Recent earnings guidance from Capital One Financial (COF) revealed that delinquencies on its credit card and auto loan portfolios are on the rise, and starting to show up as rising defaults. As I read this, it occurred to me that there are many similarities between the business models of Countrywide Mortgage Corp (CFC) and Capital One. Both are basically payment processing operations, attached to a bank, using cheap deposits to fund originations, and both cater to subprime borrowers. Both have relied on the debt markets to bundle loans and sell as securities to replenish working capital. And both, regardless of the efficiency of their operations, are at the mercy of larger trends in the economy, especially in their exposure to the fortunes of low-income working families.
As home prices fall, real estate equity evaporates. In the recent past, it was common for borrowers experiencing financial difficulty to borrow against the equity in their homes to pay off credit card debt, or in more urgent situations, to sell their homes to pay off delinquent mortgages and credit cards. As more homeowners find themselves in a negative-equity situation, this option becomes unavailable, and thus defaults and foreclosures rise.
Credit card processing, like mortgage servicing, works on very thin margins, usually only pennies per account per month, and when the economy is healthy, and borrowers are making timely payments, these costs are low, and profit margins are high. When delinquencies rise, collections expenses increase, and what were once inexpensive electronic payment transfers and simple check-processing become increasing hours of telephone calls between collections agents and borrowers, as well as mailing expenses on default notices, and then legal expenses, as more accounts go deeper into default.
What triggered the sudden drop in Countrywide's share price? The change from a buy to a sell rating by one Merrill analyst, perhaps, and the realization that there was nothing that could be done to change the trajectory of losses from Countrywide's servicing portfolio. And, of course, the mention of the "B" word. Countrywide was saved from bankruptcy by Bank of America (BAC), and I suspect that losses from CFC's operations will put a drag on BA earnings for years to come, and that potential would-be suitors for Capital One, should it find itself in the same boat, will be few, wary, and unwilling to pay aggressively to acquire their book, and the loss exposure that comes with it.
Disclosure: Author has a short position in COF
