Capital One Financial Corp (COF) 2007 Q2 法說會逐字稿

Good day, everyone, and welcome to the Capital One second quarter 2007 earnings conference call. Today's call is being recorded. 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. (OPERATOR INSTRUCTIONS) Thank you. I would now like to turn the call over to Mr. Jeff Norris. Please go ahead, sir.

Thank you very much, Katie. And welcome, everyone, to Capital One Financial's second quarter 2007 earnings conference call. As usual we are webcasting live over the internet. To access this call please log on to the Capital One's website at www.capitalone.com and follow the links from there. In addition to the press release and financials we have included a presentation summarizing our second quarter 2007 results. With me today is Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer, and Mr. Gary Perlin, Capital One's Chief Financial Officer and Principal Accounting Officer, who will walk you through this presentation. To access a copy of the presentation and the press release, please go to Capital One's website, click on investors, then click on earnings release.

Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors please see the section titled forward-looking information in the earnings release presentation and the risk factors section in our annual and quarterly reports accessible at the Caption One website and filed with the SEC. At this time I'll turn the call over to Gary Perlin. Gary?

Thanks, Jeff, and welcome to everyone joining us on today's conference call. Let's jump straight into the highlights of the quarter on Slide 3 of the presentation. Capital One delivered diluted earnings per share of $1.89 in the second quarter of '07, up 6% from the second quarter of '06. We had a larger than usual number of nonoperating items affecting our second quarter results, so we have highlighted them for you. The items with a downward impact were either anticipated at the beginning of the year or disclosed recently. And the former category is $79 million or $0.13 per share in integration expenses and core deposit and tangible amortization. The restructuring charges associated with the cost initiative announced late in the second quarter were $101 million or $0.16 per share, while the announced transition in our banking management team has a $40 million or $0.06 impact on the quarter as the result of accelerated investing of executive stock options.

Partially offsetting these expenses were two items that positive impacted quarterly results. $69 million or $0.16 per share in lower than normal taxes related to changes in our international tax position, and $17 million or $0.03 per share from the extinguishment of debt which occurred when we called high coupon trust preferred notes originally issued by North Fork Bank Corp and Hibernia. As I indicated on the first quarter call, we executed a $1.5 billion accelerated share repurchase plan effective April 2nd. In addition we executed an incremental $250 million of open market repurchases during the quarter under the same $3 billion share buyback authorization. These actions, coupled with quarterly share count growth, reduced our share count by a net 18 million shares. The restructuring charges I mentioned a moment ago are associated with an enterprise wide cost initiative begun during the second quarter and announced on June 27th. We an anticipate the result of this effort will be a reduction in the annual operating expense run rate by $700 million in 2009. I'll give you more details about this initiative in a few moments. I also mentioned the transition of our banking business leadership team. Our broader integration program remains on track. And Rich will provide some detail when he offers his update on the bank.

Moving on the Slide 4, let's refresh our outlook for the full year. We are maintaining our 2007 earnings per share guidance of $7 to $7.40, with nonoperating items moving us to the lower end of the range. Our outlook for 2007 has always included a projected $240 million post tax or $0.60 impact in integration and CDI amortization costs associated with our bank acquisitions. However, the other nonoperating items called out on the box on Slide 3 were not anticipated when guidance was last updated in April. The fact that the projected full-year impact of the negative nonoperating items are only partially offset by the positives, and by accelerated share repurchases leads us to expect earnings towards the lower end of our current guidance range of $7 to $7.40.

Let me also use this opportunity to reground the assumptions that support our current guidance. First we assume that the notable business trends in the second quarter continue for the balance of 2007. As you'll hear from Rich, these trends include: declining year-over-year ambulances with expanding revenue margin in U.S. card, and elevated levels in the dealer prime auto finance business. Our outlook also assumes no change in the following market conditions: continued pressure in secondary mortgage market pricing with whole loan bids at or around current levels; continued U.S. consumer credit normalization in the wake of the late 2005 spike in bankruptcies, a more stable UK consumer credit environment and a solid U.S. labor market and a yield curve which remains at currently flat levels.

If you turn to Slide 5, I would like to provide a bit more detail about the cost initiative which we announced a couple of weeks ago. At Capital One we have long been focused on the importance of operating efficiency to enhance our competitiveness and to help us achieve sustained earnings growth. Capital One experienced positive operating leverage each year between 2003 and 2005. While operating expense levels increased in 2006 and early 2007, as we began the integration of our bank acquisitions and made sizable investments in the infrastructure, which supports our legacy businesses, we are now well placed to move aggressively to improve operating efficiency. It was this -- it was with this in mind that we recently announced an enterprise-wide initiative expected to generate $700 million in operating expense savings by the end of 2009. This initiative will cost us approximately $200 million in 2007, and $100 million in 2008, which will appear in a new line item for restructuring expenses.

Now let me give you a sense of where these savings will come from. About $400 million of the $700 million in savings will be coming from our national lending and local lending business lines. In many of our national lending businesses, we will be leveraging the benefits of infrastructure investments we have made over the last year through process redesign and complexity reduction. In our local banking segment, we will deliver on the $110 million in net cost savings associated with the North Fork acquisition, as we look to complete that bank integration in 2008. As you know, a critical part of this integration will occur in the first quarter of 2008, when we look to integrate our banking businesses onto one deposit platform and rebrand the North Fork franchise. About $150 million of the $700 million of savings will come as a result of targeted reductions in staff functions, largely as the result of organizational streamlining.

We will also look to save an additional $150 million, by implementing and maximizing shared services across business lines. Examples of projects where we think we can harvest savings include placing many of our smaller businesses with similar asset profiles on the same servicing platform. We will also be conducting supplier and vendor contract reviews on our top 100 suppliers, and we will renegotiating many contracts where we believe we can achieve better pricing. As previously disclosed, we plan to eliminate approximately 2,000 jobs across all our business and staff functions, and a similar number of positions will largely be reduced by not filling current vacancies. Half of the job cuts have already been identified. Effected people have been notified and are in the process of receiving severance benefits in line with our commitment to treat all our associates with respect. Before leaving the cost initiative, I would like to remind you that we are also committed to investing in the growth of our businesses. That said, we currently expect to reduce the actual level of operating expenses, exclusive of restructuring charges in 2008 by $100 million to $200 million compared to 200 -- to 2007. We will be updating you on our progress on these cost-saving initiatives on our quarterly earnings conference calls going forward.

Now, let's take a look at performance in the quarter, starting with credit metrics on Slide 6. As you can see on the chart on the left of this slide quarterly losses from our local banking segment, which represents a mix of commercial and consumer loans, remains stable and low at 19 basis points for the quarter. International lending segment losses for the quarter were 3.45%, down 20 basis points compared to the prior quarter, driven largely by a change in grace period terms in our U.S. card business. You have already seen this impact in our master trust data. Without this change in account terms, the charge-off rate in our national lending segment would have been 3.61% reflecting expected credit normalization. On the chart to the right, you will see managed 30-day plus delinquencies for our national lending segment and nonperforming loans as a percent of loans held for investment for our local banking segment. The delinquency rates experienced similar trends to those we saw in our managed charge-off rates, again reflecting expected credit normalization.

Now let's turn to the next slide for a look at the income statements and the balance sheet. As we look at the income statement and balance sheet, please keep in mind almost all of the year-over-year comparisons are affected by the acquisition of North Fork on December 1st, 2006. Let's start with the income statement. First, total revenue is up on a linked-quarter basis, driven largely by revenue margin expansion in our U.S. card subsegment. You'll be hearing more about this from Rich. Provision expense was up quarter-over-quarter and year-over-year driven by the normalization of charge-offs post bankruptcy spike. The increase in provision included an allowance bill of about $15 million. Operating expense declined in the quarter by $29 million. This includes pre-tax expenses of $26 million related to bank integration, $53 million of CDI amortization, and $40 million of accelerating vesting of stock options related to the transition of our bank management team. Thus the balance of our operating expense experienced a greater decline, largely reflecting a move down from elevated levels of infrastructure investment our national lending businesses. As highlighted on an earlier slide we recognized a significant positive tax impact in the second quarter. This impact was driven by changes in our international tax position, and we expect to return to a more normal tax rate for the remaining quarters of 2007.

Now briefly looking at the balance sheet, total deposits at quarter end decreased on a linked-quarter basis, driven by the expected runoff of public funds in the bank, and especially our deliberate decision to let higher cost brokerage CDs roll off. Retail and commercial deposits were up slightly on a linked-quarter basis. Managed loans held for investment increased modestly on a linked-quarter basis driven by growth in our U.S. card and GFS subsegments and by our move of approximately $1.2 billion in mortgage loans from held for sale to held for investment as a result of our decision to hold these loans on balance sheet instead of selling them in to the secondary market. These loans now show up in our local banking segment, in our mortgage banking subsegment. Rich will touch on this as well in his business reviews, which we are now ready to begin. Over to you, Rich.

Okay. Thanks, Gary, and I'll begin on Slide 8 with an overview of our national lending and local banking business segment. On a year-over-year basis, sustained profit growth in our U.S. card and Global Financial Services or GFS businesses, more than offset declines in suto finance, mortgage banking, and local bank. As I discuss each of these businesses in a moment you'll hear some common themes. The expected normalization of credit continues in our U.S. businesses. Loan growth especially in prime markets in U.S. cards and auto finance continues to be challenging. When adjusted for changing product mix, margins, or holding up or increasing modestly across many of our lending businesses. And we're improving operating leverage across many of our businesses as we past the peak of infrastructure investment spending, and we begin to leverage the new infrastructure platforms in our cost-restructuring initiative. Each of our businesses faces it's a own unique combination of market consolidation, competitive and cyclical forces. While some businesses are well positioned to sustain and grow profits today others are hard at work addressing challenges and improving their position to win in the long term.

All in all, our businesses delivered modest profit growth versus the pro-forma profits from the second quarter of 2006. I'll discuss key trends and results in our U.S. card business on Slide 9. U.S. card delivered strong year-over-year net income growth powered by growth in revenue, reductions in noninterest expenses, and a modest decline in provision expense. Loans grew modestly from the year-ago quarter. Loan growth resulted from improving year-over-year attrition trends and growth in targeted segments. Our year-over-year loan growth rate was reduced by a decision to pull back further on our already low marketing of teaser-lead products in the prime space and the $600 million portfolio sale in the first quarter. We continue to see intense competitive pressure in the prime space with little abatement in marketing intensity.

Our focus market up is and has been to sustain strong economic returns and to grow revenues over the long term. This focus has lead us to reduce investments in marketing to subsegments like prime revolvers. We continue to believe that the headline pricing in these subsegments requires secondary pricing moves often to rates well above the go-to rate to achieve profitability. Instead, we continue to concentrate more heavily on marketing through transactors. As always we will continuously evaluate the market and competitive market and the growth and profit potential of all customer segments. We'll adjust our product strategies accordingly as we see opportunities. For the balance of 2007, we expect that our strategies will drive growth in margins and revenue, even as prime balances decline. That's because our assessment of the marketplace today indicates that the most asset-rich opportunities are not always the most profitable. In the subprime part of our business, competitive pressure continued to intensify in the quarter, but we remain confident in our efforts to generate modest growth in loans and revenues. Our focus in this part of the market continues to be providing competitively priced revolver products targeted to customers at the upper end of subprime. Purchase volumes grew 4% from the second quarter of 2006. The deceleration in purchase volume growth resulted from slower retail sales trends and our exit of two retail partnerships over the last couple of quarters. These retail partnerships were transactor intensive, but by mutual agreement with our partners we decided that the overall economics did not support continuing the relationships.

Revenue increased as a result of asset growth, the repricing of certain assets, changes to pricing and product terms, higher net interchange, and a modest mix shift toward higher margin business. The completion of the final phases of our conversion to the TSYS platform in the quarter drove several of these positive impacts. During the conversion we suspended many routine pricing and product term changes for the better part of the year. This pressured revenues during the conversion. In the second quarter we began to implement the backlog of these actions that had been on hold. The example is the repricing of assets who's matched funding had expired in 2006. Noninterest expense declined in the quarter, as we passed the peak of -- of investment spending on the TSYS conversion. We also began to leverage the new infrastructure to streamline processes and reduce our cost structure as part of the broader cost initiatives that Gary discussed earlier. Charge-off and delinquency rates rose modestly from the second quarter of 2006. The increases resulted predominantly from continued normalization of credit with the slowdown in loan growth also driving a modest denominator (inaudible). Our shift to a more industry-standard 25-day grace period, resulted in a one-time 31 basis point reduction in charge-off rates this quarter, which caused the seasonally unusual decline in charge-off rates from the first quarter.

Looking forward, we expect that many of the second quarter trends will continue to drive U.S. card results through the second half of 2007. While we expect modest seasonal growth in loans in the second half of the year, we expect to end the year with lower loan balances than at year end 2006. We expect steady growth in revenues to continue through the remainder of 2007, as many of the drivers of revenue growth in the quarter continue through the second half of the year. Charge-off dollars continue to track with our expectations for normalization, but the decline in U.S. card loan balances is likely to push the charge-off rate higher due to the lower denominator. We expect charge-offs to continue their upward trend, stabilizing around 5% at the end of 2007. With the return of modest revenue growth and continuing cost reductions, our U.S. card business is poised to sustain strong profitability despite the near-term head winds of declining loans and normalizing charge-offs.

Turning to Slide 10, I'll discuss our Global Financial Services or GFS segment. Net income rose 62% from the second quarter of 2006 to $83 million. Year-over-year revenue growth resulted from the growth in managed loans and originations. Expenses increased over the same time frame due to the same factors as well as to the impact of TSYS conversion in small business and a similar platform conversion in installment lending. Provision expense declined primarily due to a more stable outlook for UK credit. Charge-off and delinquencies rose modestly from the prior year quarter. Our U.S. businesses continued to experience the expected normalize of charge-offs from their very low 2006 levels. In the UK we believe credit has stabilized driven by a flattening of insolvency and third-party debt management charge-offs. While this is welcome news, we remain cautious. Insolvency rates are still at historically high rates in the UK, and the overall level of indebtedness remains well above the levels we see in the United States.

Managed loans grew 6% from the second quarter of 2006 to $27 billion. Our North American GFS businesses delivered strong, low to mid-teens loan growth from the year-ago quarter. Our origination businesses posted even stronger growth. In contrast, our UK loan balances declined as we continue to navigate the industry-wide challenges in that market. Overall, our GFS businesses are on a solid trajectory and they continue to drive diversification and growth of both loans and profits.

I'll discuss our Auto Finance results on Slide 11. Net income of $38 million was down significantly from last year's near-record second quarter profit. The decline in net income resulted from the significant increase in provision expense, which increased by $108 million from the second quarter of last year, when our auto business charge-off rate reached its record low of 1.54%. Credit results and outlook are the most significant story in our auto business this quarter. Both charge-offs and delinquencies rose sharply from the low levels we saw in the second quarter of 2006. We continue to experience the credit impact of two significant effects. The first is the ongoing normalization of charge-offs that we described in prior quarters. We also continue to experience elevated losses in our recent dealer prime origination vintages. As we discussed last quarter, this increase in losses is primarily related to the transition from a judgmental underwriting approach to our first generation automated underwriting model for prime loans. First generation models sometimes encounter blindspots that we can identify and corrected in second and third generation models.

We are now booking prime business under a second generation risk model. While we're optimistic that our model revisions have addressed the issue, charge-offs for the loans booked under the old model will remain elevated for several quarters as these loans season. Originations in the second quarter were $3 billion, a modest decline from the second quarter of last year. Based on elevated charge-offs and delinquencies we pulled back dealer prime originations in the first half of 2007 by about $2 billion. This pull back was partially offset by strong growth in subprime origination. Managed loans grew 18% in the second quarter of 2006. The loan growth resulted from ongoing originations, as well as the addition of about $1.4 billion in prime loans from the North Fork auto portfolio.

After successful testing for several quarters, we launched our new dealer business model in the second quarter. We developed and tested an integrated approach, so that each of our dealers can now deal with one sales rep, one underwriter, one set of products across the credit risk spectrum and one brand. We have now implemented the dealer integrated program across all of our nearly 18,000 dealer relationships. We are aggressively driving toward a lower cost structure and we have moved to the new risk model for dealer prime that I just discussed. Initial results in terms of the dealer satisfaction, loan originations and credit performance are promising, but it's still very early days. Second quarter auto finance results reflect the challenges of credit normalization and our continuing efforts to expand in the prime market. Despite these challenges we remain optimistic about the future growth and profitability of our auto business.

Turning to Slide 12, I'll review our mortgage banking business. Recall that Mortgage Banking is the legacy GreenPoint mortgage business and does not include Capital One Home Loans, our direct to consumer origination business. The secondary market challenges continue in the mortgage businesses, although trends have stabilized in the quarter. Our mortgage banking business posted a modest profit for the quarter in line with our expectations that the business would break even for the last three quarters of 2007, after the net loss in the first quarter. Net income growth in the quarter resulted primarily from a modest expansion of net gain on sale margin, and a $16 million pre-tax increase in the value of our MSR. Our MSR stands at still modest $316 million. Origination volumes declined significantly and remain under pressure.

The primary factor in lower volumes is our move to tighter underwriting standards. The challenging interest rate environment and uncertain secondary market demand also contribute to the pressure on originations. We added $688 million of helox to loans held for investment in the quarter. These loans have an average FICO of 700, and an average CLTV of 91%. The loans were originated to sell, but the bids we received below our assessment, so we decided to move the loans to our balance sheet rather than sell them into a distressed market. The gain on sale margin rebounded slightly from the first quarter to 56 basis points. There are several moving pieces that underlie this modest improvement.

About 75% of the loans that we sold in the second quarter were originated under the old underwriting standards in the first few months of the year. These loans generated a deeply discounted base gain on sale which was consistent with the held for sale warehouse evaluation adjustment that we made in the first quarter. We have now sold virtually all of these loans originated under the old underwriting guidelines. And the valuation of any loans that remain has been adjusted to reflect current market conditions. About 25% of the loans we sold this quarter were originated under our new tighter underwriting standards. On average, these loans are generating a base gain on sale in the 80 basis point range. Overall, the base gain on sale for the quarter was 59 basis points, and minor adjustments to the warranty reserve and the head -- the held for sale warehouse valuation only reduced net gain on sale by three basis points.

In the second quarter we continued to streamline and reduce the cost structure of our Mortgage Banking businesses. We consolidated several branches and servicing facilities and we continue to aggressively manage expenses as we right-size this business for the reality of sharply lower volume. The year to date results of our mortgage bank business reflect the secondary market volume and pricing risks of our originate and sale business model. Our business model continues to mostly insulate us from the big, longer-term risks in the mortgage market. We don't originate or hold subprime mortgages. If we don't securitize mortgage loans, we hold no equity residual and our MSR is still a very small fraction of our tangible equity. We continue to manage the mortgage banking business to minimize our exposure to longer-term risks, and protect the P&L while we ride out this adverse part of the cycle.

I'll discuss our local banking business on Slide 13. The slide shows actual results for the 2007 quarters and the pro-forma results for 2006 quarters. Net income of $133 million was up modestly from the first quarter. Revenues were essentially flat from the first quarter, with modest gains in net interest income offsetting the decline in noninterest income. Noninterest income would have been flat, except for the gain of sale -- gain on sale of Hibernia's insurance brokerage business we booked in the first quarter. Total deposits were flat compared to the first quarter at $75 billion. Growth in commercial deposits was offset by modest declines in public funds, consumer and direct bank deposit. As expected in the current yield environment, our deposit mix continued to shift towards higher cost deposits. Despite the shifting deposit mix, modest pricing adjustments enabled deposit net interest margin to hold steady in the quarter. Loan balances grew modestly from the first quarter to $42 billion. Commercial and small business loans grew slightly, offsetting the planned reduction in residential mortgages. The commercial real estate and multi-family loan portfolios were flat from the first quarter. Credit performance remains strong and stable with both charge-off rate and nonperforming loans as a percentage of managed loans at just 19 basis points.

The biggest news in our local banking business in the second quarter is the continued progress on integration. We announced the transition to our new bank management team headed by Lynn Pike. Starting next month Lynn will become the President of our local banking business, as John Kanas transitions to an advisory and customer relationship role. Lynn has built out her management team by selecting experienced executives from North Fork, Hibernia, Capital One and carefully chosen external candidates. Our most recent key higher is Mike Slocum. Mike was formally the head of Wachovia's real estate financial services and he'll be joining our banking team in August, as head of commercial banking. With Lynn quickly coming up to speed and getting her team in place, the time was right for this transition.

I would like to pause for a moment and thank John Kanas and John Bohlsen for all they have done over the years to built the great North Fork franchise, and to integrate Capital One's banking business and also to hire and develop the next generation of great talent to lead our banking business going forward. We look forward to their continuing advice and counsel and I thank them both for all of their contributions to North Fork and Capital One. Beyond the transition of the leadership team, our integration efforts continue to be on track. Integration efforts will accelerate later in the year with the deposit platform and brand conversions scheduled for the first quarter of 2008. We remain on track to deliver the targeted North Fork synergies, although the sources will almost certainly change and realizing the full run rate synergies may spill over into 2009. In the second quarter our local banking business continued to deliver solid results and to execute a successful integration. Now, Gary and I will be happy to answer your questions. Jeff.

Thank you, Rich. We will now start the Q&A session. If you have any follow-up questions after the Q&A session, the investor relations staff will be available after the call. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to only one follow-up question. Katie, please start the Q&A session now.

Thank you. (OPERATOR INSTRUCTIONS) And we'll pause for just a moment to assemble our queue. And we will take our first question from Laura Kaster, Sandler O'Neill.

Just two real quick questions. Could you please speak to the seasonality of the integration expenses for '08? I would assume those would be more front-end loaded due to the brand change. And, then, second, Gary, a question for you. Last quarter I believe you said you expected the UK businesses to lose money and for the mortgage business to break even. Have those two outlooks changed at all? Thank you.

Sure, Laura, a quick answer to your first question. Certainly the seasonality of the integration expense in 2008 will be front loaded because of the timing of the deposit platform conversion and the rebranding in the first half of the year. Remember it's exactly the opposite in 2007. You'll start to see those integration expenses ramping up in the second half of this year much more than they have in the first half of the year. As far as the profitability outlook goes, our overall UK business is -- is close to -- to break even. Actually the credit cards business there is -- is mildly profitable with the better performance of credit there, we have some cautious optimism that we might continue to see a bit of a better trajectory there, although it's too early to say. And the mortgage banking business, as Rich said our view was that we would break even over the last three quarters of this year, and given the assumptions that we have made about continuation of the current market environment, and our strong strides in the area of cost management, we certainly expect to try to achieve those goals in the mortgage banking business as well.

Great. Thank you.

And we will take our next question from Craig Maurer, Calyon Securities.

Yes. Good evening. My question is about marketing expenditures. I understand why they are down, it does go against seasonal trends. If you could just talk about where you are spending that money these days, just for my own -- looking at your TV ads, it seems I haven't seen much in the way of pure credit card marketing these days. So if you could just address that a little. Thanks.

Yes, thanks, Craig. The lion's share of our marketing continues to be -- first of all if you look at total market expenditure, they continue to be related to our credit card businesses, our U.S. card business, our small business business, and our Canadian and UK businesses. Mostly the marketing is -- is pretty much as it has been. The -- in terms of the direct one customer at a time marketing, the only slight change is that we pulled back a little bit in terms of the prime revolver segment for -- we are always opportunistic, Craig, every quarter on that are issues that we have with respect to the market-clearing prices of some of this highly repriced business. And so we -- recently have done a little bit less of that. Pretty much, though, all of the other places, the marketing is continuing the way it has been, a lot of investment in transactor business, continued investment, really, across the credit segment just with the isolated avoidance of some parts of the primary revolver segment. With respect to TV advertising, you actually make a good point there. I mean, for -- I think in general Capital One will continue to leverage our very big credit card customer base to help finance the -- the TV advertising, but we do have an imperative internally to do what we call stretch the brand. And you notice across now multiple products and stretching across different customer segments and in fact across distribution channels you see an extension of our marketing. So things like advertising home loans, advertising small business, these are part of our efforts to stretch the brand because what we find when we do customer research is that while it is credible to customers that they could buy products from us across any of our broad product array, they still tend to think of us more as a credit card company.

Okay. If I could just ask one followup. In regards to Texas and Louisiana, and to help us think about your strategy for New York and the tri-state area, what -- how are you using your cross-salability to entice customers to bring their business to Capital One bank? How are you using the credit card angle to make -- to try to get people to make that jump?

Craig, one thing I really want to stress is there's very little effort right now to do a lot of cross-selling, vis-a-vis the bank and the rest of Capital One. We're so focused on making sure that we do a sure-footed integration. All we're really doing is putting in the infrastructure capability to be doing that. But if I were to generalize, over time the big opportunity that we see -- one of the big opportunities we see from a cross-selling opportunity, is to drive a lot more retail volume into the North Fork franchise, which really hasn't done really any consumer marketing to speak of. And of course we have 3 million customer accounts in New York for the sake of driving them in to the branches, and a consumer brand and a broad consumer nationally priced product line, and to some extent the same story applies in Texas, the only difference is there has been more active marketing on the consumer side already in Texas. So, again, I think if -- you are just going to see the next several quarters that are still going to be very focused on integration. But infrastructure comes first, and then it's in a sense then back to business in terms of driving the sort of second generation of growth opportunities in the banking business.

Next question, please.

And we will take our next question from Michael Cohen, SuNOVA Capital.

Hi, thanks for taking my question. Can you talk about the process that you went through to convert from a manual underwriting process to the first generation and now second generation scorecard in auto? It would seem to me, that generally speaking you wouldn't have adopted something on a wider scale without testing it. How does that fit with the sort of testing control DNA and then I have a follow-up question to that.

Michael, I appreciate the question. Because we are assess and control fanatical company. So this isn't the first time we have encountered the issues associated with converting from sort of a judgmental approach to a model-based approach. Let me talk first of all sort of conceptually about the challenges one face and what we did in the auto space. It is -- even if a judgmentally based underwriter is rich in data, which typically they aren't, but if they are rich in data, one can't -- it's difficult to take their data and build models on it because they -- it tends to have blindspots. Let me give you an extreme example. Let's say in origination business people always -- they never -- they always excluded anybody who had a delinquency. The data -- the model that you build on that will have a blind spot in the sense of not -- in a sense any excluded variable judgmentally then gets difficult to calibrate into -- into a model. So this is something that we have been very aware of.

So as we talk about the auto business the issue with Onyx is it was an entirely judgmentally based approach, also fairly narrowly defined for a customer segment. And of course we -- we bought Onyx for the sake of trying to expand its business model in the prime space. We found that the -- we felt that -- and -- and early things have validated this, that expanding on the basis of the combined judgmental wisdom of the two institutions on this was something that did not look like it had promising results, so we felt the better decision -- and it was the better of the two, was to put in our best approximation of a model, and do as quickly as possible, sort of monitor and make adaptations to that. The other issue -- the other difference that one has in the auto business you don't have in the credit card business is it really isn't an option to turn volume off, because one has the whole franchise and so on. So in the card business we would have done probably a more extreme testing thing in the context of an ongoing franchise, this transition we knew would involve some guesswork and be a little ugly. It turned to be -- it was little uglier and a little worse than we had expected frankly, Michael.

Does that have any implications for any of the goodwill associated with the Onyx purchase?

No. Definitely not. We still are very bullish about the Onyx business. Let me go back to the -- Onyx had -- Onyx was in a sense one of the last franchises of -- of broad-dealer relationships. This is a great sales force that we bought with very good and solid customer relationships. The only -- there were -- the scalability, there were a number of scalability issues, one was the transition to a scalable automated model. There also were sort of differences in the sort of operating platforms, and some of the branch-based approach that was used in Onyx as well. So there's been -- it's been a bit of a tricky transition, but a lot of the future success that we hope to have in the prime space comes from the foundation of the Onyx acquisition, so we're very bullish about that.

Next question --

And Michael the other thing I want to say is we're very confident in terms of the rolloutsvwe're doing with respect to the prime originations as well.

Nest question, please.

We will take our next question from Meredith Whitney, CIBC World Markets.

Hi, good afternoon. I wanted to ask a follow-up question from what I thought was a very question posed last quarter, which was you guys clearly made people a lot money in the '90s, and over the last three years the stock has really been stuck in place. And the question on the last call was how long do investors wait? And I'm curious as to what kind of conversations you have had with your top shareholders and your board in terms of the quarter -- there's some good things about the company, but in terms of the tax rate, the provision, some other issues, it's just hard to get excited about the underlying strength of the company with continuing messiness through the quarters. And if you could just direct me in terms of what type of sense of urgency you guys have to move the stock because obviously your investors need the stock to go up for them to make money.

Thank you, Meredith. We are -- we are very focused on making sure we deliver sure footedly for the sake of our investors. We have, right now, more -- a larger than usual number of market-based challenges that we face, ranging from the mortgage marketplace to flat yield curve, the normalization of credit, and challenges that -- that, we re very focused on. What -- our way to make sure that our investors are well rewarded is to make sure that even as we have positioned the company for long-term continued success, and I think we're very well positioned for that, that we make sure we're very focused on near-term execution and delivery.

So if you look at what we have been focusing on, you see the very big efforts with respect to costs and I -- there's a tremendous momentum inside this company with respect to operating costs. We put a very big effort on the revenue side of the business to make sure that -- that we -- even as the card business backs off some of the sort of least profitable investment opportunities in the U.S. card business, that we create a steady, solid revenue trajectory, and you see the manifestations of that's going on in the quarter. Additionally we're also -- and you can watch it in action now just taking advantage of the significant capital generation that happens in the company as you can see with the -- several times we have -- in fact accelerated repurchase activity. So these are all around the company while people are happy about the long-term position of the company and the prospects for long-term returns, we know that. Our job right now is to make sure we deliver very effectively, during this period of greater than usual market challenges, and also paying for the acquisitions that we have done. And that is our focus, and I think, Meredith, despite some of the noise associated with the data, I think if you look hard at the various metrics on this call, you will in fact see the manifestation of the really hard work that's going on, and I think that our investors stand to be very well rewarded for that, although I'm not going predict the timing of that, because that's really the job of the investors.

Okay. So in terms of -- if you were to -- for specifically this quarter, I guess the thing that confuses me most is why beat on lower tax rate? Why not overprovide as opposed to -- in terms of on page 9, the charge-off rate is expected to go up to 5%. Why not overreserve in a quarter like this as opposed to beat? It's just -- it's confusing for me and it's confusing for investors, so if you want people to focus on the good of the story, I would think you would clear out that noise, and I was curious as to what your top shareholders are saying.

Meredith, it's Gary, I'm happy to take that one. I think in f you take a look at the very first slide of the presentation you will see all of the moving parts in front of you, as clearly as we could possibly put them forward for you, coming all from very natural developments, restructuring charges coming from cost moves that we're making, recognizing all of the accounting requirements that we have as a public company, trying to make them as clear and obvious do you as possible. And as Rich just said, if you simply do the simple math, you can take a look at the underlying strength of the company coming through, certainly positioning us well for the future. So when I meet with investors, what I hear from them all the time is please make sure that you are manage the company right, making the right decisions, being as transparent as you possibly can, being as [disclository] as you possibly can and try to make it easy for us to recognize the value that you have got. And certainly from an accounting standpoint we do what is appropriate try to make sure you understand it and from most of the investors I speak to, that's what they appreciate.

Next question, please.

Thank you. We'll go next to Scott Valentin, Friedman, Billings, Ramsey.

Thanks for taking my question. On the auto platform you mentioned the integration of the entire platform resulting in driving some cost efficiencies. Can you talk about maybe the goal you have there? It was down. The cost include -- improved link quarter, just curious what you see driving that number down to over time.

Scott, we -- we have -- we have looked at not only our competitor's overall cost, but we have on a segment by segment, sort of credit segment-adjusted basis looked at sort of best in class operating costs. And what we have targeted is that if we want to win in this highly consolidated competitive business, we need to be at the right cost level, frankly, in each of the segments of the business, and so I'm not going to give you numbers. You can do your own calibration to that, but we're not going to rest until head-to-head in any segment we've got the right competitive costs. If you recall, Scott, we showed a scale curve in -- in our investor meeting earlier this year. We -- we showed a scale curve that had every major player's yearly cost. This was not adjusted by credit segment, but you can see Capital One was sort of out of line a little bit. And we've been very focused on this. And a lot of the out of line comes not from not manage cost carefully, I think Dave Lawson has a long history of manage it very tightly, it comes really from having four different platforms that we're putting together. So the -- there's a double significance to this pulling together of one platform, one credit policy, and the kind of single-face to the dealer is that it is both a move to pull from four different approaches to one and get dealer penetration as a result, but it's also the thing that enables the cost reduction. And our cost as -- as a percentage of loans have declined from around 3.2% in the '04, '05 period, to 2.8% in the first quarter, to 2.6% in the second quarter. We do expect it, Scott, to be even lower by the end of the year as we finish these things, and we -- believe that we're going to be head-to-head competitive on an ongoing basis with the major players in their segments.

Okay. One follow-up question, if I may. On credit card revenue margin, you had good improvement. I was curious as to how much of that was due to repricing efforts versus maybe increased penalty fee. You did cut the grace period by five days. I was just curious whether they had age pact on the revenue margin.

Sure, Scott it's Gary. I'd be happy to take that. The change to a 25-day grace period did not really have any material impact on the P&L. It did have a material impact on the charge-off rate, which is why Rich referred to it. What we did here in aligning our business practices with industry standard was to delay the cycle start time by five days, but it had no impact on the bottom line, because although we had lower charge-offs, we also could not release the allowance associated with it. There was no P&L impact from the 25-day grace. So the improvement in card margin was the result of a number of major developments as -- as Rich described on -- with the repricing of some of the card assets to match up with funding, some of those which had been kind of held in the queue rate waiting for the TSYS conversion and some other moves with respect to customer pricing in line with our desire to make sure we provide great value, but generate a reasonable return.

Next question, please?

We will take our next question from Chris Brendler of Stifel Nicolaus.

Hi, thanks. Good afternoon. On the same topic on the card margin it typically declines in the second quarter. So I think the -- what -- from a seasonal perspective, I'm thinking that -- and Gary I think we talked about recently that -- I thought that the repricing initiative, why you started it, maybe in March, April, it really wouldn't have sort of a full run rate until the third quarter. So is the outlook for the card margin to continue to expand from here from the repricing initiatives? And then a related question is I'm very confused as to how you get to a 5% loss rate for the first quarter. There's -- on a year-over-year basis delinquencies are actually kind of flattish, there's been no real major movement in the bankruptcy rate nationwide, so what is causing the increase in losses? And I already have modeled the -- the receivables down a little bit. So I'm not exactly sure what is causing you to be so conservative on your loss forecast for the card business.

Chris, it's Gary. Why don't I start off on the revenue conversation that we've been having and then I'll turn it back to Rich on the outlook for the charge-off rate. And yes, you are right, a number of the revenue improvements started relatively early in the quarter, and -- and then kind of feathered in throughout the quarter, so you are seeing the benefit of many of those changes, and you should continue to see some upward trajectory to the card margin over the course of this year as a lot of those moves will play through. And again, in 2008 you'll see the full-year impact of some of those beneficial moves. Again, I think again you -- you have got it right that you are starting to see a movement that will be continuing in -- in many quarters to come. Why don't I hand it over to Rich for the question on the charge-off rate outlook.

Yes, Chris, the -- our dollar losses that -- that we forecast for the year and that are inherent in the guidance are coming in now six months into the year, almost exactly as we anticipated. The mix is a little different because BKs, or bankruptcies, are normalizing less quickly than we had expected, and that causes a lot of people we talk to say, hey, this normalization isn't all that it's made out to be. We have always talked about the substitution effect, where the -- as it becomes more difficult for people to go bankrupt, they charge off the old fashion way, and there's a pent up reservoir of people who otherwise would have charged off who -- and we predicted a portion of these people going in to contractual charge-offs this year. If the contractuals are higher, the bankruptcies are lower, the overall effect is just about exactly the same. The reason for us that our -- we are now guiding to a higher charge-off rate is really entirely a denominator effect, where our asset growth from the year, which we are say willing be negative, again, in the card business, is -- is lower than we had expected.

Are you talking about -- the only thing I could be missing is maybe you are talk about a significant decline in loans? Like billions of dollars to decline in receivables? I was under the impression it would be a slight decline. I think that's what you said at a recent conference.

Chris, it's Gary, the slight decline is what you might see from quarter-to-quarter. I think the bigger move is looking at it sort of an a year-on-year basis. But a couple of points that might help you kind of get to our understanding of the outlook. The first thing is, remember that the starting point here in the second quarter, although we printed a charge-off rate of about 3.75%, as I indicated there is a big impact from the change to the 25-day grace period. Without that change -- and frankly without some debt sales that happen from time to time, the charge-off rate this quarter would have been more like 4.25%. So the move from here to the fourth quarter is not nearly as big as it might otherwise appear. Remember as well, the fourth quarter is always our seasonally highest quarter for charge-offs.

And again, depending on what is going on in the -- in the denominator and the mix of the business, people all along have been asking us what does normalization mean? And if you back to the charge-off rates we were seeing in our card business before the change in the bankruptcy law was about 4.7%, 4.8%. So if we're getting back to normal, but we're getting there with a relatively different mix of business, little less balance sheet intensive, therefore a smaller denominator, that 4.7%, 4.8% can easily turn into 4.9% or 5.0%, and it would be certainly within our minds very much a normalization. So that's the outlook. Next question, please.

We will go next to Bob Napoli, Piper Jaffray.

Thank you. The -- within the credit card business, the mix shift that your reducing the prime, you said less balance sheet intensive, is that -- and the margin is going up, so it sounds like you are doing more subprime. Is that fair? Are you going back into some of the sectors in subprime that you had gone out of that you were successful in the past?

Bob, it's really -- in the subprime space there is a great consistency to what we have done, frankly for a long period of time. We ebb and flow a little bit, but generally we have going after the most northern part, if you will, of the subprime space. So there's not a lot of sort of strategy change in the subprime space. In the implicit, slight mix shift really comes from the -- what is happening on the prime side, where we are -- I mean, we have a good, solid profit story, but we are just being very disciplined about the -- the choices that we make on what -- what turns out to be the most asset intensive part of all of the origination choices. I just want to pull up for a second that it is -- the thing that most drives people's growth in assets relates to their choice about balance transfer-based origination. And that is the thing that we have our foot the most off of the gas pedal. So, again, good solid opportunities.

We continue to pursue in pretty much all other aspects of the credit card business, but there is this implicit, sort of mix shift that comes from little bit less prime. But I wouldn't -- I wouldn't get too hung up about this. I mean, we -- these are opportunistic choices we make at the line of scrimmage every quarter. It's not like we don't do any prime revolver business, these are just happen to be asset-sensitive choices. So we end up in this situation where we end up looking forward at a -- for the rest of the year at a reduction on a year-over-year basis in terms of the assets, while still the revenues and the purchase volume continue to move forward.

Thanks. And in your mortgage business, just over the last week two relatively big players, GE and CIT have announced that they're getting out of that business. The industry literally is a mess, and in many regards. I just wondered if you have any updated thoughts on the importance of the mortgage business to Capital One and what -- and the growth strategy if -- if it is still something that you deem important to the company?

Well, Bob, in the middle of sort of -- of battle, it's -- one doesn't tend to think as much about long term exactly what you are going to do after the battle. This is a very tough time in the business. What we are doing is being incredibly focused to stabilize the business along a number of dimensions, most probably probably on the cost dimension, but also very much on the underwriting side of the business in terms of the product mix and in terms of liquidity strategies and things like this. So we actually feel very good about the traction that we're getting on those dimensions, and in a sense, the stabilization with a small S if you will, in the middle of this difficult environment. We still have more work to do in terms of long-term mortgage strategy.

Obviously, we know this is a volatile business and so on, we do have a very solid franchise with respect to GreenPoint. These are very talented people with great relationships, and a great credibility in the brand in the capital markets. And this is a franchise that I think has real potential in the long term, but right now it's really more about the delivery against a set of challenges in the short term. And the other thing that I think is really striking is the Capital One Home Loans business. In the midst of sort of problems all over the industry, Capital One Home Loans is growing, which is again our originated sale business. This is a business that full credit spectrum business, it's all internet based and so on. In this business is in fact in the face of this growing, and growing profits, if you can imagine over the course of this year. In we have good anchor tenants that we can work with in a -- in the middle of -- but right now it's about near-term delivery.

Next question, please.

We will go next to Moshe Orenbuch, Credit Suisse.

Great. Rich, I was wondering if you could characterize your decision to accelerate the share repurchase into 2007. What caused that and maybe follow up after -- after you do that.

Moshe, I think we are -- I have been saying for a number of quarters, I want to make sure that -- that our shareholders are -- can be well served in a difficult time of market conditions, and challenges, as -- for investors, in this company over the last couple of years. One of the important levers that we have, Moshe, to make sure our investors get paid is -- is in fact capital, and we have seized, in a sense the opportunities that we find in front of us, even though they don't massively move the needle, every little bit helps, and we certainly seize that opportunity along with making important moves among other dimensions like cost and revenue.

I guess I'm struck that this will the first time in the company's history that you've had a year-over-year decline any credit card receivables. Given that you're generating capital in a high 20% rate, it would seem to me, that you could probably be very, very close to the point at which you are thinking about not just completing that share repurchase, but also instituted a dividend. I wonder if you have any thoughts in that respect.

Well, Moshe, as we talked about for sometime, we -- we know that we have moved -- credit card is sort of leading the way in a sense -- moved to a -- a case where our company is not on the torrid growth rate that we were in the past, and we have therefore moved from capital neutral into a situation of substantial capital generation. And we -- and we have flagged our intent to return capital to shareholders. As we have said, the form in which it comes, in the form of buybacks or dividends, is something that that we -- we are -- we continue to discuss, and right now of course we're primarily doing the -- we are entirely doing the share repurchase pursuant to the North Fork acquisition. And the latter part of this year, and -- and early into next year as we look ahead to the other side of that, I think we'll have a lot to say to the marketplace about our capital strategy and I'll -- I'll leave it at that at this point.

Next question.

Thank you. Actually we have no further questions at this time. I'm going to turn the conference back over to Mr. Jeff Norris.

Thanks, very much, Katie. Thing you all for joining us on this conference call today, and thank you for your continuing interest in Capital One. Remember the investor relations staff will be here this evening to answer any further questions you may have. Have a good evening.

We thank you for your participate on today's call. That will conclude our conference call. Have a great night. And you may now disconnect.