Capital One Financial Corp (COF) 2002 Q2 法說會逐字稿

Good afternoon. My name is Mitch. And I will be your conference facilitator today. I would like to welcome everyone to the Capital One conference earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer period. If you would like to ask a question, press star and the number 1 on the key pad. Please limit yourself to asking only one question. If you would like to withdraw your question, press star and the number 2. Thank you. I would now like to turn the conference over to Mr. Paul Paquin, Vice President of Investor Relations. Sir, you may begin your conference.

Thank you very much, Mitch.

Welcome everyone to Capital One's second quarter 2002 conference call. As usual, we are webcasting live over the internet. For those of you who would like access to the call on the internet, please log on to Capital One's's home page at www.capitalone.com and follow the links from there. The statements made in the course this conference call, that mention the companies or managements, hopes, intentions, beliefs, expectations or predictions of the future are forward-looking statements. It is important to note that the actual results, could differ materially from those in such forward statements. Additional information that concerns factors to cause actual results to differ material from those in the forward-looking is contained in the SCC filings including, but not limited to the company's report on form 10K, and the report of form 8K that we filed earlier this afternoon. Our website at www.capitalone.com contains all of the SEC filings, as well as our annual reports, quarterly earnings information, and monthly [INAUDIBLE] securitization performance data. The investor relation staff will be available after the conference call this evening to answer any remaining questions. When you call, you can ask for Jim Rothberg or me. We appreciate any comments you have regarding the conference call and any suggestions on improvement on future calls. With me today is Mr. Richard Fairbank, our Chairman and Chief Executive Officer. Mr. Nigel Morris, our President and Chief Operating Officer, and Mr. David Willey, our Executive Vice President and Chief Financial Officer. At this time, I'll pass the call over to Mr. Fairbank for his remarks. Rich?

Thank you, Paul. And thank you to all of you for joining us on the call today. This quarter is a particularly newsworthy quarter for three reasons. One, we are announcing record financial performance. Two, we are raising earnings guidance for 2002, and three, we just completed a routine, but very thorough examination by our regulators. Let me start with the examination. Coming out of this exam, we expect to have an informal memorandum of understanding with our regulators, covering capital, allowance and reserves, and systems and control. In the second quarter we have implemented levels of capital and allowance in reserves that satisfy the understandings we expect to have with the regulators. As a result our earnings guidance and the future outlook for our business that we are sharing with you today, takes all this regulatory developments fully into account. Before I cover the details of the understanding we expect to reach with our regulators, let me first put a few things in context.

First, what exactly is a memorandum of understanding, or what is commonly called an MOU? It is an informal, non public document that bank regulators use to reflect a good faith understanding, between the regulators and the banking institution to make sure there is clarity about the actions the banking institutions is taking to address the issues the regulators care about. An MOU is typically used when the regulators believe that management of the institution can fully address the issues, and circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order. Second, the regulatory climate for credit card lenders has changed considerably in recent months. A number of our competitors have experienced financial stress due largely to the failure to manage credit properly and several have entered into formal written agreements with their regulators, and indeed one has been put into receivership. Federal bank regulators have adopted and been have been applying more vigorously of late, examiner guidance that increases the capital, allowance, and reserve requirements for consumer lenders. Particularly for credit card lenders and institution that is engage in subprime lending. Under their subprime lending guidelines, bank regulators can require banking institutions to hold as much as 300% of the total capital charge that would otherwise apply to subprime loans in the bank's marketing programs that specifically target subprime customers. They also call for an allowance against subprime loans sufficient to absorb twelve months of future losses. As as a general guideline the regulator....as general guideline the regulator views any bank customer with a [INAUDIBLE] score or FICO score of 660 or below as subprime. Nigel will address FICO scores in greater detail in a few minutes.

The bank regulators also have issued recently an advisory that will require all credit card lenders that engage in securitization transactions, To hold significantly higher levels of regulatory capital against a residual interest known as an accrued interest receivable beginning at December 31st of this year. With this background, let's talk about the understandings we expect to reach with our regulators. Let me be very clear. The understanding we will have with our regulators is not about credit risk. We have always maintained a highly disciplined approach to credit risk management. The first area under the MOU is capital. The regulators have asks us to change the way we apply the subprime lending guidelines to our portfolio. We fully adopted this change in the second quarter. For purposes of the subprime lending guidelines, we will treat as subprime, all loans in our banks and our thrifts targeted subprime programs to customers with a FICO score of 660 or below. We will hold on average 200% of the total risk based capital charge that would otherwise [INAUDIBLE] to [INAUDIBLE] aspect. We have fully met these new capital requirements. Both the bank and the thrift exceed the requirements of a well capitalized institution as of June 30th, 2002, after applying the subprime lending guidelines. The next area is allowance. We have also adopted this definition of subprime loans, for purposes of our allowance for loan loss calculations. In the second quarter we added $247 million to our allowance, and hold allowance against subprime loans at an amount sufficient to absorb 12 months of future losses. Another area is finance charge and fee reserve.

You may recall that we were among the first in the industry to create a reserve to cover that portion of finance charges and fees that we deem un-collectable. The second quarter we enhanced our model for determining this reserve, and we believe that as of June 30th, we fully meet all regulatory guidelines is reserved. Going forward, we will continue to maintain capital, allowance and reserves at level that is will fully meet all applicable regulatory guidelines. We expect to maintain capital at the bank and the thrift at levels that provide a significant cushion above the regulatory, well capitalized definition. Based on our current plans for managed loan growth of about 20-25% in 2003 which I will discuss a little later. We do not see a need to raise additional equity capital through 2003. The final category is systems and controls. The regulators have noted that due to our rapid historic growth rate and to support our future growth, we need to enhance our management information's systems, adopt a more formal internal governance process, and improve the documentation of our policies and procedures to insure that our control environment is appropriate for our future plans and growth. We fully embrace the need to address these issues, and will be investing in our infrastructure to build this in the future.

The actions we have taken in the second quarter to strengthen the balance sheet with additional capital, allowance, and reserves, and the actions we will take to build more robust systems and controls, will make us a much stronger company and position us well for future growth. Now let me report on the quarterly results. The record earnings performance of $.92 a share is driven by a 42% year over year increase in total revenues. A 10% decline in operating costs per account, and another strong quarter of credit performance. The record earnings are on top of a near record $320 million in marketing, and a record $247 million addition to our loan loss allowance in the second quarter. Also in the second quarter we sold $1 billion of auto loans, with servicing retained for a gain of $10.7 million after tax. These sales completely remove the auto loans from the managed portfolio. We plan to sell some of our auto loan originations on an ongoing basis. The competitive and marketing environment we face at Capital One is mixed. On the positive side, interest rates continue to be low and we are able to market not only lowest in the nation pricing in cars, installment loans and auto loans, but also at price levels consumers haven't seen in many years. The low rates help give us a great marketing story. Another positive is the pricing environment in auto finance and in UK card has eased due significantly to some backing off by our competitors. On the negative side, we have seen record levels of mailings in the U.S. card business. After several years of being virtually left alone in the sub-10% fixed rate card market, four of our competitors, interestingly, dropped their pricing to 9.9% in the same month in February. Some are selectively pricing at 8.9%. Now we are predominantly at 7.9 and 8.9%. But it's clear that our competitors are feeling the need to close the gap. However, we still maintain a price advantage over the industry, supported by extraordinarily low losses in the segment, and our super prime marketing is backed by our national advertising campaign that explicitly promotes super prime products. While we expect intense competition, we also expect to continue to grow in our super prime business, albeit in a somewhat slower rate in the short-term.

We are enjoying tremendous earnings power at Capital One. Earnings power well in excess of the 20% EPS growth target we set last October. Accordingly we are increasing our EPS growth target to 30% for 2002. This growth in earnings is particularly striking in light of the $247 million allowance Bill we made in the second quarter in line with subprime guidance. The exceptional earnings power comes first and foremost from the continuing success of our business strategy in identifying profitable growth opportunities and exploiting them. Particularly striking is the profit growth from our diversified business line which have been in heavy investment mode. Super Prime cards, UK card and auto finance. These businesses are not only now turning a profit, we expect the improvement in profitability in these three business lines to exceed $150 million this year after tax. The additional earnings power also comes from our credit performance, where charge-offs in the first, second and third quarter are coming in well below our expectations. But we continue to be firm that our fourth quarter charge-offs will reach the low to mid-5s. The overall credit performance for the year, is a big addition to earnings power. The other contributors to earnings power are the improvement in operating efficiency we've seen in the first half of this year, and the somewhat reduced levels of marketing in the second half of 2002. As you know we target at least 20% earnings per share growth, each year. Therefore, it's not lost on us that raising this year's earnings growth to 30%, effectively raises the [INAUDIBLE] on next year's earning's. The earnings power we are enjoying is not confined to the short-term. It reflects the continuing success of our core card programs, and diversification effort. We carry great earnings power into next year. Therefore even on the higher base of 2002 earnings, we expect to grow our earnings per share in 2003 by at least 20%. Consistent with historic practices, we expect to release specific guidance on our 2003 earnings in October of 2002. At this point I'll pass it over to Nigel for his remarks. Nigel?

Thank you, Rich. Good afternoon, everybody. Our business performed well in the second quarter of 2002. Our loans increased 38% on an annualized basis, and $46.7 billion to $51.3 billion, and our account base grew 17% from annualized basis, from $46.6 million to $48.6 million. Our revenues increased from $2.1 billion to $2.3 billion. An annualized increase of 42%. The revenue margin was up slightly in the second quarter, from 1647 in the first quarter, 1655 in the second. Interchange levels increased partly due to less vehicles, due to lower redemptions and improved supplier pricing. We also saw the margin increase due to the gain on sale of auto loans which we expect to be a reocurring part of our ongoing business model. Lower late, and lower over limit fees have the effect of decreasing margin by over 60 basis points in the second quarter versus the first. The percent of loans in the manage portfolio of introductory rates decreased from 13% to 12%. Cost of funds were basically flat for the quarter. Net interest margin fell from 887 to 853, while non interest income increased from 804 to 840. In the next quarter we expect to see our revenue margin to be somewhat lower, driven particularly by the shifting up market that is generally now occurring across the whole company. Our charge-off rate increased 36 basis points in the second quarter to 436. We've been expecting our loss rate to rise, especially during the second half of this year and been very vocal about providing guidance to the market on this trend. And the reasons for the increase include, firstly, slower receivable growth resulting in less denominator effect.

Our annualized growth rate in loans in the second half of last year for example, was 57%, while we expect our loan growth in the second half of this year to slow to a more sustainable 20-25% growth. Secondly, seasoning of a large number of subprime account that is we added opportunistically in the fourth quarter of last year, and the first quarter of this year because of favorable competitive conditions in the market. Thirdly, charge-offs will rise because of the seasonality and recoveries, where we typically see our best results in the first quarter and then a decline for the remainder of the year. And lastly, the lagged effects of the economic slowdown, the end of last year on the industry as a whole. While we believe the worst of the economic downturn is over, we are somewhat less bullish on the economy near term than we were just a quarter ago. It's due to the sluggish rate of job creation, weakening consumer confidence and a stock market in decline. We have yet to see any significant effect of economic weakness on our own portfolio. In fact, we continue to see that, for the higher risk segments of our portfolio, vintage loss rates are coming in lower than expected. Nevertheless we are projecting a worsening of industry loss rates of between 75-100 basis points of 2002, bringing industry charge-offs to the low to mid-7% range by the end of the year, from 6.8% in the first quarter of this year. We expect to see charge-off rates on our own managed portfolio to increase for the low to mid-5% range by the fourth quarter of this year. For the remainder of this year and throughout 2003, however, we expect to continue to remain among the industry leaders in terms of credit quality.

Our delinquency levels were better than planned. Delinquency rates declined 26 basis points to 654. This decline is, of course, a positive development but it does beg the question how we can reconcile our projection of increasing charge-offs with our falling delinquency rate. Firstly, the current falling delinquency rates are driven by a normal seasonality pattern that is not reflected in charge-offs. Secondly, as already mentioned, in the fourth quarter last year and the first quarter of this year, we booked a large number of subprime accounts which are seasoning and in the process, create higher roll rates from delinquency to charge-offs. And lastly, the seasonality of recoveries causes higher net charge-off rates in those quarters where the recoveries are seasonably lower, i.e. the third and fourth quarter. Now our risk adjusted margin which of course is revenue margin minus charge-offs fell 25 basis points to 1253 reflecting increasing charge-offs, offset by a slight increase in margin As we look forward, we expect continued pressure on our risk adjusted margin throughout year-end. Like charge-offs however, we still believe that our risk adjusted margin will remain amongst the best in the industry. Operating expenses in the second quarter increased from $806 million to $833 million. However, the operating cost per account after marketing investment continue to improve to $70, down from $71 last quarter, down from $77 a year ago and down from $92 in the second quarter of 1999. Our cost structure now is superior to any of our [INAUDIBLE] competitors and beginning to rival the cost structures of the most efficient bank credit card issuers. Near term, we expect to see our cost per account level stabilize.

Less account growth will mean less opportunity to leverage more scale, and additionally will be increasing our investment in technology and process management, to drive down costs in the longer term to improve customer quality, and improve the company's process controls. A few minutes ago, Rich introduce the concept of a FICO score. Now for some time we've been struggling to define ours risk profile in a manner that can be readily compared to the industry. Many of you have asked questions about this. Many of you may be familiar with [INAUDIBLE] FICO score, which is the most broadly-used measure of credit risk for consumer loans in the United States. The FICO score takes credit bureau characteristics and derives a score which is designed to measure relative risk. Our methods for selecting and underwriting credit risks goes well beyond the FICO score. For example, we [INAUDIBLE] and manage credit risk by utilizing proper [INAUDIBLE] models, and experience garnered through our information based strategy, other variables based on empirical research, credit risk, credit lines by risk and assumed immediate recession in all of our underwriting and sophisticated collections and recovery segmentation. However, the FICO score is the only measure of risk which is both broadly understood and can be applied objectively across the industry. Equifax, one of the three leading credit bureaus, created analysis for us comparing FICO distributions to the U.S. credit card industry, to Capital One's U.S. card loans, using a large random sample. Specific distributions provided by Equifax, and created three segments. The first segment representing FICO scores of 660 or less, which of course corresponds to the FICO score mentioned in the regulatory subguidance that Rich discussed earlier. The results of the analysis suggest that Capital One's distribution is remarkably similar to the industry. The slightly more assets at or below 660 and slightly more assets above 710. Specifically 36.6% of industry loan balances had a FICO score below 660, compared with 39.8& for Capital One. In addition, 35.1% of industry loan balances had a FICO greater than 710, compared to 37.7 for Capital One. The remaining percentages are in the middle segment. FICO 661-709. Our [INAUDIBLE] every major U.S. credit card issuer with a loss rate in the same ballpark as the industry average loss rate, has a subprime share that is roughly the same as our share and the overall industry.

We hope this information helps shed some light on a number of issues that is many of us have been struggling with about Capital One's business mix. It clearly show that using the regulator definition of subprime, a third to 40% of the all U.S. card loans in the industry are subprime. Secondly, it shows that our business mix of loan is substantially similar to that of the industry across the whole spectrum. As we conclude my section, you'll hopefully see from the quarter results that we continue to show tremendous operating results and tremendous earnings power. With that, Dave Willey.

Thank you, Nigel, and thanks again to all of you for your precipitation on -- participation on the call today. Just a few comments and turn it back to Rich to wrap up and to Paul for Q&A. We've obviously had a very busy quarter on many fronts, and our activities in the capital markets were no exception there. Our capital managed asset ratio improved 94 basis points in the quarter to 7.78%, reflecting the mandatory convertible transaction that we executed in April. Marketing acceptance was very good for this transaction, allowing us to both upside the deal and achieve favorable pricing. Market reception was also particularly good for a number of other transactions executed during the quarter. $1.2 billion auto [INAUDIBLE] and our inaugural public market [INAUDIBLE] of our UK credit card receivable. We also established a new private program for securitizing our installment loans and tapped the U.S. credit card ABS market three times, including our largest ever deal at $1---$1.35 billion. In addition, we also raised $1.4 billion in net new deposits. The net effect of all this was to raise our liquidity portfolio, from about $3.6 billion in March 31 to about $5.6 billion at the end of June.

As we mentioned earlier, the company added to the allowance for loan losses, bringing the ratio of allowance to on balance sheet loans, to 4.95%, the highest it has ever been. The ratio reflect both the adoption of a loss reserve policy with subprime guide. And our long standing view, our charge-off rate will increase in the second half of the year. We previously held a 12 month reserve against our auto and installment loans on the balance sheet, and will continue to review our reserving methodology's at the continuation of our historical focus on strong balance sheets. In light of the recent regulatory developments, we have been in contact with our [INAUDIBLE] agency. [INAUDIBLE] and [INAUDIBLE] have told us they are affirming their current ratings and outlook. Rich advised us today on that they intend to go on a negative watch on their long-term debt rating, which has currently triple B plus at the bank level. As a result of this, We do not expect rating agency moves to negatively impact any of our funding market. While many of the financial metric [INAUDIBLE] at Capital One have never been stronger. Capital, allowance, liquidity and earnings are all at record levels. But the [INAUDIBLE] and earnings projection as we have discussed, the company has no requirement to raise capital, and will in fact accrue capital in the remainder of 2002. All this does well for continued growth and success in the future. And now back to Rich for a few comments, Rich?

Thank you, Dave. For the last several years, we have pursued a strategy of continuing to generate strong core card growth while investing significantly in diversification. Diversification up market, and diversification into other lending products and geographies. This strategy is really getting traction. It is enabling us to generate continued growth and earnings power on a stronger, more diversified business platform. Going forward we expect to grow our managed assets in the 20-25% range in the second half of 2002 and in 2003. Consistent with our diversification strategy, we expect to grow our higher end credit card portfolio at a somewhat faster rate than our subprime portfolio. We also expect to grow installment loans, auto loans and international loans at a faster rate than U.S. Credit card loans. I do want to fly one by product of this diversification strategy. Because of the large balance per account associated with higher end card loans as well as auto and installment loans, the gradual mix shift toward these loans will lead to lower account growth than loan growth. Account growth is expected to be modest in the second half of 2002, and somewhat higher in 2003.

The second quarter marks a water shed moment for Capital One. First, the diversification businesses we've invested in heavily are getting traction and they are making money. Second, after years of taking it on the chin, our competitors appear to be fighting back in super prime. I deeply believe we have a structural competitive advantage with our charge-offs, and we are ready for that fight. Third, this quarter is a profound testament to the importance of having taken a very conservative approach to credit, accounting, reserves and capital. Because of this conservatism, we have been able to meet the new challenges facing the industry, by being able to demonstrate our credit strength, and also be being able step up to meet the reserve in capital requirements. In the same spirit of conservatism and building for the future, the regulators are right to focus on our need to make sure we build a world class, scalable infrastructure and controls to handle the next generation of growth. We are working with great resolve to make it happen. Finally on top of all these developments, we have the earnings power to raise our earnings [INAUDIBLE] for this year. We believe that we are incredibly well-positioned to continue to grow our business and our earnings on a platform that is financially stronger, operationally sounder, and more diversified. With that I'll turn it over to Paul for Q&A.

Thank you, Rich. Mitch, at this time, let's start the Q&A session.

Certainly sir. At this time I would like to remind everyone, in order to ask a question, please press star and then the number 1 on the telephone key pad. Please remember to limit yourself to asking one question. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Karen Mayor with Bank of America Securities.

Good afternoon, guys. I -- the quarter was terrific. I want to ask a question regarding the MOU. Is your reserve addition done now for other than ongoing loans. Meaning did this $247 million, did it true you up to the level you expect to be at?

Karen, I'm Dave Willey. The short answer is, yes.

Thank you.

Next question please? Mitch, next question.

Your next question comes from Mark Alpert with Deutsche Bank.

Hi. MOU is typically fairly serious. And I came in a little late, because I missed ten minutes, you were talking about the conservatism and the new reserve capital requirements [inaudible] I've heard other companies sort of split it? [inaudible] -- in the MOU?

You're breaking up. Could you repeat the last piece?

I'm sorry. I'm on a cell phone from Europe. I apologize. What is in the MOU?

Okay, Mark, we had a little trouble hearing the question, but I think we can certainly, you know, figure out the key elements of what you are saying, first of all an MOU. As you can imagine, we've now become real students of what an MOU is, and basically an MOU is an informal document, Mark, that reflects a good faith understanding between Capital One regulators, and detailing the steps that need to be taken to address the issues raised by the regulators in their review. As I said in the prepared remarks, an MOU is typically used when regulators believe the all issues can be corrected by the management and the circumstances are milder than what you see in the formal supervisory actions. The agreements that you have seen elsewhere in the industry in the last year, those have been formal written agreements. There is a very different flavor and significance to these. So the question is, this question, we obviously asked ourselves on numerous occasions with the regulators. But, why really an MOU? I mean in some sense if you look at this, this is quite a unique circumstance. The regulators realize this is a very different kind of situation than typically happens with any of these regulatory actions. Typically you make credit,[INAUDIBLE] that's not been identified here, typically you have situations where... where there are actions required financially like capital and reserves and so on, the institutions are not able to step up to the plate to actually address those on the spot. So, you know, we talk to regulators and said, in this situation, we can absolutely understand that as, you know, when you look around at the industry, there have been a huge number of industries, issues in the industry equally associated with subprime lending. Very appropriate thing that the regulators do a thorough review of all institutions. And I think that, Mark, essentially what is going on here, is that while we have absolutely stepped up in that all the financial requirements, and I think the regulators are comfortable, very comfortable with that, given the track records of other lenders engaged in subprime lending, our regulators want to make sure we have a rigorous plan in place to maintain [INAUDIBLE] appropriate level of capital and reserve, and that can be captured in this memorandum of understanding. Mark, the 8K will detail these elements, but that's essentially what the MOU is about.

But typically they would list an MOU if you did everything they asked for? What does it take for them to list the MOU?

Mark---[INAUDIBLE] when I itemized it, I don't know if you heard the things we itemize. One of the elements was the controls and governance policies and procedures area. You know, I think they very appropriately have identified that at the growth rate that we are growing to take our company to the next level, there's some important changes that we can make in these areas. This is something that one doesn't do overnight. This is something we are putting a lot of energy toward, and I think we are very aligned with them with respect to taking that to the next level.

Thank you, next question, please.

Your next question comes from Howard Mason of Bernsteins

I wander if you can comment briefly on the [INAUDIBLE] ratio, and in particular this remark in the filings that says you plan to maintain a consolidated tangible capital to tangible managed asset ratio of at least 6%, how that differs from plans you may have had previously, and what you think the rating agency reaction to that level will be?

Howard, I'm Dave Willey. Thank you for your question. How does it differ from historic levels? It doesn't really. The last several times we've raised capital, we've been anticipating sort of a closing in on the 6% level. The [INAUDIBLE] conversations we've had with the agencies and I don't want to overstate them, they're not highly precise, multiple, decimal type calculations, but a general feeling was that something in the 6% range made sense. In fact, as our business has evolved in the course of the last several years, you can see, in fact, the amount of capital we have chosen to apply against the business has actually been increasing. I don't see it as the 6% is not a new minimum by any stretch.

Next question please?

Your next question comes from David Huxton with Bear Sterns.

Yeah thanks. Wondering if you could just talk about something in the 8K about additional investments and infrastructure and technology and how those additional requirements relate to the heavy investment spending you've done historically in infrastructure and if the regulators have the capacity to restrict loan growth for the overall company or just at the bank?

David, let me talk about what's going on operationally. It is true that we have been investing at a good pace in technology and process management for the last couple of years. And in many ways, that has led to the very strong reduction in operating costs across the company. You heard me mention those in my prepared remarks, and we feel that relative to the industry, we are in very good shape. It's pretty clear to us that in order to get the next quantum to be able to reduce costs by another substantial amount, we have to invest substantially. To do that getting rid of manual processes, investing state-of-the-art technology, improving our process controls and we're in the process of doing that now, and taking and investing that money to get returns down the road. It so happens that the...that many of the [INAUDIBLE] would be to reduce costs would also provide improved quality to our customers, and will improve processes across the board, and processes that are very consistent with a company now that has a loan portfolio over $50 billion. So to us, they are many of the same things. It's the holding of systems where previously we had more manual processes with that costs for quality improves and, of course, the platform to enable growth growing forward is substantially enabled. We feel this is the right thing to do for our business, and of course we have to submit for our regulators in doing that.

David, I know you asked a question about restricting loan growth. The regulators are not making specific targets or requirements about loan growth. This is a different thing I want to say for a number of things you've seen in the past with other institutions. The regulators know that we are a rapidly-growing institution. Part of the issue here is because we are a rapidly-growing institution, they want to make absolutely sure we have things like the proper controls and governance in place, the proper capital, at levels that will support the kind of growth plans that we are targeting. So I thinks its a very important thing to note that is part of this process in the rather extraordinary environment that now exists in the credit card business that we are -- while we are, you know last year's growth, the last couple years, our growth rate has been exceptionally high levels above our average. Particularly in the last years have been about 50%. This year we are growing at 30%. Next year in the kind of plans are for the 20-25% and I think the regulators want to make absolutely sure that the right capital, reserves, policy, and exceptional controls and procedures environment is in place as an institution that's growing at this kind of rates.

Next question please.

Your next question comes from Michael Frudstein with JP Morgan.

Yeah, hi. Just want to ask I guess, with respect to the MOU. I'm trying to reconcile some of the changes that you're talking about overall, expectations wise, in particular reduced marketing and figure out what is your own desire vs. What is really happening as a result of the MOU? And then in that context, of the five items, Rich, you outlined, four sounds like you are immediately compliant with, and one is in process. I guess how long will it take do you estimate, and then how long after you comply do you think it would be before the MOU would be lifted?

So many questions you asked there, Michael. They are all great questions. Let me first talk about growth. And marketing. I've often said when we've talked over the last couple years that there -- it's a strange paradox that we've talked about very significant levels of asset growth. Right into the head winds of what back then, people were thinking might be a recession. I used to say we are doing this because the planets are aligning in an extraordinary way. You know record low interest rates, and a competitive environment that also has competitors sitting on the sidelines watching Capital One pursue, you know, record low levels of APR with record total levels of marketing mailings. Our view was as long as we can continue to enjoy this unique situation, we're going to take advantage of that. Now, the environment has changed in some ways, Michael. One way is certainly that the competitive environment in super prime is a lot tougher, as we talked about. And we are practical about that. Also pragmatically even if that weren't the case, credit rates in today's environment [inaudible] I don't think are sort of practical for many of the constituents who sit on this phone, I think [INAUDIBLE] you know, in many ways,[INAUDIBLE] can't you grow at a little bit slower rate here. So, what happened here is... I think a combination of competitive environment and the overall market and constituency environment, we have selected to go with a more moderate growth rate in the 20-25% rate going forward. Now this has implications on things like marketing because the marketing levels that support 40 and 50% growth rates are different than marketing levels that support 20-25% growth rates, so that's why we talk about reduced marketing. It is relative to those extraordinarily high levels. When you ask how long will all this take, first of all, the MOU itself is not -- does not have a time component on it. As you rightly mentioned, we are, you know, virtually all the elements already compliant on it. Of course, they want to make sure we continue to be compliant on that and the controls and governance issue is one we are mobilizing with great dispatch so hard to put a time frack on it, Michael. At Capital One, anything we put our mind to, we get there expeditiously. Next question, please.

Next question comes from Tony Smith with JP Morgan.

Good afternoon. The memorandum put out by standard and poor's suggests no change to the credit processes. I wonder if you would give us more specific information on what types of systems, qualities procedures and control need adjustment going forward?

I missed one part of the question. I'm looking at the different component parts of nonfinancial targets that have to do with changes in procedures and policies, overall enterprise risk and seeking better specificity as to what types of changes in procedure currently need to be implemented.

Let me see if I can talk about this a little bit. What I think we have at Capital One is a company that has grown at a tremendous rate. As Rich mentioned our growth rate on afternoon a% a year. This company has grown massively. And the controls and procedures support that need, I think a regular basis with that kind of growth rate to be substantially upgraded. I think what has happened here is that our growth has been extraordinary. I would take advantage of many opportunities in the marketplace. You've heard in previous conference calls articulate that. What we are needing to do now is invest back in the infrastructure, taking processes that worked well when we were a smaller and less complex organization and moving them to a state-of-the-art level and a level that's more consistent with an organization that is $50 billion in size growing at 20% or more. That puts us in a unique position. We need to have the policies and procedures across the board. This is across all parts of the organization to make sure those levels of control are consistent with a large complex fast-growing company. That's what we are. Although, as Rich mentioned earlier, there's no time limit on an MOU and we will work as diligently as anybody and off to a flying start to deal with these issues of control and governance and not going to deal with them all over night and we are growing while we're doing it, and we should count on considerable regulator scrutiny going forward. That's not unusual for companies at $50-$60 billion for the growing at 20-25% a year. We take this challenge with great heart. Tony, specifically it's across the board. Not in any particular area. We have to upgrade the whole apparatus. It was perfect in times gone past. It now needs to be moved up significantly.

Also, Tony, a couple of things unique to Capital One that, you know, certainly I think cause the regulators to raise the issue more. One is, we operate on a, you know, and we talked about it, more of a decentralized methodology, supported by extensive customization, which creates a level of complexity that is not typically seen in classic financial institutions. The other thing is that we manage by a business line, which happens with our legal entity structure to not really neatly correspond with our own legal entities, the bank and the thrift. If you put yourself in the shoes of a regulator, you know, we own this in the sense, we made it complicated for them to track exactly what's going on in the bank and the thrift because we primarily are organizing a lot of our MIS systems and so on, and managed by, you know by lines of business. We need to step up significantly the capability and reporting associated with legal entities. Of course, this is one of the reasons that we also in the longer run want to merge the entities.

Next question, please.

Your next question comes from Mike Hughes with Merrill Lynch.

Hi. Ami right that with the 200% risk-based capital and all the other sort of, impediments they are putting to making quotes of prime loans that that asset is substantially less attractive for you guys than it used to be on an ROE or MCB basis?

No, Mike, it's not. You know, we have enjoyed very high returns in our business and we demand substantially higher returns for riskier assets. We've also been able to structure products with relatively low lines and high returns that have enabled us to be very confident about how credit protected these products are despite the underlying risks of the customers themselves. Again, a lot of the risk protection comes from the product structure. Also we have already sloped our capital allocations internally, so that in many ways, what the regulators are doing essentially is creating more sloping which is an appropriate thing to do, creating more sloping in how how to deal with potentials in terms of reserves and capital. We are embracing of the notion of highly-sloped allocation of capital, required returns, funds, you name it. This is -- this is a good thing, and we will continue to do it.

Next question, please.

Your next question comes from Bob Napoli with U.S. Bank Corp. Piper [INAUDIBLE]

Could you talk about the segments and loans outstanding by segment at the end of the quarter and also confused by your auto finance. Was that a cash gain on sale, or you're retaining the servicing? Or not?

Bob, Dave Willey. I'll take the cash part of that. It was in fact a cash sale. We do have a servicing fee on an ongoing basis for the performance of the servicing. Honda, we did retain. If you wait for a one second. I'll give you the breakout of receivables.

Thanks. Also when you talked about profitability on those various business'. I was wondering if you could just go into that a little bit more, I think... Did you say that auto finance international are now profitable or will be profitable this year?

We can talk about each of them separately here. Let's talk about the sizings of them and the sizing's of auto loans as of end of June, auto loans with $5.4 billion. International loans $5.0 billion. Informant loans $3.5 billion, and U.S. cars $39.2 billion and there you can comput the growth rates if you liked to. And the bottom line with all these business', and Rich mentioned this in his comments, they are all going really well. Rich's comment was that if you take them enmass and I think he did not include installment loans but included auto loans and international, if you take them enmass, they have improved their profitability by $150 million after tax. Over this year. So they've gone very well. I'll talk about international for a second and I'll let Rich chat about auto. International dominated by the UK and Canada. Th UK business is in profitability and has been now for in excess of a year. Profitability is growing. The position is enhancing. Canada is virtually profitable and we expect to be by year end, and its growing nicely, and we see ourselves in a good position there to. So I think the internation story continues to be very strong and we expect our international business in terms of loans to outgrow our U.S. card business in the year 2000 and beyond.

Yes, in the other business, I guess installment loans wasn't part of that list I had. Installment loans is also a profitable business and it is significantly growing its profitability this year. The big -- sort of the big thing that happened with respect to profitability is that we have been asking our core card business to carry from a profit point of view as opposed to asset point of everything. We have been asking our core card business to carry a heavy load for a number of years. [INAUDIBLE] our investment in all of these things I'm calling the diversification business'. You know, that's installment loans and auto finance and international. Even to some extent the significant investment in really building a presence in the super prime part of the credit card business. All these business' have been inflection points and now despite the heavy investment, they are hitting levels of profitability, and the delta profitability that the whole company is enjoying is primarily now driven by these diversification businesses. That's sort of big news for us. The auto finance business is, you know, in many ways is the most rapidly growing part of our business. It's growing so fast that from a practical point of view, we feel it's unrealistic to hold all the assets in the books. We talked about it before. It's a very [INAUDIBLE] sensitive business. This is, at least at the scale we are at, the most scale-sensitive business. Our strategy is originate at a maximal rate, service at maximal rate to enjoy scale economy, and then have the asset growth be a reasonable level of growth, and also then sell assets to others who might find our assets are superior to what they can originate, so that's worked out well there.

Next question, please.

Ladies and gentlemen, due to time constraints, we would ask you to limit your questions to one per term. Next is from Vincent Daniel with KDW.

Thanks. More of a philosophical question. One of the great things about the Capital One story is you have been ahead of the curve in terms of being conservative in all fronts. Coverage, ratios, capital and the like. It appears that you guys based on the MOU are now lagging. Can you make a comment on that, and in addition, how do you guys feel about options expense and where do you stand in terms of expensing options?

Vincent, I -- I really want to take issue with the sense of lagging there. Certainly respect your opinion on this. I would give a profoundly different interpretation. We were incredibly conservative with respect to things like accounting, reserves, capital, and credit, and the world changed, and for a lot of players, the changes that come along with that, most importantly the regulatory environment, but other environments as well could leave them in a short-handed situation, shall we say. We are in a kind of extraordinary situation that in a very compressed period of time, many changes came to Capital One. We implemented all the [INAUDIBLE] immediately and then, frankly, when we looked ahead to the earnings power of the company, we find that beyond that, we still have excess earnings power, and in fact have therefore raised our earnings guidance. Furthermore, when you get a chance, Vincent, to look at the 8K, going through these experiences, I already knew this, but I tell you I double my resolve on this issue, on any financial or credit measure, it never makes sense to run anywhere near anybody's line or edge; therefore, as an internal policy for the company, we're going public with the fact we want to hold after all this subprime guidance, we want to hold 12% risk to [INAUDIBLE] capital even though adequately capitalized is in fact a 10. Well capitalized is a 10. We are in a position to be already essentially at those levels. Virtually there in the thrift. We are over those levels at the bank right now in the very quarter of implementation, and the earnings power that we have, and the impact that's going to have on our capital will continue to put us, Vincent, in a position of being well-buffered and strong consistent with what I think you rightly say is Capital One's tradition. And we're fanatics about that.

Vincent, I just want to ask, don't mean to chime in. I think that what you are seeing today is a perfect example of Capital One staying ahead of the curve. In that the issues we are talking about, subprime guidance, its impact on allowance, its impact on capital is an industry phenomenon. What you are hearing today is us getting out ahead of this and saying this is what we are going to do about it. Capital One is recognizing that we've got a certain percentage of our loans that are under 660, and allowing for them and using the 12 months rule and we are moving to capital that is consistent with that. I think that, if not the first, one of the first that going out with this. Clearly the regulatory bodies are working together now like they've never worked before, and like to see these issues much more prevalent across the industry in the months to come and I think it's a great example of us getting ahead of the curve yet again.

Question about the stock options, we do note that a handful of companies have come out with recognizing stock options expense. We'll certainly pay attention and we'll be analyzing that, that issue. Come to any decision about that. I would point a couple things out to you. In our annual report, note F delineates the expenses we would have incurred had we adopted the alternative accounting under 123. We are still on APB 25 as most of the rest of the world is. But it was just...I just...took a mention for you, about $45 million in one and that's about $.20 a share last year on a base of 291. I would point out that in the past, a number of our larger options, actually we have recognized expense for years ago as part of our entrepreneur grant program, we've clearly been paying attention to that issue over the years. Next question, please.

Your next question comes from Mike Vincequerra with Raymond James.

Thanks very much. I just want a question just on the earning side of thing and the raising of your growth estimates for this year. Hearing several things on the negative side and one thing on the positive that it's going to be the [INAUDIBLE] Number one, you're looking for slower growth as the year progresses. Number two, probably going to have higher ongoing provisions for any on balance sheet with the subprime loans you hold. Number three, we're probably expecting lower net interest margins. Number four, high tech spending for your operations. Number five, higher losses in the second half. The only thing I heard that's offset that is the marketing. Spend a couple minutes for us how get to that 379 for the full year and then 20% on top of that given the scenario you've laid out for us. Thanks very much.

The answer is really in the incredible spending power that has come from years and years of investment in the programs that we are booking. Remember, we managed this company on every decision that we make we do on a trial basis based on historical results and so on. The reason that we've been so bullish for a long period of time is we have growing at a rapid rate. Annuities which have extraordinarily strong earnings power. Those annuities are just coming on in full force, in many cases above expectation. Even as we go, even as the planets possibly move out of alignment and we move to the kind of still significant growth rates we are talking about, along the way we have, in a sense, cherry-picked the very, very best programs that we have out there. Give you an interesting way to think about this thing. Talking 20-25% asset growth, a lot of this year and next year. Now, if we want to deliver 20% earnings per share growth, then if earnings fell out in the natural timing and they matched cash flows and so on, you couldn't do it unless you had 20% IRR's. The average internal rate of return of our programs that we are booking and have booked over the last couple of years, exceeds 30% with full highly conservative recession scenarios in them. So, an asset growth rate that exceeds 20%, we are booking assets with over 30% internal rates of return even with the sort of lack of consistency sometimes in the timings of how those earning fall out, it creates a situation of ample earnings power and that's what we seeing right now, and that's what we're seeing into the foreseeable future.

Give you a little bit of flavor for moving around here. You're right, the ongoing particular requirement for subprime loans on the balance sheet will be a little bit higher. But as the asset growth rate comes down, it is also offset in that overall the reserve Bill won't be as large as it is when we are growing more quickly, right. So that rate is higher but the volume comes down. The tax spending that you point to is going to be a function. What you're going to see there actually is that the monotonic decrease and the cost for account will stabilize for a while as we reinvest the savings and the future savings that are already in the pipeline from all the efforts that our organization has undertaken. Why I don't want to leave the impression there's going to be a massive spike in our operating cost. That's just not the case. So I think if you look for a couple of offsets, and I think that the things that you see cutting in a negative way are much less so than you might imagine on closer imagination.

Mike. A couple thoughts here. You said 20% is the earnings goal for 2002 in October of last year. Cast your mind back to last year. The issues that were flowing around there. Coming out of the tragedy of 9/11. Worried about deep and long recession come the U.S. And we said conservatively 20%. Since then a number of important things have happened I want to pile on here a little bit. At first you see our revenue levels expand tremendously. Revenues growing at 52% at the moment. We have seen as Rich mentioned, businesses that were previously investing very heavily in are now making money. Auto business, international business such as the UK, and lastly, I mentioned this on my report, we had planned on charge-offs certainly for the first two quarters of this year and perhaps later two quarters depending on how they work out coming in much higher than they actually came in. Our charge-offs 446 now, they were 4.00 in the first quarter. Much less than we had thought and very inconsistent with the raging and deep recession. That's given us the earnings power that's enabled us to increase the earnings guidance for the year.

Next question, please.

Your next question comes from. Jennifer Skutty with CIBC World Markets.

Hi. Good afternoon. I actually have a couple of questions but I'll try to limit it to the one. The issue you had mentioned, not sure if it was Rich or Nigel, in the earlier part of your comments regarding the reserve you had been building again on collectable fees and you said that you had added to that reserve but you didn't really quantify it a whole lot. Could you break that out a bit more and maybe differentiate between the reserve that you added to for the loan losses and the [INAUDIBLE]for the fee? Thanks.

Jennifer, this is Dave. I'll take a shot at this one, this is a topic of much conversation about how exactly to articulate this in a way that is clear to everyone. Firstly , the money that we mentioned in the call. The building of the loan loss allowance, you can see there on the balance sheets in the press release, that's a contrast offset against the loan balance. You can see that. The so-called finance charge and fee reserve and I'll put that in quotes. When you look at the AK, you'll see that in quotes as well. What that really is a revenue recognition policy. What that means is before we recognize amounts that we billed to our customers as revenue, we make an assessment about as to whether we are going to collect that or not. What we've really done is as we've re-developed our loan loss reserving models, allowance models, we also re-developed, refined our other models we used to measure revenue collectability. So there's just, you know, these things need to move in sync. When a customer charges off for both principal and amounts we've billed them. There's no way to see it except that it is embedded in the revenue that we do recognize. And we kind of struggled with this one. People tend to think of it as reserve. What it really is an estimation whether we are going to collect what we bill folks.

Thank you, Dave. Next question, please.

Your next question comes from Matthew Beto with Solomon Smith Barney.

Good afternoon. One thing that is still a little unclear to me, I hear you talking about wanting to move upstream and grow the super prime part of the book a little faster. On the other hand I hear you talking that that part of the market is more competitive and competitors have closed the pricing gap. I'm wondering how to reconcile those two things and I appreciate the lower need for marketing spend if the asset growth levels are going to be slower, but I'm wondering, how we can reconcile a mix shift with the more competitive condition that seem to be in that part of the market?

Matthew, that's a great question. I guess it does sound like out of different sides of my mouth, made different points, doesn't it. Things are -- let me back up a second. It is absolutely the case that that super prime market is more competitive than before. So that, all of the things being equal, that's going to be a little bit harder to grow in. Meanwhile we are mobilizing tremendous investment in super prime, spurred by a national advertising campaign, supported by a lifestyle programs targeted specifically at super prime customers, attitude by installment loan business that is entirely focused on super prime and auto finance in super prime and a huge growth area internationally, particularly in the UK, is our super prime business. Collective, across this area we see great growth opportunities in super prime. Actually domestically [INAUDIBLE] super primes can be a little bit harder but we're still going to do a bunch of growth in that area as well. With respect to subprime business, I'm -- I want to go back to Mike Hughes' question. He said financially are these new capital requirements going to change our subprime growth. If you look at the subprime environment, there's kind of nobody out there. There's nobody left, in a sense, out there. Our subgrowth is not driven by working backwards, how much could we do. It's driven by working backwards and what is being practical and realistically right level of growth. It's not lost on us that virtually all of our constituencies including the equity market ask lots of questions and want to make sure an environment with so many things going on that, you know, we are doing the right thing there. The regulators who come in, they have not made any findings whatsoever about credit risks in the subprime or any other area but nonetheless as a practical matter, we will grow our own subprime business at a more modest rate than all the rest of the portfolio. It's still going to grow but the others are going to grow faster; therefore, it's a diversification strategy is why I always call it diversify up market and also diversify into other product areas.

Thank you very much.

Oh, sorry. Oh, handing it to me. I just want to make a closing remark here in a sense. You know, this has been an extraordinary quarter for Capital One, financially. It's not been very often that we have raised earnings guidance in the middle of the year. There's a lot of great things that are coming out in these numbers. But, of course, to all of us, the getting of an MOU is something we've lost some sleep over. It's something that we take incredibly seriously, and a lot of companies could say, you know something, we don't deserve that. We are doing all the financial changes, why are you picking on us and so on but our view is this: We are incredibly embracing of the spirit of the regulators they're on exactly the right track, there are a lot of issues in this industry, there are a lot of issues with subprime lending. They have issues they are raising with respect to the credit card business and fundamentally what they stand for is conservatism and they are right. It's what we stand for. We are, you know, we are in a fortunate position to be able to have had the buffers, to be able to step right up and make these changes. We are also very embracing at the end of the day, they want to ensure our company take our controls and governance to the next level. We have operated on a relatively more than a lot of financial institutions, a de-centralized, customized, a little bit more informal basis, and as we become one of the nation's largest financial institutions, we are incredibly embracing of the fact that we need to take controls and governance and procedures to the next level. Our view internally is that we're use this, This little MOU event as really a wonderful thing to springboard, a thing to focus on to help us take our company to the next level. And pulling up all of this, I hope you got the sense today of a company that really has an incredible amount of earnings power. The diversification businesses are really getting traction and they are working and we are really in a wonderful position to take this company to the next level.

Thank you very much, Rich. We are available this evening to take your calls in investor relations. Have a good evening, thank you.

Ladies and gentlemen, this concludes today's Capital One second quarter earnings conference call. You may now disconnect.