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Capital One Copes as Customers Kick Habits

By Jonathan Starkey
Washington Post Staff Writer
Monday, August 10, 2009

Credit card giant Capital One Financial has traditionally made good money in fees from customers who pay late but ultimately pay up and others who rack up charges and surpass their credit limits. But during the recent downturn, some customers appear to be changing their habits.

Many have witnessed the financial turmoil and threats of layoffs and taken a more disciplined view of their finances, making sure to submit payments on time and adhere to limits. Meanwhile, a greater percentage of the balances that are falling behind are coasting all the way through the delinquency process and piling up as losses.

The pattern, not unique to any one credit issuer during the downturn, analysts say, has presented another in a series of challenges for the McLean-based company, which is already wrestling with new federal regulations that threaten to dismantle its old way of doing business.

"I think we are seeing some consumer behavior change where people are paying attention to their financial situation, keeping an eye on keeping their [credit] score intact," said Christopher Brendler, an analyst at Stifel Nicolaus. "Credit card [companies] make a lot of money on sloppy payers, people who pay you but pay you late. The worst case for credit card companies is when everyone who pays you late charges off."

Like most large financial institutions, Capital One has been rattled by skyrocketing unemployment, loan losses and general economic contraction in the last year and a half. In 2008, Capital One reported an annual loss, its first, of $46 million. In the quarter spanning April through June of this year, the company reported a loss of $276 million, its results hampered by June's repayment of $3.6 billion in federal rescue funds. If not for the repayment, for which the company recorded a $462 million second-quarter charge, the company said it would have posted a $224 million profit.

As the economy has worsened, Capital One has moved money into investments and away from loans to consumers. In the 12 months ended on June 30, the company's investment portfolio grew by $12.6 billion, while its loan portfolio grew by just $2.8 billion. The loan portfolio shrunk by $4.3 billion in the second quarter. Capital One has said that as the economy improves, it will shrink the investment portfolio and begin making more loans.

Also in the second quarter, while loans entering delinquency fell, losses in the company's domestic credit card portfolio moved to 9.2 percent from 8.4 percent.

The company expects losses to continue to mount, with unemployment projected to surge past 10 percent by the end of the year and some cardholders dealing with higher minimum payments due to a regulatory change.

Capital One has raised cardholders' interest rates to counter risk, but lower fee income has offset gains, Capital One chief executive Richard D. Fairbank said recently in a call with analysts and investors.

"The improvements in net interest income were offset by a decline in non-interest income, as we continue to see customers behaving defensively in the economic environment, spending less, exercising caution to avoid fees and working hard to remain current," Fairbank said on the call.

All of which is compounding Capital One's most significant dilemma: adapting to the changes required by the federal Credit Card Accountability, Responsibility and Disclosure Act of 2009 when provisions of the law take effect early next year.

Founded in 1988 by Fairbank and business partner Nigel Morris, Capital One revolutionized the credit card industry by using complex computer programs to micro-target customer groups and customize rates based on a cardholder's behavior. The company's techniques allowed it to build a business model around extending cards to customers with less-than-stellar credit histories, according to analysts.

As a result, the company has a large share of customers with low card limits, and Capital One relies more than its competitors on collecting fees when customers exceed their limits, analysts said. That leaves the company more vulnerable than its rivals to the new rule that customers must agree to pay "over limit" fees. Capital One, for its part, points out that it is already adjusting to lower fee income because of that defensive behavior on the part of customers.

The new card law also limits flexibility in changing cardholders' interest rates.

"The mechanics of the way they run their business have been really harmed dramatically," said Richard Bove, an analyst at Rochdale Research.

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