Capital One Financial (NYSE:COF)
Q4 2010 Earnings Call
January 20, 2011 5:00 pm ET
Richard Fairbank - Founder, Executive Chairman, Chief Executive Officer and President
Jeff Norris - Managing Vice President of Investor Relations
Gary Perlin - Chief Financial Officer, Principal Accounting Officer and Executive Vice President
Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.
Michael Taiano - Sandler O’Neill & Partners
Betsy Graseck - Morgan Stanley
Moshe Orenbuch - Crédit Suisse AG
Bruce Harting - Barclays Capital
Kenneth Bruce - BofA Merrill Lynch
Brian Foran - Goldman Sachs
Christoph Kotowski - Oppenheimer & Co. Inc.
Bill Carcache - Macquarie Research
Welcome to the Capital One Fourth Quarter 2010 Earnings Conference Call. [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, Marie. Welcome, everyone, to Capital One's fourth quarter 2010 Earnings Conference Call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One's website at capitalone.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our fourth quarter 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 tonight. To access a copy of this presentation and the press release, please go to the Capital One's website, click on Investors, then click on Quarterly Earnings Release.
Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factor section in our annual and quarterly reports, accessible at the Capital One 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 to the call. I'll begin on Slide 3.
In the fourth quarter of 2010, Capital One earned $697 million or $1.52 per share, down from $803 million or $1.76 per share in the third quarter, as a reduction in net interest income and increase in non-interest expenses were partially offset by improved provision expense. Compared to the fourth quarter of 2009, earnings were up $321 million or 85%, driven entirely by lower provision expense.
A modest decline in revenue over linked quarters, coupled with a 5% increase in non-interest expense mostly driven by an increase in marketing, led to a 7% decline in pre-provision earnings during the fourth quarter. The continued improvement in charge-offs across most of our businesses offset the reduced quarter-over-quarter allowance release, resulting in a 3% drop in provision expense.
At this point, I actually think it's more telling to focus on year-over-year trends. You'll find these on Slide 4. 2010 earnings reflect in large part where we've been in economic cycle and the impact of recent changes in the regulatory environment. After tax earnings, were up over 200% in 2010 from $884 million to $2.7 billion, and following the reduction of TARP preferreds in 2009, EPS in 2010 was up more than sevenfold, from $0.74 per share to $6.01.
The biggest driver of this change was a striking improvement in credit, which impact was heightened by FAS 167 consolidation on January 1, 2010, offset by several other factors. These include reduced non-interest income, largely as a result of implementing the CARD Act, declining loan balances resulting from consumer caution, portfolio runoffs and still elevated charge-offs and an increase in non-interest expense, especially as we ramped up marketing and integrated Chevy Chase Bank. We expect that some of these trends will continue to affect our 2011 results, given the outlook for a slow-paced economic recovery and the full year effect of legislative changes.
Let's look a bit deeper into recent trends and what they say about the future. Pre-provision earnings declined in 2010 over 2009 levels for several reasons: Revenues were down, but only 4% on a year-over-year basis even in the wake of a 9% reduction in the average loans and the implementation of the CARD law in 2010 as well. These negative headwinds were partially offset by margin benefits associated with a lower cost of funds.
On the expense side, marketing increased over 60%, largely in the back half of 2010 from very low levels in 2009 as the opportunity to acquire new accounts grew during this year. While operating expenses were up modestly year-over-year, the increase was primarily related to the full year effect of the Chevy Chase Bank acquisition.
The year-over-year improvement in earnings in 2010 was primarily driven by a 50% decline in provision expense as we experienced a dramatic improvement in both losses and allowance expense. As credit improved over the course of the year, we saw charge-offs fall by some 20% or nearly $1.8 billion in 2009. The combination of a consistently better outlook for future losses and a smaller managed loan book also led to a 33% reduction in our loan loss allowance from the beginning of 2010.
Looking ahead, the lingering economic and regulatory impacts of 2010 will likely impact the full year income statement in 2011. We'll experience the full year impact of CARD law-related changes, which were implemented over the course of 2010 and expect that the lower starting point for loans will cost the average book in 2011 to be comparable to that of 2010 even as balances grow over the year. Margins will be affected by cross currents as the on-boarding of lower yielding and lower loss assets are offset to some extent by a lower year-over-year average cost of funds higher transaction volume.
Non-interest expenses are also likely to increase in 2011, assuming increased market opportunities seen in late 2010 continue through this year. While it's harder to predict provision expense, recent trends suggest that we should expect charge-offs to continue their downward trend, although the outsized allowance releases of 2010 will abate at some point. It's hard to say exactly when these transitions will be complete, but several things are becoming clear. We are near the end of the CARD law-related changes and we expect relatively less impact from other aspects of recently enacted financial legislation.
Loan balances are stabilizing. Marketing and partnership opportunities are evident and headwinds such as portfolio runoffs and charge-offs continue to abate. Our banking infrastructure has matured and become stale scalable. Thus, we expect over the course of coming quarters to see evidence of the path to solid and sustained performance beyond 2011.
Before I turn the call over to Rich, I'd like to focus on the company's capital generation. Slide 5 shows that our Tier 1 common ratio increased 60 basis points to 8.8% in the fourth quarter of 2010. We continue to be very comfortable with our capital and its expected trajectory. TCE has improved consistently and regulatory ratios should rise steadily after a temporary decline in the first quarter of 2011 resulting from the final phase-in of risk-weighted assets dictated by the regulatory transition to FAS 166/167 and an increase in disallowed DTA caused by the turn of the calendar year, such that the regulatory look-back period for DTA now includes the most recession-affected years.
While we are highly confident in the level and trajectory of our Basel I ratios, I should also note that Basel III will have only minor effects on Capital One. In fact, we expect to exceed Basel III required minimums plus conservation buffers throughout 2011.
Capital One is of course one of the 19 banks participating in the Fed's current capital plan review. We submitted our capital plan including stress scenarios on January 7, and while we don't of precisely when we'll hear back from the Fed, we expect that it will be during the first quarter. We've been using stress tests as a way to assess our risks and manage our capital for years and continue to maintain substantial buffers over a full range of stress scenarios.
As for our fundamental capital trend, strong business performance, coupled with the abatement of headwinds from 2010, positions our company to be highly capital generative over the coming years. Many of the headwinds we faced in our regulatory ratios will shortly turn to tailwinds. Even with an increasing loan book, the completion of regulatory consolidation will lead to slower growth in the denominator of our regulatory capital ratios over the next couple of years as compared to the recent past. And the numerator of these ratios will rise, not only in line with earnings retention but also with a steady decline in disallowed DTA, which we expect will be around $2 billion at the end of the first quarter, and will largely disappear over the next couple of years. We expect that our strong capital position and generation will enable us to deploy capital in the service of shareholders to generate attractive returns in 2011 and beyond.
With that, I'll turn it over to Rich, to discuss the performance our businesses in greater detail. Rich?
Thanks, Gary. I'll also focus tonight on some of the underlying trends that have shaped our results in 2010 and how these trends are likely to play out in the future. I'll begin with loan and deposit volumes on Slide 6.
For the year, loans declined by $11 billion, with about $6 billion of that decline from the expected runoff of mortgages, installment loans and Small Ticket Commercial Real Estate [CRE]. In the fourth quarter, loans declined about $400 million. Our mortgage, installment loan and Small-Ticket CRE run-off portfolios declined about $1.4 billion in the quarter. So excluding run-off portfolios, loans grew by about $1 billion across our business.
In the second half of the year, we've started to see some stabilization in loan volumes and early signs of a return to loan growth in 2011. When we retrenched and repositioned our Auto Finance business early in the recession, our quarterly originations dropped to a run rate equivalent to about $5.5 billion a year. In the last two quarters of 2010, the quarterly originations have grown to a run rate of about $9 billion a year. Auto Finance loan balances hit their trough in the second quarter and grew modestly in the second half of 2010. We've also seen modest growth in our Commercial Banking loans in the second half of 2010 despite the expected runoff in Small-Ticket CRE.
In our Domestic Card business, we restarted the engine for future growth in 2010. We increased marketing investments and acquired new partnerships. We laid the groundwork for future organic growth, with improvements in customer service and great new products like the Venture card. We're gaining traction in our Domestic Card business. Fourth quarter Domestic Card purchase volumes grew 10% compared to the fourth quarter of 2009. Purchase volumes have grown even as overall loan balances have declined. This reflects an ongoing change in the mix of our Domestic Card loans toward rewards products with higher spending levels, lower revolving balances and lower loss rates.
New account originations in the fourth quarter of 2010 were more than double the originations in the fourth quarter of 2009. Excluding the installment loan runoff, Domestic Card balances grew by $700 million in the quarter. It is likely that normal seasonal patterns will drive the first quarter decline in Domestic Card loans and that the first quarter will be the bottom for Domestic card loan balance. We expect that loans will grow after the first quarter. By the end of the second quarter of 2011, we expect Domestic Card loan balances to be higher than they are or were at the end of 2010, with further growth expected in the second half of 2011.
We expect the headwinds of elevated charge-offs and installment loan runoff will subside somewhat. We are well-positioned to gain share on the new level playing field created by the CARD Act, and we expect to add partnership loan portfolios and growth platforms, including the Kohl's partnership early in the second quarter. Compared to our existing Domestic Card loans, we expect that the Kohl's portfolio will have lower revenue margin and lower charge-offs, resulting in strong risk-adjusted returns.
Deposits in our Consumer and Commercial Banking businesses grew by about $4.5 billion in the fourth quarter, continuing the strong growth we've experienced throughout 2010. The growth in bank deposits enabled us to bring down higher-cost wholesale funding. Our total cost of funds improved in the fourth quarter as a result of mix shift toward deposits and away from wholesale funding, as well as continued deposit price discipline. Our loan-to-deposit ratio now stands at 1.03.
Slide 7 shows margin trends throughout 2010. Net interest margin declined modestly in the quarter. In our Domestic Card business, loan yields declined as the result of two factors. Although the improving credit performance and outlook continue to favor margins in the quarter, the magnitude of this benefit was slightly lower than in prior quarters. And the full quarter effect of lower late fees resulting from the CARD Act also pressured Domestic Card loan yields and margins in the quarter. We now believe that substantially, all of the impacts of the CARD Act are fully reflected in the Domestic Card net interest margin and revenue margin.
Stronger than expected deposit growth in the quarter drove a mix shift of earning assets from loans to the lower-yielding investment portfolio, and the yields on investments declined modestly in the quarter. These trends were partially offset by the improvement in the funding costs.
Revenue margin declined in the quarter, driven by the same factors that impacted net interest margin. In 2011, we expect margins to remain at strong levels, though they may drift downward modestly depending on pricing in the competitive environment and the timing and pace of loan growth. We expect a continued funding mix shift toward deposits in 2011, which should provide modest funding cost benefit to the net interest margin.
Slide 8 shows credit results for our consumer businesses. Improving consumer credit results continue to be a key driver of strong profitability across our businesses. Domestic and International Card charge-off and delinquency rates improved in the quarter despite seasonal pressure. Mortgage portfolio charge-offs increased in the quarter. Loss severities were higher as a result of continuing weakness in collateral values. Delinquency trends were stable.
Seasonal pressure drove a modest worsening of Auto Finance delinquencies during the quarter. Auto Finance charge-offs were flat. The credit performance of new originations remain very strong. Credit improvements in our consumer businesses continue to outpace the modest and fragile economic recovery. This favorable divergence continued and even increased in the fourth quarter. While overall unemployment rate is expected to remain elevated for an extended period of time, we're seeing higher correlation between short-term unemployment rates and our delinquency rates.
In addition, we're seeing the benefits of seasoning loan portfolios and strong performance of recent loan vintages across our consumer lending business. We expect that credit improvement in our consumer lending businesses will continue to outpace the economic recovery.
Slide 9 shows credit results for our Commercial Banking business. Commercial Banking credit metrics showed signs of improvement for the third consecutive quarter. Non-performing asset rates were stable in the middle market C&I business and improved across the rest of our commercial lending businesses. In addition to the improvement in Non-performing Asset rates, we experienced a third consecutive quarter-over-quarter decline in the dollar amount to criticized loans, reflecting stabilization across our Commercial Banking businesses.
During the quarter, we saw continuing improvement in the commercial real estate market. For the third quarter in a row, leasing activity and vacancy trends remain strong in New York, where we have our largest CRE exposure. Traditional CRE investors continue to reenter the market providing needed liquidity. And sponsors continue to invest new equity into troubled transactions, enabling us to right-size many of our troubled loans. We expect that the worst of the commercial credit cycle is behind us, but we expect a few more quarters of uncertainty and choppiness in commercial charge-offs and nonperformers.
I'll close tonight on Slide 10. Throughout the Great Recession and the most sweeping regulatory reforms in generations, we've made tough choices and bold moves that have helped us to weather the storm relatively well and put us in a strong position to deliver shareholder value today and in the future. We've emerged from the recession as one of the nation's leading banks by combining the advantages of National Lending and Local Banking.
In 2011, we believe that our businesses will demonstrate line of sight through a very attractive destination. While we won't get all the way to the destination in our Domestic Card business in 2011, we expect to make significant progress. Excluding the runoff Installment Loan portfolio, Domestic Card loans are growing now. We expect further growth in 2011 as the headwinds in installment loan runoffs and elevated charge-offs subside.
New accounts originations are growing. Purchase volume growth is strong. Our new products and great customer service are winning in the marketplace. We're well-positioned to gain share. We're bringing new partnerships onboard, and of course, credit continues to improve. We expect that our Domestic Card business will continue to deliver industry-leading returns in 2011 and beyond.
Our Auto Finance business delivered modest growth with improving credit and strong returns in 2010. We expect that Auto Finance origination volumes and returns will remain strong in 2011. Elsewhere in Consumer Banking, our Retail Banking business is delivering strong growth in low-cost deposits and customer relationships. Our commercial business is demonstrating positive trajectory, with the worst of the commercial credit cycle behind us, we expect to grow low-risk commercial loans in 2011.
Increased emphasis on treasury management services and deeper relationships with our commercial customers enabled the strong growth in fourth quarter non-interest income, and it provides revenue growth opportunities in 2011. And we're delivering strong commercial deposit growth at attractive spreads.
Transactional services bring new commercial customer relationships, and of course, deepened existing relationships. We can generate future loan revenue growth by expanding these relationships in 2011 and beyond.
Pulling up, we built a bank that's in a strong position to deliver attractive and sustainable results, including moderate growth in card and auto loans, with high-risk adjusted ROAs; moderate growth in low-risk commercial banking loans, strong growth in low-cost deposits and high-quality commercial and retail customer relationships; and potential growth upside depending on consumer demand. We expect that our strong capital and capital generation will enable us to deploy substantial capital for the benefit of our shareholders. We expect to deploy capital for the benefit of our shareholders in multiple ways, including investing capital in organic growth, attractive acquisitions across our businesses and returning capital to shareholders.
We become one of the leading banks in the United States by combining the best aspects of national scale lending and local scale consumer and Commercial Banking, powered by a leading brand and a strong and growing balance sheet. In 2011, we expect that we'll continue to demonstrate significant progress toward an attractive destination for our customers, our associates, our communities and our shareholders.
With that, Gary and I will be happy to take your questions. Jeff?
Thank you, Rich, we'll now start the Q&A session [Operator Instructions] Marie, please start the Q&A session.
[Operator Instructions] We'll go to Brian Foran with Nomura.
Brian Foran - Goldman Sachs
I guess, when you referenced the vintages, we try to look at vintages in the Master Trust data so we're limited at what we can see. But it just strikes me the '09 vintage in particular, and I'm guessing the '10 have very high payment rates, but also very low delinquency rates, like much lower even then, back in '05. And I wonder if you look at the whole data set you have, are you seeing the same thing? And what does that tell us about, A, the ability to grow through those higher payment rates, and then, B, the credit performance with the structurally lower delinquencies. The data for the '09 vintage actually looks something like the Canada Card market more than the U.S. market that we're used to looking at historically.
So Brian, I think what you're seeing there is -- you're correct in your observation that recent vintages have -- I mean, frankly, this is a general observation across most of our company. But certainly, in the Card business, recent vintages are performing very strong with respect to credit. And it's a natural thing that they would have a higher payment rates and lower delinquencies. And let's savor, there's probably three reasons for this. We have been certainly very, very strict in our credit requirement going through this downturn. We also, as you've seen on national television, put a lot of emphasis on going after the very top of the Credit Card market, and we're happy with our success there and that certainly, most definitionally [ph] (34:30) get folks very high payment rates and low delinquencies. And the other thing, I think, that during this period in time, as consumers are delevering their sort of a temporary period of what you might call positive selection paradoxically in this part of the great recession, and all of that leads to stronger vintages. So we see very good vintages, and of course, the big issue is how quickly can we grow these. With each passing quarter, we feel we see more evidence of traction across all the parts of our Origination business and I think we should therefore be able to get a larger scale of the effect that you're observing.
Brian Foran - Goldman Sachs
And if I could follow up on the marketing budget. I guess, the question I get a lot when you see a marketing budget like $300 million, is that -- you see opportunities and you have the credit tailwinds so you are spending it offensively because you can? Or is it defensive? You have to spend $300 million just to stabilize the loan book because it's a structurally tougher market to attract consumers.
No. I mean, to us, this is very much offensive, Brian. We are very committed in this company to -- I mean, well frankly, 22 years of building a marketing and brand-oriented growth machine, if you will. And a cornerstone of that is a sustained and heavy investment in marketing. So there's a couple of components on the marketing side. Of course, we've got our actual origination programs that show up in direct mail and other Internet-based marketing that is one rollout at a time. It's a very NPV-based decision at the micro segment level. And then you also have a sustained investment my Capital One at the top of the house in terms of building brand and marketing some of our flagship products. A striking thing to us is that at a time like this when you see such weak demand generally, and frankly, quite a bit of intensity in competitor marketing, we still are finding that our returns per marketing dollars spent, and they sort of measured like NPV per marketing dollars spent, is very strong and consistent with the strong days in our past.
We'll take our next question from Ken Bruce with Bank of America Merrill Lynch.
Kenneth Bruce - BofA Merrill Lynch
I guess, the first question I have is really maybe dovetails into your last comment there. From a competitive position, it looks like you're focused much more on Transactor business. Are you in -- some of your competitors, on the other hand, are focused more on balance transfer-type promotions. And I was wondering, is that market anymore attractive to you at this point? Or is the pricing in term dynamic within the teaser arena still not an area that you think is kind of best served by having Capital One investment dollars put at it?
So Ken, let me make several comments on that. First of all, let me talk about the transactor marketplace. Transactor marketplace has been extremely competitive for the last two decades that I've been working in this business. And frankly, that's because it's a great business and all of the challenge is how do you get business. We all love the business that we get. It has amazingly low attrition and wonderful economics, and its blue-chip customer base. So there's a lot of competitive activity there. Each of the stakes had a bit of a different position there. We are very committed to that space. We like the success that we're having, and we're going to be continue to be very committed there. With respect to the revolver space -- and there are a lot of different segments within revolver. But let me say a few things about that. First of all, the revolver, a lot of the card industry has suffered very disappointing results on a relative basis with respect to the revolver space, particularly the pretty heavy-indebted revolvers that kind of showed good performance sort of until they got whacked in the Great Recession. So I think all of us in the industry are pulling back a little bit with respect to the zeal of pursuing, some of these intense revolver space. But here, the key things that we look at -- because again, we subdivide this into micro segments of course as you know, Ken. But as we look at this business, we have some high standards that we've been pointing out that sort of need to exist in order to pursue a particular revolver segment. And the stakes are higher now than sort of they were in the past with respect to this. And that's because in the wake of the CARD Act, the go-to-rate that we picked now is one that -- while there's some modest ability to do some repricing, this is really what we get is what we're going to have and the industry's old habits of believing that there's a lot of sort of secondary pricing and repricing opportunities have to be very much corrected. So we've been looking at what are the destination go-to-rates that can sustain not only current performance but, in fact, weather another significant recession. And if you look at the industry go-to-rates, Ken, they have gone up since the great recession began, they have gone up by about 200 basis points and they're sort of leveled off at this point. That understates the margin improvement that's going on because of course the cost of funds have declined during this period of time. So we had a few more hundred basis points and what has happened is that price level has put a number of the micro segments, when we look at the business, into an appropriate risk-adjusted kind of market clearing price. Whole other parts of the revolver as business are not at that level, and we are still therefore sitting on the sidelines with respect to this business. So there's definitely enough to work with here. But again, I caution that we all have to be very careful about the prices. I mean, the prices we said at this point we're going to be living with and I think you're going to see some caution in some segments as a result of that for Capital One.
Kenneth Bruce - BofA Merrill Lynch
And as a follow-up, you touched on this a bit, but obviously, the cost of funds has been a real benefit to the business over the last year or so. How much more improvement do you think that you can ultimately achieve in terms of a mix shift into deposits, and essentially, getting towards the front end of the yoke? Or how much more benefit do you think that has all together? And separately, within the context of fee suppression, could Gary provide me what the reserve level is for fee suppression or give us some sense as to how to think about that number going forward? It's obviously been a big help here in the last year.
Sure, Ken. That's two questions, and I'll be happy to deal with both of them pretty quickly. On the cost of funds, I think you've seen a very substantial decline over the course of last year. I think you will see a continued improvement. I would be surprised if it were as dramatically good as it was over the course of the last year, just given the fact that a lot of our swap out for older fixed-rates wholesale funds were being replaced by deposits. It's kind of working its way through. As Rich said, our deposit-to-loan ratio is pretty close to one at this point. So I think there will be some room for improvement, probably not as dramatic as we have seen. Obviously, we're at a particular point in the rate cycle as we go through that rate cycle, I think the potential for an improvement in margin is coming from better performance on the cost of fund side coming from deposits in the long run is going to be extremely helpful. So I think that's what you can look forward to there. On the revenue side, as you note, we saw a substantial decrease in the amount of suppression over the course of 2010. That came from two sources. We were assessing fewer fees in the wake of some of the changes that took place post the implementation of the CARD Act. And the collectability of those fees went up both with the performance of consumers in terms of credit, and also just collectability of fees when we are charging fewer fees. Given the fact that suppression was at only $144 million this past quarter, that's at fairly low levels, and we've kind of gone through now the implementation of the CARD Act. I wouldn't expect much movement off of current levels going forward.
We'll take our next question from Mike Taiano from Sandler.
Michael Taiano - Sandler O’Neill & Partners
First, I was just curious if you could maybe give us some color on response rates that you've seen over the last few months relative to maybe earlier in the year? And one of your competitors last month had said that they were seeing a change, an uptick in the spending that was being done on cardholders that were traditionally revolver versus the traditional transactor. I'm just curious if you were seeing a similar trend?
Mike, the response rates, if you look at the overall the industry reports, response rates appear to be at their kind of record low at this point. Just frankly, industry mailings, for example, have gone, have returned to 70% of their prior highs. And the amount of demand, shall we say, out there probably isn't commensurate with that. So I think overall, the industry is challenged with respect to response rates. Response rates are a measure that's getting harder to interpret nowadays. And when you look at any of the external data because more and more stuff is moving to the Internet. So I think -- and particularly for so many of us that are doing a lot of originations whenever you go at the upper end of the marketplace, that's particularly -- it's pretty high cost to originate a particular account. That's why to us, it's not about the response rates per se. It's about the overall economics of the business. And I go back to the point that we're really pleased with the net present values that we're generating now despite a really competitive marketplace and consumer demand being relatively weak. But pound for pound, we're seeing it is as strong as we've seen them in the past, and we just are looking forward to getting a few more pounds of it as demand picks up a bit. With respect to the -- I don't have a specific observation to add. It's intuitive, I'd say intuitively plausible, your observation on the uptick in spending on revolvers. I don't have a particular data point on that.
Michael Taiano - Sandler O’Neill & Partners
And then just a follow-up on just capital deployment. Just I think several months back, you had said the acquisition market, particularly for portfolios seemed relatively attractive for you guys. Just given the M&A activity we've seen, and obviously it's been more towards the bank side the last month or so. I think most people are surprised that some of the premiums that are being paid, I just wonder if your view of sort of the attractiveness for acquisitions has changed at all in the last month or two.
Well, I certainly think that we're well-positioned to be looking at acquisitions, as I've said, ranging from the performance of our business. And the triple whammy for us really has been the Great Recession, the CARD Act and FAS 166/167, and really all of that's basically moving into our rearview mirror and we find ourselves with a heavy concentration of the two businesses that are turning much faster in the recession than others. So we certainly like our positioning, and we have looked, as you mention, we have really not taken just a focus on bank acquisition, but really look across asset portfolios, asset origination deals and things on the banking side as well. And we have gone into a number of these auction-type situations and have, certainly on the banking side, we're certainly struck by how high the prices are. So we're not discouraged from that. It doesn't cause us to not take a look. But the fact that we have nothing to show for these efforts certainly on the banking side since Chevy Chase a few years ago, shows that we're still staying very disciplined. So in summary, we continue to believe the great recession will cause a lot of property to become available, and properties that otherwise wouldn't have come available across the different businesses that we're in. We're going to actively take a look, we're going to be very disciplined about it. And meanwhile, we're putting a lot of effort into restarting the origination machine. And we feel very bullish about those opportunities. The only other thing I want to say on acquisitions and that is of course we have done a number of Credit Card partnerships that involve, not only getting a partnership, but typically acquiring a portfolio there. And there's a case where we've always kind of fancied the partnership business. We go to auctions and we just couldn't believe how high the prices were years ago. Price levels have come down a lot and we're selectively going after some of the very best partnerships. And there's an example of something we've done for a long time, but waiting for pricing to get where it's right, and then we pounce.
We'll take our next question from Sanjay Sakhrani with KBW.
Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.
I guess, one question for Rich following on that acquisition question before. If we were to see you guys do acquisitions this year, where would they come from specifically? I mean, is there a kind of a priority level in where you look to add inorganically? And I guess the second question for Gary, is this on the revenue margin for CARD? You guys mentioned that since all the CARD Act impacts kind of in the fourth quarter, should we expect some kind of stabilization going forward in the U.S. card revenue margin, or could there still be some impacts from the partnerships that come on, as well as CARD Act? I don't know if there is any more impact from the CARD Act. And then maybe one more Gary, can you just talk about the impact related to FAS 166/167 on the Tier 1 capital ratios again?
So Sanjay, on the acquisition side, I think we've taken a much broader kind of scope into this then a lot of players. So literally, during this acquisition, we've looked actively in the card space, we've looked actively in the auto space, and we've even taken a look at a few growth platforms on the national lending side where we have not been in that particular business, and then we've been looking on the banking side as well. With respect to banking, certainly, our top priority is things that can enhance the footprint that we're in. We always keep an eye on attractive markets and opportunities in a market we're not in. But it would be with a very careful eye about how we could get to this kind of scale that we would want in a particular market.
Your two other questions, Sanjay, very quickly on the revenue margin, particularly in the Card business again. As we've said, both Rich and I, with most of the CARD Act implementation in our rearview mirror, I think the big effects that you're going to see over the course of the next year or so, certainly, there will be a downward impact on the revenue margin coming from the completion of some of our partnership deals. Those are both lower-yielding and lower-loss assets. And as Rich described, in particular the Kohl's portfolio in the second quarter is a $3 billion to $4 billion portfolio with both a revenue and loss sharing arrangement. And so that will -- I think it will have a material impact on the reported revenue margin in CARD. The other thing of course is that to the extent we see a pickup in volume, that often comes at a promotional rate. So that will have an effect on the revenue margin. And then lastly, as we see loss rates coming down and to the extent those appear to be something that we're going to experience for a period of time, one might expect in the competitive marketplace that margins will drift down to recognize the lower losses that we're seeing. So again, we don't see a particular change from the outlook that Rich and I have been sharing for the last year or so. On where that margin goes and those are the sources of the change. Your other question, Sanjay, on the impact of FAS 167 consolidation on Tier 1 common. So listen up, you're only going to hear this for one more quarter and then we can pretty much stop talking about it and I know we're all looking forward to that. TCE has no more effect on FAS 167. That all hit in the first quarter of 2010 when we built the allowance. In the regulatory capital ratios, the risk-weighted assets have not yet shown the full effect of FAS 167. You'll see the last dose of that in the first quarter of 2011, at which point in time, that will be complete and that will add a considerable amount of risk-weighted assets to the denominator of the Tier 1 common ratio. But still nothing that we haven't expected all along and we've been giving you a sense of that trajectory, which effectively hasn't changed. Remember, that the other item that affects our Tier 1 common or all of our regulatory ratios that doesn't affect TCE is the disallowance formula for DTA. That is at least as big an impact on our Tier 1 common in the first quarter of 2011. Because as I said earlier, we're turning the page on the calendar. When we come into 2011. Our look-back period is limited to two years for regulatory capital purposes and so now we're looking at 2009, 2010, which were the deep recession years, so disallowed DTA will go up. The net result of that is that Tier 1 common will come down in the first quarter and probably to maybe where we were a couple of quarters ago, maybe between Q2 '10 and the Q3 '10 levels but thereafter, not only will you see the fundamentally positive trajectory in our TCE flow through into our regulatory ratios, which will actually see an acceleration of accretion of regulatory capital. As the DTA rolls off, it's going to add capital to our numerator and even with loan growth, we're not going to be adding to the denominator nearly as much in the next two years as we added in the last year because of FAS 167. So hopefully, that gives you kind of most of the moving parts and pieces and explains our comfort level with all of our capital ratio and trajectories.
Our next question comes from Bruce Harting with Barclays Capital.
Bruce Harting - Barclays Capital
Running at the ROA that you're achieving right now and return on tangible comment reminds me of earlier days when you were at the earlier part of your sort of younger stages of growth when you used to talk about 20% EPS growth, 20% ROE and you're there on the ROE on tangible. And I guess, some people would say that you're not getting a higher multiple because of that reserve release. But by your estimate, provision and charge-off converged by the end of this year. So $6 seems like the right normalized number, and with more deposits and far more deposits compared to 10 years ago when those were the applicable numbers, the valuation is much, much lower. So I just wanted to see if you can comment on that and what your thoughts are on what else you could do? I mean, it doesn't seem like -- I think the ROE, if I'm not mistaken, in those higher growth days was in the 1.5 to 1.6 [ph] (57:46) range and you're operating there now. So I guess, the question I would have, Rich, is I heard you talk about the loan growth for the cards and I just wonder, where would you like to have the Card portfolio as a percentage of the total? And I didn't hear you comment on growth or I might've missed it on some the other portfolios. If you could just fill that in and then any thoughts on anything that can be -- you're doing all you can. I just wonder why the valuation isn't higher given these returns?
Thanks, Bruce. Well you got some real fans here in this room for the observations that you made. But our quest in this company is to build a franchise that can generate a very attractive value-creating blend of exceptional returns and strong growth. And obviously, the issue these days has been growth and I'm going to come back and talk about that for a second. But let's start with just the power kind of the profit model of our company here. And in the CARD business I think your back of the envelope calculations are reasonable there. I mean, in the CARD business, we're sort of settling in on a -- we're kind of settling in on a return and frankly, we've made a lot of return through the Great Recession in this business. But we can kind of reach out and sort of just about touch, sort of normalized as you get back into this business. And of course, I've been saying for a long time, the revenue margin normalized and the revenue margin is 15%, and I keep looking like a liar because it keeps staying stubbornly higher than that, but doggone it, I'm still sticking with my point here that I think the revenue margin is headed for the 15. And with the Kohl's portfolio, with the higher percentage of the portfolio at teaser rates as we still got the growth a little bit more and as the market gets a little bit more competitive. But if you kind of think about destination economics, if you will, in the current business, that kind of revenue that I talked about and non-interest expense sort of in the kind of 6% neighborhood as we step up marketing a little more from where we are, as opportunities get better, credit growing to normalized levels kind of in the 5% range. And frankly, they're going to get there probably a lot sooner than the economy really recovers. And I mean, you're looking at normalized pretax ROAs in the 4% kind of range and after tax in the high twos and maybe a little to work with around the edges there as well. And so what is the manifestation I think of the power of the profit model that we've kind of built in the current business? But of course, we have a 22-year heritage of really trying to create growth opportunities in this business, and we're really, Bruce, pretty darn bullish about growth. Certainly bullish especially about market share growth in the Card business because we just love the new level playing field that's been unlevel and getting increasingly unlevel for the last 10 years for some of the card practices. We love the level playing field and while others may be retooling their business model in CARD, ours has really made it in stride through the CARD Act, and it's really ready for business. And I think in strong shape here with respect to that. And as we said, we're already really seeing growth in that business and net of run-off portfolios, there's more growth than meets the eye, and we look forward to growth in that business. It's starting to pick up after the dip in the first quarter. In other businesses, let me talk about other businesses. So take the Auto business. The Auto business, that also is a business that we're very happy with our returns in the Auto business. It's very information-based strategy, we spent many years building that. After a bit of a rough start at the beginning of the Great Recession, that thing has really generated strong returns -- and to everybody in the business, it feels like a high-growth business right now because -- it doesn't, to you, look like it because what we're having is that the runoff, the portfolio back when we were yet larger has been sort of the overall -- been holding back the kind of growth optics of the whole thing. But when we talk about Auto originations going in the fives to now a running rate of nine, this is pretty darn rapid growth and I like the upside in our Auto business. The competition has backed off a bit and where we're getting the growth, Bruce, is in deepening dealer relationships. So what we did with our dial back is we're a lot less all things to all people and we really focused on the deep dealer relationships and build as we generate the benefits of that and then expand from there. I think it's very solid line of sight to continued growth opportunities in the Auto business. On the Commercial side, Commercial Banking is a pretty solid business. We've had a strong credit foundation, we've been spending quite a bit of time to sort of build some of the infrastructural components, consistent with a top 10 bank that were necessarily there and in some of the regionals that we bought. But that business, frankly, all you have to do is squint your eyes a little bit and look sort of do a normalization of credit and you're looking at a business with return on allocated capital in the 20s type of thing. And that certainly looks attractive to us, very line of sight. And finally, we have the retail bank which, I think, represents one of the things that, Bruce, that's very differentiated that we do with our local bank. Possibly the biggest gift we give our local banks is the ability to be unbalanced and not to have to push too hard for assets. And frankly, to be able to -- in being unbalanced, not only does that lead to mitigating credit pressures, it also enables the opportunity to grow deposits at a higher rate than a lot of other banks do. So we see good growth opportunities in that. Now to get to a higher PE -- so where does Card as a percentage of the total come out in all of that? I mean, we don't have a particular target, Bruce. But the net effect of all of this, I think Card will grow and I think the rest of the company will probably grow a little bit faster. So over time, the mix will mitigate a little bit. And to get to a higher PE, I think as we really put it in the rearview mirror, the trilogy of things that have spooked investors understandably, the Great Recession, and the CARD Act and FAS 166/167, I think that we're going to be able to demonstrate to our shareholders the sustained results, the confidence that, from a risk point of view, we just risk managed quite successfully through an amazing black swan event. And now, we're generating capital, high returns. And in fact, growth that is, I think, higher than a lot of our competitors. So I'm very bullish about it, Bruce, and we look forward to seeing this happen.
We'll take our next question from Moshe Orenbuch with Crédit Suisse.
Moshe Orenbuch - Crédit Suisse AG
Rich, I was wondering if you could talk a little bit about the competition in the Auto business. I mean, some of the regional banks that are large in the business have already said they're seeing too much competition on yields and are pulling back. Two of the big standalone providers have been acquired in the last several months and probably gives them a little more firepower kind of as time goes on. And you talked about that as a growth engine. Can you talk about the competitive environment and how you see that developing? And I'm just wondering if you would be considering breaking out the mix of yields on the loans within the Consumer Banking business now that you've got several categories in there.
Moshe, the Auto business is absolutely destined to become more competitive. It was always a competitive business. I think it got less competitive during the great recession. A lot of people backed off, a number of people literally exited the business and the Auto companies and their captives went through a number of issues. So you're absolutely right. All signs point to more competitiveness. Now with respect to the regional banks, I think what you're seeing there is less a comment on the market and more of a symptom of another issue, which is something that we believe strategically 13 years ago, when we got into this business, and that is that this is a national scale business. This is a thin margin-type business and scale. The scale of operating cost and the scale of information management in this business is going to make it increasingly difficult for regional banks to compete. And that's been a macro trend for a long time, and I really, strongly predict that will continue. So what we see is tighter pricing across the board. But it's, for us right now, the credit quality of what we've been booking, Moshe, is still enabling us even with tighter competition to generate exceptionally good returns right at the moment. But we are planning for a tougher environment. I don't think that's going to cause us to not be able to grow the way we want to in the business, but I just think that it's a very valid reminder from you that these businesses get competitive. I just think we're very well-positioned in it. We don't have any plans at this point to break out the yields with respect to the consumer portfolio. But I appreciate, it is a little complex looking at the different pieces inside that business. We'll try to do our best to give you a window into that.
Your next question comes from Betsy Graseck with Morgan Stanley.
Betsy Graseck - Morgan Stanley
I had a question on how you're thinking about the duration of the new customers that you're going after. When I hear that the hits or the response rates on the marketing is at all-time lows, but the marketing dollars are up, I just like to understand what type of duration you're expecting your new your new customers to be relative to the portfolio that's on your balance sheet today?
First of all, Betsy, I'm not necessarily saying that our response rates are at all-time low. That was an industry observation. And again these days the Internet's such an important part of the origination thing. It's response rate metric is a little bit an odd one, but it is a fair comment that the cost of acquisition is pretty high these days. Now we have been explicitly going after very high-value customers in the various segments that we go after. So it may cost a little bit more to get them, but we certainly like what we're getting. Let me make a comment on duration. First of all, attrition rates, I bet I speak for the whole industry, I certainly for Capital One -- well, Capital One our attrition rates have plummeted frankly over the years. And that's a blend of some of the change in the mix of business that we've done. It's a reflection of the huge investment in franchise that we're doing, and I think it's frankly also a manifestation of a more temporary phenomenon, which is the recession and everybody just kind of sticking with what they have. But we are finding that even with the -- all the evidence is the business that we're going after, Betsy, I think is going to have some of the best retention characteristics in the history of the 20 to 22 years I've been doing this business. And it's really -- I want to underscore how much our company is focused on building the franchise, building customers that where we can dynamically manage that customer through all of their life stages and so on. And all of this is kind of paying off in a kind of record levels of low attrition, most of which I think we'll sustain, some of it which will pick up after the recession rounds the corner.
Betsy Graseck - Morgan Stanley
So the thought is, when you're thinking about that new customer and the marketing spend associated with it, to get to the ROA hurdles that you have for the customer, are you layering in anything other than credit card? Are you layering in cross-selling other products that you have?
We actually take a very conservative approach to our MTV modeling. So most of the kind of the deep relationship upside, we don't we do not model into the original thing. So we of course make attrition estimates but things like cross sells, we really don't include them. Even a bunch of the balance build and other account management-type things that we do, we tend to take a very conservative approach on that because I've just grown to be skeptic about modeling in all of the kind of upside that's going to come, even though we believe deeply in it as a discipline. In the same way, Betsy, that we have always essentially put recessions right into -- hardwired them right into our credit forecast. We have a very rigorous kind of methodology of how do we quantify where upside exists, but make sure that we don't actually put it into our core assumptions unless we get addicted to it in a way that we could regret.
Our next question comes from Chris Kotowski with Oppenheimer & Co.
Christoph Kotowski - Oppenheimer & Co. Inc.
Just on the non-card charge-offs, were slightly up this quarter and it was actually second quarter in a row. And just is that year end cleaning up or are there some kind of trend elements in that or is there an explanation?
Yes. So in Auto, you basically -- and any credit effect we're seeing in Auto is a seasonal effect. So seasonally, this is the time that charge-offs and delinquencies are rising during this period of time. Frankly, in our own observations, if anything, the seasonal effects that the quality of the credit performance is even sometimes exceeded the seasonal effects that one would expect. But nonetheless, Auto, anything there is just seasonal. The credit performance has been very, very strong. In the Mortgage business, actually, the charge off in our Home Loans business more than doubled actually from the third quarter to the fourth from 41 basis points to 89 basis points. So I appreciate your asking that question. This was really driven by two onetime effects. First, back in the third quarter, we made a change in charge-off policy in parts of our home equity portfolios to align them all around the same charge-off policy because some of these had come from different acquisitions and things. And these have the effect of suppressing third quarter charge-offs for home loans by 15 basis points. So the fourth quarter represents more of the normal equilibrium, so it was more of a distortion in the third quarter. Secondly, we received -- as we do from time to time, we get updated home value estimates and we received updated home value estimates for 1,300 properties that were delinquent more than 180 days and that are being serviced externally. And these updated valuations led to a onetime, one-off write down on the loans, and that was a 25 basis point whack. So sort of adjusting for these onetime effects, you really had an eight basis-point move in the third quarter. In general, the home loan metrics we feel pretty good about the stabilization of those metrics. And Commercial, by the way, is a lumpy business and that is, things -- sort of if you look beyond the lumpiness, we definitely see a rounding of the corner in Commercial, and I think you're going to see commercial credit get a little bit better for next year.
Christoph Kotowski - Oppenheimer & Co. Inc.
And then just another little myth [ph] (1:17:20) kind of both on a consolidated basis and looking at your Consumer Banking franchise, the income, it's held rocksteady for the last couple of quarters. And it doesn't seem like you're experiencing the same drag on deposit service charges that some of the other banks are doing. So I'm curious what your secret is?
I really wouldn't count any kind of great secret there. Let me comment for a second on the things that are whacking the revenue model of Consumer Banking and just give you some of our numbers on that NSF/OD front we see a $75 million to $100 million annual effect. And of course, this is already has gone into effect. So you really see that in the numbers. On the Durban side, like many banks, we were certainly struck that the Federal Reserve's interpretation of an already-harsh law there. But we estimate $75 million to $125 million pretax impact of that. Now, all of these estimates I'm giving you are before any clawbacks that come from revenue choices that we make, and we have nothing to announce at this point. We're certainly spending a lot of time analyzing that. So I mean, I think our retail bank is kind of hung in there. And I think the reason -- as for Capital One overall, these effects percentage-wise are not that big because we get so much of our earnings and revenue from other places. So we're going to be working hard to make sure that we can replace the earnings in another way.
Your last question comes from Bill Carcache with Macquarie.
Bill Carcache - Macquarie Research
Since you're not being directly being impacted by the double-dinner [ph] (1:20:00) changes, just a bit of a follow-up on the last comment that you just made. I guess, my initial thinking was is it fair to conclude that you're not thinking about modifying your rewards programs or adjusting your fees, but it sounds like you may still be open to it and no final determination has been made from your last comment if you could just clarify on that?
Yes. I mean, we of course feel that we are
Directly affected by the debit interchange and I think, pound for pound, we are like other banks. We just don't have as many pounds of that business. But I think that we're looking very closely at what choices we want to make there. But I think all of our choices because this is a business that is a smaller part of our whole, we'll be done not only in the context of the local bank but also in the context of where we're trying to go as a company. Now that's a vague statement. It doesn't really -- don't read too much into it. More way of saying we're still working on it, Bill.
Bill Carcache - Macquarie Research
And as a follow-up, still on the topic of debit and everything that's been happening there. As we look ahead, do you see a shift away from debit and does that potentially present any kind of opportunity for Capital One?
It's certainly been striking the success that debit has had, it's the most dramatic probably growth vehicle in all financial services over the last number of years. Debit, while it's been pretty breathtaking growth relative to credit card, I believe most of its growth has really come at the expense of cash and check, less so in terms of substitution with credit card. But we certainly had an eye on that. To the extent, I think you kind of have to look at, Bill, how much in the banks repricing of things. Sorry, let me make the case on either side. You, of course, can have, with the various steering kind of things going on with the lower debit interchange cost, you certainly can have merchants being more active as relative to driving more debit card use. I'm going to take the under on that because there's already been lots of reasons merchants can already drive volume to lower-cost things and create discounts that consumers end up feeling their surcharges. And I guess, I'm probably going to take the under on that particular thing. Now with respect on the other side of it, to your point that might these price changes cause a move away from debit, I think the key thing to look for there is how much are banks changing the price of deposits and the deposit banking relationships overall, as opposed to charging for debit cards. So in the limit, if they -- given that there's a lot of money that's got to be recouped, the more that they put that into the price of the debit card either on a transactional basis or in terms of having one. That actually could create a mix shift towards credit cards. If it's more about just making deposit relationships that cost more, not sure that the Credit Card is going to stand to gain that much in all of this.
Thank you very much to everyone for joining us on the conference call tonight, and thank you for your interest in Capital One. If you have further questions, the Investor Relations team will be here this evening to answer them, and I wish everybody a good night. Thanks.
That concludes today's conference. Thank you for your participation.
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