It's one of the oldest tricks in the book: A company announces a big acquisition just before it hits a rough patch so that it can divert attention from its troubles and cloud its financial results.

With perfect timing, Capital One ( COF) is playing that trick with its planned purchase of southern bank Hibernia ( HIB), a deal that was announced Monday.

Capital One, arguably the nation's most aggressive credit card lender, reported a weak fourth quarter , in which it blew over $500 million on marketing and got surprisingly puny account growth in return. It was a stark sign that Capital One is finding it very hard to compete against much bigger credit card lenders, such as Citigroup ( C), Bank of America ( BAC) and J.P. Morgan Chase ( JPM).

Clearly, another quarter of worse-than-expected numbers would have sent Capital One's stock diving. Unless, of course, the company could point to something that radically changes its outlook. And the acquisition of Hibernia is supposed to do just that.

Capital One was up $2.68, or 3.6%, to $78.68 Tuesday. According to the proposed terms of the deal, Capital One is spending over $5 billion on Hibernia, which works out at 18 times earnings -- a pricey multiple for a bank, especially one with a history of blowing up like Hibernia.

To be sure, Capital One's bashers have a number of reasons to be slightly less negative after the deal. Most important, buying Hibernia will effectively drive down Capital One's cost of borrowing, which is currently above levels of its main competitors. Retail banks like Hibernia are able to amass deposits, which are then used as low-cost funding for loans. Till now, Capital One has had to rely on a mixture of higher-cost deposits and selling loan-backed bonds as its main funding sources.

In a presentation that explained the deal, Capital One said that its interest-bearing liabilities cost 4.24% and its deposits 4.15%. But after the Hibernia deal, it estimates that its interest-bearing liabilities will fall in cost to 3.70% and its deposit cost will drop to 2.98%. Given that marketing is such a massive cost for Capital One, any fall in the price of its funding is welcome. The other positive thing about this deal is that Capital One gains entry into branch banking in markets that are somewhat underserved by banks, particularly Texas.

However, nothing about the deal is likely to change the huge flaw that will ultimately cause Capital One to crater: its heavy use of late and over-limit fees. History shows again and again that lending companies that use punitive tactics don't do well over time. Two good examples come to mind. First, the old Conseco, which charged insufferably high interest rates on loans for mobile homes. The company filed for bankruptcy in late 2002 primarily because of problems in its lending arm. Second, there was Household International, a huge and often ruthless consumer lender that ended up getting bought by the U.K.'s HSBC ( HBC) at the end of 2002 when it went through a weak patch.

A Capital One fan could argue that because the Hibernia deal means lower-cost funds, the company can reduce its reliance on penalty fees on the asset side, and thus maintain margins. In theory, that could happen -- but that underestimates just how dependent Capital One is on hitting its borrowers with fees.

Bill Ryan, consumer finance analyst at New York-based Portales Partners, estimates that between 100% and 200% of Capital One's pretax earnings come from fees. Ryan has a hold rating on the stock, and his firm hasn't done investment banking with Capital One.

In other words, the company exists not to supply credit that can be paid back on time, but to supply credit that can't.

No Capital One fan has really dared to rebut the penalty-fee argument. Capital One consistently masks the true level of fees it receives by burying fee data in lines of its income statement that include other items.

When a lender relies so heavily on fees, it often happens that its borrowers' outstanding principal rises even after they've made minimum payments. That's because the minimum payment is exceeded by the newly added penalty fees. When balances don't go down for this reason, it's called negative amortization. Capital One avoids helpful disclosure on negative amortization. When asked on a conference call in January about negative amortization, Capital One CFO Gary Perlin conspicuously didn't say how many of its accounts were affected.

The added problem for Capital One is that banking regulators have introduced new lending guidelines that are designed to reduce negative amortization in the banking industry. The banking authorities dislike the practice in principle, because it traps borrowers. Regulators at both the federal and state levels are feeling pressure from politicians and groups who believe negative amortization is usurious.

Regulators also dislike negative amortization because it also helps banks mask the true level of bad loans. If borrowers had to make minimum payments that were high enough to actually pay down their balances, many of them would default because the payments would be too high. In the buoyant credit environment of the past seven years, bad loans haven't been a big problem, but a crunch could be far worse than expected at a lender that has a lot of loans on its books with negative amortization.

And it is absolutely certain now that Capital One can forget about any continued lenience from its main banking regulator, the Federal Reserve. The last thing the Fed wants is Capital One using low-cost funds raised at Hibernia being used to fund a penalty-fee model. If the regulatory threat has not been too much to worry about up to now, it will be now after the proposed Hibernia deal.
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 peter.eavis@thestreet.com.

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