Financials swooned this week as investors now seem to accept that much of the Trump program is in doubt – at least for 2017. No surprise then that yesterday large-cap financials actually closed down for the year.
In our last edition of The Institutional Risk Analyst, "Macro-Prudential Delusions: Bank Credit Outlook 2H 2017," we referred to how in April the forward guidance from Capital One Financial (NYSE:COF) caused financials to begin their swoon six weeks ago. The bank’s comments to analysts during Q1 earnings concerned prospective loss rates’ on the bank’s consumer loan book through '17.
COF is off its high of $96 per share in February and closed yesterday at $76, largely due to concerns about eroding credit quality and a failure to deliver in Washington. What gives? Short answer is that the period of artificially low loss rates c/o the FOMC is ending and investors are squirming.
The first thing to notice when starting your analysis of COF is that the majority of the bank’s loan book is in consumer loans. While the larger peers of COF tend to view credit cards and consumer lending as an important adjunct to a broader business, this bank is just the opposite.
There are two bank subsidiaries of COF, Capital One, National Association in MacLean, VA and Capital One Bank (USA), National Association, Glen Allen, VA. The risk profiles of the two banks are very different. The former earns a “A” bank stress rating from the Total Bank Solutions Bank Monitor, while the latter earns a “C” due to the high default rate on the credit card business.
Capital One Bank is about one quarter of COF’s assets and reported 721bp (7.21%) of default in Q1 ’17. Loss given default last quarter was 80%, but COF’s credit card bank boasted 1,500bp of gross spread on its loans -- not including fees. The whole company reported 300bp of default in Q1 ‘17, illustrating that COF has a far riskier portfolio than most commercial banks, large or small. The average default rate for all US banks was only about 60bp in Q1.
COF’s loan loss rate is several standard deviations above the industry average, but it is not nearly the most risky member of the credit card specialization group defined by the FDIC. Consumer lending was a traditionally hard-money, nonbank business. But COF has turned itself into one of the largest subprime consumer lending businesses after Citigroup (NYSE:C).
There are smaller niche providers of subprime credit that have loss rates and gross loan yields far above those of COF and the larger banks. But among the top 50 banks, COF is clearly an outlier in terms of business model and internal default rate targets.
By comparison, Citi’s credit card portfolio showed 125bp of default in Q1 ’17, the highest among the top four banks by assets. But then again, what COF’s team calls “commercial lending” at Capital One Bank was throwing off over 300bp of default last quarter. The industry average default rate for C&I loans is about 44bp.
Back in 2009, COF peaked at 740bp of default for the whole bank vs one third that figure for all banks. COF’s default rate for the credit card book touched 1,100bp (11%) of total loans in 2009. Obviously funding costs, which in the case of COF include core deposits as well as brokered money, are a crucial part of the model. The chart below shows COF’s gross default rate vs the large bank peer group. The red circle shows Q1 '17.
To make this subprime model work, COF and consumer lenders must make more money per dollar of assets than typical commercial banks. Adjusted operating income as a percentage of earning assets is 7.5% vs less than half that rate for the large banks in Peer Group 1. The gross yield on COF’s loans and leases is over 9% vs 4.3% for other large banks. So, for example, COF generates a net interest margin over 6% vs below 3% for most large banks.
The high yields on credit cards and consumer loans enable the bank to absorb oversize losses. COF’s provisions for loan losses are 10x the industry average, but earnings coverage of losses is far lower than for average banks, just 2x vs almost 20x for Peer Group 1. This may explain the sharp stock selloff last month following COF’s earnings warning and 50bp uptick in defaults. That said, C with a beta of 1.55 is technically a more volatile stock than COF as of yesterday’s close.
Behind the profitability, COF has a significant backstop with 13% equity to total assets. The almost $400 billion asset bank is also significantly more efficient than its larger peers. And the low double leverage at the parent level allows for accessing the capital markets to fund growth opportunities.
But the fact remains that COF is an outlier among large banks because of the high-risk nature of its loan portfolio. If you convert the 329bp (3.29%) of COF defaults into a bond rating, it comes out to a “B” rating.
The implied “B” bond rating of COF’s portfolio illustrates the deliberate business model decision that COF has made by focusing on credit cards and consumer credit. The scale below shows the approximate credit ratings breakpoints for actual credit default levels that my friend Dennis Santiago included in the original IRA Bank Monitor in the early 2000s.
Target Debt Rating/ Loan Default Rate
AAA: 1 bp
AA: 4 bp
A: 12 bp
BBB: 50 bp
BB: 300 bp
B: 1,100 bp
CCC: 2,800 bp
Default: 10,000 bp
Think about it: On a good day, the average American consumer is maybe a “B” credit in terms of a default probability, one out of 8-10. The good news is that the bank’s emphasis on consumer exposures gives COF a very short duration loan book – less than three years average life – but also more exposure at default with 150% unused lines vs credit already utilized by customers.
Even when COF has acquired other banks, the management team has tended to focus on growing the credit card book while running off other categories such as residential mortgages. The chart below shows the major components of COF’s loan book since 2011.
And even with all of the income from the below-prime loan book, COF barely manages to earn positive risk-adjusted returns in the TBS Bank Monitor, not due to the loan book but because of market exposure from the bank’s securities investments.
The big factor for investors to ponder with COF is that this 1.2 beta stock may move lower, faster than other large cap banks when default rates start to rise. Think of it as a measure of equity beta linked to loan credit quality.
If COF has 10x the default rate of other large banks now, after years of credit market manipulation by the Fed and other central banks, the downside for the stock could be considerable if our thesis about the Fed suppressing the cost of credit turns out to be correct. Only time and the FOMC can tell.