Capital One Financial Corp (COF) 2014 Q1 法說會逐字稿

Welcome to the Capital One first-quarter 2014 earnings conference call.

(Operator Instructions)

I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Global Finance. Sir, you may begin.

Thanks very much, Vicky, and welcome, everyone, to Capital One's first-quarter 2014 earnings conference call.

As usual, we are webcasting live over the Internet. To access the call on the Internet, 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've included a presentation summarizing our first-quarter 2014 results. With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer, and Mr. Steve Crawford, Capital One's Chief Financial Officer. Rich and Steve are going to 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 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 entitled forward-looking information in the earnings release presentation, and the risk factors sector in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.

With that, I'll turn the call over to Mr. Crawford. Steve?

Thanks, Jeff. Let me begin with slide 3 tonight. Capital One earned $1.15 billion, or $1.96 per share, in the first quarter. On a continuing operations basis, we earned $1.12 billion, or $1.91 per share, and had a return on average tangible common equity of 16.8%.

As you know, our capital plan was approved in the quarter, and our Board has authorized $2.5 billion in share repurchases over the next four quarters. Included in continuing operations results this quarter were a lower provision for loan losses, driven by lower charge-offs and a $208-million allowance release, and $27 million in discrete tax items primarily related to changes in New York state tax law.

Our historical financial statements have been revised, as we adopted a new accounting standard for investments in low-income housing tax credits in the quarter, resulting in the cost of investing in qualified, affordable housing projects no longer being recognized above the line in operating expense, but rather below the line as a component of tax expense. In addition, the new accounting standard results in higher costs in the earlier years of the investments' [lives] due to faster amortization, resulting in a modest reduction in historical earnings and a one-time $112-million reduction to retained earnings.

We have provided an appendix slide that outlines the impact to the consolidated Company and the segment results due to the adoption of the accounting rule. Excluding the impact above, operating expenses declined quarter over quarter, largely due to the absence of non-recurring restructuring expenses in the fourth quarter. Additionally, linked-quarter revenues were lower, driven largely by day count and lower seasonal volumes in card.

Turning to slide 4, let me briefly touch on net interest margin. Reported NIM decreased 11 basis points in the first quarter to 6.62%, more than entirely driven from the first quarter having two fewer days' worth of recognized income.

Average interest-earning assets were down modestly quarter over quarter, driven by lower average investment, securities, and cash offset by higher average loan balances. Average loans were higher on a linked-quarter basis, due to continued growth in our auto finance and commercial businesses, offset by declines in card balances, primarily due to seasonality. Our guidance for card runoff in 2014 remains $1 billion. We are updating our expectation for mortgage runoff in 2014 to $5 billion, from $4 billion previously.

Turning to slide 5, I will briefly cover capital trends. As expected, Basel III standardized became our primary regulatory capital regime in the first quarter. Regulatory capital ratios for periods prior to the first quarter are reported under Basel I.

Our common equity Tier 1 capital ratio on a Basel III standardized fully phased-in basis was 11.7% in the first quarter compared to the same number of 10.9% in the fourth quarter of 2013. With the benefit of phase-in, our common equity Tier 1 capital ratio on a Basel III standardized basis was 13%, up 80 basis points from the same 12.2% in the fourth quarter of 2013.

While there is still work in progress industrywide on the final implications for capital under the Basel III advanced approaches, we continue to estimate we are above our target of 8%. Based on the quantitative and qualitative outcomes in the recent CCAR process, we look forward to returning capital to our shareholders through the approved $2.5 billion in share repurchases over the next four quarters.

The bar for passing CCAR is high, and will likely continue to rise. We have, and will continue to invest in our processes to exceed these standards. We have demonstrated our commitment to return capital, and understand it remains an important part of the return equation for our investors.

Let me close briefly with an update of our expectations for 2014. The early adoption of the new accounting standard for low-income housing tax credits, and the change we made to prospectively recognize auto repossession expense in operating expenses instead of as a component of NCO, impact our outlook for PP&E and its components.

We had previously expected pre-provision earnings for 2014 of approximately $9.8 billion, excluding extraordinary items. Adjusting for the shift in geography of these two items, with the impact of the new accounting standard being the primary driver, we now expect 2014 pre-provision earnings to be about $10 billion, within a reasonable margin of error. Looking beyond the impact of these geography moves, we expect some modest, but principally offsetting, changes with higher revenues offsetting higher expenses.

With that, let me turn the call over to Rich.

Thanks, Steve. I'll begin on slide 7 with an overview of the domestic card business. Ending loans were down about 7% from the fourth quarter, driven by expected seasonal paydowns and continuing planned runoff. Ending loans declined about 3% year over year. Excluding the planned runoff, the year-over-year decline in ending loans was about 1%. Purchase volume on general purpose credit cards, which excludes private label cards which don't produce interchange revenue, grew about 11% year over year.

Looking below the surface, the year-over-year trends in loans and purchase volumes continue to reflect our strategic choices, which focus on generating attractive, sustainable, and resilient returns. We are avoiding high-balance revolvers, and allowing the least resilient parts of the acquired HSBC portfolio to run off. In contrast, we're seeing underlying year-over-year loan growth in many segments, including transactors and revolvers other than high-balance revolvers.

New account originations continue to grow at a strong pace, and we continue to see opportunities to increase lines for existing customers, which should improve the trajectory of both loan growth and purchase volume growth over time. As we said last quarter, we expect these improvements to result in overall year-over-year loan growth in the domestic card business sometime in the second half of 2014.

Revenue margin for the quarter was just under 17%, down seasonally from the fourth quarter. Revenue dollars were down about 10% year over year, driven primarily by our choice to sell the Best Buy portfolio.

Non-interest expenses improved by $119 million from the sequential quarter, driven by operating efficiency and seasonally lower marketing. On a linked-quarter basis, the charge-off rate increased by about 12 basis points to 4.01%. Delinquency rates decreased about 41 basis points to 3.02%. The improvement in delinquencies was better-than-normal seasonal expectations.

First-quarter charge-offs and delinquencies include the temporary increase we discussed last quarter. Recall that in July 2013 we changed a number of customer practices on the HSBC-branded card portfolio to align them with regulatory guidelines and Capital One practices. These changes temporarily increased fourth-quarter delinquency rate. The delinquency impact has largely run its course, which contributed to the improvement in delinquency rate in the first quarter.

We originally estimated that the changes to align HSBC customer practices would temporarily increase the monthly domestic card charge-off rate by about 35 basis points from December through March. The actual impact was closer to 25 basis points, and we expect it to diminish to about 10 basis points in April, and be mostly out of the charge-off rate by the end of the second quarter. Looking beyond these temporary impacts, we expect that our focus on resilience and our strong credit risk underwriting will continue to drive strong credit results with normal seasonal patterns.

Our card business remains well positioned. We're poised to return to year-over-year loan growth in the second half of 2014, despite continuing runoff and our choice to avoid high-balance revolvers. We're delivering strong, sustainable, and resilient returns. And we're generating capital on a strong trajectory, which strengthens our balance sheet and enables capital distribution.

Moving to slide 8, the consumer banking business delivered another quarter of solid results. Ending loans declined about $35 million from the fourth quarter, and about $2.9 billion year over year. Continued growth in auto loans was more than offset by expected mortgage runoff.

Auto originations increased from the fourth quarter, and remain on a strong growth trajectory. Sub-prime originations were relatively stable, while prime originations grew as we captured additional prime share from our existing dealers. Ending deposit balances grew by about $3.9 billion in the quarter. Year over year, deposit balances declined about $1.1 billion, mostly in our legacy Capital One direct banking businesses.

Consumer banking revenue was modestly lower compared to the fourth quarter, driven by declining consumer banking loan balances, persistently low interest rates, and margin compression in auto finance. Non-interest expense decreased $88 million in the quarter, as a result of lower marketing expense in our deposit businesses, the absence of several small non-recurring operating expenses we recognized in the fourth quarter, and continuating operating efficiencies. These improvements were partially offset by a change in the geography of where we recognize auto repossession expenses, which are now included in operating expense rather than in net charge-offs.

Provision for credit losses improved in the quarter. Auto charge-off rate and delinquencies improved in the first quarter, in line with expected seasonal patterns and aided by the shift in presentation of repossession expenses that I just described. Home loans credit trends remain favorable, and continue to perform well inside of the assumptions we made when we acquired the mortgage portfolios. The overall consumer banking charge-off rate remained strong at about 1%.

While we continue to expect that auto finance revenues, margins, and returns will decline as we move from exceptional levels to more cycle-average performance, we remain committed to the auto finance business. We've built deep and sustainable dealer relationships. We have developed proven underwriting and customer service capabilities, and we expect that the auto finance business will continue to deliver resilient and well-above-hurdle returns. Additionally, we expect that the inexorable impacts of the prolonged low-rate environment will continue to pressure the economics of our retail deposit business, even if rates rise in 2014.

As you can see on slide 9, our commercial banking business delivered another quarter of profitable growth. The current and historical results on slide 9 and in our financial tables have been restated to reflect the change in accounting for low-income housing tax credits that Steve described earlier. As shown in the appendix slide, the net effects on the commercial banking segment are reductions in revenue, operating expense, and income tax, as well as a modest decrease in net income from operations.

Loan balances increased about 3% in the quarter and 18% year over year, driven by growth in specialized industry verticals in C&I lending and CRE. Loan yields declined in the quarter and compared to the prior year, driven by lower market pricing from increased competition and our choice to originate loans with even better credit quality.

Revenues declined 12% from the fourth quarter. Lower loan yields, as well as lower tax equivalent yields in our equipment leasing business, drove the quarterly decrease in revenue. In contrast, revenues increased about 5% from the prior year. The year-over-year increase was the result of growth in loan and deposit balances across the franchise, partially offset by declining loan yields.

Non-interest expense was up 15% from the prior year, as a result of the Beech Street acquisition and continued growth in loan balances. In the quarter, non-interest expense was down about 9%, with lower amortization expense and seasonal trends.

Commercial credit remains very strong, with the charge-off rate at 4 basis points. While the current very low charge-off levels are not necessarily sustainable, we continue to see low levels of non-performing and criticized loan balances, so we expect the strong credit performance of our commercial banking business to continue. While increasing competition, particularly in generic, middle-market lending, may continue to impact the pricing and volume of new loan originations, we expect our focus and specialized approach to deliver strong results in the commercial bank.

I'll conclude my remarks this evening on slide 10. In the first quarter of 2014, we posted another quarter of solid results for the Company and across our businesses. We received no objection to our CCAR capital plan, and announced a $2.5-billion share repurchase program that we expect to complete by the end of the first quarter of 2015.

Capital One is earning very attractive risk-adjusted returns, and we expect that will continue in 2014. But we are always focused on the important levers that will sustain and further improve our profitability. We're committed to tightly managing costs across our businesses. We don't view this as a one-off initiative; it's a major, multi-year agenda, and it remains a top priority in all of our businesses and in every budget cycle.

Our credit results are strong, driven by our long-standing discipline and underwriting across our businesses, and our continuing focus on resilience. Growth remains a high priority for us, but only in the context of a preemptive focus on generating attractive, sustainable, and resilient returns.

We expect planned runoff will drive declining home loan balances. On the other hand, we expect growth in areas we're emphasizing, including commercial banking and auto finance, will continue, and we expect year-over-year growth in domestic card loans to resume in the second half of 2014.

And with respect to capital, our CCAR submission and our 2014 capital plan are strong evidence of our commitment to return capital to shareholders. The bar for passing CCAR is high, and will likely continue to rise. We have invested and will continue to invest in our processes to exceed these rising standards.

Our capital and liquidity positions remain strong. Our businesses continue to deliver attractive and sustainable returns, and generate capital on a strong trajectory. Industry loan growth remains low, and in our case, planned runoff frees up capital as well. We're comfortable also with our strategic footprint.

These conditions create excess capital that can be distributed to shareholders. We recognize that capital distribution is important to our investors, and capital management remains an important part of how we expect to deliver superior and sustainable value to our investors in 2014 and beyond.

Now Steve and I will be happy to take your questions. Jeff?

Thank you, Rich. We'll now start the Q&A session. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to a single question plus a single follow-up question. If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call.

Vicky, please start the Q&A session.

(Operator Instructions)

Ryan Nash, Goldman Sachs.

Yes, just two quick questions. I guess, first on loan growth. You're still talking about it turning positive in the back half of the year. Can you just help us understand some of the drivers behind that?

Is it from new account acquisitions driven from the recent marketing spend? Is there an expectation that the existing customer base will begin revolving again, slower runoff? Can you just tease out what some of the main drivers are?

And then for Steve, just thinking out on longer term on capital return, you talked several times that the bar does continue to rise. But given the strong capital position, all else equal, do you think the current year's capital return is sustainable? Or given the fact that you'd almost be advanced for several years, we could actually see further increases to capital returns in the near-term? Thanks.

Ryan, yes, we continue to be on track to have loan growth in our card business return in the second half of 2014. What's really driving that is continued success in new account origination. I think we feel very good about the results we see there.

On the existing customer base, things are going very well. We have gotten traction, a lot of traction in the line increase area, where I'm sure you know that we had sort of a brownout with respect to line increases as we were adapting to a regulatory guideline.

So that's pretty much back on track. So we feel good with respect to being able to play offense, if you will. With respect to the defense side, every year the runoff becomes less, and we continue on our journey of running off also our high-balance revolver. So net/net the line's finally crossed in the second half of this year, and I think we feel good about the trajectory from there.

So Ryan, as Rich mentioned, we're not at a point where we're prepared to provide specific guidance going forward. I'm sure you can imagine there's a bunch of reasons for that. But a couple observations, some of which you've heard from Rich and I already.

One, the qualitative bar continues to go up for all banks, and I think there are good reasons for us to emphasize flexibility in our future capital plans, which probably means that share repurchases will be a continuing emphasis. I think in terms of thinking about payout levels going forward I'd kind of go back to the way Rich ended, which is we have a really strong capital position and continue to deliver high returns.

Industrywide, loan growth is relatively low, and in our case is magnified by runoff. We continue to be comfortable with our strategic footprint, and most importantly, I think, hopefully demonstrated over the last couple of years we understand how important capital return is to delivering enduring value to our shareholders.

Next question, please?

Sanjay Sakhrani, KBW.

Thank you. I guess I'll ask my couple questions upfront. Steve, I was just wondering if you could go over that breakdown of the revision in the PP&E again? Just how much is coming from the specific tax changes versus other stuff of that $200 million increase in PP&E?

And then secondly, question for Rich. We've had a couple of large players in auto go public recently, one that's pretty focused on prime, and I think I heard to say that you guys took share in prime from dealers. I was just wondering if you could talk about how you expect the trajectory to be going forward in auto lending in terms of growth? Thank you.

Let me go first. In terms of the PP revisions, again these are primarily changes in geography. So we would have approximately $240 million of incremental operating expense if we had the current standards prevail into this year with respect to how we are accounting for LIHTC. We would similarly have $40 million that would stay in NCO instead of moving up to operating expense.

These are, again, approximate numbers. That gets you to the around $200 million, which is why the guidance went up from $9.8 billion to $10 billion. Again, that excludes extraordinary items, and we're not defining that to the last decimal point.

Sanjay, in the auto business we continue to feel very good about the auto business. We've wanted to make sure that our investors understood that the confluence of kind of once-in-a-lifetime events that led to extraordinary return opportunities and exceptional growth opportunities, that's regressing toward the mean, but that's not to take away from the fact that we continue to feel good about the opportunities to be very successful and earn well above hurdle rate returns in this business.

The growth, basically I think the way to think about the growth trajectory is sub-prime is pretty flat these days, and we continue to grow in the prime space, and that's really just further penetration of the dealers that we have very good relationships with. So it's kind of a natural to do this growth.

So despite the growing competition, and of course we see two players that are now out there with IPOs and they are going to be intensely trying to generate growth, I think we feel pretty good about our position here. Of course the prime growth, as we get a mix change with more prime growth and more flattish on the sub-prime side, that puts additional kind of pressure on the overall average margin, in addition to just what's happening competitively.

The other thing, just to say on the auto growth side is, we continue to keep a close watch on the underwriting practices that are going on in the business, and I think it's pretty much the same story I've been saying the last few quarters. There's a little slippage on some of the metrics, but overall still more slippage back toward the mean as opposed to things that would cause us to really pull back.

Next question, please.

Bill Carcache, Nomura Securities. Bill? Check your line.

Hello? Can you hear me?

We can hear you, Bill.

Okay, great. Thank you. You guys had healthy year-over-year purchase volume growth, as did some other issuers that have reported, but you, as did they also, saw non-interest income decreases in your card segments. And I was wondering if you could talk to what's driving that? It would seem that there's a benefit from the interchange revenues that would be kind of on the plus side, but maybe if you could talk about what else is going on, that would be helpful?

Bill, first of all, just your purchase volume continues strong for Capital One. We think we're continuing to gain share overall in that space. With respect to non-interest income, there are a couple of things going on.

First of all, our own interchange growth in the quarter was basically flat, despite the significant growth in purchase volume and more importantly the significant growth in general purpose credit card purchase volume. I just want to point out, there's a lot of volatility in that particular metric in any one quarter, but there's also a medium-term kind of sustaining phenomenon here where we're very committed to our rewards business and we are upgrading rewards products for some of our existing rewards customers, and consistent I think with the industry overall, extending rewards product to some existing customers who don't have rewards.

And so near term, you will see some interchange cannibalization as we do this. This is very intentional, and it's all part of building a deeper customer franchise, and all part of, frankly, our deep belief in the power of building relationships through strong rewards business.

The other thing is, the late fees were light in the quarter, reflecting the delinquency, the real strong delinquency performance, and that is probably something that a number of other competitors would have seen as well. But a little light on the interchange side and late fees that's the flip side of a very good credit effect are the contributors to a little weakness on the non-interest income.

Thank you so much, Rich. I was hoping I could ask one follow-up to Stephen. I had a question on your target 8% common equity Tier 1 ratio under Basel III. I was hoping that maybe you could discuss the extent to which the severely adverse scenario under CCAR could become your binding constraint?

I was looking to get your thoughts on whether those two ratios could produce different answers that could impact what you manage the business to? That's it. Thank you.

That's a great question. Thankfully, it's a long way off in the future for us. And we just had the first couple of banks exit parallel. And those banks, to my understanding, even in the 2015 CCAR, they're not going to be tested assuming the advanced approaches apply.

I don't think anybody can give you a really good feel as to the intersection between CCAR and advanced approaches. What I would tell you in terms of how we think about our capital, that is we start with an assessment of the proper capital levels for our inherent risk. As you know, we've talk about the Company's used stress tests for many years in assessing how much capital we need.

We're also informed by relevant experience. We had, hopefully, the most robust test we'll have for a while in the Great Recession. So a lot of that is the grounding for the capital that we need, but moving away from the internal view, there's still moving pieces.

It's not just how advanced approaches gets into CCAR. I don't think CCAR is stable at this point, and we haven't even entered parallel run. So while there is significant uncertainty, we believe the 8% target is right, and would not communicate that to you if we thought it was totally inconsistent with the regulatory framework. That's not a guarantee that 8% is the correct point estimate, but any other number at this point would be speculative, and remember our 8% number does include 100 basis point cushion above regulatory minimums.

Next question, please?

Brad Ball, Evercore.

Thanks. Could you talk about the card revenue margin, the compression this quarter? Was it entirely seasonality or were there other factors?

How do you feel about the revenue margin in the context of the growth you're talking about in the second half? Are you thinking around 17% would be still sustainable?

And then just lastly on credit, the delinquency improvement I suppose this quarter is what drove the reserve release. Is there still more room for additional reserve releases going forward? What's your thought on credit broadly? Thank you.

Okay, Brad. On the revenue margin yes. In terms of the first quarter, yes, the revenue margin for the quarter was 16.9% and that's down from 17.3% in the fourth quarter, and that decrease, you're right, was primarily driven by normal seasonality of the revenue margin. And sort of putting the revenue margin into context, in 2011 the revenue margin was around 17%, 2012 we added the HSBC portfolio, and adjusting for purchase accounting effects, the margin was also around 17%.

In 2013 after adjusting for Best Buy held-for-sale impacts and the deal-related items, the revenue margin was also in the low 17% range. The benefits from the removal of Best Buy's low-margin business were roughly offset by what we call franchise enhancements, they're basically moves that we're making to -- consistent with our very strong customer advocacy, things we're doing in the Company.

Going forward, there are going to be many puts and takes on the revenue margin. There will always be some franchise enhancement actions that we continue to take over time.

But I think overall we believe, Brad, the margin will remain healthy. We're not going to give a specific forecast about the revenue margin, but I think we believe it will continue to be strong.

And on credit, yes the delinquency is what drove the release. You probably heard, we keep saying quarter after quarter, it is hard to imagine things getting much better than this, and let's really enjoy it while we're in this part of the cycle.

I think we are struck by the strength of the credit performance we continue to see, the relatively low delinquency levels and the low roll rate. So I don't think as we look at it that we're here to declare that credit is going to get even better, but I think I would say this, that the continued strong performance of all the credit metrics reinforces our strength, our belief in the strength and continuation of a good credit performance that can help generate very nice returns in the business.

Next question, please.

Sameer Gokhale, Janney Capital Markets.

Hi, can you hear me? Sorry about that. I just had a couple of questions, and I apologize, I got to the call a little later. But one question I have is in terms of your liquidity coverage ratio requirements. Where do you stand on that? How far along do you think you are? And how should we think about the impact in net interest margin as you try to make progress on the LCR?

Was that it?

That was the first question, sorry.

Okay. So let me start with LCR. Basically, we don't think there is going to be a material financial impact. It is a little bit hard to be too definitive on the ultimate impact because we don't even have final rules at this point, but I think almost, unless the rules change materially, we would not see a real financial impact from this. There is, however, the greater operational and governance burden that's primarily a function of having to calculate this ratio on a daily basis.

And kind of when the industry needs to be able to do that certainly plays into the operational challenges. But we'll be able to satisfy what currently it seems like the bar you have to get over, which is the 80% LCR ratio requirement as of January 15.

Okay, that's helpful. And just my follow-on question is on a different note. I think you announced that you're going to cease working with some sort of providers, like payday lenders and check cashers and the like. It would be helpful just to get your sense or your perspective on that? Why cease working with all of these providers?

Why not just stop working with some of the ones who are less compliant? Or is the issue of trying to figure out who is or isn't compliant with the regulatory requirements? I would just like to get your thought process as far as that goes?

Yes, Sameer, we consistently review business plans across the Company to assure -- and our customers individually and as groups to ensure that they're aligned with our strategic goals and our objectives on all dimensions, including regulatory compliance and everything. We took a number of factors into consideration and determined that the check-cashing business and being bankers to check cashers no longer fits with our strategic priorities. The financial impact of this exit is really not material. This business was a small part of the overall enterprise.

Next question, please?

Brian Foran, Autonomous Research.

Good afternoon. I guess one question on the guidance, and then I have a follow-up on auto. Steve, you mentioned the beyond-the-geography moves, so setting aside all that there were some modest upgrades to the revenue expectations offset by higher expenses. I wonder if you could just -- what drove the upgrades to your revenue expectations? Any sense of magnitude, and are the offsetting expenses more on the marketing side or the operating expense side?

Yes, that's just to down to, as you can probably anticipate the answer to this question, down to a level of guidance and detail that we're not going to go to. Like last year, we provided guidance, and as we move through the year we really centered on [supervision] net revenue.

This is a really dynamic business with a lot of moving pieces, and as was true last year we may get to the guidance that we laid out at the beginning of the year in different ways. We've centered on pre-provision net revenue for a bunch of reasons, but it's obviously the foundation for our ability to invest for future growth and to return capital to you.

Adjusted for changes in geography, we are not changing our guidance, which obviously excludes extraordinary items. And as Rich mentioned, we're leaving out the credit story, which remains pretty strong as well.

I appreciate that. And then on auto, I guess with the benefit of hindsight, your originations pulled back a lot in 4Q 2012 through 2Q 2013. They kind of reaccelerated in the second half of 2013, and the various credit data that's out there for you and competitors suggests to the extent there was a problem, it was in the first half of 2013 vintages, and the second half 2013 vintages are improving or performing better. I wonder if you agree with that, and if -- what was it about the first half 2013, because it's not obvious when you look at average FICOs or terms across the industry why kind of across the industry first half 2013 vintages seem a little weaker, and second half 2013 and first half 2014 seem to now be doing better?

So I'm not sure what you're referring to. I don't have our original origination data right in front of me, but I'm not sure what you are referring to about a pullback in 2012. My recollections are the following, that the auto business spiked early in the Great Recession, a lot of people exited.

We pulled back to our really core dealer relationships, and then looked for the inflection point. You may remember that we've often articulated that some of the best lending opportunities are actually in the throes of downturns, when you pass kind of an inflection point relating to customer behavior and competitor supply and demand, and sort of underwriting standards.

And so really in, as I recall it was in 2009 and into 2010 that we really accelerated originations in the auto business, and we have continued very strong right through this point, all through this period believing this is kind of the best part of the cycle. And checking very carefully each vintage.

As it's turned out, despite our inflection point monitoring and our belief that this was the best part of the cycle and the supply and demand were in a good place, the vintages have actually outperformed in a good way our own expectations, and so certainly in hindsight we feel very good about our acceleration. And I'm not aware of anything that would characterize the early -- the vintages in the first half or second half of a particular year.

Along the way with these vintages there has been some expansion of -- some loosening of our very tight credit standards back to just tight, if you will. And so a couple of the vintages have had expected higher risk, but overall this has been a continuous period of accelerating originations and very strong credit performance.

Next question, please?

Daniel Furtado, Jefferies.

Hi, can you hear me?

Yes.

Great this is Martin Kemnec in for Daniel Furtado today. Thanks for taking my question. First, can you help us think about sort of the impact that higher rates have on the transactor strategy, and how you guys can maybe potentially look to offset some of the higher cost to carry there? Does that strategy become uneconomical with short rates pushing up at some point down the road? And just maybe walk us through what type of leverage you can pull, either on the funding side or the reward side.

And then secondly, Steve maybe for you, pretty impressive when we look at the recovery levels in the card book, at least what we can see from kind of the master trust seems to be pushing higher in the early part of this year. Is that kind of an organic effect as the economy improves? We're seeing a little bit better consumer spending numbers, things picking up?

Or is that sort of an inorganic effect from potentially selling those accounts and then booking the gain there? Maybe just an update on the dynamics you're seeing on recoveries and expectations for that going forward?

Okay, Martin, let me take the first of all your question about our transactor business and its exposure to higher interest rates. We fund the expected lifetime balances for our transacting customers, and we expense rewards as they are earned. As such, as rates rise we feel very good about preserving the profitability and the benefits for our existing customers.

Additionally we subject our investment decisions, as you can imagine, to worsening conditions in the marketplace, including higher interest rates. So our products have a built-in resilience, even out a higher interest rate level. Of course, should rates rise enough, I think you get kind of to the point that, and all players would be pretty equally affected. I think the industry would probably react, and the going-forward product structures would logically potentially adapt at that point.

In terms of the exposure to us, we've kind of lock in as the best we can sort of all the existing things, and we build in a buffer. And I think if there were an adaptation it would be an industry adaptation and we would react at that time.

With respect to recovery levels in the card business, I'll make just a general comment about the recovery levels. In general, recovery dollar tends to come down somewhat at this stage of the cycle. It's kind of the math of a shrinking inventory of fresh charge-offs against which to recover.

So in general, recovery rates have -- recovery dollars have been coming down just because recoveries are highest on fresh inventories and the fresh inventories, the good news is we haven't been supplying our recoveries team with as much supply as they have been used to. So that's a good thing.

It is also the case with respect to asset sales, I mean debt sales. We are probably the lowest, or among the very lowest in the industry in terms of the extent of debt sales, but those are sort of opportunistic decisions made based on pricing in the marketplace, and that can affect any particular quarter for some of the metrics as well.

Next question, please?

Ken Bruce, Bank of America, Merrill Lynch.

Thanks. Good evening, gentlemen. My first question is bigger picture. Rich, you've been a long-term observer, and Capital One has been a long-term participant in the revolving credit market in the US, in particular. And I guess looking at the market today in consumers, do you sense that there's a difference or a change in their willingness to borrow?

Obviously we've seen very slow revolver growth generally speaking. There is obviously some higher levels of debt still existing from the housing crisis. I'm wondering how you're thinking about the longer-term growth prospects for revolving credit? And I have a follow-up.

Yes, Ken. I think we all in this business have just been struck by, for really a number of years now, credit kind of comes in a little better than expected, and growth is kind of hard to come by. And I think those are the flip side of the same phenomenon, and it's really what your identifying.

The consumer is just being very conservative and in some ways, Ken, the very thing that sort of frustrates the economy from growing, which is consumers are not out spending enough. What are they doing with their money? A lot of times they are paying down debt, and just being extra careful.

From a banking point of view, we should all be careful what we wish for here because the flip side of this growth weakness on the borrowing side is a tremendous kind of strength on the credit side, and that has been powering a lot of great performance for some of the banks over this period of time. I do think, though, it's part of the macro trend in delevering that, frankly, consumers and corporations have been doing for a number of years.

It's hard to prognosticate, but we generally operate with an outlook that revolving debt will probably be growth of revolving debt will -- revolving debt will be pretty slow. You've seen student lending, of course, growth has been pretty electrifying over this period of time. And we're not in that business, we've had a few cautions about that, but certainly that has been up.

And we have been struck, too, by the strength of auto borrowing over this period of time, solid borrowing and very good credit performance. But I think overall what you're seeing is a consumer that has, I think, learned a lot through the Great Recession and is cautious, and I think that our metrics are probably likely to reflect that, for better and for worse.

Okay. And then, just as a follow-up, you had -- obviously the revenue margin has benefited from very low funding costs over the last few years. It's nice to not hear you speaking about 15% revenue margins any time soon. But I guess I'm interested in how you're thinking about defending those margins as rates rise.

Obviously funding costs have been quite low, and I guess there's discussion around whether those core deposits are going to be sticky at these levels, is really what I'm getting at. If you could give us any thoughts around that, that would be helpful.

The business overall, or for cards specifically? Because I think for the business overall, you can look at our exposure to rising rates, and we actually feel pretty good about our asset-sensitive position. And that's going to accrue to the benefit of our shareholders, because we think obviously assets are going to reprice a little bit faster.

So if it's more of a card-specific question, we can deal with that. But I think overall when you look at our position, we compare, I think, pretty favorably to the peer group.

Next question, please.

Scott Valentin, FBR capital markets.

Good evening. Thanks for taking my question. The first question, I think someone mentioned the pace of run-off in the mortgage book expected to accelerate from $4 billion to $5 billion this year. I'm just wondering, given what we see in the MBA data and the slowing refinancing activity, if there's anything specific to the portfolio, because you seem to be bucking the trend a little bit in terms of slowing prepayments?

Then the second question was regarding commercial bank yields. Did it drop pretty sharply this quarter? Just wondering if they'll continue to compress, of if this is kind of a new level going forward?

No, there's nothing specific on the slight revision and increased mortgage runoff. It may be a little bit, I think you have to go back and look at when we provided the guidance and what rates were at that point versus what rates are now. I think you'd probably find there's a better connection there between the runoff.

Scott, on commercial yields. If we take the year-over-year perspective, loan yields decreased by 44 basis points, due to a few factors. I think at the top of our list would be the increased competitive pressure in the market, especially in the vanilla markets that have very, very large number of banks competing in it, like the C&I sort of generic businesses.

We also have shifted toward -- more towards floating rate loans, that has had an impact. We have always had very high-quality originations, but we've even shifted toward loans with even higher credit quality and that was a bit of a trade-off with yields there.

And ultimately in terms of how we make money, our spreads have been somewhat -- have not decreased by the same magnitude the loan yields has, is partly offset by lower funding costs. But overall, certainly the competitive environment is contributing to that.

Quarter over quarter, I don't think I'm going to go into details that we have this whole tax equivalent yield kind of effect that makes a lot of noise. But competitively in the C&I business spreads definitely continue to compress, and there's been some weakening in the non-investment grade credit structures as well. So we're pretty cautious in those spaces.

In commercial real estate the spreads -- we see pressure on pricing and limited pockets of weaker lending terms, but that's largely in construction. I think banks are being a lot more disciplined in real estate. And also you have a big difference between the C&I business and CRE business.

In CRE the CMBS channel has been largely sidelined, while of course the CLO market is back to levels that are pretty close to 2007 levels. So that's putting extra pressure on the C&I business. So again, our strategy is mostly focused on specialty lending, which is affected by all of these trends but tends to be -- the margins are holding up better because of the more balanced supply and demand.

Next question, please.

Chris Donat, Sandler O'Neill.

Hi. Good afternoon. Thanks for taking my call. Just had one question on the comment about higher rewards that are netted against interchanges. Is this reflecting the growth of the Quicksilver card and the cash rewards, or is this more of a mix with Venture, or just a broader changes in customer behavior and use of rewards?

It's really several effects. So first of all we have our flagship Venture and Quicksilver products that have pretty rich rewards for the consumers, and as a percentage of our whole book those are growing. Then you have our extension of the richer rewards to existing rewards customers, and then you also have extending rewards further to some customers who have not been a rewards customer.

So all of those contribute to this gap between purchase volume growth and interchange growth. And in the -- there's sort of a transitionary period where some of these penetration effects are more noticeable, and I flag that only because we are in one of those kind of periods, but it is the flip side of our real belief in the power of this business model, and in many ways the success of our rewards business.

Matt Burnell.

Good evening, gentlemen. Just, I guess, a question on the income statement. It looked like professional services costs were down pretty visibly quarter over quarter, year over year. I wonder if that has to do with CCAR preparation, or if there's some other factor driving that, and how we should think about that number going forward?

I wouldn't over-read anything. There's seasonal impacts in that. The CCAR, if anything, would be a small portion of it, and it's obviously incorporated into our overall guidance for the year.

And just not to get too deep in the weeds, but commercial real estate growth continues to be high teens, 20% year over year. I guess I'm just curious, Rich, I understand your commentary about remaining very cautious or diligent in terms of your underwriting, but there's some markets in the Southeast, and particularly DC, that have been flagged as being relatively aggressive. I guess I'm just curious if you're seeing the same trends in those markets, and how aggressive the competition has gotten in those end markets for commercial real estate?

Again I would say my overall observation from the markets, the blended kind of observation from the markets we're in is that commercial real estate is quite a bit tamer than the C&I business, and I think it's really just frankly the flip side of the fact that C&I performed so well in the last downturn and is available to so many banks that you have a lot of folks rushing in there, and then you have the CLO impact, the growing CLO impact as well. So that's the area I'd flag as the biggest concern we have.

On the commercial real estate side, again I think in most places people are licking their wounds and there's -- generally we see behavior that is more careful, but that varies by markets. We don't do commercial real estate in the Southeast so I really don't have an observation on that. We're relatively small players in DC, but I guess more than half of -- the majority of our commercial real estate in fact is in New York City that has a lot of strong market dynamics going on right now, and generally the behavior is not too irrational.

But beyond sort of those qualitative descriptions, I mean we spend a lot of time looking at key metrics and what's happening to those key metrics. And when we look at LTV, debt service coverage ratio, and debt yield in commercial real estate we see things that are well within the guard rails we would look at. And frankly are still -- I think we're still pretty comfortable with how we see those metrics moving in the marketplace, at least with respect to the loans we're originating.

At this time, I turn the call back over to Jeff Norris for any additional or closing remarks.

Thanks very much, and thanks everyone for joining us on the conference call today. We thank you for your continuing interest in Capital One. Remember the Investor Relations team will be here this evening to answer any further questions you may have. Have a great evening.

That does conclude today's conference. We thank you for your participation.