DBRS Confirms Capital One Financial Corporation Issuer Rating at BBB (high), Trend Stable

DBRS, Inc. (DBRS) has today confirmed the ratings for Capital One Financial Corporation and its principal subsidiaries, including Capital One Bank, (Capital One or the Company), including its Issuer & Senior Debt rating of BBB (high). The trend on all ratings remains Stable. The rating action follows a detailed review of the Company’s operating results, financial fundamentals and future prospects.

The confirmation of the ratings reflect the strength of the Capital One franchise, which is underpinned by its leading national consumer lending franchise and its growing regional banking franchise. Moreover, the Company has maintained solid asset quality metrics, especially considering the sluggish economic recovery including weak labor and housing markets. DBRS notes that Capital One’s financial profile remains sound despite several major acquisitions that have recently closed. The ratings also consider the Company’s significant exposure to the U.S. consumer and the corresponding susceptibilities to an economic downturn in the economy.

The Stable trend reflects DBRS’s view that the underlying trends in the business are favourable, but masked by the impact of the recent acquisitions. DBRS will look to Capital One’s ability to retain ING Direct USA’s deposit base and HSBC’s private label partnerships, while optimizing the enlarged retail deposit base to drive revenue growth and profitability, without adding undue risk to the balance sheet as evidence these benefits are being captured. DBRS anticipates that these benefits will become clearer over the medium-term and could result in positive rating implications. Further, while the trend is Stable, Capital One continues to face certain challenges, which include managing the impact of the still unsettled economic environment, forthcoming regulatory changes, and managing the integration risks of the acquisitions.

In 1H12, the Company completed acquisitions of ING Direct USA and HSBC’s U.S. card and retail services business, which DBRS believes will further enhance the Company’s franchise strength, especially over the intermediate term. DBRS views Capital One’s acquisition of ING Direct USA’s (ING) leading direct-banking franchise in the U.S., as a strategic fit that complements Capital One’s national consumer lending business and local bank branch business. Furthermore, the acquisition significantly bolsters Capital One’s already solid foundation in the on-line banking market, which continues to become a more important banking channel for consumers. Meanwhile, the HSBC U.S. card business acquisition deepens the Company’s card product offerings primarily through acquiring a strong private label card business, which Capital One had lacked. While DBRS sees the high yield nature of this loan portfolio as benefiting earnings, DBRS notes that private label cards traditionally have had higher loss rates than general purpose cards, and as such, DBRS will monitor Capital One’s ability to manage the risks inherent in this loan book. Moreover, although DBRS views the acquisitions as long-term positives for the Company, short-term risks include the integrating two sizeable acquisitions simultaneously in the midst of a challenging operating environment.

Capital One’s sound franchise is underpinned by the substantial scale and size of the Bank’s national credit card lending platform. At year-end 2011, Capital One was the fourth largest issuer of Visa and MasterCard in the United States. In 1H12, Company-wide purchase volume totaled $79.7 billion, a 29% YoY increase. While the increase in purchase volume includes the impact of owning the HSBC card book for two months, DBRS considers the growth in purchase volume at a time of lower overall loan balances, subdued U.S. consumer confidence and tepid economic growth as demonstrating the strength of the Capital One franchise. From DBRS’s perspective, Capital One’s franchise is further enhanced by the Company’s growing regional banking operations. Currently the sixth largest depository institution in the U.S., Capital One’s regional banking franchise complements the credit card operations by offering other consumer and commercial banking products and services. While DBRS views the growth as an overall positive for the franchise, DBRS sees the recent $205 million settlement between the Company and the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency as a reminder of the risks inherent in managing a large, complex organization.

Capital One’s underlying earnings generation remains solid and resilient. Indeed, excluding the impact from the aforementioned acquisitions the Company’s legacy businesses continue to generate solid results underpinned by strong credit performance and a growing loan book. For 2Q12, net revenues, excluding the impact of the ING and HSBC acquisitions, were 3% higher on a linked-quarter basis at $4.4 billion. Capital One’s earnings generation benefits from a strong net interest margin (NIM), sufficient fee revenues and a well-managed expense base, which provides significant capacity to absorb credit losses, while still investing in the franchise. DBRS expects earnings to improve in 2H12 and 2013, as margins expand evidencing the benefits of the higher yielding HSBC card book and the low-cost funding of the ING Direct deposit base, as well as realizing cost synergies from the recent acquisitions.

Given the uneven and below-trend economic recovery, DBRS sees managing credit costs as an ongoing challenge for any financial institution with significant consumer and small business exposure. However, demonstrating Capital One’s sound underwriting and servicing capabilities, credit performance continues to be favorable across all three business segments. Specifically, net charge-offs (NCOs) and early stage delinquencies continue to improve across all asset classes. To this end, within the $80.8 billion Domestic Card book, NCOs are below pre-recession levels and could potentially be reaching cyclical lows. DBRS expects that credit metrics in the Domestic Card portfolio will likely migrate higher reflecting the Company’s expansion into private label cards that have historically had higher loss rates. Historically, Capital One has had limited exposure to residential mortgages, but the ING acquisition included a sizable mortgage book, as well as mortgage related securities. While there have been early indications of improvement in the U.S. housing market, DBRS remains cautious regarding the sustainability of these gains given slow job growth and modest increases in household income. These risks are somewhat mitigated, however, by purchase accounting marks taken at closing on the mortgage loan book and mortgage securities.

Capital One’s sound balance sheet is underpinned by the Company’s well-managed liquidity and funding profiles, as well as solid capital metrics. Over the past several years, Capital One has leveraged its growing regional bank franchise and most recently, the ING acquisition (added $84.4 billion of deposits), to transform its funding profile to a primarily deposit funded model. Indeed, Capital One’s loan-to-deposit ratio has improved to 94.8% at June 30, 2012, from 106% at year-end 2011 and 123% at year-end 2007. Liquidity is further enhanced by the Company’s sizable liquid reserves. Meanwhile, capital remains sound despite the recent acquisitions. Specifically, at June 30, 2012, Capital One’s Basel I Tier 1 common ratio was 9.9%, a 20 bps improvement from year-end 2011 and tangible common equity-to-tangible assets was 7.4%. However, Capital One’s double leverage is high compared to its peer group at 129%, but DBRS expects this metric to improve, especially given the Company’s solid earnings generation capabilities.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Mike Driscoll
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 17 November 2005
Most Recent Rating Update: 17 August 2011

For additional information on this rating, please refer to the linking document under Related Research.