go through it again. So in terms of year-end 2009 to year-end 2010, we expect ending loan balances to be down mid single-digit percentages. In the first quarter, we were down nearly 5% or about $6.7 million. So we’re pretty close to where we said, we thought we would be by the end of the year in terms of the overall balance shrinkage.
Now, to break that down into the segments, what we said is, that we expect another $4.5 billion worth of decline between now and the end of 2010 coming from a run-off in installment loans, that’s a couple of billion dollars. In mortgage that’s maybe another $1.5 billion and the reduction in auto outstandings would be another $0.5 billion or so. So that’s the decline from here to the end of the year, about $4.5 billion.
Just about offsetting that would be loan balances in our revolving credit card portfolio and in our commercial book, particularly in the revolving credit card portfolio, we’ll continue to have an elevated level of charge-offs.
So in effect, we’re going to have to grow that both to cover the involuntary attrition that comes from the charge-offs as well as two offset some of the decline in the other businesses.
So, all told, year-end 2009 to year-end 2010 down in the mid single digits. Again, it will be a little more -- bit more in terms of average outstandings and quite frankly, will probably remain near the bottom of the (inaudible) for a couple of quarters, before seeing that growth at the end of this year and then into next year.
Bruce Harting - Barclays Capital
Thank you. And Jeff, just as a follow-up. I mean, is the charge-off rate in the mortgage credit slide on page 10, net of the markdown? How should we think about that?
Hang on, Bruce, I don’t have the slide right in front of me.
Bruce Harting - Barclays Capital
Okay. And if I could just one…
Yeah. Why don’t you have, remember this Bruce, I’ll follow-up with you after the call.
Yeah. Just enter that one up, quick reminder that, that’s all net of the mark.
Just keep that in mind, Bruce, and will talk to you after the call about the details.
Our next question, please.
Our next question comes from Sanjay Sakhrani with KBW.
Sanjay Sakhrani - KBW
Hi. Thank you. And I was wondering, since you guys have about a month and week of the Card Act, phase two of the Card Act in revenue yield. I was wondering if you could help us think about what the full quarters worth of impact would look like.
And the second question is, if you could just go over the commentary on the revenue margin expectations in U.S. card, I think said, Rich, 15%, which would be a little bit lower than the mid 15’s you guys discussed last quarter. I was wondering if I was missing something there? Thanks.
Right. Yeah. We have revises our outlook from mid 15’s to 15 and while there are several kind of moving pieces there, essentially that’s kind of the impact of our estimation of the reasonable fees. Although, of course, getting full resolution of that still awaits us. But yes, that was the effect.
So the, a lot of our competitors have given numbers saying the Card Act, the cost of the Card Act is ex $100 million. And I find that when we listen to that, I’m not sure, how to interpret that number because there are so many effects that go on.
And so what we tried to do, Sanjay, for you is just try to guide you to a destination. Because the destination incorporates all of the combined effects of impact and counter actions and a lot of things that, so I think it would be – it’s most useful for us to really focus on that.
And so again, kind of hitting the highlights of the revenue margin, we, before, if you go all the way back to before all these changes began, in some ways our Card Act, I mean our revenue margin was in the 15%. And then the great recession came along, the regulations came along and we got to an unusually elevated level that you see at 17% really because of three factors. So we’re kind of at the peak here and I want to kind of savor the three factors.
One is re-pricing in advance of the Card Act, one is revenue benefits from improving credit, so that the fee and finance charge releases that we’ve been getting here and the third is the decline in this rate percentage because during the recession we haven’t been doing very much marketing.
So the margin is going to go down to 15% because of really three factors. The implementation of the Card Act, not getting the reserve releases that we, as much that as we enjoyed in, say in a quarter like this one and the resumption of marketing with these rates.
And the impact will be somewhat progressive in that thing like, you start to get partial quarters of effects like we had the partial impact of the partial quarter of the impact on over limits then we get the full quarter impact and then a third and fourth quarter were going to get a partial and then full impact of the reasonable fees. But we’re pretty confident about the destination of being around 15%, obviously subject to the final interpretation of reasonable fees.
Next question, please?
Our next question comes from Matthew Kelley with Morgan Stanley.
Matthew Kelley - Morgan Stanley
Hi, guys. Thanks for taking my call. So my question is what’s the logic behind your reserve release? I know you have a lot kind of noise going on there. But are you managing towards 12 months coverage ratio?
Hey, Matt, it’s Gary. We have in our credit card business been at a 12 months coverage ratio for many years. So there’s no real change there. And in effect, now that we’re post FAS 166, 167, would you can assume is that in effect our allowance is going to be relatively close to the expected losses over the subsequent 12 months.
So effectively, what you’re seeing from quarter-to-quarter is kind of a refresh of the view that we have for the next 12 month horizon and again, we’re covering, 12 months worth of expected losses in card for the balances that are on the books. Obviously, every product has its own period of coverage, but by and large that’s what you’re going to see now that we’re post-consolidation.
Matthew Kelley - Morgan Stanley
Okay. And just one follow-up for me. In terms of your marketing spending plans for U.S. card, can you maybe give us a little more color there?
Yes, Matthew. You know, we are on the way toward more normal levels of marketing over the next several quarters. The reason it’s a ramp and not an immediate step up is really two factors.
One, we’re carefully watching credit metrics. They’re really still are a lot of consumers in week situations out there. And the second and most important factor is demand is strikingly weak.
And you can just feel it as we originate. You have this kind of odd situation fairly weak demand and relatively lower levels of competition as well. I think, one of the toughest things for us to predict is what is going to be the strength of demand going forward. It’s clearly kind of weak right now.
Next question please?
And our next question comes from Joe Mack with Meredith Whitney Advisory Group.
Joe Mack - Meredith Whitney Advisory Group
Hi. Thanks for taking my question. I appreciate you sharing your outlook for loan growth in the near to medium-term. I’m just curious about diving deeper into revolving card balance.
Specifically, what does a normal economic recovery look like in terms of what you expect from loan growth? Does this environment meet that description given the changes to the Card Act and just kind of how you think about that in terms of the longer picture?
So just what was still, does the…
Joe Mack - Meredith Whitney Advisory Group
So sorry if I was broke off the…
I want to make sure that I got the last half of your question.
Joe Mack - Meredith Whitney Advisory Group
Sure. Yeah. A longer term outlook for domestic card revolving balance growth and if this economic recovery is similar to previous ones or you think the environment has changed so much from the Card Act?
Well, the Card Act, let me separate supply and demand. On the supply side, I’m bullish about the impact of the Card Act. Because we’ve spent a decade feeling like we’ve one arm and one leg tied behind our back choosing not to market in whole parts of the card business because we were uncomfortable with the practices in both the market clearing price from the credit point of view and especially the damage to franchise, building a franchise that we felt some of those practices entailed.
So we’re from a supply point of view feel that the Card Act is a very good thing for Capital One because it returns underwriting back to where it was in the 1990s, which is it’s all about up front underwriting and not about the re-pricing that follow after the fact.
So we feel good about our relative chances and I also think that Card Act is going to put a much greater rationality to the nature of the competition. And so again, on the supply side on that, quite a bit more bullish because also in terms of revenue margins and our business model, I think we feel things are relatively intact.
The wildcard is on the demand side. On the one hand, consumers are deleveraging. I think that, there has been an awful lot of noise about credit cards in the paper every day. It will be still to be determined how much demand there is on the other side of this and also to do have the growth of debit cards causing some modest encroachment into card territory.
On the other hand, however, history shows deleveraging tends to be cyclical things and also, we don’t have one of the biggest factors that held us back in the last decade and that was home equity loans were a massive cannibalize of really good core card growth.
So, I look at it this way, I mean, while there’s a big variance in our own view of the outcome in terms of demand. I’m just assuming it’s going to be flattish, industry growth will be flattish to possibly negative sort of a things stabilizer. But I’m just making that up.
The thing that makes me bullish is that while I’d love a rapidly growing industry, the most important thing is being able to have a relative competitive advantage and a level playing field in the industry, which, paradoxically the great recession and the great legislation if you will have sort of rendered that. So I’m very bullish about that and we just have to see how demand comes out.
Next question please.
And our next question comes from Chris Brendler with Stifel Nicolaus.
Chris Brendler - Stifel Nicolaus
Hi. Thanks, good afternoon. Could you give us an update on what’s happening on the over limit side? I know you’ve been trying to get consumers to opt in over limit and do you have any sort of metrics or thought process on how far along you are in the card book and getting that process out there and consumers to either opt in or accept the overlimit fee?
Yeah. Chris, of course, the rules were fairly recent in coming out relative two over limits and opt in. I think our view is that we’ll take a differentiated approach in parts of our portfolio and just not offer them. In other cases offer opt in, but it’s a little premature to conclude where that comes out. But our overall expectation is that over limit fees are substantially down versus the old days and we’ve build that -- we’ve put that into our planning. So you should assume that as well.
Significant reductions in over limit revenues and for us it’s part of the redistribution of how the revenue model works in the card business. And it’s between what’s happened on the over limit side and our expectation with respect to the Card Act with respect to reasonable and proportional fees. There is a shift in how the revenue model and pricing structure in credit card works from away from back-end pricing toward front-end, upfront APR and in some cases annual fees.
And I think there’s a lot of benefits to that model. It’s important, one of the things that I most have my eye on is to make sure that the industry price is high enough for resilience. Because the thing that I don’t think is getting enough attention is some of the resilience diminishment in APR re-pricing that comes from the Card Act.
And so, I’m bullish about the redistribution and the strength of the revenue model as the business changes. But we also are putting into our planning a fact that the expectation that resilience will be somewhat diminished.
Next question, please?
Our next question.
And the next question comes from Yanni Koulouriotis with Buckingham Research.
Yanni Koulouriotis - Buckingham Research
Yes. Thanks for taking my question. I have a couple of questions regarding the small business card portfolio. The first one is do you plan to voluntarily implement the Card Act rules in this portfolio. And also can you give us some color on the long-term for this portfolio such as growth and segmentation? Thanks.
Yeah. Well, the small business portfolio is really very much just one of the business lines that we have within our card business. It’s been very successful for us in the past. It has weathered the recession pretty will. And but you point at something that I think an important and I think overlooked issue.
The Card Act is not hasn’t, it’s not fully directed at the small business credit card marketplace. But it is our expectation that in the end cards to consumers and small businesses are going to have the same destination and we would manage with that expectation.
Next question, please.
And our next question comes from Stephen Wharton with JP Morgan.
Stephen Wharton - JP Morgan
Hi, guys. Two questions. So looks like, looking at the footnotes that the fee and finance charge reserve came down by about $135 million sequentially, $355 million if I read it correctly.
Gary, is there any way you can give us a sense of what the normalized level for that line is? I mean, clearly the change income sequentially was big. But I’m just trying to get a better sense of like will that ever go back to zero or isn’t there always at least some level there?
Hey, Steve. Yeah. Look, first of all, think of the suppression as kind of the provision equivalent for fees and finance charges and as you suggest, in the first quarter, pretty much all of the reduction and the suppression was in the finance charge and fee reserve and think of that like an allowance, okay.
So, we’re definitely seeing those numbers come down. The big reasons for the big step change this quarter were two fold. First, we assessed many fewer fees and we’re not going to suppress unless we obviously are assessing the fees and fees were down in terms of assessments because of lower over limit fees assessed in line with the Card Act.
A continued decline in the overall balances and frankly, continued general improvement in consumer behavior has had a downward impact on the assessment of penalty fees, so lower quantum of fees is driving that reserve down.
Secondly, like with an allowance, the credit improvement that we’re seeing in loan principal, we’re also seeing in the delinquency rate on finance charges and fees. So with the improvement in the consumer credit behavior there, that’s going to draw down the need for reserves.
So in that case, we could see further declines going forward. I would be surprised if we saw a step change as large as this one. Again, it’s being impacted by the one-time effect of a major change coming from the Card Act. But it could continue to come down.
Finally, in terms of where we’re going, I would certainly believe that the finance charge reserve will always exist. In fact, the redistribution of income suggests that’s going to be a larger portion of our business. So, yes, that number will go down and go up over time. But I think going forward, we shouldn’t expect to see a big step change like we did in this past quarter.
Next question, please?
And our next question comes from Henry Coffey with Sterne Agee.
Henry Coffey - Sterne Agee
Yeah. This is Henry Coffey. How are you? And at what point do you think your balance sheet will be ready for additional bank expansion and in your view are the markets where you are of feeling a hole?
Henry, I think that we have carefully crafted our strategy to try to achieve what is the most important scale in banking, which is local scale. And so if you notice with the acquisitions that we’ve done, we have gone into attractive markets with a starting position that really has -- is well beyond the threshold scale and has a real shot at being one of the ultimate large players in each market. And that’s extremely important for an institution that’s not of the scale of the really large banks.
So our big focus right now is on pulling these banks together, building a scalable infrastructure and what the regulators would call top 10 banking capability, which is something that’s really quite different from what any bank of the size of the banks we buy, there at a very different level of scalability. So it’s a big effort to pull this together and create sort of truly scalable infrastructure and that is we’re will along in the process of doing that and that’s a very top priority.
Along the way, we are really building up the capability to be able to grow our bank within our local markets and generate significant deposit growth, loan growth and ultimately growing returns. So that’s the top priority.
Now, it’s not lost on us along the way that a lot of banks have been struggling around the country and that there could be opportunities for particularly attractive deals. I mean, you saw that in fact during the great recession we bought Chevy Chase.
We always take a look at things like that and but I want you to know that it’s not a sense of manifest destiny. We’ve got to get there any particular market. The real sense is, the manifest destiny we’re pursuing is to make sure that we’ve a very well running scalable bank that’s able to take advantage of the considerable unique advantages Capital One brings to the table to leverage a large customer base, a huge national lending business, a national brand and the kind of information based capabilities that we have.
Next question, please.
Our next question comes from John Stilmar with SunTrust.
John Stilmar - SunTrust
Thanks for taking my question. My first question is for you, Gary. With an eye on expenses, how should we think about how much more you can squeeze out a deposit costs considering they down yet again this quarter? How much more do we have there?
And then also, it seemed like there were two counter statements with regards to non-marketing expense as we talk about the efficiency improvements that are likely to happen in the future as well as lower costs from an improving credit environment balanced with I believe the comment of increased spending on the bank side. Can you reconcile those and help give me a little bit of guidance about non-marketing dollar expenses, please, on a consolidated basis?
Sure. I’m happy to do that, John. Let’s start with the cost of funds. Obviously, we need to have a view about where rates are going and let’s assume that, today’s yield curve is getting accurate reflection of future rates, meaning that they’re going to be going up.
I think that that means that there is considerably less scope at this point, for continued improvement in our cost of funds. So I would say, again, assuming the curve is a good predictor of where rates are going in the short run. I’d say there’s some room for a modest decline in cost of funds over the balance of 2010. We do have some continued run-off of higher cost term funding. That would be in the form of auto securitization and some of our retail time deposits and at the margin, as you can see, we’re replacing all of these maturing funds with lower cost but the deposits.
So I’d say in the short run room for a modest decline in cost of funds, compared to the improvements we’ve seen over the course of the last year or so and from there on it’s really going to be a matter of what happens to the curve.
Now, in terms of operating expenses, what we said at the top of the house, that you should expect to see that operating expenses, that is non-interest expenses minus marketing, should stay on an annual basis with a little bit of quarterly up and down, should stay more or less constant from 2009 to 2010.
And essentially what you’re seeing there is continued investment, particularly in the infrastructure of our bank as we move towards full integration, really trying to get traction there. And that will be offset by continuing efficiencies that we’re having throughout the company, continuing the benefits that we’ve seen from some significant efficiency work over the course of the last couple of years.
So top of the house, you should expect to see operating expenses stay in and around current levels with a little bit of quarterly variability as you saw up in the fourth quarter, down in the first and we’ll see a little bit more that over the course of the year.
Next question, please.
And next question comes from Mike Taiano with Sandler O’Neill.
Mike Taiano - Sandler O’Neill
Hi. Thanks. I just had a two-part question on your strategy in the U.S. card business. I think, if I remember correctly in your trust data, going back a ways, you had about 30% of your portfolio as sub 660 or subprime. Just curious if you to refresh that today, would there have been significant change in that from downward migration in FICO scores?
And then, as part of that, it seems like obviously there’s been reduced competition in the subprime and your prime space, as your competitors have all moved up market and that seemed like a business where you’ve traditionally done well.
Do you see that as an area of growth going forward to help you guys sustained margin or is there some sort of regulatory limitation or that the effects of the Card Act that would make that look attractive for you?
Thank you, John. I mean, we, if you look at the trust data, our mix of sub 660 business is really quite similar to the other players. So, there’s a lot of, I think, everybody has a different strategy, but in the end I think that the subprime percentage interestingly is very similar.
Our mix over, the over the last year or so and probably consistent with my expectation would be flattish to declining a little bit in that marketplace. So it’s certainly not something we are planning to leap into and where you would see a big change.
As we -- a thing that I said earlier was that after the great recession and the great regulation and legislation in a sense, when we look at our business model, other than a redistribution of where pricing comes from, which generally by the way is a healthy redistribution that I embrace for the marketplace, the same strategies that we were pursuing before in the same segments are pretty much what you should expect from us.
And so, the biggest wildcard to me is, the two biggest uncertainties going forward, which are really not about mix, because I think our mix, I would expected to be pretty similar to what it’s been over the past number of years and it’s been pretty stable for a quite a long period of time.
The biggest uncertainties to me our consumer demand, like I talked about and that one we can argue all sides of it, so well just have to see. And the other very important one, Mike, is pricing in the revolver segment. Go to pricing. Because in the -- in this last past decade, the industry has slipped through its practices into a rather weak underwriting habit of originating at low rate and letting re-pricing take care of it on the other hand.
It is profoundly important that our investors and our industry understand that this is not how it’s going to work going forward. Will they never be, there will still be re-pricing in the sense, there can be forward re-pricing and in its own natural way that will always be a component of the business.
But the defining issue is that while people can use teaser rates all they want, the go to rate of APR has a very important destination importance to it that it used to have in the ‘90s, but sort of didn’t have so much in the last decade.
We’re watching that like a hawk. We’re watching it in every single state segment, every signal sub-segment. The good news is that is going up from the beginning, this first couple of quarters of 2009 to the first couple of months of ‘09 to 2010 has gone up 300 basis points that’s a good thing, while the prime rate has basically stayed flat. So you can see the market moving.
So the other thing that’s going to impact our growth will be watching where that destination go to rate goes to and we’re going to be managing our business very much building resilience into our pricing. How much growth we have in particular segments is really going to be driven on whether the industry prices prudently.
So that’s the other one to watch. And when all the dust settles, Mike, I think probably our mix of our business and the type of things we’re marketing to the customers, we are marketing is going to be pretty much the same.
Next question, please.
And our final question comes from Moshe Orenbuch from Credit Suisse.
Moshe Orenbuch - Credit Suisse
Great. Thanks. Have you discussed the impact of the overdraft changes on your P&L and I have a follow-up after that?
Moshe, no, we have not. So let me talk little bit about that. Our business practices in the NSF OD space are in line compared with other banks. But because the size of our retail bank in comparison to our overall company versus that ratio for most of the people that we compete against, the impact of this legislation on our earnings is probably going to be less. I mean, its something less than 2% of our revenue that in aggregate it represents.
So we’ve made important changes in our overdraft policies, which we disclosed on our website if you’d like to look at those. Since, well, frankly, right after we got into banking, one of our first meetings was we wanted to take a look, in the same as we try to look at practices in the card business, we took a look and started letting some of the air of those practices way back then. But we’ve made some other recent changes, which you can find at our website.
So we don’t, so if I pull way up, Moshe, I sort of philosophically feel the same way about this that I do about some of the card practices. These are things that right when you see what is legislated. It adds impact and hurts the P&L.
But I think the equilibrium that comes out of it is going to be a healthy one, certainly not a lot of reliance by us on that type of income. But I think that it will end up again helping the building of franchise and some of the same things that I felt on the card site. Go head to head a second part of the question?
Moshe Orenbuch - Credit Suisse
A follow-up, yeah, was really on the discussion that Steve and Gary had. It sounded like Gary had said that the suppression was both for lower suppression in the current period, that was the $135 million he referred to in the recovery of prior suppressed fees. So, is that correct, I mean, was actually higher than that in terms of the impact on the quarter?
No, Moshe, sorry if I give you that impression. Again, if you constantly look at suppression as the being the equivalent of the provision, there was not a lot of movement in actual reversals or recoveries. So almost all of the change in the suppression came about as a result of decrease in the finance charge and fee reserve, so think of it as kind of an allowance release for fees and finance charges. So that’s where all of the change was and that again was driven both by the lower level of fees that were actually assessed, as well as improvement in delinquency rates on the finance charge and fee receivables we have now.
Okay. Well, that concludes our call for this evening. Thank you very much for joining us and thank you for your interest in Capital One. If you have any further questions, the investor relations team will be here this evening and we’d be happy to answer your questions. Thanks and have a great evening.
That does conclude today’s conference. Thank you for your participation.
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