Capital One Financial Corporation (COF) Q2 2020 Earnings Conference Call July 21, 2020 5:00 PM ET

Company Participants

Jeff Norris – Senior Vice President of Global Finance

Richard Fairbank – Chairman and Chief Executive Officer

Scott Blackley – Chief Financial Officer

Conference Call Participants

Betsy Graseck – Morgan Stanley

Ryan Nash – Goldman Sachs

Rick Shane – J.P. Morgan

Sanjay Sakhrani – KBW

Don Fandetti – Wells Fargo

Eric Wasserstrom – UBS

Moshe Orenbuch – Credit Suisse

John Hecht – Jefferies

Bob Napoli – William Blair


Welcome to the Capital One Second Quarter 2020 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]. Today’s conference is being recorded. Thank you.

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

Jeff Norris

Thanks very much, Matt, and I’d like to also welcome everyone to Capital One’s second quarter 2020 earnings conference call. As usual, we are webcasting live on the Internet. To access the call on the Internet, please log onto Capital One’s Web site, and follow the links from there. In addition to the press release and the financials, we have included a presentation summarizing our second quarter 2020 results.

With me this evening are Mr. Richard Fairbank, Capital One’s Chairman and Chief Executive Officer and Mr. Scott Blackley, Capital One’s Chief Financial Officer. Rich and Scott will walk you through the presentation. To access a copy of the presentation and press release, please go to Capital One’s Web site, 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. And for more information on these factors, please see the section entitled Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports that are accessible at the Capital One Web site and filed with the SEC.

Now, I’ll turn the call over to Mr. Blackley. Scott?

Scott Blackley

Thanks, Jeff. Capital One recorded a net loss for the second quarter of $918 million or $2.21 per diluted common share, primarily driven by $2.7 billion allowance build, reflecting the economic downturn related to the COVID-19 pandemic. Adjusting items impacted operating expenses during the quarter and totaled $276 million or $0.60 a share, including the provision for legal matters, as well as costs related to our cyber incident. Net of these adjusting items, our EPS was a loss of $1.61 per share.

Turning to Slide 4, I’ll cover the allowance in more detail. The second quarter allowance build of $2.7 billion consists of $1.7 billion in card, $668 million in auto and $330 million in commercial.

Our allowance is based primarily on an economic forecast derived from the consensus of third party economists. That forecast includes unemployment in the second quarter of 16.9%, falling to 11.5% at the end of 2020 and gradually improving over the course of 2021 and at 8.1%.

Of course our strong credit performance so far shows that the normal relationship between unemployment and consumer credit has been significantly altered by lending hardship programs and especially by government stimulus, including direct consumer support through the CARES Act. Looking ahead, in our allowance we’ve assumed no such benefit from further stimulus beyond the residual benefits of the existing legislation, which starts running out after July.

On Slide 5, you can see the impact of our coverage ratios for various businesses. Our total allowance coverage now stands at 6.7% of loans compared to 2.7% at the end of the year for 2019. Our domestic card coverage ratio is now 11.6% and our branded card ratio is 13.5%. Recall that the primary difference between these ratios is driven by loss sharing agreements in our partnership portfolio. Our auto coverage now stands at 4.3% and our commercial reserve coverage is 2.5%.

Moving to Slide 6, I’d like to discuss our liquidity position. As we talked about for years, we have always focused on conservatively managing capital and liquidity and that’s serving us well as we navigate the COVID-19 pandemic. You can see that our preliminary average

liquidity coverage ratio during the second quarter was 146%, up from 145% at the end of the first quarter and well above the 100% regulatory requirement. Our liquidity reserves from cash securities and federal home loan bank capacity increased to $149 billion at the end of the second quarter, including about $56 billion in cash, driven by strong inflows of consumer deposits.

Turning to Slide 7, I will cover capital. Our common equity tier one capital ratio was 12.4% at the end of the second quarter, up 40 basis points from the first quarter notwithstanding our large allowance build in the quarter. Recall that beginning in 2020, our CET1 calculation excludes the mark to market impact from our available for sale security portfolio. At quarter end that portfolio had an unrecognized after tax gain of $2.4 billion, which represents approximately 80 basis points of potential regulatory capital.

During the quarter, the federal reserve released the results of their stress tests. Our capital requirement under the stress capital buffer framework as calculated by the federal reserve was 10.1% or approximately 230 basis points below our current capital levels. In conjunction with the release of the stress test results, the federal reserve also announced an additional fall stress test and the limitation on third quarter dividends based on the average quarterly net income for the prior four quarters. While our recent CCAR capital plan included a planned $0.40 quarterly dividend based on the Fed’s new cumulative earnings rule, we expect to reduce our third quarter common stock dividend to $0.10 per share subject to board approval.

Turning to Slide 8, you can see that our net interest margin was 5.78% in the quarter, which is approximately 100 basis points lower than the first quarter and the prior year linked quarter. The quarter over quarter decline was largely driven by a shift in our asset mix as average cash increased to $43 billion and average card balances shrunk by 11%. In addition to this mix shift, the low rate environment further pressured net interest margin.

With the low interest rate environment and the continued economic uncertainty, we expect to maintain elevated levels of cash in the near term. During the quarter, we deployed approximately $15 billion of cash to increase the size of our investment portfolio, prepay federal home loan bank advances and to buy back a portion of our senior unsecured debt in our first ever debt tender offer. Even with these actions, our cash at the end of the quarter was at an all time high of $56 billion, up $25 billion from the end of the first quarter.

The low rate environment is also a headwind to NIM improvement. To give you a sense of magnitude, our disclosed year end 2019 interest rate sensitivities would suggest an approximately $500 million reduction in annual interest income based on the over 100 basis point decline in the yield curve that we’ve seen here today. Looking forward, our NIM trends will depend on how the impacts of the downturn play out across our balance sheet, including asset mix, deposit balances and deposit pricing and our cash position.

And with that, I’ll turn the call over to Rich. Rich?

Richard Fairbank

Thanks, Scott. I’ll begin on Slide 10, which summarizes second quarter results for our credit card business. The impacts of the COVID-19 pandemic drove second quarter results across all of our business segments. In our credit card business, loan balances, purchase volume and revenue, declined year over year. And as Scott just discussed, we posted a significant allowance build.

Credit card segment results are a function of our domestic card results and trends, which are shown on Slide 11. Domestic card ending loan balances shrink by $3.6 billion or 3% year-over-year, while average loans declined 1%. Excluding the impact of the Walmart portfolio acquisition, ending loans shrink by around 10% year-over-year while average loans were down about 8%.

Purchase volume for the quarter declined 15.5% compared to the prior year quarter. Looking at weekly trends, the year-over-year decline in purchase volume was down 32% in the second week of April and has since rebounded. Over the last three weeks ended July 17, the year-over-year decline has averaged just 3%. Total company net interchange revenue for the second quarter was down about 18% year-over-year.

The declines in loan balances and purchase volume are a result of several factors; the broader effects of the pandemic, consumers behaving rationally in response to the COVID economic shutdown and our choices to pull back in marketing and tightened underwritings. As they’ve done in prior downturns, consumers are pulling in their spending and paying down balances. This cautious behavior is an important driver of both declining volumes and our strong credit performance.

Revenue decreased 7% year-over-year. Revenue declined more than average loans as revenue margin decreased 105 basis points compared to the second quarter of 2019. The majority of the revenue margin decrease was driven by the expected impact of the revenue sharing agreement on the acquired Walmart portfolio and the revenue benefit in the second quarter of last year from our choice to exit several small partnerships. Lower net interchange revenue also contributed to the revenue margin decline.

Non-interest expense was down $258 million from the second quarter of last year, largely driven by our choice to pull back on marketing. Provision for credit losses was up by $1.9 billion year-over-year as a result of the large COVID driven allowance build. Second quarter credit results were strikingly strong, especially in the context of the pandemic. The charge-off rate for the quarter was 4.53%, a 33 basis point improvement year-over-year. The 30 plus delinquency rate at quarter end was 2.74%, a 66 basis point improvement from the prior year.

Several factors likely drove the striking improvement. Credit performance is benefiting from resilience choices we made before the downturn began. Consumers are behaving cautiously and paying down debt. Government stimulus is dramatically altering the normal relationship between the unemployment rate and consumer credit, at least in the short term. And widespread forbearance across the banking industry is helping consumers manage through financial stress.

We’re helping domestic card customers who have been impacted by the COVID downturn.

We’ve provided more detailed information on domestic card forbearance on Slide 12. We currently offer a 30 day skip pay with an option to renew. At the end of the second quarter, total enrollments were running at about 50,000 per week, down from more than 150,000 per week at the end of the first quarter.

In recent weeks, approximately two thirds of weekly enrollments were renewals. At quarter end, first time enrollments were down 87% from the peak in early April. As of June 30th, about 2% of active accounts have enrolled at any time since the pandemic began. However, most of these customers have since exited the program. At the end of the quarter, about 20 basis points of the customer base were enrolled and eligible to skip their next payment and another 40 basis points were enrolled in the program last month and skip their payment as permitted. A portion of these customers may re-enroll.

Of all customers who have participated in the program at any point, approximately 92% were current when they first enrolled. Over the life of the program, we’ve seen largely positive customer outcomes. For customers ending their first 30 days skip pay period, more than half have made their required payment in the subsequent month and approximately 20% have re-enrolled for another month. Customers with multiple enrollments have made payments at a lower but still healthy rate.

Slide 13 summarizes second quarter results for our consumer banking business. Ending loans increased 11% year-over-year, while average loans for the second quarter grew 8%, driven by our auto business. When the COVID downturn began, we tightened our underwriting box in auto to focus on the most resilient assets. Two factors drove second quarter results — second quarter growth.

While the auto market declined sharply at the end of the first quarter, it is rebounding. The rebound thus far has been stronger for larger franchise dealers, the part of the market where we’re focused. And our digital products and services are driving growth in direct to consumer originations and growth with dealers who wants to provide a touchless car buying experience in response to social distancing. Our dealer relationship strategy and the digital infrastructure and capabilities we’ve built from the bottom up put us in a strong position to grow high quality auto loans even with tighter underwriting.

Ending deposits in the consumer bank were up $41.6 billion or 20% year-over-year. Deposit growth was fueled by the stimulus-driven increase in personal savings. Average deposit interest rate for the quarter decreased 37 basis points compared to the prior year quarter. Most of our moves to reduce deposit rates occurred late in the quarter in response to the market interest rate environment and competitive dynamics.

Consumer Banking revenue decreased 6% from the second quarter of last year. Underlying revenue growth from higher auto loans and retail deposits was more than offset by differences and the timing of federal reserve rate cuts preceding our deposit pricing moves. Non-interest expense in Consumer Banking was up 3%. Volume driven growth in expenses was partially offset by our efforts to tightly manage costs. Second quarter provision for credit losses increased $711 million year-over-year, again, driven by the allowance build that Scott discussed.

Our auto business posted strong credit results in the second quarter. The charge off rate was up just 7 basis points compared to the prior year quarter to 1.16%. The delinquency rate improved 282 basis points year-over-year to 3.28%. This strong performance is a result of forbearance, government stimulus, cautious consumer behavior, resilience choices we made before the downturn began and better-than-expected auction values. We currently offer a 30 day skip pay with an option to renew to our auto customers, who have been impacted by the downturn.

As you can see on Page 14, enrollments are trending down. At the end of the second quarter, total enrollments were running at about 30,000 per week, down from over 100,000 per week at the end of the first quarter. In recent weeks, approximately 60% of weekly enrollments were renewals. First time enrollments were down 90% from the peak in early April. Compared to domestic card, a higher percentage of auto customers have enrolled in forbearance. As of June 30th, about 14% of active accounts have enrolled at any time since the pandemic began. However, most of those customers have since exited the program.

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At the end of the quarter, about 1% of auto customers were enrolled and eligible to skip their next payment, and another 2% were enrolled in the program last month and skipped their payment as permitted, a portion of these customers may re-enroll. Approximately 75% of customers were current at the time they first enrolled. Over the life of the program, we’ve seen largely positive customer outcomes. For auto customers ending their first 30 day skip pay period, more than half have made a payment in the subsequent month, and a little more than a third have re-enrolled for another month. Customers with multiple enrollments have also made payments at a healthy rate.

Moving to Slide 15, I’ll discuss our commercial banking business. Second quarter ending loan balances were up 8% year over year, driven by customers drawing down lines late in the first quarter. After peaking in March, line draws have subsided. Second quarter average loans were up 11% compared to the second quarter a year ago. Average deposits also increased about 10%. Second quarter revenue was down 2% from the prior year quarter, while non-interest expense was essentially flat.

Provision for credit losses increased $345 million compared to the second quarter of 2019. the largest impact was an allowance build, driven by the factors Scott discussed and by downgrades to credits in industries that are most impacted by COVID. Energy had a modest relief this quarter as specific reserves set in the first quarter were converted to charge offs in the second quarter. We’ve provided a breakout of our oil and gas portfolio composition and reserves on Slide 19.

The commercial banking charge off rate for the quarter was 0.51%. The criticized performing loan rate for the quarter increased compared to both the prior year and linked quarters to 7.7%. and the criticized nonperforming loan rate rose modestly to 0.9%.

I’ll close tonight with some thoughts on our results in the quarter and our positioning for the future. Capital One’s second quarter results were driven by the near term impact of the COVID-19 pandemic. A significant allowance build and declining revenue drove negative earnings per share. Consumer credit trends were very strong. We’ve further fortified liquidity and our CET1 ratio increased to 12.4%. Based on the new cumulative earnings rule that the federal reserve announced in the quarter, we expect to reduce our third quarter common stock dividend to $0.10 per share subject to our Board’s approval.

Pulling way up, we’re more than halfway through a year, none of us will ever forget. Capital One started the year with significant momentum, then COVID-19 hit an inflection point in March, driving a sudden shutdown of economic activity, a sharp increase in unemployment and along with it the biggest and fastest government response since the great depression.

We are well positioned by the choices we made before this downturn started. Since our founding days, we have hardwired resilience into the choices we’ve made on credit, capital and liquidity through good times and bad. As a result, we entered the downturn with strong and resilient credit trends, a fortified balance sheet and deep experience in successfully navigating through prior periods of stress, including the great recession.

Our investments to transform our technology and how we work and our efforts to drive the company to digital are powering our response to the pandemic. Our technology transformation enables us to develop and scale up compelling digital customer experiences as social distancing increases demand for digital engagement. Automation facilitates rapid changes and enhancement in underwriting and analytics. And our cloud-based modern technology infrastructure seamlessly support the virtual work environment for 80% of our total associate population.

When the pandemic took hold, we took immediate actions to protect the well being of our associates, customers and communities. And we took actions to manage credit risk and further strengthened resilience. We tightened underwriting and pulled back marketing. We fortified our liquidity and capital, and we significantly built our allowance for credit losses.

We continue to lean in to resilience to weather the storm with strength and stay ready for opportunities that will emerge as the cycle plays out. As we manage through the near term challenges, we also continue to focus on the things that create long-term value. One area of continuing focus is efficiency. Prior to the pandemic, we were on a sustained trajectory of improvement.

We pursued improvements in annual operating efficiency ratio in five of the last six years, driven by revenue growth and digital productivity gain. While the pandemic has interrupted our progress, it has not changed our journey or the milestones along the way. Based on where we are in the downturn, we don’t have the visibility to commit to this specific timing that we remain committed to getting to 42% annual operating efficiency ratio over time with further improvement from there.

COVID-19 has thrown us and other companies across the economy a big curve ball, but it hasn’t changed where we think our business is headed or the long-term strategic opportunities that will be created as digital continues to bring sweeping changes to how we work, how we interact with each other and how we experience the world every day. In fact, the pandemic appears to be accelerating digital change everywhere we look.

We believe that our shareholders, customers and associates will be well served by our eight year strategic commitment to digital transformation and our steadfast focus on resilience. We remain well positioned to weather the downturn, emerge with strength and deliver shareholder value over the long-term.

And now we’ll be happy to answer your questions. Jeff?

Jeff Norris

Thank you, Rich. We’ll now start the Q&A session. As always as a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question with a single follow up. If you have any follow up questions after the Q&A session, the investor relations team will be available after the call.

Matt, please start the Q&A.

Question-and-Answer Session


Thank you [Operator Instructions]. Our first question will come from Betsy Graseck with Morgan Stanley.

Betsy Graseck

A couple of questions, just first off I wanted to understand a little bit about the folks who had enrolled but are no longer enrolled. You have those nice charts on auto and the domestic card. And I wanted to understand the folks that have rolled off. What has their payment history been like and what are you anticipating over the next quarter from them?

Richard Fairbank

So, Betsy, the no longer enrolled population includes all customers who have either made a payment, or completed a billing cycle following the forbearance period and have not re-enrolled. As such, it is mostly customers who have resumed regular payment patterns but also includes a much smaller group of customers who have not resumed paying us and are advancing in or toward delinquency. You get visibility to customers in that situation through our normal delinquency reporting.

Betsy Graseck

And so my follow-up is the delinquencies look really good this quarter, and we see it every month obviously, when you give us update on the managed data. So, I guess I’m wondering, why you think there’s that disconnect? And given the 11% reserve ratio you already have set aside against card and the low level of delinquencies you have. Do you see much in the way of reserve build in 3Q versus 2Q?

Scott Blackley

Betsy, why don’t we work backwards and I’ll go to your question on the allowance. With the allowance from here, it’s really going to depend on some of the major drivers of our reserve build in the quarter. I talked about those being our economic scenario and our approach to stimulus. And I feel like those have both a conservative bias when I look at them at this point. So, I would say that I feel very good about the allowance that we’ve got today given what we’ve seen since the end of the quarter.

But in the future, I think it’s going to come down to if the economic outlook and forecasts get worse then that would lead to an allowance build. And then on the other side of that, all else being equal, if we did see more stimulus that would be a positive to the allowance and we could see an offset to the potential effects of the economic scenario that we built the allowance on this quarter. So, I don’t have a specific guide for you as to whether we think it’s going to be going up or down. But hopefully, that gives you a sense of what may drive it in the future.


Next question will come from Ryan Nash with Goldman Sachs.

Ryan Nash

So, maybe first from the dividend. So looks like the capacity to keep the dividend was higher for 3Q. So I guess, are you factoring in the income test staying in place beyond this quarter and do you expect to maintain the dividend beyond this quarter? And then I guess second, if you did maintain the $0.10, it does seem like there’s a pretty sizable bounce back in earnings for the back half of the year. So, can you maybe just clarify what’s been baked in. And just lastly, how quickly do you think you could reinstate the dividend? Thanks. And I have a follow up.

Richard Fairbank

Thanks Ryan, and that was about four questions built into one, but let me give a couple of thoughts. So on the $0.10 dividend, I think if you did the math, which is based off of net income, technically I think we could pay about $0.13 dividend this quarter. We rounded down to a dime and of course that’s subject to you know our Board approving that at some point in the future. And in terms of looking forward with Q4 at this point, I honestly don’t know how the fed rules are going to play out into the fourth quarter. We don’t know how that income limitation test is going to work if they’re going to continue it on, you know that they’ve instituted a fall stress test for all of the 33 banks in CCAR.

So, I’m not going to give a guide on where the dividend is going to be next quarter. We’re committed to continuing to have a dividend. I appreciate how important that is to a number of our owners. And then I would just say with respect to earnings, you know we do have a net loss for the three cumulative quarters ended Q2, I think that we would need to make over $1.1 billion next quarter in order to pay dividends, whether or not that’s going to happen.

And I think it’s going to be really largely driven on what happens with the allowance, and I just talked about some of the drivers there. So, I don’t mean to not be specific as to whether or not we’re going to pay it. But I would just leave you with, we are committed to doing the best we can to make sure that we preserve the dividend.

Ryan Nash

Got it. And I’ll try to be briefer in my second one. So, I guess, Rich, you know if you think about it. You have a bird’s eye view of the most impacted verticals, consumer via card and auto, commercial including oil and gas and some high impacted commercial real estate. Could you rank order for us to just talk about your concerns in each of the asset classes where you’re feeling better or worse relative to three months ago? And then second you talked about forbearing helping in the near term. Can you just maybe help us understand how to think about that historical relationship between unemployment and losses? Because it seems like you’re reserving for a lot of historical relationships coming to fruition. But clearly, we could see benefits from the forbearance, helping customers make payments as you’ve showed in the slide.

Richard Fairbank

So on a little comparison here. Let me start with how the various parts of our business, the industries we’re in entered the downturn. Our consumer business is the industries we felt that were particularly healthy, the card business I’d put at the top of the list in terms of a rational industry conservative underwriting by the players there. And the consumer was also, given how long in the tooth the downturn was, the consumer was still acting very rationally as well.

So, all of those things are very different from the great recession and how we entered it, the industry entered that one. The auto business I’d give it pretty high marks going in for similar reasons and pretty strong consumer in a competitive environment that always kind of amplified and volatized, if you will, by dealer being an intermediary in the middle but pretty rational. We were concerned much more about the commercial business, because of practices, credit practices and behaviors, underwriting behaviors that we saw mostly outside of the banking industry in the institutional marketplace, but which it’s hard to avoid having that impact, the commercial banking part of the business as well.

So, since then to me the thing that I’m most struck by is how strong yet again the consumers steps up and the rationality of the consumer I’m so struck by. The pulling back on purchases, savings rates going way up, payment rates, which also are kind of a hidden factor in slowing down growth, the flip side of good credit, those behaviors have just been very apparent across our consumer lending businesses.

And I’ve always throughout my three decades of doing this, building this company, been very struck by how rational the consumer is and we see that there. The huge sort of elephant in the room on the consumer side and it’s an elephant on the commercial side, as well as what happens to government stimulus. And I just think a lot of things have lined up that have softened the impact for consumers, even really those who have been unemployed. And so, we are seeing this great paradox of extraordinary credit performance in the middle of the worst economy metrics in our lifetimes. So, I think that’s a hard one to prognosticate where it goes from here but I give really high marks to the strength of the consumer and I see solid continuing underwriting behavior by competitors in that marketplace.

Commercial is really a blend of so many different marketplaces. And so while we have a lot of — there’s a lot of healthy industries we’re in and where do we look with concern at the top of our list is energy, which is already taking it on the chin before the downturn, and is now struggling now even more so with what’s happening to oil prices. The places that, other places of course in commercial real estate hotel, we have very small exposure there that’s not a good area. We’re pleased that we dialed back a lot on our retail CRE exposure. So, we feel quite good there.

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We have an eye out on the multifamily side just for the, what happens with the forbearance programs. For example, in New York, we’re coming to the end of the 90-day moratorium on evictions and the increased unemployment pay. So, I think there’s uncertainty there. So, it’s a tale of a lot of different cities and commercial. But if I pull way up, I’m just — every month as we go through the downturn with strong credit performance that’s one more month of progress and it limits, it lessens the extent of the downside and the rest of the pandemic. But we’ve got the big wild card as we referred to, you see it reflected in our allowance build. And therefore, we’re managing in a very dichotomous situation here that is quite extraordinary to experience.


Next question will come from Rick Shane with J.P. Morgan.

Rick Shane

I’m really struck by the difference between the utilization of the customer assistance programs on the auto side and the card side. Is that a reflection in the current environment of the utility of the credit card versus the utility of card, or is it a function of the amortizing nature of auto loans versus the minimum payment ability on a card?

Richard Fairbank

I think it is, there are several things going on. And you see this effect to Capital One and you can also see it across the industry. There’s just naturally a lot more ambient demand or forbearance programs in the auto business than there is in cards. By the way, you could also add mortgage into that comment that there’s a lot of demand there. So, one fundamental reason is that auto payments are typically much higher than card minimum payment. And so, they’re just more likely to be beyond the reach of a given customer whose income is disrupted.

And within both businesses, not just as we compare across the two businesses but within both businesses, we’ve seen a strong correlation between demand for forbearance programs and the size of the payment due. The second reason I think also in that auto the stakes are higher for the customer and they’re very motivated to make sure that they can keep the car. So, we’re not surprised by these differences.

One thing that I think is just a point, an investor point here is that because a relatively small number of our card customers have in fact raised their hand to obtain to programs, and so many of them are already getting out of this. I think you’re able to have a really clear, pretty darn clear window into the credit performance of Capital One, even inclusive of the forbearance programs. It’s a little harder to, because the auto forbearance numbers are larger, it’s not quite as clear in terms of where the credit numbers overtime will go, even though we are certainly very bullish about how well the program is performing.

But I think what I kind of feel investors, they’re little bit throwing their hands up and say in a period of with all this forbearance going on in individual companies, how are we able to read the credit metrics. I think, there is a high level of clarity on the card side in particular at the moment.

Rick Shane

And that actually segues perfectly into my follow up, which is that when we look then at the reserve or the allowance levels for each of the products, the implied loss frequency on card is substantially higher. Is the way to think of the longer this persists there is more embedded risk in the card portfolio?

Richard Fairbank

Well, I think that the loss rates on card are higher, because it’s a unsecured product. Rick, I also think that when it comes to the auto business, we have fairly high levels of recovery on the collateral there. And then in the reserving that we’ve done this particular quarter in auto, a portion of that was actually driven by the growth that we saw there. So, I think they’re just different asset classes with different characteristics and certainly the average card book has higher losses than what we see in our auto book.


The next question will come from Sanjay Sakhrani with KBW.

Sanjay Sakhrani

I guess I have a two part question or two questions on preprovision earnings. Scott, maybe you could just outline how you see the NIM and revenue unfolding over the course of the year, and maybe any other mitigation efforts you might have? And then secondly, as far as loan growth is concerned, Rich talked about the improving trends in purchase volume. You’ve also had some of the other auto finance players talking about OEM production increasing and that might lead to no dealer inventory to sell and loan growth. Could you just talk about broadly sort of loan growth as it unfolds over the rest of the year?

Scott Blackley

So Sanjay, I’ll start off on some thoughts around NIM. And you know, it certainly feels like NIM is kind of at the low end of where I would expect it should be for our company. And there’s a few factors driving that, which I talked about in my comments and talking points. But if you think about where that might be going in the future, I’d say a couple of things.

First of all, we’re working really hard to continue to deploy more of our cash into higher yielding investments, whether that’s the investment portfolio where I think we can put some work there, offsetting wholesale funding, maturities, those are some examples. But candidly given the current rate environment where we are in this downturn, I would anticipate that cash levels are going to remain high until we start to see some stabilization there. So, we’ll try to make some progress but I don’t think we’ll be able to really change that dramatically.

On the asset mix effects, certainly the decreasing card this quarter was a big headwind on our net interest margin. I think depending on what happens with our opportunities in the market, where we feel comfortable continuing to step in, those will be major drivers of what happens to NIM going forward. And then on the deposit side, I think the benchmark rates have fallen more than what we’ve seen in our pricing.

And as Rich talked about in his talking points, some of our pricing actions happened late in the quarter. So, we’ll see the full benefit of those coming through next quarter, which should be a tailwind for NIM. I also think that we’re starting to see datas accelerating across the industry and I think there’s probably more opportunities for continuing to price down deposits at this point in the cycle. So, that’s kind of where I see NIM going from here.

On loan growth outlook, I think that that that is a bit of a question mark about how this pandemic plays out and where we see opportunities. We’ve obviously found that there’s some great opportunities in auto in ways that we feel comfortable with our origination strategy and what we’re seeing in there. With respect to card, there’s certainly pockets where we think we can continue to acquire new accounts. And we’ll have to see how payment rates play out, because that’s a major driver in what happens with outstandings. We’ve seen great credit, part of that is high payment rates. The flip side of that is that that has a tendency to drive down outstanding.

So, on low growth, I think that we’re a little bit kind of looking at what is available in the market is going to drive our behavior. And it’s a time now to be to be cautious but we also are always looking for opportunities to take advantage of spots where we see the market available to us.


And our next question will come from Don Fandetti with Wells Fargo.

Don Fandetti

I know there’s some concern around economic weakness in the south and southwest more recently. Have you seen anything that would suggest there’s some pressure? And also the forbearance and cards, looks like it maybe have ticked up a little bit. Just curious if that’s continuing to hold steady?

Scott Blackley

So Don, we have not seen any big geographical effects. We certainly are on the lookout for them. I think the government stimulus and the forbearance that’s generally going on in the industry has sort of moderated credit issues broadly across all the geographies. With respect to forbearance, there’s a reasonable amount of variation by state in a way that’s intuitive given the differential impact of the virus so far. So for example, in our card business, Florida, New Jersey, New York, certainly, earlier on have been states with some of the highest enrollment rate. So, the forbearance thing it matches intuition pretty closely.

Richard Fairbank

Don, just one more comment on your question about regional differences. A lot of the information that we’re looking at tends to be backward looking. And so as this pandemic is evolving, we haven’t seen anything specific with the south or the southwest just yet, that may be because we’re looking at backward facing data and there may be more coming.

Don Fandetti

And then I guess, you’d mentioned there’s no additional stimulus built into your reserve build. The $600 extra average weekly unemployment is pretty material. Would you agree that that could have a material impact on your charge-offs if that were not extended?

Richard Fairbank

Well, that’s a big part of why our allowance builds have been the size that they are is that we had certainly seen that there has been an effective income replacement with a lot of the unemployment benefits that you talked about, as well as just other direct-to-consumer stimulus. And to the extent that that unemployment isn’t offset with other programs or even forbearance, our allowance is built on a premise that that would translate into higher losses at some point in the future.


Next question will comes from Eric Wasserstrom with UBS.

Eric Wasserstrom

Rich or Scott, my question is about the loss curve. My own model is showing an very unusual shape which is as, it’s pretty flat to the third quarter and stairs up higher in the fourth as some of the deferral actions have been. And then set functions higher again in the second quarter of next year when the deferral on the assumption that some of those deferred cash flows are going to service other kinds of debt. Could you just give me a sense of about your own view of the loss curve looks like and whether it looks unusual relative to…

Jeff Norris

Eric? Excuse me, Eric. I’m so sorry. We’re having a great deal of difficulty understanding you.

Eric Wasserstrom

Okay. Can you hear me better now?

Jeff Norris

It’s still a little muddled. I’m so sorry.

Eric Wasserstrom

Is it any better now? That’s much better.

Jeff Norris

Okay. Sorry about that. My question was just about your expectations for the shape of the loss curve, whether in fact it still looks like a curve or more like a step function at different levels of forbearance, whether it’s your own or whether it’s things like GSE forbearance, which may influence how other asset classes perform.

Richard Fairbank

Eric, one of the challenges that we faced in our allowances this exact point that you’re bringing up. We’ve got a delinquency inventory that has incredibly low delinquency embedded in it right now and an unemployment forecast that’s suggesting that that’s got to normalize at some point. How that’s going to workout I think is going to really depend on what happens with stimulus. If we do see some of this stimulus just suddenly drop-off, I think we will see some clip function around that starting to translate into delinquencies. Whether or not how forbearance impacts that, I’m sure that there will be some tempering with forbearance that will continue on in those periods. But I would anticipate that the lack of stimulus would be the major driver in terms of where loss curves would look like here in overtime if those benefits weigh off.

Eric Wasserstrom

And then my follow-up is just on OpEx. Rich, obviously good to hear about the reinstation of the, the reinstatement of the efficiency target. But has there been any change or incremental actions or anything incremental to the prior target that you’re looking at given the current circumstances?

Richard Fairbank

So, Eric, there are natural forces in a sharp downturn like this that pressure the revenue trajectory. Certainly, with the purchase volume declines the demand for card loans drop and interest rates fall. So, we certainly, the pressure is certainly coming on the revenue side. So, in terms of what we’re doing, the actions that we’re taking, we talked about we’re tightening our extension of new credit. We’re pulling back on marketing. And these things naturally put pressure on loan growth.

So, kind of to your point. So what we’re, first of all on the revenue side, we, it’s not a binary thing to us that where there’s a downturn so therefore, one hunkers down. We have a lot of experience over all these years living through downturns. We have to us, all of our choices are very, very segment and micro segments specific. So there’s going to be a real gradient with respect to how we lean into those opportunities in this environment. But I don’t want to leave the impression that we’re just totally in hunker down mode until the pandemic end.

But what we have done is we kind of started the downturn with a pretty broad pullback as the world was kind of in physical free fall. And then we have really carefully assessed by segment what are we getting as, what kind of information we have that can help us predict how consumers are going to do in this particular pandemic? What are we seeing with respect to adverse selection, or in few cases maybe even some paradoxical positive selection that you sometimes see in a downturn like this.

So, our energy is particularly focused on the response, the differential response we’re doing during the pandemic and leveraging the information we have, including the ability to get a bunch of information in real time, because of our tech transformation in order to find some good revenue opportunities.

On the expense, side we have really tightened up on hiring. For example, that’s a very natural thing to do and we have done that. We are meeting very frequently, just working on overall how can we manage our expenses really tightly. And this is all in the context where we still importantly making the necessary investments to manage the pandemic response. We don’t want to certainly cut back on that. We still expect to benefit from the exit of the data centers. Later this year, all of that is unaffected by the pandemic. And of course, in terms of the total efficiency ratio, the reduction in marketing is a good guy for total efficiency ratio.

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So, when we look at what it was that drove us to target to 42% annual operating efficiency ratio. All of those same factors and the things happening with our business model and the success in technology and all of that, all of that is still entirely intact with respect to the business model. This is all about timing at this point. And so, we’ve pulled back on the timing of our commitment to that target. But the energy and what led us to achieve the kind of success we have on the efficiency side, what led us to achieve the tech success and all the things that had gotten us where we are on the credit side, all of that energy is we’re all in on that.


Our next question will come from Moshe Orenbuch with Credit Suisse.

Moshe Orenbuch

I guess Scott or Rich, could you talk a little bit about when you think about the level of reserves going forward. You talked a lot about, Scott talked a lot about stimulus a couple of times. But assuming that that’s going to be one item that when you think about changes, is it going to be changes in unemployment? Or how much can the consumer behavior that you’ve seen that’s a positive impact your kind of expectation for how much reserves are needed? Or is it just going to be based on that employment level?

Scott Blackley

Well, I think Moshe, thus far, a lot of the consumer behavior is driving what we’re seeing in terms of credit performance. So that’s a huge part of it some of that stimulus but I think some of it is just disciplined behavior by consumers and by a lot of our competitors in the industry. As I think about going forward, I do think that as I talked about earlier. I think stimulus is going to be a major driver of what happens with the reserve. But I do believe that the consumer had that experience from the financial crisis. A lot of wisdom that has been learned there. And we’ve seen a lot of discipline in that regard.

So, I’m not sure that as I think about where the allowances going while unemployment is going to be a major driver, I think that some of the other factors that we’ve talked about and Rich mentioned several of them in his talking points, are going to be important offsets there in terms of what might happen in terms of good relationship between unemployment and the credit losses as we go forward.

Moshe Orenbuch

And following up on the previous question about marketing, I mean, it’s kind of pretty stark if you think about. You probably have, I don’t know, north of a 60% decline in credit card marketing in the quarter and you’ve got volumes actually up double digits in auto. Can you talk a little bit about what you’re seeing in the two markets that kind of make that the right way to go right now? And what would make you want to start marketing again more activity in the card space?

Richard Fairbank

So Moshe, let me just talk a little bit about auto and then move to credit card. So, we actually in both card and auto, our first response was to tighten underwriting and we have had a tighter credit box in both of the businesses. There are number of things happening in the auto business that sort of are causing better high-quality volume to come Capital One’s way even with the tighter credit box. And so, we’re scrutinizing very, very carefully with everything about what we see in this volume and the early performance. But, I wouldn’t underestimate the importance of the digital capabilities that we have that have been helpful during the pandemic.

But we’ll have to see what competition does overtime. And we’re going to again really, really carefully scrutinize what comes in. There’s also in the auto side particularly in certain segments of the business ability to have a lot more information in real time, which can allow one to have more clarity on the customer’s condition, situation and with better guess then on how they may perform. So on the card side, typically in underwriting there is less information available in unsecured loan of course. And we’re even at a time where the reliability of credit bureau information is likely less over this period of time, just because of certain things about companies not reporting on forbearance during this period of time. So, that also make things a little bit more challenging.

Now the flip side of that, Moshe, for us where we have been, we always talk about the origination lever and the credit line lever are two separate decisions. And we’ve always said that the real, for a lot of our business, the real exposure comes on the credit line side, not really the origination side. So, we have been more leaning in on the origination side and the conservatism has particularly come with respect to credit lines.

And as you know from having watched us manage that through time, we’re trying to continue to build the potential energy as carried by the originating new accounts, hold back for the time being on the credit line and then trying to get as much information as we can on each customer and watching very carefully their situation, pick — over time really open up on the credit lines. But the loan growth will come more on the credit line side and that is a level and a dial that we’re going to be managing along the way during the downturn. So, the net effect of all of that is something that ends up with, you know, at this point higher volumes in card.

And then the final point I want to make is the relationship of course between marketing and all this, because you know dial backs in marketing tend to therefore generate lower volume. So, what early on in the downturn like most of the other players, we dialed back in marketing. What we are doing is like everything is not a one size fits all, but it’s going to be a sloped level of marketing by channel, by segment, by product. But we’re hopeful that we can generate some good origination results over time by a very sloped differential customized effort on the marketing side.


Our next question will come from John Hecht with Jefferies.

John Hecht

Richard, pretty high level question and you touched on some of the components of the answer it is, but I figure I’d still ask it anyway. So, you’ve managed this business through variety of different downturns and pullbacks, and recognizing that this one is much different than and they all are different I suppose. At this point of the downturn, how do you see yourself as prioritizing different objectives, and what kind of opportunities might come out of that if you compare and contrast this one to the last few downturns?

Richard Fairbank

I think a few things about this downturn that are different. Again, I think on the consumer side, significantly more healthy consumer and marketplace going into this one then the last one. So the last one had to work its way through so many kind of structural problems on the way to getting to the other side of the downturn. It made the last great recession that was tough. So, it’s a cleaner situation on the consumer side of the business. The really striking thing about this downturn is how immediate it was. You look back to the great recession. I mean, lots of the indicators were there in ‘07, but this was a rolling downturn that took a lot of months and even sort of measured in years to play out.

In this one, I’m so struck by the fact that everybody sort goes down the elevator at the same time. We’re talking about consumers, we’re talking about companies who serve them, banks and the government. I think, so because of the vertical drop down the elevator where it’s not clear what floor it’s going to stop at you saw such a conservative response by consumers that that’s the flip side. So that’s bad for volumes but really good for my credit health and savings and all the aspects of that. That is really striking in comparison to any downturn I’ve seen before.

Because of the vertical drop, you’ve also seen companies really you know mobilize in very rational ways and pull back much more quickly than they did in the downturn and that leads to a healthier situation as well. And then I think the vertical drop allowed the political environment to coalesce around significant stimulus programs that would be so difficult if this were rolling 18 months to really get into this then. So that to me is what is so unique about this.

And so, now it’s led to this really extraordinary kind of paradoxical situation where the actual performance of the customers. And I’m especially talking about the consumer business, the performance is so strong but the economic numbers are so bad. A lot of, how these things play out is really going to be driven by choices that happen on the government side or perhaps the collective forbearance choices that will be made by the banking industry and beyond.

But another thing that I think is important, Jeff, as a mental thought here is think about a metaphor of a downturn tends to have. Worsening is like big mountain and things go way up and then they come down. With every month of solid performance by the consumer in a sense, we’re burrowing a tunnel through the mountain. And every month that passes as you get through the mountain in some sense, all other things being equal, it can serve to limit some of the downside that can come in even as there’s a fairly rapid sense if some of the stimulus, for example, is removed.

But in all of this what I find this very energizing times from a business point of view to look for where are the risks, where are the differential opportunities, how can we capitalize on the ability to do real time underwriting and leverage a lot of data and that data is a pay off of our tech transformation and leverage three decades of experience, but also really understand what is unique about this downturn. And I think, we are — that’s what we’re spending so much energy doing with right now. And I think across our businesses, there’s going to be a very sloped kind of amount of growth or shrinkage depending on the unique opportunity.


And our final question of the evening will come from Bob Napoli with William Blair.

Bob Napoli

Strange times indeed, most of the questions on credit. But I guess, Rich, I think just one thing. And I tend to agree with your comment that the longer this goes the less risk I think on the consumer side. And do you think that the stimulus and the consumer reaction has essentially covered some of the charge-offs that would have occurred, that they will not occur because of the thing of those funds that were available? And then I know the the team said that some people think that companies such as yours don’t make any adjustments to the underwriting side. But what percentage of your current borrowers in the credit card business are unemployed? And when you’re making underwriting new loans, I would assume that new loans don’t go to people who are unemployed. You don’t extent credit lines to those that are generally unemployed. But you also carry that further and look by industry and say, well, Delta Airlines is about to lay-off half of their workforce, we probably should be more conservative with airline employees. And so just some thoughts on what you think those charge-offs are permanently removed, because of stimulus potentially. And then just some comments on the underwriting. How many of your current borrowers are unemployed and how you have changed underwriting?

Richard Fairbank

So, I don’t think we have a rigorous measure of how many of our current borrowers are unemployed. But since we have a big chunk of America, I think that our borrowing base is reflective of America. And there are a lot of people that are in different degrees of unemployment right now. And so, even as there’s such great credit performance right now, what we’re obsessing about is kind of looking beyond that to a number of the things that you’ve talked about how to underwrite with as much information as we can and as wisely as we can.

Past performance is not necessarily such a great predictor of future performance at a time like this. But we call our whole strategy at Capital One the information based strategy. This is a time where data really matters. And so, we’re putting a lot of energy into that very thing, along the lines of a lot of things that you’re talking about. So, marshaling as much information as we can, leveraging the capabilities Capital One has built to having data is one thing, getting data and leveraging it in real time is another thing. And that’s one of the things that we’ve been focused on with respect to our technology transformation.

And then finally, how does one also in a world where you can’t be assertive on the underwriting side, how do we put other mitigating protections in, in the structure of how we build our products. And the low line credit, the low line strategy that Capital One particularly is beneficial at a time like this. Originating with lower lines and saying we’ll waiting for awhile on the line increase side of things. But we will continue to originate the account subject to the tighter credit box we talked about.

On the auto side, we have invested very heavily in real time information based underwriting. And like I said earlier, the amount of data available in the auto underwriting process in real time compared with card is a whole level higher. I mean, it’s partly an industry point and some of the particular places that we’ve gone at Capital One. And so, I think that with some of the clarity that we’re able to see particularly well there, we can make some good choices but also we’re able to put in more structures, more protections, stronger pricing, into the underwriting that’s a very important thing in addition to just the prediction of the underlying risk of the consumer themselves.

Bob Napoli

Great, appreciate your answers and have good evening.

Richard Fairbank

Thanks very much, Bob.

Jeff Norris

I’d like to thank all of you for joining us on this conference call today and thank you for your continuing interest in Capital One. Remember, investors relations team will be here this evening to answer any further questions you may have. Have a good night, everyone.


That does conclude our call for today. Thank you for your participation. You may now disconnect.