The Bill Comes Due for Capital One

It loaded up on subprime accounts. Then the economy tanked

`What's in your wallet?" That's the tagline for Capital One Financial Corp.'s (COF ) lighthearted TV ads featuring yetis eager to fleece people who pay too much interest on their credit cards. Those catchy ads, along with a proprietary approach to identifying consumer credit risks, have helped make Capital One the nation's sixth-largest credit-card company, with an estimated $9.2 billion in revenues this year and 20% or more annual profit growth since 1994.

Until this year, Capital One's system appeared flawless. Using sophisticated data-mining techniques to come up with just the right rates, fees, and conditions for each customer, the company pitched a wide array of Visas and MasterCards--and had one of the industry's lowest level of bad loans. Its charge-off rate, a key indicator of credit-card company health, was only 4.36% in the second quarter, vs. a weighted average of 6.25% for the top 10 card issuers. Capital One's risk-management methods, in fact, made it a Harvard Business School case study, while BusinessWeek this year ranked it No. 47 among the top-performing public companies.

No one's handing out awards now, though. Over the past year, as rivals in the high-risk, subprime credit-card market, such as Providian Financial (PVN ), Metris (MXT ), and NextCard, ran into trouble, Capital One swooped down and scooped up many of their customers. Chief Executive Richard D. Fairbank bet that Capital One's credit-risk model could cherry-pick the best ones. The result was an explosion of subprime customers--all told, about 40% of the 8.1 million new customers Capital One added in the past year.

What Fairbank also got, though, was a blast of bad debt. Charge-offs hit 4.96% in the third quarter. Capital One expects them to reach the high 6% range in the first half of 2003, before receding.

Company execs maintain that they knew what they were doing when they decided to take on more high-risk customers. Indeed, Fairbank says that investors were warned early this year that bad debts would rise. He insists the company's risk management model isn't broken. The trade-off is what he expected: More charge-offs for higher profits. Card rates for subprime borrowers are 15.9%, vs. 8.9% for better credit risks.

Earnings did indeed jump 57% in the third quarter, to $259 million, and the company projects a 15% profit gain for 2003. But the market isn't buying Fairbank's explanation. Investors, stunned by the deteriorating credit picture, pushed the stock down 20%, to $27.85, when quarterly results were announced on Oct. 16. That followed a hair-raising drop of 40%, or $20 per share in July, after regulators, worried about the buildup of bad credit, told Capital One to boost reserves.

It isn't just the ill-timed expansion that's spooking investors. Much of their discontent can be traced to the likelihood that Capital One may lose some of its best methods for wringing out credit-card profits. The Federal Financial Institutions Examination Council (FFIEC), a coalition of banking regulators, is getting set to crack down, industry-wide, on late fees and over-the-limit charges. Why? On some subprime accounts, balances rise even when customers make the minimum payment. Regulators want to give consumers some relief.

While Capital One won't say how much it earns from such charges, Fitch Ratings analyst Thomas J. Abruzzo estimates fee income is about 50% of the company's revenue, with over-limit and late fees "a substantial part" of that. The FFIEC has not said what it plans to do. But Fairbank understands the potential impact on his business and his stock. "I empathize with investors in an [unpredictable] environment like this," he says. He believes Capital One can make up for lost fee income by raising rates and other fees and by expanding further into other markets. His targets include auto finance--where Capital One already advertises heavily on the Web--unsecured personal loans, and international credit cards.

But with regulators breathing down the company's neck, says Kathleen M. Shanley, a debt analyst at Chicago bond-research firm Gimme Credit Publications, "it would be fair to say I am skeptical the company can achieve its still-aggressive growth projections." Gimme Credit has put Capital One on its "bottom 10" list of U.S. financial companies with deteriorating credits.

So what's in your wallet? For Capital One investors, the unsettling answer lately has been "not much."

By Geoffrey Smith in Boston

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