Capital One Financial Corp (COF) 2007 Q3 法說會逐字稿

Welcome to the Capital One third quarter 2007 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS) I would now like to turn the conference over to Mr. Jeff Norris, Vice President of Investor Relations. Please go ahead.

Thank you very much, Shirlon. Welcome, everyone, to Capital One's third quarter 2007 earnings conference call. As usual, we are webcasting live over the Internet. To access the webcast, please log on to Capital One's website at capitalone.com and follow the links from there.

In addition to the press release and financials, we have included a presentation summarizing our third 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 "Quarterly 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 in 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 Capital One website and filed with the SEC.

At this time I'll turn the call over to Mr. Perlin.

Thanks, Jeff, and good afternoon, everyone. Let's jump straight into the highlights on the quarter on slide 3 of the presentation. Capital One posted a loss of $0.21 per share in the third quarter of 2007, comprised of a profit of $2.09 per share from continuing operations, offset by a loss of $2.30 per share associated with the shutdown of GreenPoint Mortgage. More on the shutdown and how it impacted our financials in a moment.

EPS from continuing operations in the quarter grew smartly from the second quarter of 2007 and the third quarter--and a third quarter of 2006 reflecting significant revenue growth offset in part by higher provision expense. Rich and I will focus on each of these important trends in greater detail throughout the call.

Moving on with the third quarter highlights, we executed on $480 million of open market share repurchases. In addition, our $1.5 billion Accelerated Share Repurchase, or ASR program, was completed in August. Although you'll recall that the ASR program reduced our share count by about 20 million shares as of April 2 when that program was launched. We are on track to meet our objective of completing $3 billion in share buybacks, originally projected by mid-2008, by the end of this calendar year. This means we'll target about $770 million of repurchases in the fourth quarter.

The third quarter of 2007 was the first full quarter for our cost restructuring initiative. Although in its early days we are gaining good traction and feel confident that the benefits will be realized as planned through 2009. More details on this in a moment.

Finally, despite the very difficult capital market conditions we all experienced in the third quarter, Capital One executed nearly $4 billion in funding transactions across a variety of asset classes, two-thirds of which was asset backed funding and the balance was long-term unsecured funding for the holding company. For 2007 we continue to expect diluted earnings per share of approximately $5.00.

Moving on to slide 4, let's take a look at how the shutdown of GreenPoint impacted our results in the quarter. When we announced the shutdown of GreenPoint operations on August 20, we estimated the associated charges would total $860 million after tax. As we moved towards completion of the shutdown and final disposition of loans, we now expect the total charges will be slightly higher than that or just over $900 million, the vast majority of which was recorded in the third quarter.

You can see this in the box at the top of slide 4, along with the results from GreenPoint operations in the quarter. A modest operating loss of $15 million combined with $883 million in charges resulted in a total loss from discontinued operations of $898 million.

There are two notable variances in current estimated charges as compared with the estimates we made and shared with you on August 20. A higher than expected level of charges related to valuation adjustments partially offset by lower than expected restructuring charges associated with our exit from the origination business. The evaluation adjustments include a $74 million allowance build related to the $680 million in loans held for investment in the GreenPoint or mortgage banking segment.

These Heloc loans were transferred from held for sale during the second quarter of 2007 and we anticipated this allowance build as a component of our estimated charges on August 20. The balance of valuation adjustments represent lower of cost or market marks on loans committed or sold subsequently or moved to HFI. The bulk of GreenPoint's loan warehouse and pipeline was subject to forward sales commitments, or flow agreements, when we announced the shutdown and were valued accordingly at that time.

However, certain long-term buyers backed away from their bids which caused us to remarket a substantial portion of those loans. Lower gain on sale margins contributed to the loss from operations, all downward valuation adjustments were required on loans to be sold or moved to HFI.

The lower box on slide 4 provides details on the disposition of GreenPoint's HFS loans. I won't walk you through all the data, but would highlight that of $3.7 billion in HFS loans about $1.3 billion were sold by the end of the third quarter. We had firm commitments to sell an additional $1.2 billion in loans as of September 30, more than half of which have already settled in October.

We chose to hold for investment about $1 billion in loans, the characteristics of which are detailed for you on the slide. Having marked those loans, we believe they will produce attractive risk adjusted returns.

After disposing of the bulk of GreenPoint's HFS loans we are left with approximately $151 million of repurchase and other loans in the warehouse we intend to sell. These loans are being carried at an average of 55% of par.

Lastly, we retain risk for further repurchases of sold loans for which we are currently carrying a [reppin] warranty reserve of $146 million related to this exposure. We are in the final stages of shutting down various GreenPoint facilities and expect to terminate the last leases by early 2008.

A GreenPoint team continues to manage the origination shutdown process with the same professionalism that characterized the way in which they ran the business for so many years. Impacted employees have been notified and are receiving severance benefits. Moving forward, GreenPoint's mortgage servicing operations and the $1.7 billion of HFI loans held in our former mortgage banking subsegment will be included in our local banking segment in the fourth quarter.

Let's now move to slide 5. While improving operating efficiency is not a new area of focus for Capital One, we formally launched a significant enterprisewide cost initiative in June as we completed a number of important improvements to our operating infrastructure. We remain on track for realizing gross cost savings of $700 million by 2009 and recognized $15 million of run rate savings in the third quarter.

We continue to expect the reported level of operating expense to fall in 2008 by $100 million to $200 million. We also continue to expect overall program charges of around $300 million or slightly less. However, our expectations for restructuring charges to be incurred in 2007 have been reduced from $200 million to about $150 million.

Realized and expected charges and savings related to GreenPoint Mortgage are now captured in discontinued operations. As a result they are no longer accounted for in our cost initiative. Still, we remain committed to the targets for charges and gross cost savings in the broader program and will continue to update you on our progress.

As we turn to slide 6, please keep in mind that year-over-year comparisons on the balance sheet and income statement are affected by the acquisition of North Fork on December 1, 2006. For that reason, we have noted changes on a linked quarter basis. Let's start with the balance sheet. Total deposits at quarter end decreased by about $2 billion on a linked quarter basis. The largest driver of the decline was the intended run-off of high cost brokered and public fund deposits.

During the quarter, we executed seven wholesale funding transactions for nearly $4 billion of funding despite difficult capital market conditions. We took advantage of our diverse and stockpiled funding options to sit on the sidelines during the period of highest uncertainty in the capital markets and executed our transactions when we saw attractive opportunities to do so.

Managed loans held for investment increased on a linked quarter basis largely driven by loan growth in our GFS subsegment. Looking forward, we expect low to mid-single-digit loan and deposit growth in 2008. Our tangible common ratio at September 30 was 6.17%, slightly above our 5.5% to 6% target range.

As I indicated, we expect to repurchase about $770 million in shares during the fourth quarter of '07. We've also indicated that we expect to increase our dividend beginning in the first quarter of 2008, to a fixed dollar amount of approximately 25% of expected 2008 earnings. Beyond that, we expect to return the balance of our excess capital generated in 2008 through continuing share repurchases.

Finally, revenue and net interest margins both expanded in the quarter. Margins were relatively stable in the bank while our U.S. card subsegment suffered significant margin expansion. Rich will walk through margins in our subsegments in a moment.

Turn now to the next slide for a quick look at the third quarter income statement. Allow me to focus on just a few highlights. First, revenue from continuing operations is up on a linked quarter basis, driven primarily by revenue margin expansion in our U.S. card subsegment that Rich will discuss more about in a moment.

Looking forward, we expect 2008 revenue growth will be in line or slightly higher than asset growth of low to mid-single-digits. Operating expense declined in the third quarter by $35 million, driven by continued efficiency gains across our businesses. Operating expenses include pre-tax expenses of $30 million related to bank integration and $52 million of CDI amortization.

Looking forward, we expect our operating efficiency ratio, including marketing but excluding restructuring charges, to be in the mid-40s for the full year 2008. Provision expense was up quarter-over-quarter and year-over-year as charge-offs rose and as delinquency experience caused us to anticipate higher charge-offs over the next 12 months, particularly in our U.S. card and auto finance subsegments. The increase in provision included an allowance build of $124 million.

This build represents an increase to the allowance of about $200 million for our national lending businesses partially offset by a $68 million reduction in the banking segment which itself was driven by a $91 million reduction due to the alignment of allowance methodology across our local banking franchise.

Please note that the provision expense does not include the $74 million allowance build related to the HFI mortgage loans I discussed earlier. Those loans and the associated allowance are currently held in discontinued operations, although both will move to the local banking segment beginning in the fourth quarter.

With that, I'll turn the call over to Rich.

Thanks, Gary. I'll begin on slide 8 with a look at overall credit trends. In our local banking segment losses remain stable and low at 19 basis points for the quarter. Non-performing loans as a percentage of loans held for investment increased by eight basis points. Charge-offs in our national lending segment increased 49 basis points driven by credit performance in our U.S. card and auto finance subsegments. Delinquencies in national lending rose to 4.7% in the third quarter from 3.89% in the prior quarter. I'll describe the reasons for these changes in the context of our operating segments in just a moment.

Based on year-to-date trends we're currently expecting charge-offs in the fourth quarter of 2007 to be about $1.2 billion. In 2008, we expect charge-offs of approximately $4.9 billion. This represents an increase of approximately $800 million over 2007. Our $4.9 billion estimate for 2008 charge-offs includes a full-year effect of the credit normalization we've been experiencing throughout 2007. It also reflects the delinquency trends we have witnessed in recent months, but doesn't speculate on future trends.

In this light, it is worth remembering that we're not estimating total provision expense which would require that we speculate on the level of allowance that we might need to build in 2008 based on expected losses well into 2009. Our actual charge-off experience in 2008 could vary significantly from the current estimate, given current uncertainties in the outlook for the credit markets and the broader economy.

Still, we think it is helpful to quantify our current view given what we've experienced thus far and to update you regularly on changes to our outlook as we see how things play out. One way we will help provide insight is to publish managed credit metrics for our major businesses on a monthly basis. We'll begin providing that data in November 2007 for this month's results.

Slide 9 is an overview of our national lending and local banking business segments. On a year-over-year basis sustained profitability in our U.S. card, global financial services and local banking businesses more than offset the declines in auto finance. You'll note some continuing themes across our businesses in the third quarter. Loan and deposit growth remains modest while revenue growth and revenue margins are strong. Credit losses and delinquencies across our national lending business have risen largely as a result of continuing normalization and expected seasonality.

In the third quarter, we've also observed some business-specific credit trends that I'll discuss in a moment. And our focused cost and efficiency moves continue to pay off resulting in improving operating leverage across our businesses.

I'll discuss our U.S. card business on slide 10. Once again U.S. card delivered solid year-over-year net income growth as increasing credit costs were more than offset by strong revenue growth and expense reductions. But looking beyond third quarter results for a moment, our U.S. card business has been and continues to be an important source of strength as we've anticipated and met Company-wide challenges throughout the year.

Most of the third quarter results in U.S. card are rooted in a set of carefully chosen moves we've been making throughout the year as we've anticipated these near-term challenges. We've selectively moved to enhance revenue in anticipation of credit normalization. We've stayed focused on subsegments of the market with the best risk adjusted returns and the most resilience through economic cycles.

We've maintained pricing and credit line discipline, balance with our continuing commitment to long-term customer value and we've leveraged our new operating platform and infrastructure to streamline processes and increase our operating efficiency. Collectively, this set of moves has driven the trends in revenues, loans, credit metrics and operating efficiency.

Managed loans declined 3% from the third quarter of 2006 to just under $50 billion. As we've discussed for several quarters, we've chosen to avoid parts of the market like prime revolvers which are dominated by very long teaser pricing, high credit lines and high asset turnover. We believe this combination of factors hinders the building of a long-term customer franchise and results in a portfolio of loans that is less resilient to economic cycles.

We've mostly been on the sidelines in these subsegments for several quarters. In the third quarter, we chose to reduce our investment in teaser-led marketing to prime revolvers even further. As a result, we've seen a significant decline in low margin, high balance prime revolver assets.

We continue to focus on product and marketing strategies with the most attractive risk adjusted returns and resilience. These include transactor products for prime and super prime customers, and attractively priced revolver products across the risk spectrum that do not rely on aggressive penalty repricing in order to achieve profitability.

Our marketing investments have resulted in solid growth in parts of the market that do not generate big balances, but in our assessment they have the best potential for prudent growth and profitability in the long run. The net effect of our marketing choices has been modest shrinkage in overall managed loans and a shift toward higher margin business. While we expect seasonal loan growth in the fourth quarter, we expect to end the year with lower loan balances than at year-end 2006.

Purchase volumes were essentially flat to the prior year quarter. The deceleration in purchase volume growth resulted from slower retail sales trends, our exit from two transactor focused retail partnerships earlier in the year and the decline in prime revolver loans I just mentioned. We expect a return to modest growth in purchase volumes in the fourth quarter.

We continued to generate strong revenue growth in the third quarter as we played catch-up and relieved the pent-up demand for customary account management moves that had previously been suppressed due the conversion of our card billing system. For example, following the TSYS conversion, we cleared a sizeable backlog of accounts where the funding had expired after several years and which needed to be repriced to market rates.

We also implemented selected fee policy changes following the conversion to bring our policies nearer to or in line with the industry. For example, the industry typically has a 20-day grace period and we moved our grace period from 30 days to 25 days. Collectively, these moves accounted for the bulk of our revenue growth in the quarter.

The revenue margin expansion we experienced in 2007 has mostly run its course. While we expect that revenue will grow in 2008 largely due to the full-year impact of the revenue moves we made this year, our revenue margin is likely to moderate somewhat. We believe that the significant revenue benefits we're currently experiencing will be partially offset by somewhat higher attrition and charge-offs in the coming quarter. Raising prices generally causes increased attrition which then creates some adverse selection.

Additionally, raising prices can cause an acceleration in delinquency roll rates followed by subsequent rise in charge-offs. We expect these effects to be more than compensated for by the significant revenue benefits of these pricing changes.

Charge-offs increased on both a year-over-year and linked quarter basis. Continuing charge-off normalization and the mix effects of our decline in prime revolver loans drove the year-over-year increase. The sequential quarter increase resulted from the same factors, plus the fact that our June implementation of the 25-day grace period, suppressed second quarter charge-offs by 31 basis points. Delinquencies rose more sharply than charge-offs, increasing 105 basis points from the sequential quarter.

While these numbers might suggest pressure on credit quality, most of the increases explained by factors that don't indicate any fundamental deterioration. Normal seasonality drove about 35 basis points of the increase. Another 35 basis points resulted from the 25-day grace implementation, which had two effects. The change in grace period suppressed delinquencies in the second quarter and created a one-time increase in delinquencies.

Another 15 basis points resulted from the mix effects of our decline in prime revolver balances. The remaining 20 basis points includes the early effects of credit worsening associated with fee and pricing policy changes I just discussed, as well as other economic factors. These delinquency trends are largely consistent with the expected rise in card charge-offs in the fourth quarter which we have been signaling for some time.

We expect that the recent increase in delinquencies associated with both the 25-day grace implementation and the fee and pricing policy changes, will roll through the delinquency buckets to charge-offs in the first quarter of 2008. We expect that this will result in about $175 million of extra charge-offs in the first quarter. This amount is included in the expected 2008 total Company charge-offs of $4.9 billion that I mentioned earlier.

We continue to expect rising charge-offs for the balance of the year. Previously, we had indicated our expectation for fourth quarter charge-offs were about 5%. Given further declines in prime revolver loans and current delinquency trends we now expect the charge-off rate to be closer to 5.25% in the fourth quarter. With continued revenue strength and operating leverage, our U.S. card business remains well positioned to sustain strong profitability.

Results for our global financial services or GFS businesses are summarized on Slide 11. GFS net income for the quarter was $118 million, up 10% from the third quarter of 2006. Net income growth resulted from strong revenue growth and increased operating leverage partially offset by higher provision expense. GFS managed loans ended the quarter at $29 billion, up 8% from the year-ago quarter.

About half of the dollar growth resulted from stronger Canadian and U.K. currencies versus the third quarter of last year. Once again, North American GFS businesses provided the strongest growth in both loans and profits. Small business, installment loans, and Canadian credit cards all delivered double-digit loan growth and our origination businesses also grew.

Point-of-sale originations were up 23% year-over-year. Capital One home loans originations were up 26% as compared with the third quarter of 2006, although originations declined modestly from the linked quarter as expected in the current mortgage markets. U.K. credit card loans declined modestly year-over-year as we maintain a cautious posture in that market.

In the third quarter, charge-offs and delinquencies were essentially flat versus the sequential quarter. Charge-off rate rose by 30 basis points and delinquencies were up by 16 basis points from the prior year quarter.

In North American GFS businesses, the story is very similar to our card business minus some factors like the 25-day grace period change that are unique to card. The biggest factor in GFS is the continued gradual normalization of charge-offs from their very low levels in 2006. Credit in the U.K. remains stable. Our GFS businesses delivered another solid and steady quarter of profitable growth.

You'll see a summary of third quarter results for Capital One auto finance on Slide 12. Our auto finance business posted a $4 million net loss for the quarter, compared to a profit of $38 million in the third quarter of last year. While revenues were up 6% with strong operating leverage, these trends were more than offset by a 52% increase in provision expense.

Credit results and outlook continue to be the key story in our auto finance business. Both charge-offs and delinquencies rose sharply from the very low levels we experienced in the third quarter of 2006. They have also risen significantly from the second quarter of this year. Both delinquency and charge-off performance are driven by the same three factors. First, we experienced a normal seasonal increase this quarter. In a sequential quarter comparison this is the largest single driver.

Second, we continue to see elevated losses from our recent dealer prime originations. As we talked about in the past two quarterly calls, we've responded by implementing second and third generation credit models and adjusting underwriting criteria. We believe we've turned the quarter in the dealer prime business and the loans we're originating today have better credit characteristics. However, actual loss levels on earlier vintages will remain elevated until those loans amortize.

The third factor driving credit performance is elevated losses in our dealer subprime business. We are continuing to see the impacts of industrywide risk and underwriting expansions over the past several years. Risk expansion across the industry and in our auto businesses include things like longer-term loans and higher loan-to-value limits. While losses on these loans have risen, the business remains highly profitable and we're quite comfortable with the credit performance and risk adjusted returns of these loans.

Originations in the quarter were $3.2 billion, roughly flat compared to the third quarter of 2006. Originations were pressured downward by declining auto sales across the industry and by our pull-back on dealer prime volumes. These pressures were offset by continued success in subprime and direct prime, as well as the early success of our new business model with dealers. As I discussed in the last quarter call, we implemented an integrated program across our 18,000 dealer relationships completing the rollout in the latter part of the second quarter.

While it is still very early days, our first full quarter of results has been encouraging. Dealer satisfaction has increased and loan originations are strong and the credit quality of new originations is better enhanced by positive selection. Obviously, auto finance results thus far in 2007 are disappointing largely as a result of the credit challenges I've discussed.

But based on solid originations, improving operating efficiency and the early success of our integrated dealer approach we believe our auto finance business is positioned to return to stronger growth and profitability in early 2008.

I'll discuss our local banking business on Slide 13. The slide shows actual results for the 2007 quarters and pro forma results for the 2006 quarters. Net income for the quarter was $192 million, up more than $50 million from the second quarter. The primary driver of the increase was a reserve release that resulted when we aligned our local banking segment loan loss allowance methodology to be consistent with Capital One methodology.

Revenues declined modestly from the second quarter as did non-interest expense. Total deposits declined by about $1 billion from the second quarter to $73 billion. Several large customers withdrew a portion of their deposits in the quarter as they repositioned their real estate holdings. Deposit mix and pricing were stable in the quarter. Loan balances were flat at $42 billion.

Commercial loans grew modestly offsetting the expected paydowns in the mortgage portfolio. The commercial real estate and multi-family loan portfolios were flat from the second quarter. Credit performance remains strong and stable with charge-off rate remaining at just 19 basis points. Non-performing loans as a percentage of managed loans rose 8 basis points to 27 basis points.

Once again, the biggest news in our local banking business in the third quarter is our continued progress on integration. Lynn Pike has built her leadership team by selecting experienced executives from legacy Capital One, North Fork, Hibernia and key external candidates. The senior management team is now largely in place.

Beyond the transition of the leadership team, our integration efforts continue to be on track. Integration efforts will continue to accelerate over the next two quarters with the deposit platform and brand conversions scheduled for the first quarter of 2008. In the third quarter, our local banking business continued to deliver solid results while managing and delivering on a successful integration.

I'll close tonight on slide 14, which is a summary of current expectations we've provided for 2008. The expectations we provided for key operating metrics and capital targets effectively constitute our guidance for 2008. While they provide enough inputs to develop a reasonable range of expected earnings for 2008, we believe there are both longer-term and shorter-term benefits to providing you with this level of detail.

As compared to a calendar year EPS range, these metrics provide visibility as to how we're doing against the goals and targets we've set that will deliver long-term shareholder returns like operating leverage and capital discipline. Moreover, this approach sheds light on important top line as well as bottom line trends which will drive performance in the future.

In the shorter term this approach allows us to give you a clear picture of where specific variables like credit are pointing in the moment and the factors which are likely to drive them going forward without embedding them in an earnings range wide enough to capture all possible scenarios, especially during uncertain economic times such as these.

It also allows us to provide frequent updates on those variables which are more visible to us, like monthly credit metrics in our national lending subsegments and expectations for future quarter charge-offs without having to speculate on variables like the allowance we might need to build over the course of a given calendar year to anticipate loss experience another 12 months out.

I hope you'll be able to join us in McLean or over the webcast for our fall investor conference on November 6. At that time, you'll have a chance to hear directly from the leaders of our businesses about our strategy and outlook for 2008. Gary and I will also discuss our overall corporate outlook with a focus on how we expect our strategic and business results to translate to shareholder value over the next couple of years and longer term.

Now Gary and I will be happy to answer your questions. Jeff? Thanks, Rich. We'll now start the Q&A session. If you have any follow-up questions after the call, the investor relations staff will be available to answer them.

As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to only one question and one follow-up question. Shirlon, please start the Q&A session.

(OPERATOR INSTRUCTIONS) We'll have our first question from Bob Napoli, Piper Jaffray.

Thank you, good afternoon. Rich, question, in order to get your stock moving, I appreciate the return of capital, and the dividend is certainly a significant moves, but I'm trying to get an understanding of kind of the growth rate of the Company.

If I think about your business, the card business, it appears to be a cash cow with the return on assets is very high, probably not going to get a lot of expansion in ROA, so probably grow maybe in line with loan growth. The auto business, a bit challenged, not a great growth industry. The bank seems to be modest growth. It seems like you have some growth drivers in GFS, but looking at this, trying to understand, maybe you can give me some color on the long-term growth potential of Capital One?

Thank you, Bob. I think certainly Capital One relative to the Capital One of many years ago, where we were growing at double-digit rates, and pretty strong double-digit rates, it is a very different Capital One at this point. We have two anchor tenants that are both in relatively slow-growing industries. The most striking thing about these anchor tenants is both their franchise potential in terms of enhancing the overall business of the Company, but also their very strong capital generation.

So you are right in the sense we're not going to push these businesses to do unnatural things for the sake of growth. What we are going to do is leverage these businesses to generate the value that they can which is primarily at this point around very substantial return of capital, and we--all the actions that you can see are consistent with doing that.

So the bank at the moment, of course, is mostly, is in pretty stable situation, but mostly really the focus is on integration. But I think the card business is a classic case, Bob, where you can see that as we react to the pressures in the marketplace, we are not doing anything unnatural. Instead, we're really driving a lot of capital generation and that creates value in a way different than from just, underlying asset growth.

You talked about the auto finance business, the auto finance business, while the industry is honestly growing at a couple of a percent, in fact this year is very slow for the industry, the auto business, like virtually like all of our GFS businesses are, leveraging our strategy of being consolidators and while the industries may grow slowly, I think in GFS and auto we have the chance for substantially higher growth . All of that growth needs to be cautiously pursued in the context of the credit markets that we have out there.

Additionally, though, on how we drive shareholder value, I mean, we have--you can see the actions we've taken on the revenue side of the business, the dramatic actions we've taken on the cost side of the business, and again making sure on the capital side of the business that we are very careful with our investments and, both with respect to return of dividends and but also in comparing alternative investments to understand the power of share buybacks, particularly in the context of our stock price right now.

So, to me, at the end of the day, our focus isn't making Capital One a growth company. Our focus is in value creation and I think we're very well positioned to do that, even in the context of a company that still has, I think, a lot of growth potential relative to the industry over the longer

Thank you. Just to follow-up on the credit side, are you seeing anything alarming? Obviously, you've raised your charge-off outlook a little bit for the fourth quarter. You broke down the pieces. But are you feeling much more concerned with the economy today than you were even 30 or 45 days ago?

Well, Bob, the economy itself is, depending on whether your glass is half full or half empty, you can look at the economy and see a lot of things to like or a lot of things not to like. Certainly, the metric we've always focused on is we look at the economy has always been employment, and, I think, there's a lot of strength and consistency with respect to the most important metrics we look at at the economy.

We also look at our, just the trajectory of our underlying businesses and as we talked about when you see a spike in delinquency or some of the big changes you see, obviously, we do a lot of digging to make sure that we can explain the various effects and always in the, in search of sort of worsening on a stand alone basis. As you can see there are strong explanations for some of the credit metrics, as we've talked about.

You know, as we look we continue to not see direct effect from the mortgage crisis affecting our own customers. We see very stable differences between our mortgage holders and renters. And we've talked a lot about this in the past.

We have -- now that more data has come out, we've done a pretty deep look at the markets where housing prices have -- home price appreciation has been very dramatic over the last number of years. And what we see, Bob, is if you go all the way back to 2004, we can see that in those markets the credit performance on our portfolio of the sort of the high octane HPA markets, the credit performance improved differentially more in those markets than everywhere else on our consumer portfolio.

It peaked in '05. It was stable -- this differential peaked in '05, it was stable in '06. And what we see in '07 is it's basically regressed back to the mean. So, in other words, the Californias, the Floridas, Arizonas, the superior performance in consumer credit we've observed over the last few years has more or less regressed toward, or to the mean. So as we look at those markets also we see that again this is not, doesn't appear to be the direct mortgage effect. Renters and homeowners in those markets in the past and in the present, they've tended to move together.

What does this all spell to us? It basically goes back to the core principle that it is about the economy. We see a strong economy, we see basically stable performance adjusted for the things we're talking about in our own portfolio, and so I think we -- I think we feel very good about that.

Nonetheless, I think there's more uncertainty, Bob, than usual at the moment. It is why we're making--just being extra careful in underwriting and doing the things we have, it is a reason behind the revenue moves we've done to put ourselves in a position to weather the storms that may or may not be out there in the future.

Next question, please.

We'll go next to Ken Posner, Morgan Stanley.

Hi, Richard, I just wanted to clarify that one last point you made. Your explanations are very helpful compared to just looking at the raw numbers in the press release. So you're saying you're seeing no real deterioration in the underlying consumer at this point when you factor out the policy and pricing changes?

Yes, Ken, let me try to clarify, because one thing I want to say is all this time when we've been talking about normalization, I've always said, my caution has always been, here you had incredibly good consumer credit performance in '06. And we all knew that it can't--that can't last forever, and we all declared there would be quote, unquote, normalization, a return to normal.

Now, normalization itself, as people become delinquent or charge-off, they don't have labels on them saying I'm here normalizing. They don't have labels that say I'm a substitution effect, or whatever. So my caution has always been in some ways in an environment of normalization, what is worsening versus normalization? It is a little bit of an art form.

We've said all along that our credit performance has been coming in pretty much on top of a forecast we made a year ago and that is comforting to us. When we get--when we get behind the normalization that is happened over the past year, remember we always talked about the one thing that was puzzling was that the lull in charge-offs was greater than the spike in bankruptcy. So in some sense 2006 fooled us by virtue of how good it was.

I think now as we dig into the numbers, it wasn't only the bankruptcy effect, but there was also this exceptional performance in the rapidly home price appreciating markets that is more now regressing through the mean. So, to us, I think, broadly, Ken, I would call this all part of normalization in the sense those things are regressing to the mean. We've got bankruptcies returning more to normal level, I think, while there are no labels on it that's substitution, that we would expect certainly is consistent with what we see.

So as we itemize this delinquency spike, if I could clarify one thing, Ken, to you, the delinquency spike that we had in the third quarter, we spent a lot of time looking at this thing, and, of course, given that we projected charge-offs would be quite a bit higher by the end of the year, this is a natural effect on the delinquency side of what we already projected. But to just go back and itemize, again, the fact that the 25-day grace effect is very isolatable and it is a bubble kind of moving through the pipe in a sense and that's 35 basis points of these delinquencies.

The seasonality, honestly, seasonality doesn't have labels associated with it, but when we look over the past six years we find seasonality that would be consistent with about 35 basis points of this. Absolutely it is just math. The mix shift that comes from fewer revolver balances so that is the 15 basis points.

What I want to say is that the 20 basis points that's left over, it is our belief, but we can't prove it at an early point, that that's a very natural effect of the fee and pricing policy changes. But, I mean, I can't prove that to you. In hindsight we could find, Ken, that that is worsening in another form. Kind of what we've done is we've isolated a relatively small amount of the delinquencies that we're going to keep an eye on. But the net effect of all the things I'm saying is there's a -- it is more uncertain than usual, but I think there is solid and explainable performance that is going on.

Richard, thank you, and it is reassuring to see that contrast to some of the mortgage companies which have seen a very sudden deterioration in credit. So I really appreciate the clarification.

Thank you.

Next question, please.

We'll go next to Chris Brendler, Stifel Nicolaus.

Hi, thanks. Good Evening. I hate to keep harping on it, but I'm going to anyway. On the credit side, I understand a lot of the stuff you've discussed, the drivers, but it looks to me, if you look at your competitors, the major bank competitors, in the card business, the few subprime competitors we look at in the auto finance business, your trends are not in line with a lot of those companies.

And I think that, I'm sort of worried about the concept of adverse selection. The pricing strategy you're using, it doesn't seem to be tracking the way you expected it, because you're already raising your fourth quarter loss guidance for card. So I just wanted to know, do you feel--is it an accurate statement that you're getting some semblance of adverse selection in both the auto or card business, or is there a better explanation?

Chris, really a bunch of things wrapped up into your question. First of all, when us versus competitors, I think we have tracked on top of or maybe slightly better in the subprime auto space, than the competitors. We talked about in the prime auto space, I've talked extensively about some of the issues that were Capital One specifically in some of the vintages there.

But I think the auto, overall, the auto performance is very much tracking the way that we see the industry tracking and we can talk more about that in other questions if people want to ask.

On the card side, this is not a story of adverse selection. This is a story of consistency about things we've done for many, many years. So compared with competitors, they didn't have the 25-day grace effect. They--generally if you look at us versus competitors, everybody has a bit of a different portfolio. We definitely have more seasonality than they do and this is the period of the most significant seasonality increase that you see with respect to delinquencies.

The mix shift, again, every company has their own mix thing. This is absolute math, just the effect of the mix shift out of the prime revolver business. So the--as I said, there actually is some adverse selection that, Chris, that comes with pricing changes, and we're pretty much in advance declaring that we expect that and we expect attrition and we expect some adverse selection with pricing changes.

We expect that to be swamped, frankly, by the revenue benefits, but honestly, there is some adverse selection with respect to that, but that is not a -- that is not a big effect related to the current numbers that we're--

Let me ask it a different way, then. It was only a quarter ago you talked about a 5% loss rate in the fourth quarter. Now you're talking about a 5.25% and it is not a macro thing. So are you seeing, did the pricing not work the way you expected it to, or the grace period? The grace period really shouldn't drive losses, it should be a temporary late fee benefit and a delinquency blip.

Customers are not going to go bad because they're missing their payment because it was five days. What exactly drove the increase in losses for the fourth quarter? And in a related question, did you have any meaningful adjustment to your I/O strip in the card business this quarter?

Okay. First of all in the fourth quarter losses, quite a while ago we said, look, we expected charge-offs to be around 5%.

And I think a number of people said--I'm having trouble getting myself to 5%, how do we get there? We said, look, I think it is essentially just baking in the math of the things that have been going on in the business, and the increase in that estimate to 5.25%, about half of that is, or a good chunk of that is basically the denominator effect related to less asset growth and some of it -- a lot of it just relates to the math that's working through that itemization associated with delinquencies that I did earlier, including, again, the numerator effects associated with the mix change.

So that's pretty much how I would explain that. Gary, you want to talk about the I/0 strip.

Sure, Rich. Hey, Chris, we actually had a small write-up in our card I/O strip during the third quarter, something between $17 million and $18 million. I know that is a little different than what you've seen with some other folks, and just keep in mind that there was some positive benefits from the strong revenue growth which more than offset the increase in credit costs and some of the small increase in funding costs. So up $17 million to $18 million.

Next question, please.

We'll go next to Steven Wharton, JPMorgan.

Hi, Rich and Gary. I guess my question is, I appreciate the kind of initial 2008 guidance that you provided, and as it relates to the charge-off guidance, first of all, I wonder if you could maybe perhaps highlight a little bit what sort of economic environment you would expect, in terms of like GDP to get you to $4.9 billion?

And then secondly, I want to get a better sense of where you are from a reserve standpoint. A number of banks had found themselves in a position where when things were good they were releasing reserves and running down reserve coverage ratios in addition to just having approving net charge-offs and now it is like kind of the opposite.

So not only do you have the increase in the dollar provisions, then you have to provide and increase your coverage of your loan portfolio. So my understanding--I thought that Capital One had done a little less of the former in terms of bleeding the reserves, and which would imply that maybe there will be less of the latter. Can you just talk about that a little bit?

Yes, thank you, Steve, I'll take the first part and Gary can talk about the reserves. I'm glad you asked the question about 2008 credit guidance because I want to be as clear as we can. You know, it's, a year ago when we set out, it turned out one of the most, probably of all our metrics one of the ones that turned out most close and our own internal forecast turned out to be the charge-offs.

We know any year, and particularly in a year like this, it is something that can have a lot of variance to it. So our approach is we don't just want to take an unusually large number just to make sure we come in under it. What we want to do is try to have you see it as we see it at this point, and it could, of course, be subject to change.

So the way we're looking at it, Steve, is that we are--we are assuming with the economy, I mean, we don't--we don't model it so we say if unemployment is exactly X percent then it means this on our charge-offs, but generally we are viewing a continuation of the economy pretty much the way that we see it.

We are assuming that the dollars, which are currently delinquent, will flow through to charge-offs. We assume the effects of normalization and our shift in loan mix will continue. We assume seasonality follows its normal patterns . We also assume that temporary factors like increase caused by policy changes will go away over time. So, this is pretty much a fair way estimate.

It is certainly not an estimate that is massively conservative. I think what we tried to do--so we don't assume a lot of additional changes in the economy or credit performance from here. It is more just how what we see will play out over the course of 2008. And that is why, also, the important choice of not trying to predict what our reserve build will be next year.

Gary, you want to take the other part of

Sure, absolutely. Hey, Steve, just taking a look, I obviously don't need to remind you that our allowances, our best estimate of future losses, and in order to be able to come up with those estimates we need to take a look at the experience we're having with our book right now. Future allowance will really depend on how that book changes.

So as Rich says, as our mix may shift from time to time, that is going to have an effect on future reserving needs. Obviously, the actual performance of the book that we have, so looking at delinquencies is the best predictor of future losses. That is going to get into the thing.

Bottom line, it is very hard to get ahead of future reserving needs because one would need a crystal ball about actions, about markets, about credit, that we simply don't have. But taking all of that into account, certainly in this past quarter, is significant increase in our coverage ratio in card from about 4.7% to 5.5%, and that's, again, because we've seen the effects of the mix shift that comes from the reduction in the amount of prime revolvers in the books, as well as the higher delinquency rates.

The other business coverage ratios are actually quite stable, and that's kind of more of what you might expect given the performance that we have seen. Kind of a final note, Steve, if I could, on the allowance overall for the quarter, just so everyone has the numbers kind of straight. We did add $200 million more or less for national lending.

Normal banking operations would have led us to increase the allowance there by about $24 million or $25 million, and then the allowance was also increased $75 million related to discontinued operations, the Heloc loans that were moved from HFS to HFI at GreenPoint in the second quarter. And then netting out of that $300 million more or less of allowance build, was about $65 million to $67 million resulting, sorry, $91 million change in the bank, a net of $67 million. But a gross of $91 million reduction in the bank largely as a result of what you see when any bank integration takes place is you integrate all the methodologies.

Remove the commercial methodologies of North Fork more to what we would consider to be mainstream methodologies, such as we had at the old Hibernia franchise and then the consumer coverage was moved to industry norms, moving away from lifetime losses to 12-month losses.

By and large we would love to get ahead of the future, but you would need to tell us what the future is in order to do so. We'll continue to do our best job of trying to anticipate based on the facts as we have them.

All right. Thanks.

Next question, please.

We'll go next to Scott Valentin, FBR Capital Markets.

Good evening. Thanks for taking my question. Some of your peers on other calls, at least one peer, noted some changes in the credit card usage patterns, such as more cash advance and maybe payments coming in slightly later. I was curious if you noticed any change in payment patterns for your cards or even payment rates? That is my first question.

Second question is on deposit trends. I would thought with the ABS market disruption, maybe you would have emphasized deposits more, maybe grown deposits this quarter. Just curious to get your reaction, maybe a thought when deposit growth may resume?

Okay, Scott. On our competitor that did reference spending patterns, we did take a look at that, of course, we look at these things all the time.

That competitor saw ramping of cash advances and rising utilization rates which tend to be triggers of higher risk. We have looked for this and we have not seen it. So really, honestly, things are pretty stable. The things that are--that are--well, the things that are moving in our portfolio are the things that we identified related to mix and things like that. Gary, you want to take that deposit question?

Sure, absolutely. Hey, Scott, in terms of deposits the big shift down in the deposit balance in the third quarter was really driven by a reduction in the high cost deposits, so broker deposits and especially public funds.

In fact, the level of retail deposits, meaning the deposits in our branches without public funds included, actually rose by about half a billion dollars. The basic funding sources for our portfolio in the third quarter were cash that we had raised earlier this year as it turns out quite opportunistically given the kind of dislocation in the markets in the third quarter. So we ran down some of our cash balances in the third quarter.

We also had some funding, as you know, at the holding company, which is important to kind of maintain our liquidity levels there. And we found things like home loan bank advances to be very attractive funding on a marginal basis.

But certainly when it comes to deposits, especially with short-term rates starting to move down, we're going to be watching very carefully for opportunities to grow deposits and to do so in a way that builds the franchise and helps us achieve better funding costs overall.

Next question, please.

We'll go next to [Greg Regan], Cedar Hill Capital.

Hi, guys, thanks for taking the call. Just a point of clarification on the reserve. The $75 million of HFS loans you said were--excuse me, HFS provision was being captured in discontinued operations, so that did not hit the provision this quarter, but that will be going back into the retail bank in 4Q, so can you just--how does that work on the P&L next quarter?

Okay. Well, again, Greg, it is already hit the P&L through the P&L of discontinued operations. And so the allowance is on the balance sheet and what we'll be doing in the fourth quarter is simply moving those loans, as well as any other HFI loans that were moved from HFS in GreenPoint. We'll be moving the loans and the associated allowance to the banking segment. It will simply be a move on the balance sheet, no effect in terms of a P&L.

Okay. Thank you.

Next question, please?

We'll go next to Rick Shane, Jefferies & Company.

Hi, guys. Looking at the auto business, one of the things I'm sort of struggling with is given where loss rates are right now, and even just assuming that provision matches the loss rate in '08, does this business become profitable again?

Maybe what you can do is sort of dive a little bit more into your predicted loss rate for '08 and give us some sense as to where auto charge-offs are going to go.

Yes, Rick, it is Gary. I don't want to do too much speculation, but certainly as Rich described a lot of the you know business that we've been putting on the books of late is business that's going to be highly profitable.

The auto business has been doing significant work to try and improve their operating leverage, so we expect that they're going to be coming down quite substantially in terms of costs as a percentage of outstanding loans. And certainly at the investor conference you'll be hearing from our business folks there about some of the improvement there.

So I think the combination of operating leverage having really kind of improved, our risk models around the prime dealer business generating good volume growth, I think, the decline in profitability that you've been seeing in auto we would consider to be temporary based on the kinds of credit we've been seeing to date.

Obviously, we don't have a cystal ball about what credit will be in the future, but we'll apply that same kind of cautious underwriting we have to the rest of the book and we're certainly determined to make that business profitable.

Okay, and I guess the way to look at this and I guess this gets back to Rich's comment about the bubble going through the tube. When do you think on the auto side we'll see, and again, I realize on the card side one of the issues you're dealing with is sort of a broader macro picture, but on the auto side what you're describing is a little bit of a seasoning associated with the prime portfolio.

When do you think--because that is easier to predict given the statistics you're looking at. When do you think that will pass through? That is probably a better way I should have asked the question to begin with.

Well, Rick, as you know, these vintages are much shorter in their overall life than credit card vintages and already what we're seeing in the prime business is significantly better. Now, I don't want to declare victory there because it takes a while to look at vintages as they progress, but looking at just a lot of this sort of metrics at the time of origination and then the early vintage performance, we like a lot more of what we've done in prime.

In fact, if you recall, we actually backed off prime originations and, significantly backed off pending the rollout of our integrated auto program which I think is really helping on the adverse selection side. It is a combination of really getting more positive selection through dealer relationships and also much better data for which we have built second and third generation models.

So the early reads on those are good and it is matter of the math of better vintages sort of carrying the day as the other vintages work their way through the business.

On the subprime side of the business, here is how I describe what is going on. It was something like a couple of years ago that the industry table stakes rose in terms of things like, a lot of things started going to 72-month, up from 60 months. You had higher LTV and there were things associated with the higher table stakes.

We looked at that at the time. We were concerned about it. We did our best to model the results from this and we concluded that while there's higher risk, there is on a risk-adjusted basis these loans should be very, very solid.

We then did those originations and what we found, if you will, in maybe the first year of this two-year industry change, we actually did better than we had projected on a vintage basis. And what we have seen of late is things have come in a little worse than we have projected on a vintage basis, sort of net/net. The net effect of this, and this certainly has impact on profitability going forward.

These things are still very profitable loans. It is just that kind of the second-year vintages versus the first, has been worse, and some of that is normalization and all of the things we've talked about. So that is really one I deeply believe is an entire industry phenomenon there.

We've noticed the industry has stabilized, the pricing seems rational. And I think while the whole industry underwriting is sort of a notch at a higher level, I think that of risk, that on a risk-adjusted basis we feel that this is a solid business.

I think it is a stable outlook there. So we think profitability -- if you take all of these effects between the big allowance builds we had to do this year and the vintages running through the pipeline, I think we look to a substantially better year in the auto business next year.

Next question, please.

We'll go next to Moshe Orenbuch, Credit Suisse.

Thanks. I wanted to kind of follow up a little bit on the auto business, because really if you do look at the history over the last kind of two and a half years, it doesn't--forget the loss this quarter--it doesn't seem you made the hurdle rates in the majority of that period of time.

Certainly from the second half of '05 it is probably only two or three quarters, three quarters maybe of that period of time since that hurdle rates. That is my question is that is there like a longer term strategic plan? I understand getting back to profitability is important, but how do we kind of look at that in that context?

You know, Moshe, obviously the auto business on a vertical current period basis looks way under hurdle rate because not a lot of earnings there. But when we look at the--from a life cycle or horizontal basis.

I'm talking about three years, Rich. That is almost a life cycle of a loan.

Let me just finish my point here for a second. I'm sorry here. On the subprime side, these things have been solid in terms of risk adjusted returns. On the prime side, they have been well below risk-adjusted returns, and the--so the thing that has hurt the performance has been just the general underperformance of the prime things that we've talked about and the successive allowance builds that--well, from a vertical perspective, these successive allowance builds that we have undertaken this year.

So--so again I think the subprime has consistently been well above hurdle, Moshe, and I think our outlook on the prime originations, as I talked about, and confirmed by the early vintage results of these, is pretty positive, too.

Along the way, can I say one other thing, Moshe, very importantly has been a significant effort on the cost side in the auto business. Progressively every quarter you can go back and look at the numbers, but we're dropping by 10 and 20 basis points a quarter the operating costs of the business, and that is a very important part of long-term profitability.

Next question, please.

We'll have our next question from Bob Hughes, KBW.

Hi. Thanks for taking my question. Rich, I really appreciated your conversation about credit performance, particularly in some of the markets that have experienced much higher housing price appreciation and that you're seeing some reversion to the mean. As we look out to 2008 and consider your charge-off assumptions in the economic backdrop, to what extent have you factored in additional housing price deteriorations in some of those markets?

I think, Bob, our projection for 2008 is a--it is, again, the models are not--are not--our forecasting of 2008 is not one metropolitan area at a time. In some sense there is not a mechanical linkage of that to the other.

My point about HPA is that the high home price appreciation, those markets that where there's been a big change in home price appreciation, I think that is reflective of changes in the economy in those markets. Our overall assumption about the economy is one that is pretty static.

We have kind of intervened and altered some of our underwriting in some of those HPA affected marketplace, but we have not put into our credit forecast for next year, we have not put an assumption of further degradation in the nation's economy or the economy in any specific market. It is really more of just an overall consistency from where we are.

Okay. I mean, it is an interesting topic of discussion. I think a lot of folks would argue that housing price appreciation in a lot of those markets was not necessarily driven by a stronger underlying economy, but rather lower interest rates, lax underwriting, et cetera, speculation.

So the extent that the housing price appreciation in some of those markets helped to maybe mask some credit deterioration and resulted in a much longer lull in the return of normalization post a spike in bankruptcies.

I just wonder what your thoughts might be on how that could impact you on the other side to the extent that some of those markets really start to see faltering housing values and you see a deteriorating loss effect as well?

Yes, look. One thing I want to make sure I don't get on the other side of a discussion is if I'm an advocate there won't be any economic worsening. For years and years we worry about all these things. I'm more talk to you about mechanically about what's in our credit forecast.

The thing I want to say about the housing price--the high-octane housing price markets is the thing that we have found, is that's most correlated is the rate of change of house price appreciation, and actually we don't really believe necessarily that is the causal variable, because if it was the specific causal variable, we'd see a homeowner effect instead of, in fact, what we see is the same effect with renters, as well. So it is a local economy effect.

The main thing that we've seen there is a regression to the mean. You know, it is entirely possible those markets could, in fact, worsen beyond the mean.

It is not something that we have put into our forecast, but, again, part of our reason for giving you a window into how we think about credit is I think the most useful thing we could do for you is tell you what we see and how that mathematically works its way into charge-offs over the course of the next year. And all of us will watch with a lot of anticipation how the economies both locally and nationally move.

[Shirlon], are there more questions?

That does conclude our question-and-answer session, sir. I'll turn the conference back over to Mr. Norris for closing remarks.

Thanks, [Shirlon.] And thanks to all of you, again, for joining us on the call tonight. Thank you for your interest in Capital One. I'd like to just make sure we remind all of our listeners about our upcoming fall investor conference which will be held on Tuesday, November 6, 2007. The conference will be held at our McLean, Virginia headquarters and will also webcast live. You can find more details about this on our website at capitalone.com or you can contact Investor Relations at investor.relations at capitalone.com. The Investor Relations staff will be here this evening to answer any further question you may have. Thanks, again, and have a good evening.

That concludes today's conference. You may disconnect at this time. We do appreciate your participation.