Capital One to Test Fed's 'Too Big To Fail' Cred

NEW YORK( TheStreet) - "Too big to fail" will get better definition as the Federal Reserve rules on Capital One Financial's ( COF) proposed $9 billion acquisition of ING's ( ING) U.S. online banking unit ING Direct on Monday, following a delay.

If the Fed were to reject the acquisition, which would make Capital One the fifth largest bank by assets in the U.S. to JPMorgan ( JPM), Bank of America ( BAC), Wells Fargo ( WFC) and Citigroup ( C), it would signal that the "systemically important financial institution" designation of the 2010 Dodd Frank Act may extend to a new range of large but not titanic sized U.S. lenders, putting industry consolidation in doubt. For Capital One, the deal breakup would cast a pall on its growth prospects.
Federal Reserve Chairman Ben Bernanke

The June deal is the largest U.S. bank acquisition yet to face regulatory inquiry into mergers that considers systemic risk in consolidation attempts, as post-crisis laws like the Dodd Frank Act seek to make the banking system less of a threat to the wider economy.

During the financial crisis, a string of bank failures precipitated hundreds of billions in bailouts and instability caused a near freeze of credit in the U.S. Still, the definition of what is a "systemically important" bank and what is just a large lender has not been defined by regulators, with serious implications to bank capital costs, earnings growth and M&A activity.

"This deal could be seen as a marker for what the Fed perceives is too big to fail," says KBW bank analyst Sanjay Sakhrani of the Federal Reserve's pending decision on the Capital One acquisition.

Sakhrani says that if the merger were to be blocked, it would signal that large regional lenders like U.S. Bancorp ( USB) and PNC Financial ( PNC) are also systemically important, making attempts at growth through acquisition unlikely.

A rejection would also be negative for M&A across the bank space, adds Sakhrani, who believes that the deal will be approved because, "it's a combination of two pretty simple banks that use deposits to make loans to consumers."

The Federal Reserve was expected to rule on the merger on Wednesday, but pushed a decision to next Monday. Capital One attributed the delay to a "scheduling conflict" in a statement.

On Wednesday, the National Community Reinvestment Coalition said hundreds of callers to the Federal Reserve expressed concern on the deal. The NCRC opposes the tie-up, calling Capital One a risky lender with large subprime holdings. The group has also asked for the Federal Reserve to be more transparent in its methodology for determining systemically important banks.

If the Federal Reserve were to approve a deal, it could signify that large banks without significant securities and trading operations can still make transformative acquisitions in the wake of post-crisis regulation. About what represents "too big to fail", FBR Capital Markets analyst Scott Valentin says "I think it would come down to the size and scale of the capital markets business." He expects the deal to pass because of Capital One's ability to bolster credit extension and its business of taking in deposits to make loans, or "spread based banking."

Capital One's shares have slightly outperformed the Financial Select Sector SPDR ( XLF) in 2012, even as disappointing earnings weigh on share gains. In 2011, Capital One shares significantly outperformed the sector, as it unveiled an aggressive acquisitions strategy.

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For more on Capital One shares, see the 10 most profitable bank stocks.

In December, the Federal Reserve approved PNC Financial Services' $3.6 billion acquisition of the Royal Bank of Canada's ( RBC) U.S. credit card operations, giving the first meaningful insight into how "too big to fail" may impact M&A.

The ability for PNC to add assets signals to Valentin of FBR that similar sized banks like BB&T ( BBT) and SunTrust ( STI) with modest trading operations can still pass Fed M&A tests.

However, Capital One's ING Direct acquisition is of a completely different scale than previously approved deals. The acquisition would make the McLean, Va., -based lender the fifth largest bank in the U.S. boosting from its No. 8 spot.

With ING, Capital One is trying to add liquid deposits and an online presence, which will grow its assets, while providing the liquidity to complete a $2.6 deal to buy a private label credit card portfolio from HSBC ( HBC). Those deals are expected to be a boost to Capital One's earnings, while providing a strategic entry into higher yielding assets. Both moves could one day be considered opportunistic acquisitions as European banking conglomerates sell U.S. assets to bolster their capital.

In doing diligence on its "systemically important" decision, the Federal Reserve has held three public hearings on the proposed merger and has taken comment from advocacy groups like the National Community Reinvestment Coalition.

Five of the Federal Reserve board governors will need to approve Capital One's acquisition for it to be approved. The Federal Reserve can also approve the deal subject to divestiture, lending and hiring conditions.

Capital One has said that the move will increase the flow of credit to U.S. banking customers, while also committing to investment in hiring and low-income lending. In fourth quarter earnings, Capital One Chief Executive Richard D. Fairbank said that the "game changing" deal is on track and is expected to close in early 2012.

In January, Capital One missed its fourth-quarter earnings per share estimates of $1.56 among analyst polled by Thomson Reuters, on rising noninterest expenses. Net earnings of $407 million, or 88 cents a share, declined from $697 million, or $1.54 a share, a year earlier.

Another major factor in Capital One's earnings decline was the absence of a significant release of loan losses during the fourth quarter. The company's fourth-quarter bottom line saw only a $30 million boost from a reduction in loan loss reserves, while reserve releases totaled $208 million the previous quarter.

In reaction the banks' earnings, Guggenheim Securities analyst Marty Mosby reiterated his neutral rating on Capital One, saying that his rating "has been based on COF's earnings transition to a lower base, as we expected loan loss reserve release to run out."

Mosby expects "that once COF resumes earnings per share growth, which we expect following the completion of the ING Direct and HSBC Credit Card portfolio acquisitions, stock price appreciation should return."

Capital One said that the sharp increase in fourth-quarter noninterest expenses was "primarily due to a seasonal ramp in marketing expenses and an increase in operating expenses," which included roughly $90 million in litigation expenses and $40 million in asset write downs. The fourth-quarter expense spike also included items related to the company's coming ING Direct purchase.

Capital One expects to leverage its improved liquidity in a subsequent deal to purchase HSBC's U.S. credit card portfolio for a premium of $2.6 billion during the second quarter, while raising between $750 million and $1.25 billion in common equity through a public offering of shares.

Nevertheless, Capital One reported that its total loan balances had increased 5% sequentially and 8% year-over-year, to $135.9 billion as of Dec. 31, with credit card balances and commercial loans growing 6% and 14% respectively, compared with 2010.

Analysts give Capital One a price target of $56.86 and expect the bank to earn profits of $3 bilion on sales of $19.7 billion, according to consensus estimates compiled by Bloomberg. Both Sakhrani of KBW and Valentin of FBR give the bank an "outperform" rating, with $62 and $60 price targets, respectively.

Interested in more on Capital One? See TheStreet Ratings' report card for this stock.

-- Written by Antoine Gara in New York

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