Capital One Financial Corporation Q2 2008 Earnings Call Transcript

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Capital One Financial Corporation (NYSE:COF)

Q2 2008 Earnings Call

July 17, 2008 5:00 pm ET


Jeff Norris - Managing Vice President of Investor Relations

Gary L. Perlin - Chief Financial Officer and Principal Accounting Officer

Richard D. Fairbank - Founder, Chairman, and Chief Executive Officer


Robert Napoli - Piper Jaffray

[David Hoppenstein] - Buckingham Research Group

Richard Shane - Jefferies & Co.

Bradley Ball - Citigroup

Brian Foran - Goldman Sachs

Scott Valentin - Friedman, Billings, Ramsey & Co.

Christopher Brendler - Stifel Nicolaus & Company, Inc.

Bob Hughes - Keefe, Bruyette & Woods, Inc.

Kenneth Bruce - Merrill Lynch

Moshe Orenbush - Credit Suisse


Welcome to the Capital One second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the call over to Jeff Norris, Managing Vice President of Investor Relations.

Jeff Norris

Welcome to Capital One's second quarter 2008 earnings conference call. As usual, we're webcasting live over the Internet. To access the call on the Internet, please log on to Capital One's website at and follow the links from there.

In addition to the press release and financials we have included a presentation summarizing our second quarter 2008 results. With me today is Richard Fairbank, Capital One's Chairman and Chief Executive Officer, and 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 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 Mr. Perlin.

Gary L. Perlin

I'll start on Slide 3 of the presentation.

Capital One earned $1.21 per share in the second quarter and $1.24 per share from continuing operations. EPS from continuing operations was down $0.69 from the year ago quarter, driven largely by higher provision expense. EPS from continuing operations was down $0.46 from the prior quarter, driven largely by lower revenues. I'll address quarter-over-quarter revenue drivers, both onetime and market related, following the rest of the highlights on Slide 3.

Non-interest expense was down $54 million from the first to the second quarter, adjusting for the onetime legal reserve release last quarter. Credit performance in the second quarter was largely in line with our expectations for a weakening economy that we laid out one quarter ago.

Our managed charge-off rate increased 19 basis points from the first quarter to 4.15%, and the 30plus delinquency rate in our managed national lending book increased 14 basis points to 4.87%.

While these credit metrics reflect modest credit pressure in the second quarter, there was a more pronounced deterioration in broader U.S. economic indicators. We assume this will translate into additional credit pressure in future quarters, causing us to increase our allowance coverage ratios and revenue suppression in the second quarter.

You may recall that we began tightening our underwriting during the first quarter of 2007 in anticipation of a weaker economy. You can see the effects of this tightening on our loan growth this quarter. Managed loans declined by $800 million as we've been more selective in originating new loans. Our originations in recent quarters have been focused on those business segments with greater resilience and lower loss profiles.

The balance sheet remains a source of strength and stability for Capital One. Our philosophy of holding significant excess liquidity and leveraging diverse funding sources is of particular value in the current environment. During the quarter we grew our readily available liquidity position by $3 billion to $33 billion as we continued to accelerate funding originally scheduled for the second half of the year into the first half. We grew deposits by $4.7 billion in the quarter and maintained continued strong access to the capital markets through $2.6 billion of credit card securitizations. Finally, after paying dividends, our ratio of tangible common equity to total managed assets increased 15 basis points to end at 6.18%.

Turning to Slide 4, I'll cover revenue trends. Our revenue and net interest margins experienced significant declines in this quarter after having risen substantially over the course of the previous 12 months due to a number of actions taken to protect the profitability of our lending businesses and to take advantage of the yield curve and fixed income credit market conditions. Our risk-adjusted margin has been declining since net charge-offs began rising in the middle of 2007. Revenue and net interest margins declined in the second quarter due to a number of onetime and seasonal events plus other drivers reflecting credit and market conditions.

I'll revenue these drivers and what they may say about future margin performance on Slide 5. I'll focus my comments primarily on the drivers of overall revenue margin because I believe the explanations for revenue margin decline are largely the same for our net interest margin as well since late fees, an important component of our national lending revenues, are included in our NIM. I would note from the outset however that margins in our local banking business actually improved modestly in the second quarter, as Rich will describe in a few moments when he reviews segment performance.

I'll start by discussing three factors that boosted our first quarter revenue margin and that either went away or were substantial lower effects in the second quarter. The first such factor is the changing interest rate environment.

Please recall the dramatic action by the Federal Reserve lowered short-term rates by 200 basis points within the first quarter. This unprecedented decline in rates in such a short period of time, coupled with the repricing lag between our funding instruments and variable rate card assets drove a temporary expansion of our first quarter margins. This temporary expansion reversed in the second quarter as the variable rate card assets repriced lower, catching up to our funding costs. Meanwhile, funding rates were little changed in the second quarter given the much more modest 25 basis point change in LIBOR. The negative effect of these interest rate movements on our first to second quarter revenue margin was approximately 30 basis points.

The second factor which boosted our first quarter margin was the seasonality of revenue in our Credit Card businesses. First quarter margin seasonality is driven by the combination of high balances entering the year at elevated delinquency status along with the seasonal paydown and delinquency curing that typically occurs during the first quarter. Second quarter margin seasonality is related to the absence of these effects, though margins typically decline to their more normal levels.

You can see these effects in some of our past year results, although I would caution you that 2007's results were distorted by the significant repricing actions we began in the second quarter of last year, which largely muted these seasonal effects. We estimate seasonality of revenue margin from credit cards to drive an approximate 15 basis point drop from the first quarter to the second.

The third factor boosting our first quarter margin was the $109 million gain in Visa stock sales, coupled with the $52 million gain on early extinguishment of some higher-cost debt. Together these onetime items added 35 basis points to revenue margin in the first quarter. In the second quarter we recognized a $45 million gain on the sale of MasterCard stock, which boosted revenue margins by 10 basis points in the quarter. Netting these onetime gains creates a quarter-to-quarter margin decline of approximately 25 basis points.

There were two factors that affected the second quarter margin more directly. The first is the increase to the investment portfolio, an offshoot of our continued focus on building liquidity in the current environment. Since these investments are much lower yielding than our loan portfolio, their inclusion in the managed asset book had the effect of lowering revenue margin by approximately 25 basis points.

The second factor affecting quarterly revenue margin is the weakening economy, which we estimate drove approximately 35 basis points of the margin drop in the quarter. When economic stress increases, more delinquent customers fail to make payments and therefore flow to the next delinquency bucket. This increase in flow rates is the primary driver of the increased level of finance charges and fees that we're not recognizing as revenue. You'll note from the first footnote to our financial tables that revenue suppression in the second quarter was some $68 million more than in the prior quarter.

While the collectibility of assessed finance charges and fees is decreased as delinquent borrowers become less likely to cure, we are also assessing less because of a decline in the number of borrowers in the early stages of delinquency. This reduction is probably related to consumers taking a more disciplined approach to managing their finances in light of the economic uncertainty. We've also taken actions over the past quarters to respond to the weaker economy, namely tighter underwriting and more aggressive collections to play a role in keeping early delinquencies lower. Additionally, the economic stimulus payments that were provided to Americans in the second quarter likely had a negative effect on late and over limit instances, although it's difficult to model this impact.

Without these mitigating factors keeping early delinquencies low, margins would have been higher but so would future charge-offs. This is, therefore, a trade-off we're happy to make.

Before moving on let me note the approximate $80 million impairment to our interest only strip valuation, which reduced non-interest income in the second quarter. This impact is included in the revenue margin described on Slide 5, reflecting the quarterly change in interest rates and credit. $42 million of the write-down relates to our U.S. Card Master Trust and was driven by the factors I just described. An additional $20 million of the IO strip impairment is related to our credit card trust in the U.K., a market which is once again experiencing increasing credit pressure, and the remainder is attributable to a variety of other securitizations, most of which are experiencing some credit pressure.

As this myriad of effects has run its course through our margin we expect revenue margin to be more stable going forward and continue to expect low to mid single-digit revenue growth in 2008. The biggest factor driving revenue growth within that range will be how credit trends play out, especially on our early delinquencies. If early delinquencies remain low, late and overlimit fees will also remain low and will come in nearer the low end of our revenue growth range. If delinquencies increase, then revenue growth will move towards the higher end of the range.

With that, let's look at non-interest expenses on Page 6. Adjusting for the $91 million legal reserve release related to the Visa IPO in the first quarter, second quarter operating expense would have decreased by $45 million versus the prior quarter. We continue to focus on driving operating efficiency across the business, and are well on our way towards meeting the target announced in the second quarter of 2007 of reducing run rate expenses by $700 million by 2009. We also expect to exceed $200 million in reduced operating expenses in 2008 versus 2007. Marketing expenses have also been declining modestly, $10 million less in the second quarter than in the first quarter, as we maintain our cautious approach to booking new loans in the current environment.

Despite reductions in marketing and operating expense, the quarterly decline in revenue caused our efficiency ratio to rise by a few percentage points. For full year 2008 we continue to expect our efficiency ratio to remain in the mid-40% range or lower. We also expect seasonality higher expenses in the second half of the year to put upward pressure on the efficiency ratio, but revenue trends will continue to be the primary driver of variation within the range.

Turning now to Slides 7 and 8, I'll discuss credit and allowance. As I mentioned earlier, credit performance in the quarter reflects both the weakening economy as well as the actions we have taken to position our business to weather this cyclical downturn. Rich will discuss credit at the segment level in more detail in a few moments. I'll discuss how these credit trends affect our allowance for loan losses on Slide 8.

Credit performance in the quarter was largely in line with the expectations we laid out one quarter ago. Based on the combination of stable delinquencies, portfolio contraction, and stable performance in the now $700 million plus runoff portfolio of Helocs originated by Greenpoint and held in other, our base allowance requirement called for a reduction of more than $100 million. However, deterioration in key U.S. economic indicators such as unemployment, housing prices, consumer confidence and inflation, continue to point to future weakening of our economy.

Given the weaker economic indicators, we are assuming credit pressure will rising in the coming quarters. We're assuming that delinquency flow rates will further deteriorate as this pressure mounts, gross charge-offs will rise, and recoveries effectiveness will degrade. Recognizing these factors results in our building rather than releasing allowance by a total of $38 million. This brings our allowance for loan losses to $3.31 billion.

Our allowance to delinquency coverage increased for most businesses as you can see on Slide 8. These rising delinquency coverage ratios are consistent with an assumption that future credit pressure will be greater than that currently being experienced by our portfolio. Our auto finance coverage ratio fell a bit in the quarter due to seasonality and the seasoning effect of a contracting portfolio. Adjusting for these effects, however, our auto finance coverage ratio also would have increased.

Our allowance now provides us the capacity to absorb the equivalent of about $7 billion in managed charge-offs over the next 12 months. While we can't make a direct linkage between the level of future charge-offs and specific levels of economic indicators, we view this scenario as consistent with the views that the U.S. is in recession.

At this point, I'll cover capital on Slide 9. Capital One continues to generate excess capital and continues to have navigated the current downturn without raising any form of capital in the market. The ratio of tangible common equity to tangible managed assets rose in the second quarter by 15 basis points to 6.18%, above our target range of 5.5% to 6%. Our regulatory capital ratios continue to be extremely strong as well, with our ratio of Tier 1 capital to risk-weighted assets at about 11.4%.

We will continue to pay our $0.375 quarterly dividend, but we currently view share buybacks as unlikely to resume until the economic outlook improves. Given the volatility and strains in the financial system these days, we expect to continue retaining excess capital despite the fact that our TCE ratio is above our long-term target range.

Moving to Slide 10, I'll cover liquidity funding. Despite the difficult market conditions, we increased our readily available liquidity position by $3 billion to approximately $33 billion in the second quarter. This liquidity is five times our capital markets funding plan for the next 12 months, a coverage ratio that has steadily risen over the last few years as you can see on Slide 10. This strong liquidity position results from our conservative liquidity management mind-set, a lower asset growth plan, and the lowest volume of maturities we have seen in many years.

Additionally, our holding company liquidity remains quite strong, with sufficient cash on hand today to cover more than two years of parent obligations, including our current stock dividend.

As I mentioned earlier, we increased our investment portfolio by $3 billion to $25 billion as we built liquidity amidst difficult capital market conditions. While this incremental liquidity does reduce our margins a bit, current spreads between the bonds purchased and CDs issued this quarter enabled this position to be put on at an above-hurdle risk-adjusted return and is not preventing us from deploying capital elsewhere. When our economic outlook improves we expect to use this excess capital and liquidity to support future loan growth.

We continue to manage our investment portfolio with no exposure to SIVs, CDOs, leveraged loans, nor any equity or hybrid exposure. Our portfolio is highly liquid and is 97% invested in AAA-rated securities.

On the funding front, the second quarter featured a significant improvement in market liquidity versus the prior quarter. We took advantage of this improvement to issue $2.6 billion of credit card asset-backed securities, largely completing our 2008 credit card issuance plan. We may opportunistically issue modest additional asset-backed funding if circumstances warrant.

[Despite] the improvement in capital markets, we once again capitalized on the strong demand for insured deposits. We grew by $4.7 billion in the quarter.

Overall, and despite the significant pressure the current environment is placing on the profitability, liquidity and capital of financial institutions, Capital One remains rock solid.

With that, I'll turn it over to Rich.

Richard D. Fairbank

I'll begin on Slide 11.

Significant cyclical headwinds drove a decline in our quarterly net income to $463 million. I'll discuss our U.S. Card, Auto Finance and Local Banking businesses over the next few slides. But before leaving Slide 11, let me make some brief comments on our International business, which is comprised of our credit card businesses in the U.K. and Canada.

Our International businesses posted $34 million in net income in the second quarter, in line with first quarter profits and up from the prior year quarter. Continued strong performance in Canada offset trends in the U.K., where the credit environment grew more challenging in the second quarter. We remain cautious about growth in the U.K. given considerable economic uncertainty there. Our U.K. loan balances continue to decline. While revenue margin in the U.K. is holding up, the lower loan volumes caused modest declines in revenue. Modestly lower revenue combined with increases in provision expense pressured our U.K. profits in the quarter.

Our Canadian credit card business continues to perform very well, with stable credit performance and solid returns. Finally, we booked a $12 million net loss in the other category. The sequential quarter decline resulted from differences in the IO valuation and onetime items that Gary mentioned earlier.

I'll discuss our U.S. Card business on Slide 12. Remember, the U.S. Card business now includes our legacy U.S. consumer card business plus our installment lending, point of sale and small business card businesses. To provide some additional context on the performance of the broader U.S. Card sub segment, we released historical pro forma credit results on July 15th along with the June monthly credit results.

Second quarter net income declined to $340 million due to continuing economic and cyclical headwinds. We're taking many actions to navigate the current downturn. We remain cautious on loan growth. We continue to focus our marketing and originations on the parts of the U.S. credit card market that we believe provide the best combination of risk-adjusted returns and losses through the cycle. We're maintaining increased intensity of collections and recovery operations, and we continue to aggressively pursue operating efficiency improvements.

Ending loans grew modestly from the prior year quarter and from the first quarter of 2008. In contrast, average loans are down modestly from the first quarter, reflecting our cautious approach to growth in the current cycle. We expect that our continued caution on loan growth will result in loan balances that are flat to slightly down in 2008.

Credit performance in the quarter was largely in line with our expectations. The 30plus delinquency rate improved in the quarter. Continuing economic pressures on delinquencies was offset by the expected curing of the temporary impact of the pricing and fee policy moves we made in the second half of last year. These offsetting effects allowed the typical seasonal improvement trends to show through in the second quarter delinquency rate.

The managed charge-off rate increased in the quarter, consistent with the low 6% range of expectations we discussed a quarter ago. The increase in charge-off rate resulted mostly from the continuing deterioration of the U.S. economic environment. We expect charge-offs for the third quarter to remain in the low 6% range, then rise to about around 7% in the fourth quarter.

We expect charge-offs to increase as a result of three factors. First, expected seasonal patterns would result in higher charge-offs levels in the fourth quarter, all else equal. Second, we've observed continued weakening in economic indicators throughout the first half of the year. The impact of economic weakening is likely to be evident in our U.S. card charge-offs in the fourth quarter. And finally, the initial impacts of the OCC minimum payment changes I discussed last quarter are expected to begin in the fourth quarter.

Non-interest expense declined on both a year-over-year and sequential quarter basis. This is the result of our continuing operating and process efficiency efforts, as well as our more cautious stance on marketing.

Revenue and revenue margin declined from the first quarter of 2008, driven by three factors. First, finance charges declined from their first quarter levels. First quarter finance charge revenue was unusually high as a result of the Fed interest rate cuts and contractual repricing lag that Gary discussed earlier. A seasonal build in our finance charge and fee suppression in the second quarter also contributed to the decline in finance charge revenue.

Second, fee revenue declined as our customers continued to adjust to the pricing and fee policy changes we implemented in the second half of 2007. We originally expected this customer adjustment to be a bigger factor in the first quarter, but we actually observed most of the effect in the second quarter. We believe that our customers have now largely adjusted to the new terms, so we expect that the temporary impacts on both revenue and credit metrics have run their course.

Third, we've seen a persistent pattern of delinquency flow rates during this economic downturn, with early stage flow rates remaining quite low while later stage flow rates have increased, as Gary talked about. The slope of delinquency flow rates has two negative impacts on revenue. First, the stable, early stage flow rates mean that loan balances moving from current to the first delinquency bucket are not increasing and therefore are not generating increased late fee revenues. Second, finance charges and fees we've already charged on balances that are at later stages of delinquency are becoming less likely to be collected, so we suppress them and reduce revenues accordingly.

We expect the revenue margin to stabilize around its current level, with some month-to-month variability for the balance of 2008. This assumes that the drivers of revenue we experienced in the second quarter persist throughout the year.

Our U.S. Card business continues to deliver solid profitability and generate excess capital for the enterprise despite cyclical credit challenges. And our U.S. Card business remains resilient and well positioned to successfully navigate near-term challenges and deliver solid results through the cycle.

Turning to Slide 13, I'll discuss our Auto Finance business. Our Auto Finance business posted net income of $34 million for the quarter. The return to profitability this quarter was driven by the seasonal improvement in charge-offs, solid revenue margins, and continuing reductions in operating costs. But looking beyond the second quarter, our Auto Finance business continues to face significant challenges from the seasoning of 20062007 origination vintages and cyclical economic headwinds.

Additionally, auto resale values are falling as a result of declining auto sales and the rapid shift in consumer preferences to more fuel-efficient cars as gas prices continue to rise. To address these challenges we took aggressive steps to retrench and reposition our Auto business last quarter, and we continue to take decisive actions to position the Auto business to deliver above-hurdle risk-adjusted returns over the cycle. We're pulling back on originations and shrinking managed loans, we're improving the credit characteristics of the portfolio, we're leveraging pricing opportunities in the face of shrinking competitive supply, and we're reducing operating costs.

Originations for the second quarter were $1.5 billion, 38% lower than the first quarter and 49% lower than a year ago. As we mentioned last quarter, we expect auto loan originations for the fiscal year of 2008 to be at least 40% lower than 2007 originations. The total auto loan portfolio shrank by $1.2 billion during the quarter and by $1.7 billion year-to-date.

By stepping back from our riskiest segments and focusing only on our best dealer customers, the credit characteristics of new originations continue to improve as evidenced by rising average FICO scores and improving loantovalue ratios. Although it's still very early and the sample sizes are small, the first few months of delinquency performance of 2008 origination vintages reflect the improved risk profile of our new bookings.

Operating expense as a percentage of managed loans improved in the quarter despite the shrinking loan portfolio, however we expect that the lower level of originations will result in continuing declines in loan balances over the course of the year, which would impact the metrics of our Auto business. For example, declining loan balances would reduce the denominator for calculations of metrics like charge-off rates, delinquency rates, and operating expenses as a percentage of loans. This would put upward pressure on these ratios, making them appear more negative than the actual trends in charge-off, delinquency and operating expense dollars.

Seasonal credit improvements helped the profitability of the Auto business in the second quarter, but expected seasonal increases in charge-offs will pressure the profitability of the business for the remainder of 2008. We believe the aggressive repositioning of the business and our continued actions to navigate the downturn will result in a substantially smaller auto business that can deliver above-hurdle risk-adjusted returns over this cycle. We're monitoring the business results closely, especially the performance of new originations, and we'll be prepared to take further appropriate actions based on the results and industry conditions we see over the next few quarters.

I'll discuss our Local Banking business on Slide 14. Results in the Local Banking business remain steady and solid even as we complete the final pieces of a major integration and launch our brand in New York. On a sequential quarter basis, loan growth was largely flat as expected runoff of residential mortgage loans offset growth in the core commercial franchise. Local Banking deposits grew modestly in the quarter, despite the planned runoff of public funds. Profits declined as the economy continued to weaken during the quarter. Profits for the quarter were $67 million. Rising provision expense in the current economic downturn is the largest factor in both the sequential quarter and year-over-year decline.

While charge-offs have increased modestly, nonperforming loans as a percentage of total loans has risen more sharply, driving an allowance build in the quarter. We also added to the allowance in the quarter based on the qualitative economic factors that Gary described earlier. With the Local Banking charge-offs rate at just 34 basis points, we continue to believe that our Local Banking loan portfolio is very well positioned and is delivering solid credit performance as compared to other banks. Credit performance is supported by our favorable mix of loans.

We've included additional detail on the composition and credit performance of our local banking loan portfolio in the press release schedules. We have relatively low exposure to construction lending, residential mortgages, and other types of lending that are being hardest hit at this stage of the economic downturn. In our $28 billion commercial loan portfolio, we have less than $3 billion in construction loans and only about half of that amount is for residential for sale construction. And although we've observed increasing risk in our legacy Greenpoint small-ticket commercial real estate loans, it is a small $2.8 billion portfolio from a business we've discontinued and it's in runoff mode.

On the consumer side, Local Banking includes about $11 billion of mortgage and home equity loans. We hold approximately $8 billion of residential mortgages which are well seasoned, low LTV first mortgages with a chargeoff rate of 36 basis points. We also have about $2.5 billion in home equity loans which are included in the branch-based home equity and other consumer category in the press release tables. The branch-based home equity portfolio is about half first liens, and has a charge-off rate around 35 basis points. The remaining $900 million of other consumer is comprised of miscellaneous consumer loans with a charge-off rate of about 3.5%.

Outside of the Local Banking portfolio we have less than $1 billion of the remaining Greenpoint home equity loans, which are held in the other category. While these loans continue to perform poorly, between reserves and marks we hold the equivalent of about a 21% reserve against future losses, and this portfolio continues to runoff.

So in total, Capital One holds approximately $12 billion in residential mortgage and home equity loans, about 8% of our total managed loans.

In addition to a favorable loan mix we have the good fortune to have our branch network and banking relationships in states and regions that are holding up well in the current downturn. Texas and Louisiana are both bolstered by the energy economy and the fact that they were never really part of the boom and bust cycle that is impacting other parts of the Sun Belt, and metro New York has a strong local economy that continues to perform well.

Net interest income improved during the quarter as net interest margin on loans and deposits increased slightly. Loan spreads have improved due to mix and better pricing in the market, while deposit pricing came down in the second quarter following the Fed's first quarter rate cuts.

Revenue was negatively impacted in the quarter by reduced volumes at Capital One Home Loans as the mortgage market continued to suffer from weak demand. In addition, Home Loans recorded a $9 million increase in its reserve for repurchases based on an increase in repurchase requests received in the quarter. Finally, we wrote down our mortgage servicing rights by $10 million during the quarter to reflect the changes in the fair value of our servicing portfolio. Without these mortgage-related items, Banking segment revenues would have shown a slight improvement from Q1 levels.

Non-interest expense declined from Q1 levels due to reduced integration costs and reductions in salary and benefit costs in the segment. Offsetting declines in operating expenses were increases in marketing expenses to support our brand launch and Q2 marketing campaign. We expect loan growth to remain flat for the remainder of 2008 as growth in commercial loans continues to offset the expected runoff of residential mortgages in the small-ticket commercial real estate portfolio.

We expect stronger Local Banking deposit growth in the second half of the year. We continue to focus on building and maintaining relationships with our commercial and small business customers, and although it's an early read, we've seen strong consumer results following our platform conversion and brand launch in metro New York.

In our Local Banking business, we're building on our recent integration and brand launch to develop and execute new growth strategies and continue the tradition of providing great customer service to our banking customers across the franchise.

Slide 15 summarizes our updated outlook for 2008. For the last three quarters we've provided guidance on key operating metrics. We've updated our expectations based on results and trends we've observed in our own portfolio and the broader economy through the first half of the year.

Specifically, in 2008 we expect a low single-digit decline in ending managed loans and double-digit growth in ending deposits. In the current economic and capital markets environment, we remain cautious on loan growth and bullish on deposit growth.

We expect low to mid single digit revenue growth. If revenue margins remain at or near second quarter levels, we'd expect to be toward the lower end of this range for the full year 2008.

We expect efficiency ratio for full year 2008 to be in the mid-40% or lower, with the quarterly efficiency ratio drifting up modestly in the second half of the year. Revenue trends will be the biggest driver of efficiency ratio. We expect 2008 operating expenses to be at least $200 million below their 2007 level.

From a credit standpoint we expect continued pressure as the economy continues to weaken. And, as Gary mentioned earlier, we expect our TCE ratio to remain above our 5.5% to 6% target range until our economic outlook improves.

I'll conclude tonight on Slide 16. Despite continuing economic headwinds, Capital One continues to deliver profits, generate capital and build resilience. As a result, we remain well positioned to navigate the current economic cycle.

As I said last quarter, it's the decisions one makes in the good times that largely determine how well one does in the bad times, and that's why, in many ways, we've been preparing for an economic downturn like this for years. We've chosen resilient businesses and avoided many of the significant exposures and risks facing other banks. Residential mortgage and home equity lending is about 8% of our total managed loans, and construction lending comprises less than 2% of our total managed loans.

We have no CDOs or SIVs, and no exposure to leveraged loans. We moved decisively to exit businesses we didn't like, such as the Greenpoint origination business. We've consistently embedded conservatism into all of our underwriting decisions. We've built and fortified our funding and liquidity, and we've completed our transformation from a capital markets dependent lender to a diversified bank.

All of these moves have put us in a strong position to successfully manage the company through today's near-term challenges.

Of course, the decisions one makes during the bad times are also critical, and we continue to act decisively and aggressively to manage the company for the benefit of shareholders in the face of cyclical economic headwinds. We've been through cycles before, and we're tapping that experience to inform and shape our actions today.

We've tightened underwriting standards across the board, and we've pulled back sharply on the most challenged housing markets in the least resilient credit segments. We've retrenched and repositioned the auto business. We dialed back to the highest ground across the business and in parts of the business, like near-prime auto, we've essentially exited entirely.

We've continuously tweaked our underwriting models to recalibrate variables that may be unstable in this environment. For example, having a mortgage in California used to be a positive risk indicator, but not anymore. We've adapted our models and approaches as the economic environment has changed. We've gotten more conservative on credit line assignments and line increases. We increased focus on collections, with earlier entry, higher intensity, and new tools.

Even as we've invested in increased collections, we've made great progress on our efforts to reduce our cost structure and improve operating efficiency to enhance our long-term competitive position and build resilience to rising credit costs.

We've further strengthened and diversified the balance sheet in the quarter, adding to our solid liquidity and capital positions. We've raised our dividend last quarter, and our TCE ratio now exceeds the top end of our target range. Our balance sheet strength and our confidence in the future capital generation of our businesses allows us to maintain our dividend while also keeping our TCE ratio comfortably above our long-term target range until our economic outlook improves.

I should note that our core tenet in underwriting is to always assume the future will be worse than the past. That doesn't immunize us from the cycle, but it does help ensure that we are well positioned to absorb the punishment of a down cycle from a capital and earnings perspective.

Our experience in the last two down cycles is that as the economy worsens, recent vintages tend to perform worse than the rest of the portfolio, so we are being extra careful with new originations in this environment.

Finally, I should note that we also believe that some of the best business tends to be generated as the downturn bottoms out and credit starts to improve. But until we see signs of the bottom, we're going to be very cautious.

Like all banks, we face significant cyclical, economic and market headwinds, but when I look at how we're positioned and the actions we're taking, I remain confident that we'll be able to navigate the near-term challenges and put our company in a position to deliver strong shareholder value through the cycle.

Now Gary and I are ready to answer your questions.

Jeff Norris

We will now start the Q&A session.

Questions-and-Answer Session


(Operator Instructions) Your first question comes from Robert Napoli - Piper Jaffray.

Robert Napoli - Piper Jaffray

My question and follow up both are tied to regulatory and accounting issues. I just wondered if you could give an update on your thoughts on the potential effects and where you think FAS 140, 146, securitization assets moving back on balance sheet, where you think that's going to end up and the effect on you. And then any thoughts you have on the regulatory adjustments potentially being made to the credit card business as a whole. Thank you.

Gary L. Perlin

I'll start with the view on the proposed change to FAS 140, and I know Rich will pick up some views about some of the other pending regulatory changes in the credit card space.

Certainly with FAS 140 we are at a situation now where we don't have an exposure draft yet and, of course, the timing is uncertain, but as you might imagine, this is important to us and we're actively engaging with those who will shape the outcome. I should say we have sympathy and understanding for the desire to improve transparency on off balance sheet vehicles and ensure there's a clear picture of financial institutions' risks to all investors.

That said, not all off balance sheet vehicles are created equal. Plain vanilla revolving credit card trusts are fully disclosed. We give monthly performance data, credit profiles and, of course, they remain firmly off balance sheet. And until we see the implementation details it will be hard to know exactly what the impact is, which is why our efforts and focus of late have been on trying to make sure that all those involved take the necessary time to make sure that all of the work is done to make sure we understand the impacts before moving to the finalization and, of course, the implementation of the new FAS 140.

There are a lot of imponderables, both on the accounting side and on the capital side. Certainly we, like you, can come up with an absolute worst case of an initial impact on the accounting and capital side. And let me just cut to the chase and say that if you took the most conservative assumption on the accounting side in terms of no grandfathering, valuing all assets at par, needing to build allowance for everything that's currently off balance sheet, and assuming that there is no regulatory relief in terms of how that's treated, put all of that together and we would be in a position of not needing to raise any common equity.

So we know, just as well as you do, Bob, and you've looked at it carefully, how to calculate the worst case, and we've done the same. But I think it's important that we recognize that there will be lots of decisions to be made that will affect the final outcome, and we certainly stand ready to work with FASB and with the regulators to try and get to the policy results that I think everybody really would like to see happen.

So that's our view on FAS 140.

Richard D. Fairbank

Bob, with respect to the proposed Federal Reserve regulations on credit card practices, the proposed Fed rule is in a comment period, and we, of course, plan to provide our feedback directly to the Federal Reserve as part of this process.

Many of the practices covered by this proposed rule are things that we have never done. Practices like universal default, double-cycle billing, but we're still analyzing the expected impact of the regulations. Our current view is that implementing the regulations as proposed would have potentially significant costs in the near term for Capital One and certainly for the credit card industry. In addition, the proposed rule likely will result in a reduction in resiliency in the industry as the ability of issuers to reprice existing balances is restricted.

On the other hand in the longer term it's very plausible that the regulations could create some competitive opportunities for Capital One. Bob, we have not been comfortable with some of the prevailing practices in certain parts of the market, like the prime revolver segment, and we have for several years sat on the sidelines of very significant portions of that entire market. So if the new regulations level the playing field we could find some sizeable opportunities to reenter parts of the market like prime revolver with practices that we think enhance customer loyalty and drive long-term profitability.


Your next question comes from [David Hoppenstein] - Buckingham Research Group.

David Hoppenstein - Buckingham Research Group

Could you give us some color and what you're seeing in terms of regional differences in spending and payment and maybe in the uncollectible fees and interest?

Richard D. Fairbank

David, certainly purchase volumes are weaker. The most striking thing that we see regionally is weakness on the credit side of the business. So delinquencies, charge-offs, recoveries, bankruptcies, these are significant, these are now above portfolio averages for the 25% of the country that is going through the boom and bust, and they are worsening at a more rapid rate.

We also do see mild effects on declining payment rates, a little bit higher relative utilization rates, although those are more modest. I don't think the primary news is really what's happening on the purchase side or in any of these usage-based metrics. The striking thing to us, again, is that folks in the boom and bust markets are certainly having a tougher time in this downturn, and we haven't seen any relief of that effect or really any recent closing of the gap between the rest of the country and their problems.

David Hoppenstein - Buckingham Research Group

Did you see any change over the course of the second quarter? Was June particularly worse than April and May?

Richard D. Fairbank

I'm not sure I can speak to June with respect to the boom and bust, but I think that when I've looked at just all the charts on annual trends, it again is this effect we've talked about for some time we certainly see.

One other effect I would say that we have seen, David, that's a little different from what we talked about last year is that the challenges consumers in the boom and bust markets are having are differentially hitting the mortgage holders more than the non-mortgage holders. Now in many ways this is intuitively plausible. It's just that we said last year in many ways it was more universal effect we saw in the boom and bust markets across mortgage holders and non-mortgage holders.

But lately we have seen actually more of the struggle concentrated with respect to the mortgage holders themselves.


Your next question comes from Richard Shane - Jefferies & Co.

Richard Shane - Jefferies & Co.

I just want to go back through something, some comments that have been made, and just try to reconcile a couple things. You made the comment that credit is generally in line with your expectations. You made the comment that you built the allowance by about $38 million during the quarter. Last quarter you said that on a next 12-month basis you expected about $6.7 billion of charge-offs or you had an allowance to $6.7 billion of charge-offs. This quarter you say $7 billion allowance over the next 12 months. And again, there's slippage because the 12 months aren't quite comparable.

Basically the implication is there's a $3 million increase in terms of allowance expectations. I'm not sure how that relates to the $38 million. But more importantly, when you look at the three quarters that are in common for those comparable periods - Q3, Q4 and Q1 of next year - is there any increase in your loss expectations for those periods, or is this entirely driven by higher expectations for Q2 in '09, which would be a huge increase on a year-over-year basis?

Gary L. Perlin

I certainly understand that every quarter that we have been talking about an allowance billed or released, and trying to relate that to an equivalent level of managed losses over the following 12 months. Remember that that is a bit of an approximate calculation because we only build allowance for the losses we expect for the loans which are on our balance sheet and therefore appropriately reported.

So, for example, in this quarter where we built allowance by $38 million but can absorb losses of an extra $300 million over the course of the next 12 months, part of the reasoning behind that - in fact, the single biggest driver - is that as of the end of the first quarter, given the capital market conditions at the time, we assumed that we would not be able to securitize any additional loans. We thought that was the appropriate and prudent assumption.

As I mentioned, we had better opportunities over the course of the quarter. We securitized $2.6 billion worth of loans, and therefore, with a higher level of securitization for a shrinking loan book, a smaller number of dollars of allowance against the reported balance sheet can actually absorb a higher level of managed losses.

So, again, we feel it's important to give you both a loss outlook through the managed number but also to give you a sense of how that might affect the allowance itself. So I think it's important to keep that in mind.

In terms of the pattern of losses that we might expect, again, as you've heard us say before, when we take a look out six months we have a relatively good view of what to expect because we've got a situation for folks who are already in the delinquency buckets, and therefore the comment that I made and you repeated about our outlook not having changed dramatically means that for the third quarter of '08, the first quarter of '08 and the first quarter of '09, our charge-off outlook hasn't changed very much. Those were already captured in the 12-month forward view at the end of the first quarter.

What we have done is to swap out Q2 '08, which we've just finished, and now we're capturing the second quarter of '09 in our 12-month outlook. And as a result, that does assume that with rising loss rates, we're simply going to have a higher level of losses in Q1 '09 than in Q2 '08, and that's the reason that we've gone ahead and increased our coverage ratios to anticipate all of that.


Your next question comes from Bradley Ball - Citigroup.

Bradley Ball - Citigroup

Gary, did you say that you did not expect to issue any credit card ABS in the second half of this year? And I wonder if you could talk about the deposit growth expectations. Are those deposits coming mostly through purchase money through Internet offerings, and what rates are you offering there and what are the implications for your net interest margin if you're purchasing those deposits through the brokerage channel?

Gary L. Perlin

With respect to our funding plan, as I said, over the course of the second quarter we were able to access sequentially better and better terms on asset-backed funding. We did a total of $2.6 billion going from everywhere at about $175 over down to $110 over. And so what we did was to accelerate to the early part of the year some of our funding plan that would have normally come later in the year.

So my point here is that we have no need to issue asset-backed securities in the second half of the year but, again, if market conditions turn favorable we'll look at our other alternatives in terms of private conduits and so forth, and we may find that it's opportunistically appropriate to go ahead and do some additional funding. But there's certainly no need to do it, and that's why I wanted to give you that update on our plan.

Part of the overall funding plan, of course, is what we expect in terms of deposit growth and Rich reiterated for you our expectations for deposit growth. And we expect that we'll be using all of our channels to grow deposits. There is, Brad, a good demand for guaranteed deposits. And we're seeing it in our branches; we're seeing it in our national direct bank. And we've also done some brokered CDs as well. I think we will be tilting more towards branch and national direct bank deposits over the balance of the year.

And as far as the terms and the price at which we're operating, if you take a look at even our brokered CDs have been, with weighted average maturities, well beyond two years. So I you have to recognize that we're being very price sensitive there and not doing anything to speak of inside of one year with the national direct bank, again, some of the longer maturities, although we have some new money market accounts that we've been putting out there.

And again we expect we're going to get some more business in the branches now that the conversion is behind us and a lot of the new products that Rich mentioned are being rolled out. You can see the prices certainly for our national direct bank on our website. And if you take a look at the results in the second quarter you'll see the deposit margins have improved. So, although we've been able to get a good volume of deposits, those have not come at the expense of margin.

Bradley Ball - Citigroup

Could you talk quickly about your strategy in the U.K.? We note that you haven't grown there for awhile and you're indicating credit conditions have gotten worse. Where do you expect the U.K. franchise to be a couple years down the road? Where do you see it positioning relative to the High Street banks?

Richard D. Fairbank

Brad, right now we are very focused on being in the most secure position possible to weather a potential storm in the U.K. And we've been in that mode for quite some time because, of course, there was a fair amount of credit pressure through insolvencies in the industry as a warm up, in a sense, for a downturn that happened a couple of years ago. And that put us even more so into a very extra cautious, only grow if we're very comfortable it's well above hurdle rate, again, some pretty tough assumptions.

So really ever since then, Brad, not a lot has happened in terms of the metrics. We've spent a lot of time working on the business and rebuilt some of the operating infrastructure and so on along the way.

We remain really pretty cautious about the U.K just looking at the U.K. environment, it's certainly challenging. Consumer indebtedness is still at record levels. And, more certainly, the declining home values, inflationary pressures are certainly something that we worry about. There are some other factors actually that make the U.K quite a bit better than the U.S. The other factor that the industry's still adjusting to is the cap on fees that was implemented over the past year or so.

So generally we're just being very cautious, make sure that we can weather the storm resiliently, but to keep our optionality on the other side of this in terms of the ability to go back and do what we have done in credit card businesses over the years.


Your next question comes from Brian Foran - Goldman Sachs.

Brian Foran - Goldman Sachs

I'm just trying to get my arms around the remaining Greenpoint exposure, and the first thing is the small ticket CRE loans, are those the loans that North Fork used to try to sell through the Greenpoint sales force?

Gary L. Perlin

Yes, the small ticket commercial loans are the same that was being done through the entire Greenpoint network on behalf of Greenpoint. Those were being originated for sale, and then we ended up holding the last couple of billion.

Brian Foran - Goldman Sachs

And then how is the NPL ratio 2.4 but the losses are at 2.7.

Richard D. Fairbank

Brian, that's a bit of an anomaly because typically what we've done with that portfolio is rather than have it go to charge-off we have sold the assets prior to that point. We just didn't happen to do any sales in this particular period, and none of the business on the portfolio actually made it to charge-off. So that's more of an anomalous performance in the quarter.

Brian Foran - Goldman Sachs

The $0.03 discontinued ops charge, is that a rep and warranty reserve or is that something else?

Gary L. Perlin

No, the $0.03, Brian, again, there was no additional rep and warranty charge for the Greenpoint book. That is in discontinued operations. So really all you're seeing there is the expenses related to maintaining that book, and also some advances on a couple of Heloc deals that had been previously securitized by Greenpoint. So that accounts for the $0.03.


Your next question comes from Scott Valentin - Friedman, Billings, Ramsey & Co.

Scott Valentin - Friedman, Billings, Ramsey & Co.

With regard to account attrition in the credit card portfolio, you mentioned low receivables growth. I'm just curious if that's targeted attrition, and if it is targeted, maybe what credit tiers you're targeting?

Richard D. Fairbank

Well, first of all, just an overall comment about our attrition, Scott even despite the change in terms and repricing actions that we took in 2007, we actually are seeing the lowest account attrition rates that we've seen in years. So we're quite positive about that.

The relatively, well, the low to negative growth that you generally see going on recently with Capital One in the Card business is a matter of just our picking our spots selectively, really one customer at a time and one segment at a time. We generally have had the least growth in the prime revolver space, and so net-net that is still - netnet our portfolio is suffering some attrition there because it's not getting replenished as we're staying out of much of that part of the marketplace because of the same issues we've been talking about for years. We don’t think the risk-adjusted returns in that market clear our own estimation of some of the risks.

But generally it's pretty much the same story we've said for a long time. This business, generally we find it resilient and continuing to be profitable. One other striking thing I'll say is that recent vintages - the universal principle that I've seen in prior downturns and I've seen in this one - that recent vintages tend to not, as the downturn really takes off, tend to not do as well as prior ones. We see that effect everywhere, but we see that effect the smallest in the Credit Card business where, again, I just think manifestation is the power of some of the underwriting choices we made and to some extent the performance of the business.

We've also, Scott, just across the board tightened up our underwriting. We have continued every quarter to raise the bar on the boom and bust markets with respect to credit policy. Within the segments that we have been in we've gone to the highest ground. And in our own forecast, even our baseline forecast, we put a worsening in and then worsen that by another 40%. So the net of all of this, it doesn't generate much growth, but I think it puts us in a very solid position to be ready for the turn in the market.

Scott Valentin - Friedman, Billings, Ramsey & Co.

Auto originations are down. I know you have talked about shrinking that portfolio as well. Is $1.5 billion, I think that's the number, is that a good number to use going forward or do you expect a further reduction in originations?

Richard D. Fairbank

That is ballpark the running rate we're going to be at, plus or minus.


Your next question comes from Christopher Brendler - Stifel Nicolaus & Company, Inc.

Christopher Brendler - Stifel Nicolaus & Company, Inc.

Just a little follow-up on the revenue margin, if you could, or revenue trends. I think you look back a little bit, you had a really good first quarter, 17% growth. All of a sudden it drops like a rock. I think you actually raised your revenue guidance last quarter from low to low to mid, and now you're saying if trends stay stable you're going to be at the low end of the range, which means that revenue margins on a year-over-year basis are going to have to fall even further from here.

What changed from the time you put the Q out in mid-May to today, I just wanted to know, of those factors you detail in the presentation, is it really just the credit performance that changed so dramatically, that late stage roll rate, or are there other factors that you didn't anticipate that caused the revenue margins to collapse so quickly. And if it is the late-stage roll rate, what do you think is causing that? Is it housing that's causing people to go from delinquency to charge-off more quickly?

Richard D. Fairbank

We're not changing our range of guidance with respect to revenue that we had last quarter, but certainly you can see our commentary relative to the very plausible conditions that could take us to the low end of that revenue range.

So let me comment on what we see happening with respect to revenue, and we're at a moment in time when I think there's a lot of moving parts and more than usual level of uncertainty about the forecasting of this number. But let's talk about a few factors.

Certainly, economic stimulus payments which, particularly in May, they came out, but they're still coming out over this period of time. I don't think anybody's got a measure of that effect but, we see in various news reports that some people are using it to pay off their credit card balances, and I think that's been a downward stimulus on the early delinquencies, which, of course, affect revenues.

A very important Capital One effect that we've been talking about for, really, I don't know, four quarters now, something like that, is the impact of our pricing and policy changes that we did last year. And if you look at the series of conversations we had in the later part of last year and every quarter in just about every conversation with Wall Street in the first half of this year we've said, look, this is a very beneficial thing to do, but it's going to put some noise into the credit metrics and into the revenue metrics. And I think we've really seen on the credit side how we deviated from the norm in the credit card industry and have pretty much now come back to the pack.

Chris, we were surprised by the lateness, how belated it seemed that the revenue effects seemed to manifest themselves. And we definitely outperformed our own expectations in the first quarter as the customers adjusting and that impact on revenue just still was stubbornly not manifesting itself. And we think, certainly importantly, that effect played out in the second quarter. Probably net-net relative to our expectations at the time we launched the pricing and policy changes, we have outperformed our own revenue expectations. But certainly there was a significant falloff between the first and second quarter with respect to that, and we believe that that thing has mostly run its course.

The other one I think is really probably the most pivotal one to talk about and one that we'll continue to talk about every quarter as we watch it unfold in this downturn is what's happening with respect to roll rates of delinquencies.

The conventional wisdom in the credit card industry I think, among outsiders, certainly, has been that when consumers worsen, it shows up as early delinquencies, then it rolls through and six months later there are charge-offs. And that there is, along the way to higher charge-offs, there's also a significant clawback or a significant, in a sense automatic resilience, if you will. And, we've spent a lot of time studying this over the years. Even before this downturn we had been more skeptical from our analysis of just how much automatic resilience there is. But certainly I would say during this downturn, I don't think we're seeing a lot of automatic resilience.

What's actually happening, Chris, is if you picture the roll rate curve, what we call the roll rate curve, which is the rate at which consumers move into each stage of delinquency, that curve has pivoted so that the rate at which they're entering the very first bucket, which is the bucket before the one you see. You see the second bucket, which is the 59 days of delinquency, but the rate at which they enter the first one is strikingly low, and that is a very important component in the total revenue equation.

And as Gary and I talked about, the rate at which they're moving between delinquency buckets into the later stages has, in fact, increased, so what's happened is the delinquency roll rate curve has actually pivoted in a sense around the very first bucket which, if anything, has actually dropped.

What this would mean is for a given level of charge-offs there's going to be less revenue certainly than conventional wisdom would have it. We are taking the interpretation that this pivot is a sustained effect and, not declaring victory from early stage positive delinquency, but in fact saying that this is probably a natural effect of how consumers are behaving in this downturn. And we see other manifestations of this effect, too. We see it on the over limit side.

I think what's going on, Chris, in consumer behavior is the consumers who can manage their finances are in fact really going to extra lengths to be very careful on all fronts. But being careful not to pay over limit fees, being careful not to get a late fee, whereas those that are well on their way to charging off are at a more distressed and less empowered situation than normal.

So I would counsel you to take our view that it's more likely that this pivoted roll rate curve will stay this way. And the one thing I want to say about clawback is I've spoken a lot about the resilience of the credit card business. There are two types of resilience. There's the - to whatever form, there's automatic resilience in the form of what we call clawback, and the other is proactive resilience. The overwhelmingly big effect is proactive resilience. You've seen it in our own book with respect to the ability to dynamically manage the portfolio, most importantly in terms of pricing, but also very much into credit line management and so on. The proactive resilience in this business is very much on display at Capital One, and is the dominant form of clawback.

Christopher Brendler - Stifel Nicolaus & Company, Inc.

It sounds like it could be housing related if you think about the last cycle that you had, people taking equity out of their house in home equity loans. If they ran into trouble, they ran into some delinquency and some hardship, they could use the house to fall back on, and now you're just not seeing that because once people get in trouble there's no other options. They're starting to - the roll rates are deteriorating in the later stages. Do you see that more in the regions with the hot housing markets, this effect, or is it nationwide?

Richard D. Fairbank

Well, the fact that we've increasingly of late seen a differential performance with respect to delinquencies and charge-offs of mortgage holders in the boom and bust markets versus the renters would suggest your hypothesis is correct. And it's very plausible.


Your next question comes from Bob Hughes - Keefe, Bruyette & Woods, Inc.

Bob Hughes - Keefe, Bruyette & Woods, Inc.

The first question relates to the allowance in the quarter. Gary, you mentioned that some of the observed delinquency trends in the quarter were a factor in reducing the base allowance requirement. I'm curious if you were able to quantify any impact on delinquencies in the quarter from stimulus checks? And the natural follow on to that is do you think that the stimulus checks did reduce delinquencies and therefore directly reduce your allowance requirements this quarter, which might serve to be caught up in the next quarter?

Gary L. Perlin

Yes. As both Rich and I have said, Bob, we'd love to be able to give you more insight on the impact of the stimulus payments. Unfortunately, it's just very hard to model. It's something out of the ordinary. Certainly one can read various accounts in newspapers and so forth on how people are using the checks. It's reasonable to believe that people are using it in a defensive way, either to purchase necessities or to manage their debts. And it's not inconsistent with the behavior we're seeing, but I don't think we can get to the point of suggesting that there's a clear correlation there.

In terms of the calculation of the allowance, again, different impacts in different businesses. So, as Rich said, with the old Greenpoint Heloc portfolio, for example, Rich described that, although at a very high level of losses, that's stabilized and that portfolio is running off pretty quickly. That's the kind of thing that would tend to have us reduce the allowance. Again, in the auto business, where we're seeing some contraction, what you can assume is that, with the allowance thing pretty stable, quarter to quarter, the contraction is more or less offsetting for any degradation that we may be seeing or assumptions on recovery rates and those sorts of things.

I think by and large if you take a look at the big drivers of loss outlook, which is in all these macro statistics, whether it's housing crisis, unemployment, consumer confidence and so forth, that is consistent with greater weakness going forward than we have seen in our portfolio up until now, and that's why you see the coverage ratios of allowance to 30-plus delinquencies going up. And it's about as good as we can do, particularly when we have to capture that back six months of the 12-month outlook, where we have to make assumptions about people who are going to charge off between months 7 and 12 who today are current. And, again, all we can do is use our best models to come up with that.

Bob Hughes - Keefe, Bruyette & Woods, Inc.

When I looked at the other segment, there was about a $4 billion increase in core deposits. Is that out of the direct bank, and where is the new online product offering's house, in the Banking segment or separately?

Richard D. Fairbank

Bob, all of the deposits that are in the other segment are deposits raised through the broker channel because that is considered a treasury instrument. It's simply a funding instrument. You would see all of the national direct bank deposits in the local banking segment, as Rich described it. But when you add them all together and you can take a look at the margins, you can see that we are obviously very proactive in managing the channels to get the best possible pricing among the various choices.


Your next question comes from Kenneth Bruce - Merrill Lynch.

Kenneth Bruce - Merrill Lynch

My question relates to your capital retention strategy. I'm hoping you might be able to add some additional clarification. You're generating capital internally, which is, frankly, a very anomalous event in the financial services world these days. You have been very capable at growing deposits, reducing receivables. Your ABS is fairly stable. Can you give us some additional insight into your decision to want to retain capital going forward please? And then I have a follow up as well.

Gary L. Perlin

Well, Ken, I think it should pretty much speak for itself. We are in the same boat as everybody else to understand that our economy is under great pressure; hard to know exactly how deeply pressured the economy gets or how long it lasts. And as a result, while our allowance obviously will reflect our view of expected losses, one can only assume that the level of unexpected losses is higher today than it was, and therefore holding capital at this point in time beyond that which is used to pay our dividend is the appropriate thing for us to do from a defensive standpoint.

But the same capital that we're holding onto today, Ken, for defensive purposes, is available to support the growth in the book that Rich described us to expect to pursue as we see the economy improving. So think of it as defensive in the short run, but it's also my need to be able to make sure that when our businesses see the opportunities to grow I don't hold them back by virtue of not having the right amount of capital for them.

Kenneth Bruce - Merrill Lynch

So in summary it's just you [inaudible] it in the short term. It gives you maybe some drag on earnings, but that's a reasonable price to pay for one, just protection on the downside, and two, the growth on the flip side of this cycle should ultimately see nice margin expansion so you don't need to borrow as much at that point?

Gary L. Perlin

Yes, drag on returns, not on earnings, but certainly a drag on returns. And as I said, even in our investment portfolio, because that capital is available to us and because of the anomalies we're seeing in the market, we've been able to generate some pretty good investment returns there. Normally we would prefer to use that capital towards the building of our loan book.


Your next question comes from Moshe Orenbush - Credit Suisse.

Moshe Orenbush - Credit Suisse

It seems like your reserving methodology, as you've rolled forward this loss over the next four quarters, you don't really assume an improving economy. So given the fact that a number of your competitors actually have worse results than you now, what is going to be the signal that it's time to start investing that capital and growing the receivables again?

Richard D. Fairbank

Moshe, from my experience of 20 years of doing this consumer lending business, I think the term we use is the inflection point. How will you - if you believe the thesis that probably the worst business is the business book during the later part of a boom and then into the down cycle and the best is that which is booked past that inflection point, I think the key indicators would be, first of all, obviously ones looking at the economy and so on, although we certainly have seen, Moshe, that a lot of times our own, say, credit card performance is an early indicator of economic indicators and not the other way around.

But we'd certainly have an eye to the economy, although my hunch is it might be a little late to the party from a metrics point of view. Obviously a big one is just looking at our own portfolio. But I think looking at recent vintages is very, very important, and the nature of positive or negative selection that we see coming right over the transom at the origination stage because what I've found over time, you don't necessarily have to wait a year to figure stuff out.

There's a lot of signs associated with the flow of applications at the point of origination that, looking at distribution of scores, looking at the credit profile, and a whole variety of metrics that we have that I think that the challenge we put out to all of our businesses, Moshe, is how will you know it when you see it, when the inflection point has come, and what are you going to do about that?

I don't think it's necessarily a universal Capital One moving at all times across all businesses. I think certainly between our commercial business in local geographies and nationally on the consumer side, these may come at different points. The key thing - my key pitch is this is asymmetrical risk until you hit the inflection point. And I think, back to Ken's question, we are best served by being extremely conservative, stockpiling capital, funding and credit capacity, if you will, to take advantage in a weaker market that comes on the other side of this.


Your next question comes from Kenneth Bruce - Merrill Lynch.

Kenneth Bruce - Merrill Lynch

Could you remind us just in terms of how the trusts are structured, at certain points in terms of either delinquency or default there is a cash-trapping mechanism. Could you just remind us maybe how that works and any levels that it would be areas to be considered in that? I know back in late '05 there were some trusts that may have triggered those outcomes.

Gary L. Perlin

Ken, it's a much longer answer than I think we should give you on the phone here certainly. The IR team can give you the details. Let me just leave you with two quick thoughts, the first of which is you can certainly look at excess spread in the trust as one good indicator of the health of the trust. And when you look at it, you'll realize that, even if you don't talk to IR tonight, you've got plenty of time to learn about it because we're nowhere close. But certainly I think it's a good time for you to make sure that we give you the fully story, and we'll be happy to do that.


And that concludes the question-and-answer session.

Jeff Norris

Thanks to all of you for joining us on the conference call today, and thank you for your interest in Capital One. The Investor Relations team will be here this evening to answer any additional questions you may have. Have a good evening.

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