Capital One Financial: Is COF Just Like Other Big Banks? January 23, 2007
Capital One Financial: Is COF Just Like Other Big Banks?
"Real estate bottomed months ago."
Jim Cramer CNBC
First, some background.� For the past
several months, we've been hearing various media�pundits declaring that the worst
is over in the US real estate sector -- this even as anecdotal
reports from the credit channel indicate that fundamentals are continuing to deteriorate.
Indeed, the divergence of opinion on the housing sector is so
wide as to remind us of the late 1990s, when a growing chorus of disapproval questioned tech
stock valuations, even as the true believers refused to acknowledge the
realities in the marketplace.� The song remains the same.
The FDIC Quarterly Banking Profile released
in November reported that "the amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased by $3.4 billion (6.9 percent) during the third quarter. This is the second consecutive quarter that
noncurrent loans have increased, and it is the largest quarterly increase since the third quarter of 2001."
Nowhere is
the battle over the�condition of the
US real estate sector
more intense than in the financial media.� Last week, for example, we witnessed CNBC commentator Larry Kudlow and his free market�sidekick, Art Laffer, dispute the notion that US real estate was on the verge of a serious correction and, even if it is, that a�real estate deflation�would effect the nation's economic growth.
Even as Nouriel
Roubini of NYU's Stern business school reported that more than a dozen
subprime mortgage lenders had closed their doors in the past year and that the subprime sector
was in a state of "collapse," Kudlow and Laffer refused to concede
that�the speculative craze in US real estate�finally might�be at an end and may hurt
the economy in 2007.� Check out the comment Roubini posted�in his blog (www.rgemonitor.com
) on January 9th:
"Sub-prime mortgages have been a crucial element of the
real estate boom of the last few years. While in 1994 only 5% of mortgage
originations were subprime, in that last two years 20% of all mortgage
originations have been subprime. Note also that interest-only and payment-option
ARMS � many of which are to subprime borrowers - were 2% of loan originations in
2000; while by 2006 they accounted for 40% of loan originations. So what happens
in the subprime market is of great importance for developments in the housing
market in 2007."
Meanwhile in Barron's, we
observe another indication of the widening gulf between housing bears and
bulls.� The usually prescient Archie MacAllaster of MacAllaster Pitfield
MacKay in NY, opining in this week's Barron's Roundtable, recommended
that investors put their money into Capital One Financial (NYSE:COF
), the $150 billion bank holding
company which just completed the acquisition of North Fork Bank.��
MacAllaster waxed effusive on COF, saying that "it is deserving of a higher
multiple -- say the 12 times earnings a lot of banks sell for.� People are
starting to look at it more as a bank."
But another Barron's Roundtable regular,
Scott Black of� Delphi Management in Boston, was having none of it
and called COF "an accident waiting to happen" because of the high proportion
of subprime loans.� Noting that most of COF's mortgage�portfolio is "Alt-A," meaning
alternative documentation subprime paper, Black disclosed that Delphi had been a
holder of North Fork, but chose to sell rather than take the COF paper into the
portfolio.�
Frankly we have to side with Black when it comes to COF, not just because the subprime real estate�market
seems to be melting down, but because the subprime loan business just does
not deserve the same multiple as other banks, in any economic environment.�
Looking at the COF asset mix prior to the close of the North Fork transaction at
the end of Q3 2006, what you find is $100 billion in assets with a gross loan
yield of over 1,000 basis points, some 3.68 standard deviations ("SDs") above
the large bank�peer group, using�data from the FDIC and calculations
from the IRA bank Monitor.�
The ROA of 3.5% and ROE of 20% for
COF are likewise stellar and
well-above peer -- several SDs above peer --�but�this is precisely why we
feel that MacAllaster is wrong to compare COF with other banks,�say Bank of America (NYSE:BAC)
or Wachovia Bank (NYSE:WB
).� Note, however, that the portfolio of
COF rates out to a "B" because of the 236bp of defaults in the first nine months
of 2007, a default rate that is�6 SDs above peer.�
Below is a table showing the
accumulated gross loan yield,�default rates and weighted average
maturity�for COF and a number of larger BHCs�at the end of Q3
2006.� Notice that none of these organizations, including Citigroup (NYSE:C)��and
HSBC (NYSE:HBC),�have default rates or loan yields
even remotely comparable to those of COF.�
BHC
Loan Spread
(bp)
Loan Defaults
(bp)
WAM
(Yrs)
Bank America�
704
57
7.3
JPMorgan Chase
717
59
3.1
Citigroup
737
88
1.6
Wachovia
653
15
5.8
US Bancorp
647
37
4.0
Suntrust
621
13
4.8
HSBC
609
80
2.8
Capital One
1,024
236
2.5
Source:�
FDIC/IRA Bank Monitor
Like non-bank lenders in
the subprime sector, the reason�institutions like COF have such
high returns is to build a capital cushion for when
the economy slows and mortgage loan�default rates rise -- a lot, some times double
digit percentage defaults.� COF's capital to assets stood at 14% at the
end of Q3 2006, but�gross defaults were 570bp in 2004 and 480bp in
2005.� If the current trend continues, gross defaults for 2006 should be
just over 310bp, 35% below 2005 but still many times the average of the larger
BHCs.�
Now Archie, answer this question: does COF's 10% plus gross loan spread
make up for the fact that the gross default rate is 4x
peer?� We don't think so, especially if�the real estate market is truly headed for a
correction.
If you are going to peer COF with larger bank holding
companies, the best choices in our view would be C and HBC, both of which sport
large subprime lending portfolios and, as a result, lower PE multiples than less
risky franchises like BAC or WB.� While COF may indeed be among the best of
the subprime lenders, at least in the banking industry,�to us that means it
deserves a lower PE multiple to compensate investors for the higher risk.�
Indeed, if Nouriel Roubini is correct about the trend in the subprime sector in
2007, COF may have already seen its high market valuation for the year, directly
contrary to what MacAllaster suggested in Barron's when he noted that the 52- week range of
COF�was $69.30-$90.04.� COF closed at $79.00 yesterday in NY.�
Archie, hit the
bid.
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