Capital One Financial Corp.'s announcement late Tuesday that some of its standard practices had come under fire stunned Wall Street into the realization that even the good guys of specialty finance are vulnerable.
And it led to speculation that the other fair-haired card monoline, MBNA Corp., might be the next to prove fallible.
Favored by analysts for its steady quarter-to-quarter earnings growth and well-managed risk levels, Capital One, of Falls Church, Va., was the anti-Providian - a better-run version of companies like NextCard Inc. that invested more in banner ads than in risk management.
And while Capital One again showed record earnings and substantial growth in the second quarter, its earnings report was also laced with shockers.
These included the revelations that its subprime book is 40% of its portfolio, not 20% as previously understood by most analysts, and that Capital One had reached a "memorandum of understanding" with the Federal Reserve Board and the Office of Thrift Supervision. The Fed and OTS found the company's operating infrastructure inadequate to support its relentless growth.
Capital One added $247 million to its loan-loss reserves in the second quarter, and its portfolio grew by $4.6 billion in the period, to $53.2 billion. The company was compelled to change the way it reported revenue on uncollectible finance charges and fees.
Amid the alarm and a spate of downgrades from Wall Street, Capital One tried to be reassuring. It said that it had already met most of its regulatory requirements during the second quarter and that, indeed, it elected to disclose the entire matter in the first place.
Capital One's stock closed at $30.48 Wednesday, down 40%. Volume was 42.7 million shares, 15 times Capital One's daily average.
In an 8-K statement filed Tuesday with the Securities and Exchange Commission, Capital One said that the memorandum of understanding "is characterized by regulatory authorities as an informal action, that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order."
The announcement is just the latest indicator of regulators' determination to crack down on card issuers. In coming weeks, the Federal Financial Institutions Examination Council, which includes all of the bank and thrift regulators, is expected to issue examiner guidance laying out stricter account management standards.
Among other things, the guidance will force card banks to carry higher reserves by requiring that they reserve against uncollectible fee and finance charge income. Examiner guidance issued last year tightened standards for subprime portfolios and for asset securitizations.
Regulators have also said that they may consider stronger action, including the revocation of an exemption that allows banks to postpone charging off uncollectible loans.
During Tuesday's conference call, Capital One chairman and chief executive Richard D. Fairbank said its regulatory situation did not reflect its credit risk levels, as has been the case in the latest monoline disasters.
In an interview Wednesday, Mr. Fairbank underscored the distinction between his company's regulatory agreement and previous ones involving other companies. In those situations, he said, "the fundamental issue was credit quality. The regulators did not have any issues with our credit."
"I don't think regulators are fundamentally opposed to monolines," Mr. Fairbank said. "They have specific concerns about certain practices in the credit card industry, particularly in the subprime business. It happens that many of the monolines are concentrated subprime issuers. Capital One is a full-spectrum player with asset distribution that mirrors the industry average."
Last week Capital One asked the credit bureau Equifax Inc. to perform a random sampling of all card issuers' credit score distributions against Capital One's. According to Equifax, 36.6% of all industry loans fell below the Fair, Isaac & Co. score of 660 (classified by regulators as subprime), compared with 39.8% of Capital One's loans. In the superprime category of 710 and higher, 36.7% of Capital One's balances qualified, against 35.1% in the industry.
Notably, Mr. Fairbank and president and chief operating officer Nigel Morris do not receive base salaries or bonuses, but are paid strictly in stock options, which they are allowed to divest only if the stock price rises 20% every year for a period of three years. Last year, Mr. Fairbank, who is 51, made $142.2 million, and Mr. Morris, 43, $89.5 million from the sale of options that they had held since 1994.
Some analysts have raised concerns about this compensation arrangement, including Kenneth A. Posner from Morgan Stanley, who reduced his price target and long-term earnings forecast on Capital One. "The argument runs that when managers are paid with options, they attach greater value to volatility, because higher volatility makes options worth more, but that's not necessarily the case with equity investors and it's absolutely not the case with fixed-income investors," he said.
"In my opinion, not keeping the regulators absolutely happy with controls, systems, and operational risks represents a major error in judgment and execution," Mr. Posner added.
He said that the deal with the regulators "should not introduce risk" to near-term earnings but "does cause me to rethink the balance between competitive advantage and risk-taking at this company. And I feel now that there is less competitive advantage and more risk-taking in the company's strategy."
Despite the implementation of regulators' requirements, Capital One's second-quarter earnings rose 37%, to $213.3 million, from a year earlier. "We had the extra capital and earnings power to absorb these regulatory changes without any interruption in the trajectory of our business," Mr. Fairbank said.
Mr. Posner's advice to Capital One was to implement the provisions of the regulatory agreement and then "demonstrate over the next year that the rapid growth of last year has been digested without ongoing stresses in operations, credit, profitability, systems, or elsewhere."
A Capital One spokeswoman said Wednesday that regulators found fault only with the company's management structure, and not with the technology or systems that support its "information-based strategy," the model for all of its consumer lending activities. "These are bank regulators, and we are not structured like a bank, but we're going to be. That's the bottom line," she said.
Analysts said regulators probably will not be satisfied with cosmetic fixes. They "clearly don't like subprime lending, and they won't let high returns stand in their way," said Bear, Stearns & Co.'s David Hochstim, who maintained his "attractive" rating on Capital One.
Mr. Hochstim said that investors had been aware that regulators were imposing higher capital requirements and reserves. Nonetheless, he said, "There was a perception that if it hadn't happened at Capital One yet, maybe it wasn't going to happen. The company had been very successful, and regulators were satisfied with their mix of business." Arguably, he said, the way Capital One managed it subprime book was not causing it any problems.
"Basically, the regulators have created a lot of uncertainty for investors," Mr. Hochstim said. "It's very difficult to predict or anticipate what they might do next, and the market does not like uncertainty."
Even sacred cows like MBNA, prime lenders with few low FICO scores on their books, may be exposed. "There shouldn't be any change in their status, but the market is obviously nervous, and just as there was a change at Capital One, there could be a change anywhere," Mr. Hochstim said.
Reilly Tierney at Fox-Pitt, Kelton, who downgraded his rating from "buy" to "attractive," said, "The fact that these reserves were needed in the business, the fact that we didn't see this coming, that the regulatory rules are changing in midstream raises long-term questions about the sustainability of Capital One's growth rate and the business model."
Mr. Tierney lowered his ratings on MBNA, of Wilmington, Del., and on Household International - both of which had reported solid quarters - and said that Capital One's management had misled investors about how big a part of its business subprime lending had been.
"We spoke with management a couple of months ago about the fact that the government had, in our minds, arbitrarily assigned higher risk-based capital rules for Metris, Providian, and Household and why it hadn't been applied to them," he said. Capital One's response - that the government respected its financial performance and the fact that most of its growth was not coming from its subprime book - made sense at the time, Mr. Tierney said.
"The symbolism" of the regulators' action "is much more significant than the operational impact of what they're doing or any impact on Capital One," he said. "What they're saying is, 'We don't like how fast you're growing. Stop it.'"
"What this represented to us," Mr. Tierney said, "was a kind of policy decision by regulators that they don't like" the monoline card issuing business "and they want to put the clamps on its growth."
MBNA did not return phone calls by press time.
Rob Garver contributed to this article.
