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With the market nervous that

Capital One

(COF) - Get Capital One Financial Corporation Report

has a problem with bad loans, investors are paying close attention to credit-quality numbers that the credit card lender releases each month.

November's bad-loan numbers were taken on Wall Street as mildly disappointing, prompting a brief selloff. But the data would have looked considerably worse, and the stock's decline much steeper if Capital One hadn't added an extraordinarily large amount of new loans to the off balance sheet entity that reports the credit-quality data.

Any indications that Capital One's bad loans might exceed company expectations could punish the company's stock. After years of meteoric growth, the Falls Church, Va., lender has suffered through an unkind 2002.

Credit-quality fears have proven hard to dispel as bad-loan numbers have crept higher in the lackluster economy. In July, Capital One announced that the

Federal Reserve

and the Office of Thrift Supervision had asked it to enter an "informal memorandum of understanding" -- effectively a request by the regulators that Capital One address issues that concerned them. It was then that Capital One revealed for the first time that 40% of its loans were to people with poor or patchy credit histories.

And last month,

Detox suggested that a crackdown by regulators would hurt Capital One's fee revenue, a key measure because that type of income is practically pure profit. Its stock, down 41% this year, fell 32 cents to $31.93 Tuesday.

Hawthorne and Briar

Like most credit card lenders, Capital One sells a large proportion of the loans it makes to investors. It transfers the loans to an off balance sheet trust that issues bonds that are backed by the loans. Capital One makes money if the interest paid on these bonds is less than the income from the loans after bad-loan losses and other costs.

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These trusts are required by regulators to report each month how many of their loans are in default or are past due. There are about $28 billion of loans in the Capital One Master Trust, about the same as the company holds on its balance sheet.

In November, the trust reported that annualized defaulted loans were equivalent to 6.88% of total loans, up from 6.57% in October and 5.43% in November 2001. Though an increase in defaults was expected, the data did help push Capital One stock as much as 5% lower on the trading day after it was released.

But the stock slide might have been worse if Capital One had not added $2.6 billion of loans to the trust in November, an amount that far outstrips previous monthly additions. Default ratios benefit when loans are added to a trust because the additions mean that the defaults are compared with a larger number of loans. Most newly added loans won't be past due, so the change will add almost nothing to the default total.

So, if the $2.6 billion of new loans are stripped out, the default rate in the trust would've been an unpleasantly high 7.59%. If Capital One's November trust contribution had been in line with its monthly average addition for the 12 months through October -- $634 million -- the default rate would've been 7.4%. That's still not very good, and suggestive of a marked deterioration in credit quality.

Recovery Operations

Not so fast, responds Capital One. The lender says it's more appropriate to look at bad loans after recoveries on defaulted loans. This so-called net charge-off number was 5.33% in November. Without the addition of the $2.6 billion in loans, the company says it would've been 5.88%. In an email, a company spokeswoman says these two net charge-off numbers are "within Capital One expectations, and are consistent with guidance provided in October 2002." She asserts that "these figures do not reflect a quality problem for Capital One," adding that the company's "credit-quality trends come in within expectations and below industry averages."

Capital One's supporters are betting that a recovery in the economy will keep bad loans from rising too much further. But if the lender has been picking bad borrowers in order to post strong growth rates, defaults could continue to rise even if the economy doesn't slip back into recession.

Capital One watchers also are waiting with for a final version of the new regulatory guidelines on lending to people of low creditworthiness. A bank regulators' umbrella group, the Federal Financial Institutions Examination Council, is expected to release the guidance on this so-called subprime lending by the end of the year. When it comes to Capital One, the rules could inhibit the amount it charges in over-limit fees, a large source of revenue and earnings at the lender. The proposed guidance is tough, saying that: "The policies of subprime lenders should prohibit or severely restrict over-limit authorization on open-end subprime accounts."

Trans Am?

On subprime accounts, the FFIEC is particularly keen to stop the practice of negative amortization, which happens 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. As a result, loan balances increase rather than decrease or stay flat. The bear case on Capital One is that the company would have to cut back sharply on its late and overlimit fees to avoid negative amortization.

But the company responds that negative amortization from late fees can be avoided by raising minimum payments by the amount of the late fee. On the question of overlimit fees, Capital One says: "We've been in constant conversations with the regulators regarding the safeness and soundness of our business, and believe we've addressed the key issues the regulators are concerned with in our case."

When this column looked at a possible hit to earnings from the new subprime rules, it said they could cause earnings to be more than 50% below expected levels. Not so, according to Capital One. Its 2003 earnings guidance of $4.55 per share "incorporates what we believe to be the most likely scenarios that would result from final FFIEC guidance."

In other words, Capital One will remain one of the biggest bull-bear battlegrounds into 2003.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to