On Wednesday, January 16, 2008, Fitch affirmed its previous A- ratings on Capital One Financial (NYSE:COF), citing the company’s strong business and solid liquidity. The stock closed the day up 3% from its previous day's $42 close. The Fitch report presented a fairly stable picture of the company and handed a bit of hope to the bulls.
However, I want to take a look at the language in the report, and a few other facts, and show why I think this presents a rather bearish case for the company. Fitch had this to say about the company’s situation: Credit deterioration beyond current expectations with a corresponding hit to segment profitability, particularly in US Card, an absence of earnings and asset quality improvement in the auto segment, decreased liquidity, or weakening risk-adjusted capitalization could trigger negative rating actions (and earnings potential).
I would like to substitute that word “could” in the report with “will”. If we take a look at the business segments mentioned we will see that the credit card and auto loan segments are the areas in which the latest round of the subprime situation has manifested itself. There have been recently published reports of increased credit card delinquencies and auto loan defaults. And get this- Capital One is one of the leading subprime credit card issuers with a reputation of extending credit to less than suitable borrowers. As far as the part about decreased liquidity is concerned, we all know that reasonably priced financing is hard to come by with the confidence in the credit markets so seriously shaken and most lenders taking a wait and see approach or seeking capital injections to beef up their own balance sheets.
The fact is that the worsening macroeconomic conditions will only impact negatively on the business segments mentioned and you can add to that the personal, student and mortgage loan businesses which Capital one also operates. But just in case we are too far gone with the pessimism, Fitch wants us to know that all is not lost and that stabilization of segment credit metrics, improvement in the UK credit card portfolio, and a turnaround in the auto business with the development of consistent segment profitability, could provide positive rating momentum.
Interpreted to mean they are hoping that not withstanding the mess in the credit markets, the economy and an increasingly burdened consumer, improvements in the auto business will save profitability. We know better. Just last Thursday the company announced that its full year profit would come in 21% lower than forecast citing, among other things, mounting consumer loan losses. I think it only gets worse from here on. I also get the feeling that there is a lot of crisis management taking place. Evidence of this lies in the fact that the company basically had their bank, Capital One National Association, through a holding company; take over the Auto Finance portfolio on the basis that it will allow: the auto business to leverage the bank's deposit funding. This change will make COF less reliant on the capital markets, which is a positive development, given the uncertain environment.
It seems to me that they are seeing early signs of trouble in the Auto loans business and are taking preemptive steps. This could be seen as good management if it were not for the fact that the auto loan business will not be the only segment that will need propping up. Furthermore in its most recent sec filing COF stated that their balance sheet position is very strong with some 29 billion in available liquidity. But I would like to point out that this “liquidity” consists of: unencumbered and highly liquid investment securities, unused committed conduit capacity, and available borrowing capacity from the Federal Home Loan Banks.
OK. I have a few questions here. What exactly are these highly liquid investment securities? Are they of the subprime variety? How long will they remain “highly liquid” in this credit environment? Just how committed is this unused conduit capacity in this increasingly recessionary economy? And when they speak about borrowing from Federal Home Loan Banks are they referring to the Macs- meaning Fannie (FNM) and Freddie (FRE)? The same Fannie and Freddie with the ailing balance sheets? The present situation does not look so good for COF. They are trying to deal with the problems but their methods are suspect (shifting auto finance to its bank). And their contingencies are questionable at best.
I expect a little more light to be shed on the COF situation at their earnings conference call later this month when the questions start coming in. If the answers to some of these questions do not hold water (and I suspect they won’t) the downgrades will be fast and furious and the stock price will falter further. Of course, the Fed will probably dish out a 50 basis point cut at the end of the month and throw a lifeline to COF and the entire financial sector. I expect an initial positive reaction in the stock price and then, when the situation is reassessed, we should continue on our downward march. The Fed will not be able to help everybody. The reason why capital is so hard to get these days is not due to a lack of money; there is plenty of money in the system. The problem is a lack of confidence in the system - and a lot of uncertainty about what lies on the balance sheets (and in the SIVs) of financial companies like COF.
Disclosure: Author has a short position in COF