Fed Crackdown Threatens Earnings at Capital One

Much of the lender's growth has been coming from now-scrutinized fees. Plus, kicking the tires at Ford.
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Capital One's (COF) - Get Report earnings look vulnerable to a government clampdown on the credit card industry practice of repeatedly hitting borrowers with hefty penalties.

Falls Church, Va.-based Capital One has posted bubble-era earnings growth even as the economy has slowed. In the first nine months of the year, per-share earnings surged 36% from a year ago, to $2.88.

That jump was mostly attributable not to the money Capital One makes from interest income, but to the hundreds of millions of dollars in late and over-limit fees paid by borrowers. Many of those fees were charged on subprime accounts, which are loans to people with tainted or incomplete credit histories.

Now, analysts are beginning to wonder what will happen to Capital One's profitability once new federal guidelines on fees take effect. Nervous about the massive growth subprime loans, four Washington banking regulators in July together issued some tough draft guidance on how lenders should manage their credit card accounts and book their provisions against bad loans. Lenders had time to comment on the guidelines, but the regulators are not expected to change the wording significantly in the final version, which could be issued imminently.

Capital One's stock could be hit particularly hard by any reduction in the fees it takes in. Amid rumors that the company is an acquisition target, the stock jumped $3.38, or 11%, to close Thursday at $32.76.

Big Numbers

Bill Ryan, consumer credit analyst at Portales Partners, says that Capital One's 2003 earnings could fall more than 50% below expectations if the new regulations cause the lender to eliminate just one fee on each of its roughly 30 million subprime accounts. (Ryan rates Capital One a sell and his firm doesn't do investment banking.)

Down for the Count
Capital One's summer setback

Analysts expect Capital One to make $4.50 next year, but the loss of one fee per account could chop that to around $2, Ryan says, adding that the wording of the federal guidance could lead to Capital One having to dispose of more than one fee.

Capital One didn't comment.

In addition, Capital One specifically has caught regulators' attention. In July, the lender 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. The memo led to higher regulatory capital and increases to the bad loan reserve, as well as a commitment to improve management. When the action was revealed, Capital One also publicly disclosed, for the first time, that 40% of its $55 billion loan book is subprime. Both revelations whacked Capital One's once-highflying stock, which has been in the doldrums since.

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.

Kicking the Tires at Ford

Ford

(F) - Get Report

has been getting kudos in the market and the media for selling $3 billion worth of auto loans to investment bank

Bear Stearns

in a transaction that the carmaker announced Tuesday. The sale allowed the company to free up around $200 million of capital, according to a favorable account of the deal in Wednesday's edition of

The Wall Street Journal

. The capital released would otherwise have been held as a reserve against bad loans, the

Journal

said.

But without further financial disclosure, it's hard to give the sale a proper assessment -- and it may not have been the home run that investors and the business press appear to have taken it as. For example, Bear Stearns would have wanted to be compensated for the credit risk of the loans, and that would partially or fully offset any capital boost that came from releasing the loan loss reserve. Ford declined to say how much of an offset took place.

To reflect the credit risk, the loans may have been sold at a discount, but Ford didn't give that either, saying more details would be available in its 2002 annual report.

Moreover, loan sales of this type are one of the least profitable ways for lenders to make money because in selling the bonds the holder forgoes the interest income, as well as the credit risk. This loan sale shouldn't be confused with securitization, which is a sale that still gives lenders some exposure to the interest income and credit risk.

The transaction is more a sign of a company in need of liquidity. And cynics might even say that Ford wanted to be rid of its own credit risk. In other words, caveat emptor.