Capital One Financial Corporation (NYSE:COF)
Q3 2007 Earnings Call
October 18, 2007 5:00 pm ET
Jeff Norris - VP of IR
Gary Perlin - CFO and Principal Accounting Officer
Richard Fairbank - Chairman and CEO
Bob Napoli - Piper Jaffray
Ken Posner - Morgan Stanley
Chris Brendler - Stifel
Stephen Wharton - JP Morgan
Scott Valentin - FBR Capital Market
Greg Regan - Cedar Hill Capital
Rick Shane - Jefferies & Company
Moshe Orenbuch - Credit Suisse
Bob Hughes - KBW
Welcome to the Capital One Third Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).
I would now like to turn the conference over to Mr. Jeff Norris Vice President of Investor Relations. Please go ahead.
Thank you very much, Sharvon and welcome everyone to Capital One's third quarter 2007 earnings conference call. As usual, we are webcasting live over the internet. To access the webcast please log on to Capital One's website at www.capitalone.com and follow the links from there.
In addition to the press release and financials we have included a presentation summarizing our third quarter 2007 results. With me today is 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 will walk you through this presentation.
To access a copy of the presentation and the press release, please go to Capital One's website, click on "Investors" then click on "Quarterly Earnings Release."
Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials, speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise.
Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled "forward-looking information" in the earnings release presentation and the risk factor section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.
At this time, I'll turn the call over to Perlin. Gary?
Thanks, Jeff and good afternoon everyone. Let's jump straight into the highlights of the quarter on slide 3 of the presentation.
Capital One posted a loss of $0.21 per share in the third quarter of 2007 comprised of a profit of $2.09 per share from continuing operations offset by a loss of $2.30 per share associated with the shutdown of GreenPoint Mortgage.
More on the shutdown and how it impacted our financials in a moment. EPS from continuing operations in the quarter grew smartly from the second quarter of 2007 and the third quarter of 2006 reflecting significant revenue growth offset in part by higher provision expense. Rich and I will focus on each of these important trends in greater detail throughout the call.
Moving on with the third quarter highlights. We executed on $480 million of open market share repurchases. In addition, our $1.5 billion accelerated share repurchase or ASR program was completed in August. Although you recall that the ASR program reduced our share count by about $20 million shares, as of April 2nd, when that program was launched.
We are on track to meet our objectives of completing $3 billion in share buybacks originally projected by mid 2008 by the end of this calendar year. This means, we will target about $770 million of repurchases in the fourth quarter. The third quarter of 2007 was the first full quarter for our cost restructuring initiative. Although, it is early days, we are gaining good traction and feel confident that the benefits will be realized as planned through 2009 more details on this in a moment.
Finally, despite the very difficult capital market conditions, we all experienced in the third quarter, Capital One has executed nearly $4 billion in funding transactions across the variety of asset classes, two-thirds of which was asset-backed funding and the balance was long-term unsecured funding for the holding company. For 2007, we continue to expect diluted earnings per share of approximately $5.
Moving on to slide four, let’s take a look at how the shutdown of GreenPoint impacted our results in the quarter. When we announced the shutdown of GreenPoint operations on August 20, we estimated the associated charges would total $860 million after tax. As we move towards completion of the shutdown and final disposition of loans, we now expect the total charges will be slightly higher than that or just over $900 million. The vast majority of which was recorded in the third quarter.
You can see this in the box at the top of slide four along with the results from GreenPoint operations in the quarter. The modest operating loss of $15 million combined with $883 million in charges resulted in a total loss from discontinued operations of $898 million.
There are two notable variances in current estimated charges as compared with the estimates we have made and shared with you on August 20. The higher than expected level of charges related to evaluation adjustments partially offset by lower than expected restructuring charges associated with our exit from origination business.
Evaluation adjustments include a $74 million allowance billed related to the $680 million in loans held for investment in the GreenPoint our Mortgage Banking segment. The HELOC loans were transferred from held for sale during the second quarter of 2007 and we anticipated this allowance billed as a component of our estimated charges on August 20.
The balance evaluation adjustments represent lower of cost or market marks on loans committed are sold subsequently or move to HFI. The bulk of GreenPoint's loan warehouse in pipeline was subject to forward sales commitment or flow agreements, when we announced the shutdown and we valued accordingly at that time. However, certain long-term buyers backed away from their bids, which caused us pre-market a substantial portion of those loans.
Lower gain on sale margins contributed to the loss from operations. All downward evaluation adjustments were required on loans to be sold or move to HFI. The lower box on slide 4 provides details on the disposition of GreenPoint's HFS loans. I don’t walk you through all the data, but would highlight that $3.7 billion in HFS loans about $1.3 billion were sold by the end of the third quarter.
We had firm commitments to sale an additional $1.2 billion in loans, as of September 30 more than half of which have already settled in October. We chose to hope for investment about $1 billion in loans, the characteristics of which are detailed for you on the slide.
Having marked those loans, we believe they will produce attractive risk adjusted returns. After disposing of the bulk of GreenPoint HFS loans, we are left with approximately $151 million of repurchase and other loans in the warehouse, which we intend to sell. These loans are being carried in an average of 55% a part.
Lastly, we retain risk for further repurchases of sold loans, but which we are currently carrying a rep and warranty reserve of $146 million related to this exposure. We are in the final stages of shutting down various GreenPoint facilities and except to terminate the last leases by early 2008.
A GreenPoint team continues to manage the origination shutdown process with the same professionalism that characterize the way in which they ran the business for so many years, impacted employees have been notified and are receiving severance benefits.
Moving forward GreenPoint’s mortgage servicing operations, and the $1.7 billion of the HFI loans held in our former mortgage banking sub segment will be included in our local banking segment in the fourth quarter.
Let’s now move to slide 5. Improving operating efficiency is not a new area of focus for Capital One. We formerly launched a significant enterprise wide cost initiative in June, as we completed a number of important improvements to our operating infrastructure. We remain on track for realizing gross cost savings of $700 million by 2009 and recognized $15 million of run rate savings in the third quarter.
We continue to expect the reported level of operating expense to fall in 2008 by $100 to $200 million. We also continue to expect overall program charges of around $300 million towards slightly less. However, our expectations for restructuring charges to be incurred in 2007 have been reduced from $200 million to about $150 million.
Realized and expected charges and savings related to GreenPoint Mortgage are now captured in discontinued operations. As a result they are no longer accounted for in our cost initiative. Still we remain committed to the targets for charges and gross costs savings in the broader program and we will continue to update you on our progress.
As we turn to slide 6, please keep in mind that year-over-year comparisons on the balance sheet and income statement are affected by the acquisition of North Fork on December 1, 2006. For that reason we have noted changes on a linked quarter basis.
Let’s start with the balance sheet. Total deposits in quarter end decreased by about $2 billion on the linked quarter basis, the largest driver of the decline was the intended runoff of high cost brokered and public fund deposits.
During the quarter we executed seven wholesale funding transactions nearly $4 billion of funding, despite difficult capital market conditions. We took advantage of our diverse and stock filed funding options to sit on the sidelines during the period of highest uncertainty in the capital market and executed our transaction, when we saw attractive opportunities to do so.
Managed loans held for investment increased on a linked quarter basis largely driven by loan growth in our GFS sub-segment. Looking forward we expect low-to-mid single digit loan and deposit growth in 2008.
Our tangible common ratio at September 30 was 6.17% slightly above our 5.5% to 6% target range. As I indicated we expected to repurchase about $770 million and shares during the fourth quarter of ’07. We have also indicated that we expect to increase our dividend beginning in the first quarter of 2008 through a fixed dollar amount of approximately 25% of expected 2008 earnings. Beyond that, we expect to return the balance of our excess capital generated in 2008 through continuing share repurchases.
Finally, revenue and net interest margins both expanded in the quarter. Margins were relatively stable in the bank, while our U.S. Card sub-segment experienced significant margin expansion. Rich will walk through margins and our sub segments in a moment.
Turn now to the next slide for a quick look at the third quarter income statement. Allow me to focus on just a few highlights. First, revenue from continuing operations is up on a linked quarter basis driven primarily by revenue margin expansion in our U.S. Card sub segment that Rich will discuss more about in a moment.
Looking forward, we expect 2008 revenue growth will be in line or just slightly higher than asset growth of low to mid single digit. Operating expense declined in the third quarter by $35 million driven by continued efficiency gains across our businesses. Operating expenses include pretax expenses of $30 million related to bank integration and $52 million of CDI amortization.
Looking forward, we expect our operating efficiency ratio including marketing, but excluding restructuring charges to be in the mid 40s for the full year 2008. Provision expense was up quarter-over-quarter and year-over-year as charge-offs rose. And as delinquency experience cause us to anticipate higher charge-offs over the next 12 months particularly in our U.S. Card and Auto Finance sub segments.
The increase in provision included an allowance build of $124 million. This build represents an increase to the allowance of about $200 million for our national leading businesses partially offset by a $68 million reduction in the banking segment, which itself was driven by $91 million reduction due to the alignment of allowance methodology across our local banking franchise.
Please not that the provision expense does not include $74 million allowance billed related to HFI mortgage loans I discussed earlier. Those loans and the associated allowance are currently held in discontinued operations, although both will move to the local banking segment beginning in the fourth quarter.
With that I turn the call over to Rich.
Thanks, Gary. I'll begin on slide 8, with a look at overall credit trends.
Now local banking segment losses remain stable and low at 19 basis points for the quarter. Non-performing loans as a percentage of loans held for investment increased eight basis points.
Charge-offs in our national lending segment increased 49 basis points driven by credit performance in our US Card and Auto Finance sub-segment. Delinquency in nation lending rose to 4.7% in the third quarter from 3.89% in the prior quarter. I will describe the reasons for these changes in the context of our operating segments in just a moment.
Based on year-to-date trends, we are currently expecting charge-offs in the fourth quarter of 2007 to about $1.2 billion. In 2008 we expect charge-offs of approximately $4.9 billion this was represents an increase of approximately $800 million over 2007.
Our $4.9 billion estimate for 2008 charge-offs include a full year effect of the credit normalization we have been experiencing throughout 2007. It also reflects the delinquency trends we have witnessed in recent months, but does not speculate on future trend. In this slide, it is worth remembering that we are not estimating total provision expense, which would require that we speculate on the level of allowance that we might need to build in 2008 based on expected losses well into 2009.
Our actual charge-offs experienced in 2008 could vary significantly from the current estimates, given current uncertainties and the outlook for the credit markets and the broader economy. Here we think it's helpful to quantify our current view given what we have experienced thus far and to update you regularly on changes to our outlook, as we see how things play out.
One way we will help provide insight is to publish managed credit metrics for our major businesses on a monthly basis. We will begin providing that data in November 2007 for this month results.
Slide 9 is an overview of our National Lending and Local Banking business segment. On a year-over-year basis sustained profitability in our U.S. Card, Global Financial Services and Local Banking businesses more than offset the declines in Auto Finance. You will note some continuing themes across our businesses in the third quarter.
Loan and deposit growth remains modest, while revenue growth and revenue margins are strong. Credit losses and delinquencies across our National Lending businesses have risen largely, as a result of continuing normalization and expected seasonality.
In the third quarter, we have also observed some business specific credit trends that I will discuss in a moment and our focused cost and efficiency moves continue to payoff resulting in improving operating leverage across our businesses.
I will discuss our U.S. Card business on slide 10. Once again, U.S. Card delivered solid year-over-year net income growth, as increase in credit cost were more than offset by strong revenue growth and expense reductions.
But looking beyond the third quarter results for a moment, our US Card business has been and continues to be and important source of strength, as we have anticipated and met company wide challenges throughout the year.
Most of the third quarter results in US Card are eroded in a set of carefully chosen moves we’ve been making throughout the year as we have anticipated these near term challenges. We selectively move to enhance revenue and anticipation of credit normalization.
We’ve stayed focused on sub-segments of the market with the best risk adjusted returns and the most resilient through economic cycles. We maintained pricing in credit line discipline, balanced with our continuing commitments for long-term customer value. And we’ve leveraged our new operating platform and infrastructure to streamline process and increase our operating efficiency.
Collectively, this set of moves has driven the trends in revenues, loans, credit metrics and operating efficiency. Managed loans declined 3% from the third quarter of 2006 to just under $50 billion. As we have discussed for several quarters, we’ve chosen to avoid parts of the market like prime revolvers, which are dominated by very long teaser pricing, high credit line and high asset turnover.
We believe this combination of factors hinders the building of the long-term customer franchise and result in a portfolio of loans that is less resilient to economic cycles. We have mostly then on the sidelines in the sub-segments for several quarters. In the third quarter we chose to reduce our investment in teaser led marketing to prime revolvers even further. As a result we’ve seen a significant decline in low margin, high balance prime revolvers assets.
We continue to focus on product and marketing strategies with the most attractive risk adjusted returns and resilience. These include transactor products for prime and super prime customers and attractively price revolver products across the risk factor that do not rely on aggressive penalty repricing in order to achieve profitability.
Our marketing investments have resulted in solid growth in parts of the market that do not generate big balances, but in our assessment they have the best potential for prudent growth and profitability in the long run.
The net effect of our marketing choices has been modest shrinkage in overall managed loans and shift toward higher margin businesses. While we expect seasonal loan growth in the fourth quarter, we expect to end the year with lower loan balances than at end 2006.
Purchase volumes were essentially flat to the prior year quarter. The deceleration in purchase volume growth resulted from slower retail sales trends, our exit from two transactor focused retail partnerships earlier in the year and the decline in prime revolver loan I just mentioned. We expect to return to modest growth in purchase volume in the fourth quarter.
We continued to generate strong revenue in the third quarter, as we’ve played catch-up and relieved the pent-up demand for customary account management moves that is previously have been suppressed due to the conversion of our card billing system.
For example following the TSYS conversion, we cleared the sizable backlog of account, where the funding had expired after several years and was needed to repriced to market rate. We also implemented selected [C policy] changes following the conversion to bring our policy nearer to or inline with the industry. For example the industry typically has a 20-day grace period and we moved our grace period from 30 days to 25 days.
Collectively, these moves accounted for the bulk of our revenue growth in the quarter. The revenue margin expansion we experienced in 2007 as mostly run its course. While we expect that revenue will grow in 2008 largely due to the full year impact of the revenue moves we have made this year.
Our revenue margin is likely to moderate somewhat. We believe that the significant revenue benefits we are currently experiencing will be partially offset by somewhat higher attrition and charge-offs in the coming quarter. Raising prices generally causes increased attrition, which then creates some adverse selection.
Additionally, raising prices can cause an acceleration in delinquency [bill] rates followed by subsequent raises in charge-offs. We expect these effects to be more than compensated followed by the significant revenue benefits of these pricing changes. Charge-offs increase on both a year-over-year and linked quarter basis. Continuing charge-off normalization and the mix effects of our decline in prime revolver loans drove the year-over-year increase.
The sequential quarter increase resulted from the same factors plus the fact that our June implementation of 25-day grace period, depressed second quarter charge-offs by 31 basis points. Delinquencies rose more sharply then charge-offs increasing 105 basis points from the sequential quarter. While these numbers might suggest pressure on credit quality most of the increase is explained by factors that don’t indicate any fundamental deterioration. Normal seasonality drove about 35 basis points of the increase.
Another 35 basis points resulted from the 25-day grace implementation, which had two effects. The change in grace period suppressed delinquencies in the second quarter and created a onetime increase in delinquencies. Another 15 basis points resulted from the mix effects of our decline in prime revolver balances. The remaining 20 basis points includes the early effects of credit worsening associated with and pricing policy changes, I just discussed as well as other economic factors.
These delinquency trends are largely consistent with the expected rise in card charge-offs in the fourth quarter, which we have been signaling for sometime. We expect that the recent increase in delinquency is associated with both the 25-day grace implementation and the fee and pricing policy changes will roll through the delinquency buckets to charge-offs in the first quarter of 2008.
We expect that this result in about $175,000 million of extra charge-offs in the first quarter. This amount is included in the expected 2008 total company charge-offs of $4.9 billion that I mentioned earlier. We continue to expect rising charge-offs for the balance of the year. Perilously, we had indicated our expectation for fourth quarter charge-offs were about 5%.
Given further declines in prime evolver loans and current delinquency trend, we now expect the charge-off rate to be closer to five and a quarter percent in the fourth quarter. With continued revenue strength and operating leverage, our U.S. Card business remains well positioned to sustain strong profitability.
Results for our Global Financial Service or GFS business are summarized on slide 11. GFS net income for the quarter was $118 million up 10% from the third quarter of 2006. Net income growth resulted from strong revenue growth and increased operating leverage, but partially offset by higher provision expense. GFS managed loans ended the quarter at $29 billion up 8% from the year ago quarter. About half of the dollar growth resulted from stronger Canadian and UK currencies versus the third quarter of last year.
Once again North American GFS businesses provided the strongest growth in both loans and profit. Small business, installment loans, and Canadian credit cards all delivered double-digit loan growth and our origination businesses also grew.
Point-of Sale originations were up 23% year-over-year. Capital One home loan originations were up 26% as compared with the third quarter of 2006, although originations declined modestly from the linked quarter as expected in the current mortgage market.
UK credit card loans declined modestly year-over-year as we maintain a cautious past year in that market. In the third quarter charge-offs and delinquencies were essentially flat versus the sequential quarter. Charge-off rate rose by 30 basis points and delinquencies were up by 16 basis points from the prior year quarter.
In North American GFS businesses the story is very similar to our card business minus some factor like the 25-day grace period change that are unique to card. The biggest factor in GFS is the continued gradual normalization of charge-offs when they very low levels in 2006. Credit in the UK remains stable. Our GFS businesses delivered another solid and steady quarter of profitable growth.
You see a summary of third quarter results for Capital One Auto Finance on slide 12. Our Auto Finance business posted a $4 million net loss for the quarter compared to a profit of $38 million in the third quarter of last year, while revenues were up 6% with strong operating leverage. These trends were more than offset by a 52% increase in provision expense.
Credit results and outlook continued to be the key story in our Auto Finance business. Both charge-offs and delinquencies rose sharply from the very lower levels we experienced in the third quarter of 2006. They have also risen significantly from the second quarter of this year.
Both delinquency and charge-off performance are driven by the same three factors. First we experienced a normal seasonal increase this quarter. In a sequential quarter comparison this is the largest single driver.
Second, we continue to see elevated losses from our recent dealer prime originations. As we talked about in the past two quarter early calls, we have responded by implementing second and third generation credit models and adjusting underwriting criteria.
We believe we have turned the corner in the dealer prime business and the loans, we are originating today have better credit characteristics. However, actual loss levels on early advantages will remain elevated until those loans amortize.
The third factor driving credit performance is elevated losses in our dealer sub-prime business. We are continuing to see the impacts of industry wide risk and underwriting expansion over the past several years.
Risk expansion across the industry and in our Auto businesses, include things like longer-term loans and higher loan to value limits. While losses on these loans have risen, the business remains highly profitable and we are quite comfortable with the credit performance and risks adjusted returns of these loans.
Originations in the quarter were $3.2 billion roughly flat compared to the third quarter of 2006. Originations were pressured downward by declining Auto sales across the industry and by our pullback on dealer prime volumes. These pressures were offset by continued success in sub-prime and direct prime as well as the early success of our new business model with dealers.
As I discussed in the last quarters call, we implemented an integrated program across our 18,000 dealer relationships completing the rollout in the latter part of the second quarter. While it is still very early days, our first full quarter of results has been encouraging. Dealer satisfaction has increased and loan originations are strong and the credit quality of new origination is better enhanced by positive selection.
Obviously Auto Finance results thus for in 2007 are disappointing largely as a result of credit challenge as I discussed, but based on solid originations improving operating efficiency and the early success of our integrated dealer approach. We believe our Auto Finance business positioned to return to stronger growth and profitability in 2008.
I will discuss our local banking business on slide 13. The slide shows actual results for the 2007 quarters and pro forma results for the 2006 quarters. Net income for the quarter was $192 million up more than $15 million from the second quarter. The primary driver of the increase was a reserve release the result when we aligned our local banking segment loan loss allowance methodology to be consistent with Capital One methodology.
Revenues decline modestly from the second quarter as did non-interest expense. Total deposits declined by about $1 billion from the second quarter to $73 billion. Several large customers withdrew a portion of their deposits in the quarter as they reposition their real-estate holdings.
Deposit mix and pricing were stable in the quarter. Loan balances were flat at $42 billion. Commercial loans grew modestly offsetting the expected pay down in the mortgage portfolio. The commercial real-estate in multifamily loan portfolios were flat from the second quarter.
Credit performances remain strong and stable. The charge-offs rate remaining is just 19 basis points. Non-performing loans as a percentage of managed loans rose eight basis points to 27 basis points.
Once again the biggest news in our local banking business in the third quarter is our continued progress on integration. Lynn Pike has built her leadership team by selecting experienced executives from Legacy Capital One, North Fork, Hibernia, and key external candidates. The senior management team is now largely in place.
Beyond the transition of the leadership team our integration efforts continue to be on track. Integration efforts will continue to accelerate over the next two quarters with the deposit platform and brand conversions scheduled for the first quarter of 2008. In the third quarter, our Local Banking business continued to deliver solid results, while managing and delivering on a successful integration.
I will close tonight on slide 14, which is the summary of current expectations, we provided for 2008. The expectations, we provided for key operating metrics and capital targets effectively constitute our guidance for 2008. While they provide enough inputs to develop a reasonable range of expected earnings for 2008, we believe there are both longer-term and shorter-term benefits to provide a new with this level of detail.
As compared to a calendar year EPS range, these metrics provide visibility as to how we are doing against the goals and targets we have set that will deliver long-term shareholder returns like operating leverage and capital discipline. Moreover this approach shed light on important top line as well as bottom line trends, which will drive the performance in the future.
In a shorter-term this approach allows us to give you a clear picture of where specific variables like credits are pointing in the moment and the factors what you are likely to drive them going forward without embedding them in an earnings range wide enough to catch your all possible scenarios especially during uncertain economic times such as lease.
It also allows us to provide frequent update on those variables, which are more visible to us like monthly credit metrics In our national Lending sub-segments and exceptions for future quarter charge-offs without having the speculate on variables like the allowance, we might need to build over the course of the given calendar year to anticipate loss experience another 12 months out.
I hope you will be able to join us in McLean or over the webcast for our fall investor conference on November 6th. At that time you will have a chance to hear directly from the leaders of our businesses about our strategy and outlook for 2008.
Garry and I will also discuss our overall corporate outlook with the focus on how we except our strategic and business results to translate the shareholder value over the next couple of years and longer term.
Now Garry and I will be happy to answer your questions, Jeff.
Thanks, Rich. We will now start the Q&A session. If you have any follow-up questions after the call, the investor relation staff will be available to answer them.
For the courtesy to other investors and analysts and they wish to ask a questions, please limit yourself to only one question and one follow-up question. Sharvon, please start the Q&A session.
(Operator Instructions). We will have our first question from Bob Napoli, Piper Jaffray.
Bob Napoli - Piper Jaffray
Thank you. Good afternoon. Rich, question in order to get your stock moving appreciate the return of capital, the dividend certainly a significant moves. But I’m trying to get understanding of kind of the growth rate of the company, if I think about your business, the Card business there appears to be a cash call with net of return on assets is very high probably not going to get a lot of expansion in ROA.
So, probably grow maybe in line with the loan growth? The Auto business, a big challenge not a great growth industry, the bank seems to be modest growth, it seem like you have some growth drivers in GFS? But I just looking at this, I’m just trying to understand maybe you can give me some color on the long-term growth potential of Capital One?
Thank you, Bob. I think, certainly Capital One relative to the Capital One of many years ago, where we are growing at double digit rate, pretty strong double digit rate. It’s a very different Capital One at this point. We have two anchor tenants that are both in relatively slow growing industry. The most striking thing about these anchor tenants is about their, they are franchise potential in terms of enhancing the overall business of the company. But also, they have very strong capital generation.
So, you are right in the sense that we are not going to push these businesses to do natural thing for the sake of growth. What we are going to do is leverage these businesses to generate the value that they can, which is primarily at this point around very substantial return of capital. And all the actions that you can see are consistent, we are doing that.
So, the bank at the moment of course is mostly, is in pretty stable situation, but mostly really the focus is on integration. I think the Card business is a classic case Bob, where you can see that as we react to the pressures in the marketplace. We are not doing anything unnatural instead we are really driving a lot of capital generation, and that creates value in a way different from just underlying asset growth.
And you talk about the Auto Finance business, the Auto Finance business, while the industry is honestly growing in a couple of percent in fact this year very slow for the industry. The auto business like virtually all of our GFS businesses are leveraging our strategy of being consolidators and while the industries may grow slowly. I think in GFS and auto we have the chance for substantially higher growth. All of that growth needs to be cautiously pursued in the context of the credit markets that we have out there.
Additionally though on how we drive the shareholder value that we have, you can see the actions we have taken on the revenue side of the business, the dramatic actions that we taken on the cost side of the business and again making sure on the capital side of the business. That we are very careful with our investments and both with respect to return of dividend and but also in comparing alternative investments to understand the power of share buybacks particularly in the context of our stock rates right now.
So to me at the end of the day our focus is in making Capital One a growth company. Our focus is in value creation and I think we are very well positioned to do that. Even in the context of the company that still has I think a lot of growth potential relative to the industry over the longer run.
Bob Napoli - Piper Jaffray
Thank you. Just a follow-up on the credit side, are you seeing anything alarming obviously ranges raised your charge-off outlook a little bit for the fourth quarter, you broke down the pieces, but you feeling a much more concerned with the economy today in your even 30 or 45 days ago?
Well, Bob the economy itself is depending on whether your glass is half full or half empty. You look at the economy you will see a lot of things to like; there are, lot of things not to like. But certainly the metric, we’ve always focused on as we look at the economy has been employment and I think, there is a lot of strength and consistency with respect to the most important metrics, we look at the economy.
We also look at just the trajectory of our underlying businesses and as we talk about when you see a spike and delinquency here are some of the big changes you will see. Obviously, we do a lot of digging to make sure that we can explain the various effects and always in search of sort of worsening on a standalone basis. And as you can see, there are strong explanations for some of the credit metrics, as we talked about.
As we look, we continue to not see direct effect from the mortgage crisis affecting our own customers. We see very stable differences between our mortgage holders and renters, and we talk a lot about this in the past. We have now that more data is coming out, we’ve done a pretty deep look at the markets, where housing prices have, home price appreciation has been very dramatic over the last number of years, and what we see Bob as we go all the way back to 2004.
We can see that in those markets, the credit performance on our portfolio of the sort of the high octane HPA market. The credits performance improved differentially more in those markets than everywhere else on our consumer portfolio. It peaked in’05. It was stable. This differential peaked in ’05.
It was stable in ‘06 and what we see in ‘07 it basically regress back to the main. So in other words the California’s, the Florida’s, Arizona’s the superior performance in consumer credit that we have observe over the last few years is more or less regress toward or to the main.
Though as we look at those markets also we see that again this does not then appear to be the direct mortgage effects, renters and homeowners in those markets in the past and in the present they tend to move together. So what it offers to us, it basically goes back to the core principle of that. It’s about the economy. We see a strong economy. We see basically stable performance adjusted for the things. We are talking about in our own portfolio.
And so I think we feel very good about that. Nonetheless I think there is more uncertainty Bob, than usual at the moment. It’s why we are just being extra careful in underwriting and doing the things we have the reason behind. The revenue moves that we’ve done to put ourselves in a position, whether this norm may or may not be out there in the future.
Next question please?
We will go next to Ken Posner, Morgan Stanley.
Ken Posner - Morgan Stanley
Hi, Richard I just want to clarify the one last point you made. Your explanations were very helpful compared to just looking at the raw numbers in the press release. So you are saying you are seeing no real deterioration in the underlying consumer at this point, when you back throughout the policy and pricing changes?
Yeah. Ken, let me try to clarify because one thing I want to say is all these time when we have been talking about normalization, I’ve always said my caution is and always has been that here you had incredibly good consumer credit performance in '06. And we all knew that that can’t last forever and when we all declared there would be “normalization” a return to normal. Now normalization itself as people become delinquent to charge-offs. They don’t have labels on and that’s say, I’m here normalizing. They don’t have labels that say I’m a substitution of factor whatever.
Ken Posner - Morgan Stanley
So, that my caution is always been in some ways in an environment of normalization what is worsening versus normalization, it’s a little bit of a hard form. We’ve said all along that our credit performance has been coming in pretty much on top of the forecast, we made a year ago, and that comforting to us. When we get behind the normalization that has happened over the past year remember we always talk about the one thing that was puzzling was that the low in charge-offs was greater than the spike and bankruptcy. So, in some sense 2006 fooled us by virtue of how good it was.
And I think, now as we dig into the numbers it was not only sort of the bankruptcy effect, but there also was this exceptional performance in the rapidly home price appreciating markets that is more now regressing through the mean. So, to us, I think broadly Ken, I would call this all part of normalization in the sense those things are regressing through the mean we've got bankruptcies returning more to normal level, I think.
Well, there are no labels on the substitution that we would expect certainly is consistent with what we see. So, as we itemize this delinquency spike, if I too clarify one thing Ken to you the delinquency spike that we had in the third quarter, we spend a lot of time looking at this thing and of course given that we projected charge-offs would be quite a bit higher by the end of the year.
This is the natural effective on the delinquency side of what we have already projected. But to just go back and itemize again the fact that, the 25 day grace effect is very isolatable and it’s a bubble kind of moving through the pipe in a sense and that’s 35 basis points of the delinquency.
The seasonality, honestly seasonality now it doesn’t have label associated whether we have been look the over past 6 years we find seasonality that would be consistent with about 35 basis points to this. Absolutely it just math the mix shift that comes from fewer revolver balances. So that’s the 15 basis points.
What I want to say is the 20 basis points that left over. It is our belief, but we can’t prove it at an early point. So that’s a very natural effect of the fee in pricing policy changes, but I can’t prove that to you. And I said we could find agenda that is worsening in another form. What we’ve done is we isolated a relatively small amount of delinquencies that. We are going to keep an eye on but the net effect of all other things saying is, it is more uncertain than usual, but I think there is solid and explainable performance that’s going on.
Ken Posner - Morgan Stanley
Richard, thank you and it is reassuring to see that contrast with some of the mortgage companies, which we have seen a very sudden deterioration in credits. So I really appreciate the clarification.
Next question please?
We will go next to Chris Brendler, Stifel
Chris Brendler - Stifel
Hi, thanks. Good evening. On the credit side I just, I understand all the subjects you’ve discussed, the drivers, but it looks to me, if you look your competitors. The major bank competitors in the Card business the few sub-prime competitors, we look out in the Auto Finance business, your trends are not in line with lot of those companies.
And I think that I’m sure, you are worried about the concept of adverse selection, their pricing strategy you are using, it doesn’t seem to be tracking the way you expected it because you are already raising your fourth quarter loss guidance for Card? So, I just want to know, do you feel that it’s an accurate statement that you are arguing with some ones of adverse selection in both the Auto or Card business or was there a better explanation?
Chris, there are really a bunch of things wrapped up in your question. First of all, when us versus competitors, I think, we tracked on top of it or maybe slightly better in the sub-prime auto space than the competitors. We talked about in the prime auto space; I have talked extensively about some of the issues, I think that was Capital One specific and some of the vintages there.
But I think, overall the auto performance is very much tracking the way that we see the industry tracking and we could talk more about that in other question questions if people want to ask. On the Card side, this is not a story of adverse selection. This is a story of consistency about things we’ve done for many, many year.
So, compared with competitors, they didn’t have the 25 day grace effect. They generally if you look at us versus competitors everybody has got bit of a different portfolio. We definitely have more seasonality than they do, and this is the period of the most significant seasonality increase that you would see with respect to delinquencies. The mix shift again every company has their own mix thing.
This is absolute map just the effect of the mix shift out of the prime revolver business. As I said there actually is some adverse selection, Chris that comes with pricing changes. And we are pretty much in advance declaring that we expect that and we expect attrition and we expect some adverse selection with pricing change. We expect that to be slump frankly by the revenue benefit, but honestly there is some adverse selection with respect to that. But that is not a big effect related to the current numbers that we were.
Chris Brendler - Stifel
Let me ask in a different way in the linked quarter you guys talked about 5% loss rate in the fourth quarter. Now you are talking about 5.25% and it's not a macro thing. So are you seeing the deeper pricing not worked the way you’ve expected to whether grace period? I mean grace period really shouldn’t drive losses. It should be a temporary late fee benefit and a delinquency blip because in couple of times you bad you are charging them. They are missing the payments for the five days. So what exactly drove the increase in losses for the fourth quarter? And then a related question did you have any meaningful adjustment to your IO strip in the car business this quarter?
Okay. First of all in the fourth quarter losses quite a while ago we said we expected charge-offs to be around five. And I think a number of people said I’m troubled getting myself. So how do we get there, and we said, look I think essentially just making in the math of the things that have been going on in the business.
And the increase in that estimate to five in a quarter about half of that is or good chunk of that is basically the nominator a fact related to less asset growth and some of it, a lot of it just relates to the math that’s working through that itemization associated with delinquencies that I did earlier including again the numerator effects associated with the mix change. So, that’s pretty much how I would explain that. Garry, you want to talk about the IO strip?
Sure, Rich. And hey Chris, we actually had a small write-off in our Card IO strip during the third quarter something between $17 and $18 million. I know, that’s all different then what you have seen with some other folks and just keep in mind that there are some positive benefits from the strong revenue growth, which more than offset the increase in credit costs, and some of the small increase in funding cost, so up $17 to $18 million.
Next question please?
We’ll go next to Steven Wharton, JP Morgan
Stephen Wharton - JP Morgan
Hi, Rich and Garry. I guess, my question is, I appreciate the kind of initial 2008 guidance that you provided, and as it relates to the charge-off guidance. First of all, I wondered; if you could, may be perhaps highlight a little bit what sort of economic environment you would except in terms of like GDP growth to get you the $4.9 billion?
And then secondly, I just want to get a better sense of where you are from a reserve standpoint. A number of banks had found themselves in a position where, when things were good they were releasing reserves and running down reserve coverage ratios in addition to just having improving net charge-offs, and now it’s kind of like the opposite.
So, not only do you have the increase in the dollar provisions and you have to provide and increase your coverage of your loan portfolio. So my understand I thought that Capital One had been low less of the former in terms of bleeding the reserves and which way to imply that maybe the less of the ladder. So can just talk about that a little bit?
Thank you, Steve. I will take the first part and Gary can talk about the reserves. I’m glad you asked the question about 2008 credit guidance, because I want to as clear as we can. It’s a year ago, when said out it turn out one of the most
probably all the metrics want to once it turn down most close and our internal forecast turn out to be the charge-offs. But we know any year in particular a year like this it something that can have a lot variance to it. So our approach is we don’t want to just take an unusually large number just to make sure we come in 1000.
What we want to do is try to, have you see it, as we see it at this point and could of course be subject to change. So the way we’re looking at it Steve, is that we are assuming with the economy we don’t model it. So we say if unemployment is exactly X% then it mean this on our charge-offs.
But generally we are viewing a continuation of the economy pretty much the way that we see it. We are assuming that the dollars, which are currently delinquent will follow through to charge-offs. We assume the effects of normalization and shift in loan mix will continue we assume seasonality follows it normal patterns. We also assume that temporary factors like increase cost by policy changes will go way overtime.
So, this is pretty much a fair way estimate. It’s certainly not, it not an estimate that is massively conservative, to be conservative, I think, what we try to do. So, we don’t assume a lot of additional changes in the economy or credit performance from here. It's more just how what we see will play out over the course of 2008. And that’s why; it also the important choice of not trying to predict, what are reserved bill would be next year. Gary, do you want to take the other part of that?
Sure. Absolutely, hi, Steve. Just taking a look I obviously don’t need to remind you that our allowances are best estimates of future losses. In order to be able to come up with those estimates, we need to take a look at the experience; we’re having with our book right now. Future allowance will really depend on how that book changes.
So, as Rich said, as our mix may shift from time to time that’s going to have an effect on future reserving needs, obviously the actual performance of the book. So, looking at delinquencies as the best predictor of future losses that’s going to get into, I think.
So, bottom line it’s very hard to kind of get ahead of future reserving needs because one would need a crystal ball about actions, about markets, about credit that we simply don’t have. But in taking all that into account certainly in this past quarter, there is a significant increase in our coverage ratio in Cards from about 4.7% to 5.5%.
And that’s again because we've seen the effects of the mix shift that comes from reduction in the amount of prime revolvers and the books as well as the higher delinquency rates. The other business coverage ratios are actually quite stable and that's kind of more of what you might expect given the performance that we’ve seen kind of a final notes Steve, if I could on the allowance overall for the quarter just everyone has the numbers straight.
We did add $200 million more or less for national lending, normal banking operations with let us to increase the allowance there by about $24, $25 million and then the allowance was also increased $75 million related to discontinued operations. The HELOC loans that will move from HFS, HFI GreenPoint in the second quarter and then netting out of that $300 more or less million [with aligns] allowance build was about $65 to $67 million resulting -- $91 million change in the bank and that is $67.
But gross of 91 reduction in the bank largely as a result of what you see when any bank integration takes places, you integrate all of the methodologies, remove the commercial methodologies of North Fork more to what we would be considered to be mainstream methodologies such as we added the old Hibernia, our franchise when the consumer coverage moved to industry norms, moving away from life time losses to 12 months losses. So by in large we love to get a head of the future, but we need to tell what the future is, in order to do so, we will continue to do our best job of find and anticipate based on the facts as we have been.
Stephen Wharton - JP Morgan
Next question please?
We will go next to Scott Valentin, FBR Capital Market.
Scott Valentin - FBR Capital Market
Good evening. Thanks for taking my question. Some of your peers in the call, I see one peer noted some changes in the credit card usage patterns such as more cash advance or any payments coming in slightly later and I was curious maybe if you notice any change in payment patterns, fewer cards or even payments rates? That’s my first question.
Second question on the positive trends, out of thought that with the ABS market disruption maybe would emphasize deposits more, maybe growing deposits this quarter? Just curious to get your reaction maybe a thought when deposit growth may resume?
Okay Scott. On our competitor that did reference spending patterns. We did take a look at that. Of course, we would look at these things all the time. That competitor saw ramping of cash advances and rising utilization rates, which tend to be triggers of higher risk. We have looked for this, and we have not seen it. So, really, honestly, the things are pretty stable. But we have things that are moving in our portfolio, the things that we identified related to mix and things like that. Gary, you want to take that deposit question.
Sure, absolutely. Hey, Scott. In terms of deposits the big shift down in the deposit balance in the third quarter was really driven by a reduction in the high cost deposit. So, broker deposits and especially public funds in fact the level of retail deposits meaning that deposits in our branches without public funds included actually rose by about $0.5 billion.
The basic funding sources for our portfolio in the third quarter were cash that we had raised earlier this year, as it turns out quite opportunistically given the kind of dislocation in the markets in the third quarter. So, we’ve rundown some of our cash balances in the third quarter.
We also had some funding as you know at the holding company, which is important to kind of maintain our liquidity levels there. And we found things like home loan bank advances to be very attractive funding on a marginal basis. But certainly, when it comes to deposits especially with short-term rates starting to move down, we are going to be watching very carefully for opportunities to grow deposits and to do so in a way that builds the franchise and help us to achieve better funding cost overall.
Next question please?
We'll go next to [Greg Regan], Cedar Hill Capital
Greg Regan - Cedar Hill Capital
Hi, guys thanks for taking the call. I just had a point of clarification on the reserve. The $75 million of HFS provision was being captured in discontinued operation. So that did not hit the provision this quarter, but that will be going back into the retail bank in 4Q. So just how did that work on the P&L next quarter?
Okay. Well, again Greg it's already hit the P&L through the P&L of discontinued operations. And so the allowance is on the balance sheet and what we will be doing in the fourth quarter is simply moving those loans as well as any other HFI loans that will move from HFS and GreenPoint, we will be moving the loans and the associative allowance to the banking segment it will simply be a move on the balance sheet, no affect in terms of P&L.
Greg Regan - Cedar Hill Capital
Okay. Thank you.
We'll go next to Rick Shane, Jefferies & Company.
Rick Shane - Jefferies & Company
Hi, guys. Just looking at the auto business, one of the things I’m start to struggling with this given where loss rates are right now and even just assuming that provision matches with the loss rate in ’08, does this business become profitable again. I mean, maybe what you can do is, you can sort of dial a little bit more into your predicted loss rate for ’08 and give us some senses to where auto charge-offs are going to go?
Yes, Rick, it’s Gary. I don’t want to do too much speculation. But certainly as Rich described a lot of the business that we’ve been putting on the books of late is business that’s going to be highly profitable. The auto business has been doing significant work to try and improve their operating leverage.
So, we expect that they are going to be coming down quite substantially in terms of cost, as a percentage of outstanding loans. And certainly at the Investor Conference, you will be hearing from our business folks there about some of the improvement there. So, I think, the combination of operating leverage having really kind of improved our risks models around, the prime dealer business generating good volume growth.
I think the decline in profitability that you have been seeing in auto, we would consider to be temporary based on the kinds of credit we’ve been seeing to-date obviously. We don’t have a crystal ball about what credit will be in the future. But we’re going to apply that same kind of cautious underwriting we’ve for the rest of the book, and we’re certainly determined to make that business profitable.
Rick Shane - Jefferies & Company
Okay. And I guess, the way to look at it is, and I guess this gets back to Rich’s comment about the [bubble] going through the due. When do you think on the auto side, we will see and again, I realize on the Card side one of the issues you are dealing with this sort of a broader macro picture?
But on the Card side, I think, on the auto side, what you are describing is a little bit of seasoning associated with the prime portfolio. When do you think because that is easier to predict given the statistics that you are looking at? When do you think that will pass through? That’s probably a better way I should have asked the question to begin with?
Well, Rick as you know these vintages are much slower, I mean, they are much shorter in their overall life then credit card vintages and already what we are seeing in the prime business is significantly better. Now, I don’t want to declare victory there because it takes a while to look at vintages that they progress. But looking at just a lot of the sort of metrics at the time of origination and then the early vintage performance, we like a lot more what we’ve done in prime.
And in fact, if you recall, we actually backed off prime originations, and significantly backed off pending that the rollout of our integrated auto program, which is I think is really helping on the adverse selection side. It’s a combination of really getting more positive selection through the old relationships and also much better data for which we have build second and third generation model.
So, the early routes on those are good and it’s the matter of the math of better vintages sort of carrying the day as the other vintages work their way through the business. On the sub-prime side of the business, there is sort of, here is how I describe what's going on. It was something like a couple of years ago that the industry table stakes rose in terms of things like a lot of things started going to 72 months from 60 months.
You had higher LTV. And there were things associated with the higher table stakes. We looked at that at the time, we were concerned about it. We did our best to model the results from this, and we concluded that while there is a higher risk, there is on a risks adjusted basis this loan should be very, very solid.
We then did those originations and what we found and sort of, if you will maybe the first year of this two year industry change, we actually did better than we had projected on vintage basis. And what we’ve seen of late is things have coming a little worse than we had projected on vintage basis. Sort of net, net, the net effect of this is, and this certainly has impact on the profitability going forward. These things are still very profitable loans. It’s just that the kind of the second year vintage versus the first has been worsened and some of that is normalization and all the things that we’ve talked about.
So, that is really one that I deeply believe is an entire industry phenomenon there. But we noticed the industry has stabilized, the pricing seems rationale. And I think for the whole industry underwriting is sort of a notch a little bit at a higher level, I think of risk. I think that on a risks adjusted basis that we feel this is a solid business.
Well, I think, it’s a stable outlook there. So, we think profitability. If you take all these effects between the big allowance builds we had to do this year and vintages running through the pipeline, I think, we look to a substantially better year in the auto business next year.
Next question please?
We'll go next to Moshe Orenbuch, Credit Suisse.
Moshe Orenbuch - Credit Suisse
Thanks. I wanted to kind of follow-up a little bit on the Auto business this is because really if you do look at the history over the last kind of two and half years, it’s doesn’t seem forget the last whisper; it doesn’t seem that you really made the hurdle rates in the majority of that period of time.
Certainly from the second half of ’05 it’s probably only two or three quarters, three quarters may be at a period of time since that internally. So, and I guess that’s my question is that, is there like longer-term strategic plan, I mean, I understand getting back to profitability support, but how do we kind of look at that?
Moshe, obviously the auto business on a vertical current period basis, looks way under hurdle rates, there is not a lot of earnings. But when we look at it from a lifecycle or horizontal basis that are…
Moshe Orenbuch - Credit Suisse
But I am talking about three years Rich, that’s almost a lifecycle alone?
Maybe let me, let change my point for a second I’m sorry. On the sub-prime side these things have been solid in terms of risk adjusted returns on the prime side. They have been well below risks adjusted returns and the, so the thing that as hurt the performance has been just the general underperformance of the prime things that we’ve talked about and the excessive allowance builds that was within the vertical perspective these excessive allowance build that we’ve undertaken this year.
So, again, I think the sub-prime has consistently been well above hurdle Moshe and I think our outlook on the prime originations, as I’ve talked about and confirmed by the sort of the early vintage results of these is pretty positive too along the way, can I say one of the thing, Moshe very importantly has been a significant effort on the cost side in the auto business that progressively every quarter you can go back and look at the numbers. But we are dropping by 10 and 20 basis points a quarter. The operating cost of the business and that is a very important part of long-term profitability.
Next question please?
We’ll have our next question from Bob Hughes, KBW.
Bob Hughes - KBW
Hi, thanks for taking my question. Rich, I really appreciated your conversation about credit performance particularly in some of the markets that have experienced much higher housing price appreciation and that you are seeing some reversion to mean. As we look out to 2008 and consider your charge-off assumptions and the economy backdrop to what extent, if you factored in additional housing price deterioration in some of those markets?
I think Bob our projection for 2008 is again the models are not -- our forecasting of 2008 is not one metropolitan area at a time. So, in some sense, there is not a mechanical linkage of that to the other. My point about HPA is the high home price appreciation, those markets that where there has been a big change in home price appreciation. I think that is reflective of changes in the economy in those markets.
Our overall assumption about the economy is one that is pretty ecstatic. We’ve kind of intervened and altered some of our underwriting in those HPA affected marketplace. But we’ve not put into our credit forecast for next year. We’ve not put an assumption of further degradation in the nation's economy or the economy in any specific market. It’s really more of just overall consistency from where we are.
Bob Hughes - KBW
Okay. I mean, it’s an interesting topic of discussion. I mean, I think, a lot of folks have argued that housing price appreciation as one of those markets was not necessarily driven by stronger underlying economy rather lower interest rates like underwritings et cetera speculation.
So, to the extent that the housing price appreciation in some of those markets help to maybe mask some credit deterioration and resulted in a much longer role return to normalization suppose to spike and bankruptcies? I just wondered, what your thoughts might be on how that could impact you on the other side to the extent that some of those markets really start to see altering housing values and you see a deteriorating loss effect as well.
Yeah. Look now one thing I want to make sure I don’t get on the other side of the discussion, as if I am an advocate that there won’t be any economic worsening. For years and years, and we had worried about all these things. I am going to talk to you about mechanically what how we are, what's in our credit forecast.
The thing, I want say about the housing price the high octane housing price markets is the thing that we’ve found is that’s most correlated it’s the rate of change of house price appreciation. And I don’t, I actually we don’t really believe and that’s really that’s the cause of variable because it was the specific cause of variable.
We see a [hormone] effect instead in fact what we see is the same effect with renters as well as so in it’s a local economy effect. The main thing that we’ve seen there is a regression to the main. Its entirely possible those markets could in fact worsen beyond the main, it’s not something that we have put into our forecast.
But again part of our reason for giving you when to and how we think about credit as I think the most useful thing we can do for you is tell you what we see and how that mathematically works its way in the charge-offs over the course of the next year. And all of us will watch with the lot of anticipation, how the economy both locally and nationally mood.
One or more questions.
That does conclude our question-and-answer session, sir. I will turn the conference back over to Mr. Norris for closing remarks.
Thanks, Sharvon. And thanks to all of you again for joining us on the call tonight. Thank you for your interest in Capital One. I’d like to just make sure we remind all our listeners that our upcoming Fall investor conference, which will be held on Tuesday November 6, 2007.
The conference will be held in our McLean, Virginia Headquarters and we will also be webcast live. You can find more details about this on our website at capitalone.com or you can contact investor relations at email@example.com. The investor relation staff will be here this evening to answer any further questions you may have. Thanks again. And have a good evening.
That concludes today’s conference. You may disconnect at this time. We do appreciate your participation.
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