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Risk Profile Punishes Capital One

The market cut up its credit card stocks Wednesday after Metris (MXT) reported a diabolical second quarter and Capital One (COF) finally let on just how many high-risk customers it has.

Soaring losses, slowing growth and a debt-laden capital structure have crushed Metris' stock this year, but its second quarter was worse than even the bears had expected. The setback came a day after Capital One, one of the nation's most highly regarded lenders, shocked investors Tuesday evening by revealing that 40% of its loan book is made up of loans to borrowers with patchy credit histories -- a far higher share than analysts had estimated. Capital One had previously declined to break out the share of these so-called subprime loans, something this column had complained about.

The reports stunned an otherwise upbeat market Wednesday. Metris stock dived 38% to $3.77 and Capital One skidded 34% to $33.72. Other lenders slumped as well, with Household (HI) dropping 10% to $41.57 and little-regarded Providian (PVN) sliding 16% to $3.40.

The bad news will strengthen the view that U.S. lenders did far too much subprime lending when that risky enterprise looked profitable. The credit card issuers are now paying the consequences, as more borrowers than expected encounter difficulties in repaying their loans.

Jam and Preserves

Metris executives moved into self-preservation mode Wednesday by repeatedly asserting on a conference call that the company had solid long-term prospects and that its balance sheet was strong. But by any yardstick the company's prospects aren't good. As losses increase -- they jumped to 15% of the total loan book in the second quarter -- Metris will have to add more to its reserve, which punishes profits.

Increased funding costs also will push up expense levels. A clear indication that funding costs are rising is that deposits, a cheap source of funds, have fallen by more than $700 million since the end of last year -- almost certainly the result of regulatory pressure to cut down on federally insured deposits. At the same time, Metris will have to slow growth and, consequently, see interest income and fee revenue droop. The net effect will be higher loss ratios and much thinner margins.

All that doesn't necessarily kill off a credit company, but Metris is trading at a level that implies extinction. That's because of potential cash demands the company may have to meet. The first big cash drain could occur if Metris has to add cash to the off-balance sheet vehicles, called master trusts, that it sells its loans through. When certain profit margins on loans in the trusts sink below 5.5% over a certain period, Metris has to deposit cash with the trust.

On the conference call Wednesday, a Metris executive said that margin was 5.9%, but he played down the likelihood that the triggers would be hit. However, one of the ways that the margin falls is if losses go up; Metris officials wouldn't say on the call that losses have peaked. In fact, in June, they were 16.2% of the trust, compared with 15.8% in May. And if losses jump a few more percentage points and interest income dips, the profit margin trigger could dip below zero. If that happens, Metris would have to pay off the principal of the trust, a massive cash drain.

But the liquidity concerns don't stop there: Metris may have to find $100 million in June next year to pay back a term loan of that size that matures then. Metris executives pooh-poohed suggestions that Metris faced a liquidity crunch on the call, pointing to available funding sources. The company didn't immediately return calls seeking comment.

Quality, Job One

At first blush, Capital One's selloff would seem odd, given its increase in earnings guidance for 2002 and the fact that it beat profit expectations. But numbers weren't as clean as usual. For example, Capital One allowed its marketing expense to drop $33 million from the prior quarter. If it had kept marketing at the prior quarter number, earnings would've been 9 cents lower.

As for guidance, credit card earnings are relatively easy to manufacture, due to the fact that the accounting method used in the industry allows fast-growing lenders to book big profits upfront. And Capital One's explanation Tuesday about how it intends to keep increasing earnings appeared inconsistent to some observers. The company said that it intends to keep adding loans to highly creditworthy customers but also conceded that this market segment is getting increasingly competitive. A company spokeswoman responded: "We still have a large amount of opportunities in the marketplace."

Also, now that the company has revealed its subprime loan book to be higher than market estimates, analysts will probably start to up bad loan forecasts. The other jarring revelation in Capital One's release Tuesday was the requirement from regulators that the company improve its systems. The lender was long been considered a leader in technology. The company spokeswoman responded that Capital One's data-mining IT that it uses to find profitable borrowers is excellent, adding that the regulatory agreement concerns "internal government structures."

Capital One's "memo of understanding" with the regulators also increases expenses for Capital One. The higher bad loan reserves required by the regulators almost certainly pushed up the provision expense in the second quarter, and the cost of upgrading systems will also add to overhead.

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