Fed Crackdown Threatens Earnings at Capital One

Though Capital One's fee disclosure is poor, the lender does seem to be heavily dependent on fees. The company says late fees were $260 million in the third quarter, but that number was for on-balance sheet loans only. Judging by the roughly equal amount of loans the company has off-balance sheet, total late fees on Capital One's accounts could have hit $525 million in the third quarter, according to Portales' Ryan.

As for over-limit fees, industry experts might say they should be roughly the same as late fees. But Ryan assumes they are 75% of late fees, and thus has them at $394 million for Capital One in the third quarter. That makes $919 million for late and over-limit fees combined, which is 220% of Capital One's pretax profits in the period.

And it is over-limit fees that the regulators seem most concerned about with subprime loans. Their July guidance to credit card lenders is unequivocal: "The policies of subprime lenders should prohibit or severely restrict over-limit authorization on open-end subprime accounts."

Balancing Act

If Capital One had to stop allowing subprime lenders from going overlimit, it would obviously be deprived of the lion's share of its over-limit fees. Losing one putative $29 fee on each subprime account would deprive the company of $900 million of fee revenue. Seeing as almost all that fee revenue drops straight to the bottom line, pretax earnings would be hit by a similar amount. That's around $560 million, or $2.45 a share, of after-tax earnings.

The feds are also keen to see more conservative management of subprime accounts, preventing people from borrowing more than they can repay. That would hurt late fees, too. And they are also nervous about something called negative amortization, which is when a minimum payment for a billing period is less than the amount owed in fees and finance charges on a credit card loan for that same period. When that happens, loan balances increase rather than decrease or they are kept flat by minimum payments. If a lot of Capital One's loans show negative amortization, the regulatory guidance may force the company to demand more in minimum payments. And if borrowers can't make those, the loans could go past due much more quickly than they are now, hitting Capital One's bad loan numbers.

Many investors believed Capital One's model was smart because it was keeping subprime balances low. But it appears that the goal was to keep balances low while maximizing fee revenue. The regulatory crackdown may put an end to that.

If Capital One were to make $2 a share next year, it makes little sense for the stock to be trading at current levels, even if the acquisition rumors aren't completely groundless. That's because HSBC's proposed purchase of subprime lender Household International had the British bank paying around eight times earnings. If a buyer were to pay the same for Capital One on $2 a share of earnings, the stock would be worth $16 -- half current levels.