Capital One Financial Corp. (NYSE:COF)
Q4 2007 Earnings Call
January 23, 2008 5:00 pm ET
Jeff Norris - Managing Vice President of Investor Relations
Richard Fairbank - Chairman and Chief Executive Officer
Gary Perlin - Chief Financial Officer and Principal Accounting Officer
Bruce Harting - Lehman Brothers
Bob Napoli - Piper Jaffray
Steven Wharton - JP Morgan
Meredith Whitney - Oppenheimer
Rick Shane - Jefferies and Company
Chris Brendler - Stifel Nicolaus
Scott Valentin - FBR Capital Markets
David Hochstim - Bear Stearns
Brad Ball - Citi
Bob Hughes - KBW
Good day, everyone. Welcome to the Capital One fourth quarter 2007 earnings conference 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 call over to Mr. Jeff Norris, Managing Vice President of Investor Relations. Sir, you may begin.
Jeff Norris - Managing Vice President of Investor Relations
Thank you very much Cynthia, and welcome to everyone, to Capital One's fourth quarter 2007 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 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. Rich and Gary will walk you through this presentation.
To access a copy of the presentation and the press release, please go to Capital One's website, click on "Investors" then click on "Quarterly Earnings Release." Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and materials speak only as of the particular date or dates indicated in the materials.
Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on those factors, please see the section titled "Forward-looking Information" in the earnings release presentation and the "Risk Factors" 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 Mr. Fairbank. Rich?
Richard Fairbank - Chairman and Chief Executive Officer
Thanks, Jeff, and thanks to everyone for joining us on the call tonight. I'll begin by summarizing the results of the quarter on slide three. Capital One posted diluted earnings per share of $0.60 in the fourth quarter and $3.97 for the full year 2007.
As you know, we announced our fourth quarter and full year 2007 earnings per share on January 10th. Today's earnings release adds more detailed financial tables for the company and for our business segment, but it's consistent with our announcement two weeks ago.
Given the January 10th announcement and the opportunity we’ve had to engage with investors and analysts since then. Our presentation tonight will focus on key issues rather than our traditional walkthrough the company and segment financial results. We have included all the usual financial slides in an appendix for your convenience. But our discussion this evening will focus on the most important issues on investor's mind beginning with the credit and market environment.
Simply put we are acting decisively and aggressively to manage the company for the benefit of shareholders in the face of cyclical economic headwind. In essence, we are managing the company today as it for recession we already here. We are pulling back on loan growth, focusing on our most resilient businesses, and closely managing credit with the insights and experience we have garnered in prior economic downturn.
We are attacking cost and pushing for further operating efficiency gains. We are building revenues and focusing on achieving strong risk adjusted returns across our businesses and we are being disciplines towards the capital.
We are maintaining our commitment to return excess capital to our shareholders, while at the same time building our capital position in today's economic and capital markets environment. And all our actions are designed to ensure that our business has achieved above hurdle returns on capital or have clear line of sight to doing so in the near future.
Our fourth quarter and full year 2007 results reflect challenges we faced throughout the year as well as continuing uncertainty and challenges going into 2008. But we remain confident, that our strong balance sheet, resilient businesses and decisive actions were successfully help us navigate an economic downturn and the Capital One will be poised for a strong rebound on the other side of the cycle.
I will discuss credit beginning on slide four, with the look at credit metrics in our national lending and local banking businesses. Because of our credit results and how we are responding are best understood by looking at each of our businesses.
I will turn now to a discussion of credit performance and the actions we're taking to mange credit in each of our national lending businesses and then our local banking business.
Slide 5, shows quarterly net income and credit results for our US Card business. Fourth quarter net income of $522 million was up strongly from the fourth quarter of 2006. As revenue growth and expense reductions more than offset increased charge-offs and allowances. Delinquencies and charge-offs increased on both a year-over-year and sequential quarter basis.
Like others in the US Card business, our delinquency and charge-off increases resulted in part from the normalization of charge-offs following the unusually favorably credit environment in 2006 and from economic weakening, evidenced in recently released economic indicators.
The sequential quarter increased also reflects expected seasonal pattern. Our rising credit metrics in 2007 were exacerbated by our significant pull back from the primer revolver's base throughout the year and by our pricing and fee moves in the second and third quarter.
Both the prime pull back and the pricing in fee moves contributed to the increases in our credit metrics several months before the deterioration in economic indicators became apparent. But they also contributed to revenue margin expansion that helped our US Card business to post more than $2 billion in net income and returns on allocated capital in excess of 40% in 2007, even with significantly higher provision expense.
Looking forward, we expect US Card revenue margins to decline from peak fourth quarter levels in the first quarter and to be in the high-teens throughout 2008. There are several reasons for the expected decline. In other words this is the fourth quarter that will be RP, can we expect the decline in 2008. We expect to assess fewer fees on customers as they continue to adjust to new pricing in fee policies.
We're also making planed fee policy adjustments in the first quarter, such as a more generous and targeted fee waiver policy, which will reduce fee revenues somewhat. We expect the seasonal decline in purchase volumes and interchange fees. And we expect an increase in introductory rate assets in our card portfolio, as we pursue some opportunities we see in super prime revolver segment.
We remain confident that strong revenue margins will help our US Card business to whether cyclical economic pressures. We expect the US Card managed charge-off rate to be in the mid-6% range in the first half of 2008, consistent with delinquencies throughout the latter half of 2007.
Additionally, we expect the January monthly managed charge-off rate to be a bit higher, around 7%, as the initial impact of our move from 30-day to 25-day grace period last June, complete its move through six months of delinquency buckets to reach charge-off this month.
While we're confident that our US Card business is well-positioned today, we're also taking action to further strengthen our resiliency and sustain our ability to deliver well above hurdle financial returns in the phase of cyclical credit challenges.
We're applying lessons we've learned in prior cyclical downturns. For example, we specifically design product structures and tightly manage credit lines appropriate to each part of the credit risk spectrum, an approach that served us very well in the last downturn in the United States.
We're maintaining a prudent and measured approach to underwriting and marketing. In 2008, we expect to little to no loan growth in US Card, and no change in the mix of our portfolio. We've ramped up collections capacity and intensity earlier in this cycle.
We are taking the more opportunistic and flexible approach to charge-off debt sales as a recovery tool. And we are aggressively pursuing process and efficiency improvements leveraging the new infrastructure platform we implemented successfully in 2007.
The choices we have made in our US Card business over the years, have always prioritize profit growth over loan growth, with the particular focus on ensuring resilience to credit cycle. Our choices in 2007 and now as we entered 2008 are consistent with this long standing approach.
Slide six summarizes quarterly results in our auto finance business. Charge-offs and delinquencies in auto finance have followed expected seasonal patterns in 2007, but it continued to worsen from 2006 levels. Because we hold the vast majority of our auto loans on balance sheet, the deterioration in charge-off and delinquency also results a significant allowance build. The combination of rising charge-offs and allowance has driven overall 2007 auto finance results that are clearly unacceptable.
In the fourth quarter we took decisive action to refocus and reposition the auto business for improved performance through cyclical credit challenges and return to better profitability and financial return. Our actions result in a significant growth pullback and a focus on loans with better credit characteristics across the risk spectrum. We have scaled back our dealer prime business by focusing on a much smaller network of dealers with whom we have deeper relationships and better credit and profitability performance.
We focused on originating loans with better credit characteristics by tightening underwriting and steering our originations up market within both the subprime and prime parts of the market. In subprime, we have stopped originating loans to the riskiest sub-segments were essentially existing the riskiest 25% of subprime originations from the third quarter and earlier time period.
In prime, we have almost completely exceeded the so called near prime space, which is resulted in dramatic improvement an average FICO scores in our prime originations. Today, the average FICO scores of our prime originations are 30 points better than prime originations from the fourth quarter of 2006, and 70 points better than prime originations from the fourth quarter of 2005.
We will also able to increase pricing on fourth quarter originations as competitive supply decreased. Thus, while originations continue to grow in October and November, the loans we originated had both better credit profiles and higher pricing.
As we continue to pull back in December, originations declined by about 25% from run rate in the first two months of the quarter. Despite our confidence in the improved credit characteristics, profitability, and resilience of the loans we are now originating and despite the reduction in competitive supply, prudent lead us to scale back our auto business even more giving the cyclical credit challenges in 2008.
Overall, we expect to ramp down origination volumes with origination run rate down significantly by the second quarter of the year. This should result in a decline in auto loan balances in 2008 with further migration to higher quality loans within both prime and subprime.
Lower loan balances will have several effects on the optics of our auto business. For example, declining loan balances will reduce the denominator for calculation of metrics like charge-off rate, delinquency rate, and operating expenses as percentage of loans. This will put upward pressure on these ratios making them appear more negative than the actual trends in charge-off, delinquency, and operating expense dollars.
Declining loan balances may also have a meaningful substantive of benefit to the net income of our auto business, because most auto loans are held on balance sheet, lower loan balances means that all else being equal, we won't need to add as much to our allowance for loan losses.
While auto finance results in 2007 are unacceptable, we believe that significantly reduced originations, a smaller portfolio with better credit characteristic, improved pricing and aggressive management of operating expense should combine to help our auto finance business achieve better financial returns in 2008.
We will be monitoring our performance carefully and will be ready to adjust quickly inline with rapidly changing market conditions.
Slide 7, summarizes the results of our global financial services business. Credit metrics and global financial services or GFS were up modestly in the fourth quarter. In the domestic GFS businesses, the credit performance and drivers are very similar to the US Card businesses that I just discussed. These results are muted by strong credit results in our Canadian credit card business as well as stable to modestly improving credit performance in our U.K. credit card business.
Despite the more favorable credit performance outside the US, we remain cautious in our outlook for the U.K. and Canada, given the risk that US economic pressures could spread to other parts of the world.
In the fourth quarter, GFS continued to deliver solid loan growth. Profits in the quarter were driven by a one-time gain on the sale of our Spanish credit card portfolio as we exited that business.
Slide 8, shows quarterly results for our local banking business. Starting with credit, our local banking loan portfolio continues to perform well, though we've seen some charge-off increases from the third quarter. Just as in our national lending businesses, we're coming off a period of historically low losses, at 28 basis points, the level of losses in our local banking portfolio is well within our expectations, and continues to represent solid credit performance.
The fourth quarter increase resulted mostly from modestly higher losses in our bank consumer real estate portfolio, though they remain very low. Losses were also up in unsecured lending in bank, primarily due to higher losses on consumer loans in Texas.
We have adjusted our lending policy and pricing in Texas, but expect see some further increases there at that portfolio season.
Our commercial portfolio continues to perform very well. We have also look closely our exposure to residential real estate and feel quite good about where we are. We are seeing some weakening in construction loans particularly in the New Jersey area. The New Jersey construction loans represent just 1% of our $27 billion commercial book.
It should be notice that just under a third of our commercial real estate portfolio is a multifamily housing, which is historically performed exceptionally well through economic downturns.
Finally, it's worth noting that our bank loan portfolio is concentrated in the New York area and in Louisiana and Texas, out side of the real trouble spot in the housing market.
Overall, local banking delivered solid results and remains on track to complete our integration efforts later in the first quarter. Profits remained solid with the sequential decline driven by fourth quarter provision bills consistent with the credit trend I just discussed. Loans grew modestly and deposits were flat as compared to the prior quarter, margins were stable.
Under the talented and experienced leadership team that is now fully in place our local banking business continued to delivered solid results and has poised for the final face of the successful integration.
We are taking decisive actions across the company to manage through cyclical credit challenges and slide 9, summarizes these actions. We have pull back and continue to pull back on our lending programs. We have tightened underwriting across our businesses and we've selectively increased the pricing to build more resilience into our loan portfolios.
Overall, we remain cautious on loan growth across our businesses, and we remain focused on the part of each of business that we believe to be the most resilient to economic stress. In contract, we expect to grow deposits both in the branches and through our direct-to-consumer and brokered deposit channels. Some of our most important actions levered the strength of our balance sheet and the transformation of our company that we completed with our bank acquisitions, which Gary will discuss in a moment.
There is no doubt, that we like other banks will continue to face cyclical credit challenges in 2008. But we are well positioned for the challenges with resilient businesses, experience in managing through prior cyclical downturns, ample liquidity, funding flexibility, and strong capital position. We are not just well-positioned. We are actively managing the company to protect our franchise and to deliver shareholder returns over the cycle.
Now I will turn the call over to Gary, who will pick-up on the theme of decisive actions, as they relate to our income statement and balance sheet. Gary?
Gary Perlin - Chief Financial Officer and Principal Accounting Officer
Thanks, Rich. Turning to slide ten, I will summarize the income statement and balance sheet actions we have taken and are taking to protect the franchise from economic downturn. On the income statement maintaining our high-revenue margins, while taking out costs will partially offset the higher levels of provision, a result from weakening economy. And the balance sheet, our diligence in maintaining high levels of liquidity coupled with enhanced funding flexibility provide us wherewithal to support the needs of our business to periods of economic weakness. Additionally, our high levels of return on tangible equity provide sufficient capacity to increase our capital base.
Turning to page 11, I will discuss our revenue and expense trends. Our fourth quarter revenue margin rose 62 basis points versus the prior year quarter, principally due to the pullback in US Card prime and the pricing actions that Rich discussed a few minutes ago. Despite an expected decline in 2008 from our fourth quarter high point revenue margin should remain at very strong levels going forward.
Our efficiency ratio has trended downward in recent years, as we've been aggressively streamlining operations and driving costs out of our business. As you can see, this improving trend continued in 2007, with the exception of the fourth quarter due to some one-time legal expenses.
We remain on track to deliver the $700 million in cost savings anticipated in the restructuring program we launched just last year, and are accelerating our efforts to drive out costs in this tough economic environment.
This is evidenced by the fact that we have already eliminated nearly 2,000 jobs, since our June 2007 announcement, not counting those associated with the shutdown of originations at GreenPoint Mortgage and canceled the substantial number of acquisitions for previously planned headcount growth.
As a result of actions we have taken and continue to take, we expect 2008 operating expenses to be at least $200 million lower than in 2007. This takes into account the fact that increases in collections and recovery expenses are likely to offset the effects of one-time legal expenses in the fourth quarter of 2007.
We continue to target an efficiency ratio in the mid 40% range for 2008. The operating leverage demonstrated here will help to partially offset the higher levels of provision that result from a weakening economy.
Turning to slide twelve, provision expense in the fourth quarter was approximately $1.9 billion, which includes $643 million of build in our allowance for reported loan losses. This build raises by 20% our coverage ratio of allowance, as a percent of reported loans, from 2.4% as of the end of the third quarter in '07 up to 2.9% as of the end of the fourth quarter of 2007.
The resulting allowance, as a percent of 30-day plus delinquencies, is in excess of 100% for all of our unsecured consumer lending businesses just under 50% for our secured auto business and almost 300% of the GreenPoint mortgage originated consumer loans now help for investment in the other category.
The allowance is driven by the loss outlook at yearend which reflects fourth quarter credit metrics and the recognition of the weakening trends in the US economy as we entered 2008. At yearend, our allowance for loan losses was $3 billion, which relates exclusively to loans reported on our balance sheet. This is consistent with an outlook for managed charge-offs including those in our securitize portfolios of approximate $5.9 billion for 2008.
Now moving to slide 13, I will cover some highlights of our balance sheet strategy. You heard Rich mentioned several times tonight that our experience in managing through difficult environments in the past provides us confidence that we can do so again in this current market. This is especially true in terms of funding and liquidity, since in the past Capital One have to navigate difficult markets as a smaller lower rated company with more modest liquidity and a significantly greater reliance on the capital markets than we have today.
One of our core tenants is maintaining the ability to fund our growth in refinancing needs in the wake of might major market dislocations. This has led us to build a substantial supply of committed or readily available liquidity in general in particularly for those assets which we typically fund in wholesale markets.
At present, we have approximately $29 billion in total liquidity comprised of the $12 billion of cash and highly rated unencumbered marketable securities, $11 billion of undrawn but committed conduit capacity the vast majority of which is committed for three year terms and more than $6 billion of collateral that we can fetched to the Federal Home Loan Bank using current market advanced rates.
Now because other banks are taking significant write-downs on their investment portfolios, I am often asked about ours. The securities portfolio has zero exposure to CDOs or SF's and includes only $40 million in subprime securities.
The value of Capital One's Investment portfolio increased nearly $300 million in the second half of 2007 and now has a small unrealized gain. As the benefit from lower rates has exceeded the impact of wider spreads, keeping our modest credit sensitivity.
Now beyond holding liquidity for general market conditions, we structured our balance sheet and legal entities to maximize flexibility and to address potential challenges in accessing particular funding markets.
In line with this strategy, we recently moved Capital One Auto Finance previously a wholly owned finance company subsidiary of our holding company to become a direct operating subsidiary of our national bank.
This move significantly expands the range of funding choices for our auto finance business and improves the holding company's liquidity profile. We fully expect to tap markets throughout 2008. Still, our substantial stock file of subordinated card securitization notes thinks that we could limit our issuance to AAA securities for over a year.
Even if markets were totally closed, our term conduit capacity would allow us to cover maturities and planned growth without issuing public securities at all into 2009.
Now, these are clearly extreme contingencies which we do not expect to materialize. But even in improving markets, our funding flexibility allows us to achieve favorable results by tapping the most attractive markets and market windows.
Finally, with our expanding branch footprint in our direct banking channels, we would expect to increase our level of deposit funding overtime, especially when wholesale markets are relatively less attractive.
Moving now to slide fourteen, we ended 2007 with a tangible common equity to tangible managed assets ratio of about 5.8%, within our target range of 5.5% to 6%. Given the current uncertainty in the economic and capital markets environment, we expect to manage our TCE ratio toward the high-end or possibly above our target range into 2008.
Our business remains strongly capital generative. High margins, coupled with slower growth expectations, yield significant excess capital, even in times at elevated losses. We have modeled a variety of the economic scenarios, using our direct experience as well as overall industry performance in past recessions.
We used these historical stress scenarios to simulate the potential impact of a weakening economy on our earnings and capital forecasts. We modeled both the percentage increase and consumer charge-offs, experienced in past recessions across product lines, as well as the shape and duration of these impacts to charge-offs by product.
Against an even more stress scenario, one which also includes simultaneous increases in loss rates in our non-consumer businesses. A normalizing for the unusually low level of consumer charge-offs at which we began the current cycle, we expect our business to remain solidly profitable.
Indeed, our portfolio would continue to generate sufficient excess capital to support our target TCE ratio, while allowing us to return an increased level of capital to shareholders. We have completed our $3 billion stock buyback program by purchasing $772 million in stock in the fourth quarter.
We continue to expect our Board of Directors to declare a 2008 dividend of approximately 25% of expected 2008 earnings beginning with the dividend payable in February 2008.
Even the increase in our TCE target for 2008, we will likely be foregoing stock buybacks for the next few quarters, as we further build our capital ratio through the internal generation of capital. Whether we resume buybacks in the second half of 2008 or into 2009 will depend substantially in how well or how poorly for that matter the US economy performs.
As I have said before, our top priority uses of capital generation to support organic growth into pay dividends. Stock buybacks are secondary use of excess capital. It will be used to keep our capital base at an efficient level.
Turning to slide 15, let me end by summarizing our outlook for 2008. Even the significant uncertainty in the US economy we are not providing EPS guidance for 2008. Instead, we will continue to provide guidance on key operating metrics and we will discuss our ongoing view of credit risk as the future unfolds. We believe this represents a more thoughtful way to discuss our business prospects with our investors.
Specifically in 2008, we expect balance sheet growth in the low single-digits. While we remain cautious on loan growth we are bullish on deposit growth. Revenue growth should be in the low single-digits, is the positive margin trends in US Card moderate somewhat in 2008. And our efficiency ratio should be in the mid 40% with overall operating expenses coming in at least $200 million below their 2007 level.
From a credit standpoint, we expect continued pressure if the economy continues to weaken. And as I mentioned a moment ago, we expect to hold a bit more capital this year for continuing our pattern of returning excess capital to share holders.
In closing, I would like to remind you with my presentation at our annual investor conference just a few months ago, when I discussed our expected returns over the cycles. While returns in 2008 will likely be pressured by credit headwinds as the economy weakens.
Once the economy begins to stabilize, we would expect the rate of growth and provision expense to mere that of loans. At that point, rising revenue, operating leverage, and ongoing capital by dividends and buybacks we deliver mid-to-high-teen's total return for shareholders assuming no PE multiple expansions. This in a nutshell, is the longer term value proposition we see for Capital One shareholders.
With that, we will open it up for Q&A. Jeff?
Jeff Norris - Managing Vice President of Investor Relations
Thank you, Gary. We'll now start our Q&A session. It occurs to see the other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up question. If you have any follow-ups after the Q&A session, the Investor Relation staff will be available after the call. Cynthia, please start the Q&A session.
Thank you, sir. (Operator Instructions).We will take our first question from Bruce Harting with Lehman Brothers. Please go ahead.
Is the strategy on the dividend, just inform us so that when you actually have first quarterly numbers and then can you talk about the various impacts of the said years, and I imagined that the North Fork brand and balance sheet is probably the most sensitive and most likely to experience most rapid margin expansion and if you can quantify that perhaps Gary or some of the moving parts appreciated? Thanks.
Sure, Bruce I will be glad to take up both. The timing of the dividend announcement will be as normal for the dividend to be paid in February as soon as our board has met, and made that decision, it will be communicated to you.
I do understand that because the board has indicated that their intent is to start the '08 dividend level at around 25% of estimated '08 earnings, pretty tempting they have kind of multiply that number by 4 to come up with guidance, which of course Rich and I aren't giving you on this call, and the reason of course is because the degree of uncertainty in the economy.
So, I'm sure our board will be looking at the operating metrics, I've already shared with you, they will be looking at the uncertainties in the economy, and do recall that the board is not committed to a fixed payout ratio ex-post, but rather to use X and T some sort of sense of '08 outcomes is way of starting themselves on a dollar level of dividends that's consistent with our capital requirements and our commitment to deliver shareholder value.
But I would simply suggest in advance of the Board's decision that you take a look at their dividend declaration and you treat that as a commitment rather than as a forecast. With respect to the action by the Fed, Bruce, yesterday and what might come forward, looking at our balance sheet, as a whole, we are mildly liability-sensitive, perhaps not as much as some, but we are liability-sensitive, so lower rates will be mildly beneficial to us.
You won't see those results necessarily in the banking segment. You will see it at the top of the house because of the way in which we centralize the management of our net interest margin, but we should get some mild benefit at least depending on the amount of easing the Fed ultimately does.
And then, of course to the extent lower interest rates would help to avert or perhaps soften the impact of a possible recession, we would certainly expect the benefit there from lower charge-off. So, whether we get the bigger benefit from our balance sheet or from the potentially positive impact on charge-offs kind of early to say, but certainly welcome move as far as we are concerned.
Next question please?
We will take our next question from Bob Napoli with Piper Jaffray. Please go ahead.
Thank you. First question is on the credit trend at end of the quarter and then going in to we’re getting near the end of January, I mean it was a spike I think things that worse accelerating pace in December. What are you seeing or are you seeing that spike continue into January in each of your businesses or you seeing moderation or you seeing it differently and what do you think cause that sudden weakness at the end of the quarter?
Bob, it’s Gary, I’ll start with we’ve saw perhaps Richard want to talk a little bit about what we’re seeing now. Again what we saw in December was quite consistent with our expectation things that we had signal because of elevated delinquencies in flow rates for variety of reasons through the second half, but we certainly wanted to see those results come through in December before we were able to close the books and share the results that we did with you on January 10th. So nothing unexpected in those results, in fact they were quite consistent with our expectations.
In the month of January, the trends in January versus December?
Bob, we don’t have -- you maybe surprise to hear that, but the way it works in the business, we don’t have a great view mid month on the credit trends. We really, we like you really wait till the end of the month and look at the numbers. So but speaking the overall card business, when we're talking about, charge-offs going to around 7% in January. Certainly that is so to speak baking in the oven in a sense and that's pretty much charge-off math. And we're confident also of the sort of decline of that peak for the rest of the first half of the year.
Next question please?
We will take our next question from Steven Wharton with JP Morgan. Please go ahead.
Hi, Rich and Gary. I was just trying to get a better sense of where we are from a card charge-off perspective in relation to kind of your prior history in the economic outlook. I mean, we haven't really seen negative job growth yet and yet I think in the maybe the first quarter of 2003 you had card charge-offs of around 770.
I know you had a lot more denominator growth back then, but you also had a lot more subprime and I think that was also consistent with the so called diabolical spike. For those I remember that (inaudible). So, I just wonder what you thought going forward from here, if job growth does turned decisively negative I guess what's the upper range of potential U.S. Card losses.
Steve, let me make a comment about unemployment and credit, card credit, for example as we have talked about the reasonably strong relationship that exist, that we have seen in the prior two recessions with respect to this. If you look back to the last two recession, there was a key difference in that the early -- the 2001 recession was sort of an event base thing than led to sort of a rapid set of changes, whereas the 91 recessions was more probably similar to the one we have now, in a sense there's a rolling set of bad development out there.
What we have found particularly, when we have looked back at the 90, 91 recession, interestingly the credit card metrics moved six months before the -- a lot of the government metrics, and particularly the unemployment metric.
So, when we look back and track the hump from credit card delinquencies and then the hump from unemployment, the credit card preceded it by about six months and also, preceded it up and preceded it down.
Now first of all, analyzing one or two humps on a camel is a little bit risky in terms of making any definitive statements. But I kind of felt as we were going through that recession, that I remember saying that, the government should be looking more at credit card metrics as one of the indicators that belatedly they come upon.
So, I do believe that, gut feel Steve that, some of the worsening that maybe hasn't shown up in some of the unemployment metrics is already being reflected in the credit card performance that we see now.
We also have some unique things related to mix and things like that are also in our numbers. That said, of course, it would be our expectation, that if unemployment worsen significantly that, that would still have a, from here, negative effect on our credit card metrics.
Next question please.
We will take our next question from Meredith Whitney with Oppenheimer. Please go ahead.
Good afternoon. I just have one quick question. For 2008, do you expect to be profitable in your auto division?
Yes, Meredith, we are actually doing everything we can to make sure that we achieve the profitability we have been looking forward in that business by -- we are continuing to reduce our cost, as Rich said, we are going to be focused on the more profitable parts of that business and pulling back over the course of the year, in such a way that we can return to profitability, that's certainly our goal.
To return to profitability by the end and just for modeling purposes, beginning…
That's as far as go in terms of…
Well, again with the uncertainty in the credit and how these things play through and the seasonality of this business, I think it's easy to look at it for the whole year Meredith.
Meredith, the other thing I want to say that's striking as we live both the credit card business and the auto business because auto is essentially all on balance sheet, the impact of changes in the credit outlook are much more dramatic in the vertical P&L of the auto business than they are in the credit card business and of course, we have 70% of our credit assets securitized and essentially off balance sheet.
Next question please.
We will take our next question from Rick Shane with Jefferies and Company. Please go ahead.
Thanks guys, when you look at the sort of outlook for credit, I mean, you're very specific in terms of where you see US Card losses in the first half of the year, do you see that as the peak at this point, what's your view, should we expect in the back half of the year, its going to continue to rise or/and if you can sort of, layout sort of what the cases or whatever you think the outlook would be?
First of all, we have specifically not given a credit forecast for the year and when you watch our experience in, given you some guidance associated with credit, you've seen that we ourselves have been challenged to stay up with some of the changes in the economy. Let me comment, though just as a general comment, there are seasonality benefits that play out over the course of the first half of the year that been reserved themselves in the second half of the year.
So, in a typical year, you’ll see actually a higher charge-ff in the second half of the year than in the first half of the year. So, we talked a lot about how can we best help you all things through, you know the future credit environment, we don’t want to just say, well gosh, who knows how the economy is going to go.
So, we don’t want to be in the forecasting business. What we’ve done is given you our view through the window that is much more reliable for us, which is the first, is the six months that are essentially cooking in the oven of our credit card business. It doesn’t mean that we can be absolutely precise with that, but generally we can be fairly close on that, outside of that what is cooking of course are bankruptcies and recoveries that are not actually part of that process, but generally we have pretty good reliability in the window for the first six months. Beyond that it really is going to be driven by the economy and I think your views on that are probably as good as our views on that.
And Rich, that's a very fair answer and again I realized probably that's exactly why you gave first half guidance. In the lot of ways I think we are struggling with the issue that Steve brought up, which is simply, we are seeing this develop relatively rapidly and by your own admission, in ways that I don't think you certainly expected three or four months ago without arise unemployment. I mean what's your intuition here. I can't imagine that you think this will decouple from employment in the back half of the year?
My intuition I certainly believe that some of what we’re seeing is early read on economy worsening that maybe preceding metrics. I really do believe that is going on. I do think though we’re also seeing a really consumer lead worsening, which in some ways well certainly very different than the kind of sequential dynamics of what happened in the 91 recession.
So, its funny thing here, we worry all the time every day we obsessed how bad could it get and the real answer nobody knows how bad this environment could get and nobody -- and we can't tell you how higher charges-off will peak. What really does give me confidence though is when we stress tested, we feel a tremendous amount of resilience and in many ways what’s really happening here is we get a chance to see the impact of choices we’ve made for really 20 years, which is essentially what business do we want to be in and what kind of structure do we want to have essentially of our balance sheet.
And what I like, I will tell you what my intuition says, it's that the sort of the unsecured paradox. I think credit cards are in particularly good position. It's a bad place to be in general and consumer lending right now, but credit cards, the paradox have unsecured credit cards if they were underwritten solely and entirely on the basis of a customers willingness to repay and have a lot of flexibility and things like dynamic management of the portfolio as we watch our fixed secured loans and watch some of the collateral changing value and the much thinner margins and the absolutely nothing situation that you can do about them.
And again reminded, if why we are attracted to credit cards in the first place, I think this is by a considerable margin, the best place to be in a challenged consumer space right now. And then, when I look across on the bank side. In addition to buying two banks that I think had very solid underwriting in their tradition, we also were fortunate that we got a good mix geographically relative to where we are right now. So, essentially, we all brace for bad time just like you do but I think, deep down within, there's a lot of confidence about the resilience that we have.
Next question please.
And we'll take our next question from Chris Brendler with Stifel Nicolaus. Please go ahead.
Hi, thanks, Good evening, I guess, on the gross outlook, you are flat or may be shrinking little bit on card, you're definitely shrinking on auto, didn't kind of bank was going to be growing so, that means, the largest growth has been coming from GFS, how comfortable are you with the credit trends you're seeing in the GFS business, particularly the domestic installment loans business and small business?
Well, in some of our GFS businesses are benefited by macro trends where the underlying business itself is growing nicely. So, I will take -- take an example like small business card, I mean, just left to its own devices, it did inherently has a much higher growth rate for the very same credit choices that we make relative to the much more kind of material unsaturated regular old consumer card. So, I think, part of what is powering GFS is sort of inherent growth dynamics. And then, we overlay on that in the sense the same conservatism.
So, I would say overall with respect to small business card, we are pretty much doing similar underwriting choices that we're doing on the consumer card business, is just that that you can still feel throughout just an underlying growth of the business itself. Our installment loans -- our installment loan business has been super prime business. So, it's good news is, it's got very high credit quality folks, the bad news is that it's a relatively thin margin business.
So, that one we're watching very carefully and are going to be cautious on that, we have great success going on in Canada. Canada is the whole country right now is doing very well and even though as we mentioned earlier, we worry about thing spreading internationally.
We certainly feel, we're in a strong position to enjoy some growth in Canada. But overall, the real message you should take away is, we are airing on the side of caution. So, and the one hand while we are confident of our resilience, I will give you a great example as our subprime card business, that continues to perform nicely, things are coming in consistent with projections as we look at the vintages. But just out of abundance of caution right now, we just do left than we other wise would do and I think that's a prudent thing to do here.
And just a follow-up, does that mean that you are not seeing the same level of deterioration in the installment loans business. And also, can you just give us a little more color on a separate question just, a little more color on the shut down or exiting the near prime auto business. And this is an acquisition that was made relatively recently and I am surprises to you to give up on it if that's -- in case if you are doing and what's the dynamics there that's causing that decision to exit the near prime auto business?
To comment upon installments loans, I think installment loans just as a general statement is, you are seeing the kind of trends that we're generally seeing in unsecured consumer credit. So and we're taking similar measures of caution there.
In the near prime, auto space, this is a, I mean auto is a tough business. Anywhere we plan the auto space, it is a tough business. We've got quite a few scars on our back from some of the challenges in the auto business as you well know. I think one of the tough things in auto in a thin margin business, at a time when the economy is so challenged, it's really hard to do repositioning and changes of share in the business.
So the subprime business, we feel very confident about that and that feels good. We have got a lot of heritage. You remember our second stage of evolution in the auto business was in super prime, and then the last part was to kind of fill in between and go into the middle and lower parts of prime.
That has been a challenging transition and at a time when the economy is having so much challenge, and our results are so challenged, we just think the really wise thing to do at this point is to, in some sense retreat to the high ground, if you will, a very solid performing subprime business and the low risk and empirically high-performing parts of our very top-end of card.
And the other part of this whole thing, I mean of auto, excuse me. The other striking thing is we've analyzed dealer relationships, is a very big difference in the profitability between our established long time and deep dealer relationships as opposed to the, occasional flow that we get from a lot of other.
And so, part of this in a sense move to high ground, is to move to a high ground in terms of the credit spectrum, to move to high ground, in terms of the dealers that really over, with a lot of debate on this thing. We really understand that we are not getting adversely selected and half of that high ground, I think, that we are going to be in the best position to whether the current economic storm and still be position to have a strong business on the other side of that.
Next question please?
We will take our next question come from Scott Valentin with FBR Capital Markets. Please go ahead.
Good evening. Thanks for taking my question. Regards the ABS market, maybe you can talk a little about the depth of liquidity you are seeing in credit card and auto ABS and also given the more stable deposit funding you have now, maybe discuss a comparison between the return equity you can generate from keeping assets on balance sheet versus securitizing.
First Scott, just in terms of ABS, obviously, we have to look at both, credit card and auto. The market for credit ABS, obviously has been stronger and more resilient in terms of the level of activity in the depth of that market than the auto. Obviously, spreads have widened out, pretty much across the board, but given the margins in that business, it certainly doesn’t jeopardize the economics of that business.
We are in the market considerably in the fourth quarter, doing things all the way from AAA down to BBB, well over $1 billion dollars and we did two auto transactions in the fourth quarter, one prime and non-prime. I think that market is certainly more attentive now. Although we have seen some of our competitors come to market there.
We are currently, certainly, in dialogue with investors. We have now chosen to bring an issue to market yet in the first couple of weeks of the year. We wanted to see how things moved around, little bit get things get settled out. We are certainly seeing some of enquires and again we are intend on using the flexibility we build to try and make sure that we access the market on the best terms at the right time. And I expect you will be seeing us pretty active certainly on the card side over the course of the year.
In terms of Auto, again with the movement of the Auto Finance business into our bank, we certainly have choices to had fund it whether with deposits or with Auto ABS. Remember that both are on balance sheet, regardless of whether we securitize or not. Spreads are certainly more attractive, if we fund it with deposits right now, and so are you going to see a certainly a better return characteristic in a current market if we fund it with deposits and again there is no change in the capital we allocate to the business and it is on balance sheet regardless.
So again, we are quite confident that these markets will ultimately sort themselves out and we are certainly pleased that we've brought ourselves the time to be able to make sure that we don't push them any faster than we think they are ready to.
Next question please.
We will take our next question from David Hochstim with Bear Stearns. Please go ahead.
Thanks, follow-up to Chris question about auto. Is there anything else you have learned about problems create besides that adverse selection from the dealer if there are some common characteristics of bars that we ended up with or kinds of a vehicles or geography? And then, I had a follow-up.
David, basically in prime and near-prime, so keeping aside the very top part and subprime. I think generally our challenge was adverse selection and the challenges of competing and building up long enough credit histories.
And also transitioning judgmental models that clearly were not extensible into the classic Capital One risk based model. So that was particularly in sort of near-prime that was a challenge. If I would have comment in general there has been some industry risk expansion in the auto space and one of the worries that we've always had -- one of the bad things that sort of can happen to is an overly good credit environment such as we had in 2006.
In some sense all the industries are paying the consequences of in a sense some over confidence and what we saw and I think we mentioned several times over the course of last year. There has been some risk expansion pretty much crossed the boards in the auto space and it becomes a little bit the table stacks for playing its hard to say well, people structure products that way we won't offer them that way and then there is a sense nobody comes now that is the main you just go out and do it everybody else does.
But the good thing that its happening now is that practices and pricing is becoming and product structures are becoming more sensible and this is basically positioning this industry to be healthy on the other side of the other big inside David in the auto space is the housing markets correction market which is basically 25% of the country and 25% of our portfolio has certainly taken it on the chin the most.
Okay. And then I wonder and guys could you talk about any difference you’re seeing in terms of behavior in spending or credit between customers that have rewards products and the customers have done, how much of the card base by the end of the fourth quarter on rewards products?
David, I don't have an answer to your questions specifically about rewards versus non-rewards customers.
Next question, please.
We will take our next question from Brad Ball with Citi. Please go ahead.
Thanks. I'm wonder if you could comment on your deposit growth outlook, where do you expect those deposits to come from are you currently employing a campaign of higher pricing in certain markets, will you be doing more wholesale deposit growth, will come to the branches, etcetera?
Also a follow-up on Steve’s original question on US Card credit. If you look at the net charge-offs in US Cards right after the one or two recession, I think the peak was around 7.7% that was a time when your mix was much higher subprime. I think you've had 39%, subprime in the middle of 2002. So I just wonder if the different mix that you have today would lead to expect the net charge-offs peak to be below that 7.7% range or there other factors to consider? Thanks.
Brad, let me take the first question and again we are bullish on deposits, although I think its important to remind you that this is the quarter in which we will be completing the important conversion of our deposit system at the end of this quarter and certainly we’ve been so focused on making sure we get a good square footed integration and make sure that our customers see a very seamless integration that we have been sort of calibrating the timing of our rollout some of our brand work as well as some of our product policies and strategies to make sure that we are able to deliver flawlessly.
So, I think you will see a little more of that after the first quarter. Certainly, I'd also recognize that with a very rapid change in market condition, with the Fed easing very dramatically. We have had some products rolling out and some of our competitors have as well. And I think this is the time that people are watching each other to see, whether or not we're going to see the sort of continued normalization of the livewire market and what that’s going to mean for demand for deposits, whether banks will use this opportunity as we would intend to try to move down with the Fed and gets some better execution in terms of deposits.
We have got again a couple of dozen branches being built this year. We’re continuing to have good progress in our direct bank as well as our branches. So, I think that something that we believe in the current environment is going to be beneficial to us. It’s a little early to put numbers on it, but as soon as the integration is complete, I think you can expect our bank team will be going full-bore and what should be a pretty good environment to try and take advantage across all of the channels both in the branches and direct.
Okay. And let me comment about the question of, if you look back, to just kind of summarize and if we look back to the O1, O2 recession, our credit card charge-offs were in a zip code not too different from where we're saying that there are going to be in January for example. And so the question being, but didn’t hear more subprime there and, shouldn’t that have been lot higher back then.
The big difference, if you look at those numbers is the rate of growth of our assets. So, essentially there is quite, the peak was a lot higher in '02, excuse me, '03. The '02, '03 time period than now if you adjust for growth, because we're basically in an environment of essentially shrinking our portfolio today, and in an environment of very rapid growth back then.
David, last time you asked a question, when I said, well, I'm not really sure on the transactors versus kind of thinking transactors versus result revolvers. Let me actually kind of grab your question, now I make a point that I think it's an interesting one.
As we look across our portfolio and things like super-prime and subprime and different parts of the portfolio and see how they are moving right now and the trends that we see over the course of the year. Interestingly, in terms of percentage worsening, it's really similar, and of course super-prime comes off of the lower base than subprime for example. But that is definitely what we see and what we expect over the course of the coming year.
Next question, please.
And we will take our final question from Bob Hughes with KBW. Please go ahead.
Yeah, thanks for taking my question. Two questions, the first one, previously, I believe your guidance for '08, laid out late summer or early fall was for managed revenue growth to maybe slightly exceed managed loan growth. I'm curious what has changed between then and now?
I think it's pretty simple explanation, Bob, you saw a significant increase in the revenue margin through the course of 2007. So, I think that was a faster rate of revenue growth than we might have anticipated. So, we're just starting from the higher base, and as Rich indicated there are couple of things that would cause the fourth quarter of '07 to be kind of at the peak, and will come down a bit. Although, it's still at very high levels, but when you compare year-to-year, we thought it more prudent not to assume another repeat of the third and fourth quarter of 2007 in terms of the rate of growth.
Okay. And is that in part also driven by increased fee waivers et cetera and what's driving the decision to do that?
There is a couple of parts to this, the most important is the somewhat mechanical one Bob, which is that included in revenue is fees and as the estimate of losses goes up and certainly we have a higher loss outlook today than we did back in September that is going to affect the expected collect ability of those fees and those changes move in fact show up as reduction in revenue.
So again, there is a connection between credit and revenues that is very important for us to anticipate. And again, I think, keeping revenue growth in line with deposit growth is certainly our objective we thought it, we might have a slightly higher revenue growth at the time but there is still pretty much in line on an average basis over the course of the next year.
Bob, let me just also if I could just pile on here for a second. You noticed this sort of revenue changes that we made in our Card business have been a rolling set of changes that really started in the second quarter. There were some in the third quarter, there was some in the fourth quarter and there some affect in the first quarter as well.
It's all part of an overall plan but the timing of things have been different part of what's going on in our repricing is a bit of restructuring of how and where revenue we get revenues from our customers. One of that things that we use to find when we did customer research is people thought we had a knowingly the most regency waiver policy is out there and sometimes people care as much about buying gosh, I didn't get that waiver as much, waived as much as sort of overall pricing and other things.
So, what we have done and it just hasn't all happened with the same timing, has done some restructuring of where revenue is increased and where relief is provided both at what stage in the process relief is provided and also to which customers relief is provided. Because there is a lot of sort of targeted revenue benefits that we also have through this plan that we are putting in place.
The reason for the last of couple of quarters that have been kind of escalating my caution to investors don't get too carried away with the revenue benefits because an integrated plan was being ruled out over the course of actually fourth quarters.
Okay. In the follow-up Rich, I know there has been lot of discussion about credit trends, particularly in auto and specifically within the high HPA markets. Can you talk a little bit about how the credit card experience looks in those markets, is it similar or is it somehow differentiated?
The credit card experience is very similar to what we're seeing in auto. So, the only difference that I would say about, what we observed in credit card versus elsewhere is there are certain things that are happening in credit card that related to choices that we've made. Both things on the definitionally, things like modest exchange and some of the reprising, in fact those things can definitionally don't have a geographical component to it, but when we isolate for those this is very much across all our consumer lending businesses, we see this sort of, if you will the kind of HPA effect that is commonly seen.
But I do want to say also those that this is not an issue, where our customers with mortgages are having unique problems because actually we find renters and home owners tend to be following very similar patterns its just that renters and home owners in all of our consumer lending businesses renters and home owners together in the challenged housing price market are degrading in parallel and together.
Okay, Cynthia, since there are no more questions. We will conclude our question-and-answer session. I would like to thank you all for joining us on this conference call today and thank you for you interest in Capital One. Investor relations staff will be here this evening to answer any more questions you may have. Have a good evening.
Ladies and gentlemen this will conclude today's Capital One fourth quarter 2007 earnings call. We thank you for your participation. And you may disconnect at this time.
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