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Capital One Sinks

Merrill downgrades the stock after a guidance cut, sending it down 6%.

Updated from April 19.

Capital One

(COF) - Get Capital One Financial Corporation Report

dropped 6% Friday on a Merrill Lynch downgrade following a weak earnings showing.

The downgrade to hold from buy came a day after the credit card lender missed first-quarter profit targets and trimmed guidance, warning that its mortgage business may lose money this year.

The McLean, Va.-based bank made $675 million, or $1.62 a share, down from the year-ago $883 million, or $2.86 a share. Analysts surveyed by Thomson Financial were looking for a profit of $1.99 a share.

Capital One pointed to its December acquisition of lender North Fork, which specializes in making loans in the so-called nonprime segment of the market -- that is, higher interest-rate loans to customers with sketchy credit histories or without full documentation.

"Assuming no improvement in the unusually weak conditions now present in the secondary market for non-conforming prime mortgage loans, including Alt-A, we expect that reduced volumes and margins would result in our mortgage banking business delivering no incremental earnings for the balance of 2007," said finance chief Gary L. Perlin. "Our expectations for consumer credit to return to more normal levels and the yield curve to remain flat are unchanged. The company's core operations remain strong, and infrastructure upgrades completed in the quarter will provide opportunities to generate efficiencies and cost savings benefits in the future."

Capital One cut its full-year earnings forecast to a range of $7 to $7.40 a share, well below the $7.71 Thomson Financial analyst consensus estimate.

Merrill said the stock has become a show-me story, given that the "breadth of the margin pressure seems likely to overwhelm any credit tailwinds."

Profit for the company's "national lending" unit, which includes its mortgage, U.S. credit card, and auto finance businesses among others, fell 23% from a year earlier to $602 million due to increased charge-offs. Capital One said its "managed" loan charge-off rate in the unit rose 66 basis points from a year ago to 3.65%.

Mortgage banking reported a net loss of $12.6 million.

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Capital One said "pressures in the secondary capital markets for loans associated with non-conforming prime mortgage loans, including Alt-A," resulted in a $19 million addition to reserves and a $21 million warehouse valuation adjustment.

Capital One originated $6.8 billion of loans in the first quarter, down 13% from a year earlier.

The bank is not the only one having trouble in the Alt-A sector. Alt-A loans include option adjustable-rate mortgages, negative amortization loans and other nontraditional loans.

Late last month,

M&T Bank

(MTB) - Get M&T Bank Corporation Report

surprised investors with an earnings warning related to its Alt-A business.

American Home Mortgage


also slashed its earnings guidance earlier this month as the market for the securitization of subprime loans diminishes. The Melville, N.Y., firm also said a disproportionate share of its nonperforming loans are repurchased Alt-A loans and that it ceased offering those loans that resulted in a high proportion of repurchases.

Capital One, which is known for its eye-catching What's in Your Wallet advertising campaign, said its U.S. cards profit fell 18% from the first quarter of 2006 but rose 47% from the fourth quarter as charge-offs picked up and credit "returns to more normal" levels.

Capital One has 720 branches across New York, New Jersey, Connecticut, Texas and Louisiana.

Shares fell $4.64 to $72.70.