Capital One Financial 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2006.
For the transition period from to
Commission File No. 1-13300
CAPITAL ONE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (703) 720-1000
Securities registered pursuant to section 12(b) of the act:
Securities Registered Pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the close of business on January 31, 2007.
Common Stock, $.01 Par Value: $32,670,240,108*
Common Stock, $.01 Par Value: 410,593,824 shares
DOCUMENTS INCORPORATED BY REFERENCE
CAPITAL ONE FINANCIAL CORPORATION
2007 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Capital One Financial Corporation (the Corporation) is a diversified financial services company, incorporated in Delaware on July 21, 1994, whose banking and non-banking subsidiaries market a variety of financial products and services. The Corporations principal subsidiaries include Capital One Bank (the Bank), a Virginia state chartered bank that currently offers credit card products and deposit products and also can engage in a wide variety of lending and other financial activities; Capital One, F.S.B. (the Savings Bank), a federally chartered savings bank that offers consumer and commercial lending and consumer deposit products; Capital One Auto Finance, Inc. (COAF), which offers automobile and other motor vehicle financing products; Capital One, N.A. (CONA), a national association that offers a broad spectrum of financial products and services to consumers, small businesses and commercial clients; and North Fork Bank (North Fork Bank), a New York state chartered non-member bank that provides a broad range of deposit and lending services for consumer, commercial and small business customers. Capital One Services, Inc. (COSI), another subsidiary of the Corporation, provides various operating, administrative and other services to the Corporation and its subsidiaries. The Corporation and its subsidiaries are collectively referred to as the Company. Unless indicated otherwise, the terms Corporation, we, us, and our refer to the Corporation and its consolidated subsidiaries.
The Corporation became a financial holding company on May 27, 2005, thereby giving the Corporation the authority to engage in certain activities that are not permissible for bank holding companies.
As of December 31, 2006, we had $85.8 billion in deposits and $146.2 billion in managed loans outstanding. We are among the largest issuers of Visa® (Visa) and MasterCard® (MasterCard) credit cards in the United States based on managed credit card loans outstanding, and we are the 11th largest depository institution in the United States.
We offer our products throughout the United States. We also offer our products outside of the United States principally through Capital One Bank (Europe) plc, an indirect subsidiary of the Bank organized and located in the United Kingdom (the U.K. Bank), and through a branch of the Bank in Canada. Our U.K. Bank has authority, among other things, to accept deposits and provide credit card and installment loans. Important factors underlying the growth of our lending and deposit activities include strategic acquisitions, industry dynamics, including the level of competition, and our customer oriented business strategies and brand.
Our common stock is listed on the New York Stock Exchange under the symbol COF. Our principal executive office is located at 1680 Capital One Drive, McLean, Virginia 22102 (telephone number (703) 720-1000). The Corporation maintains a website at www.capitalone.com. Documents available on our website include (i) Codes of Business Conduct and Ethics for the Corporation; (ii) the Corporations Corporate Governance Principles; and (iii) charters for the Audit and Risk, Compensation, Finance and Trust Oversight, and Governance and Nominating Committees. These documents are also available in print to any shareholder who requests a copy. In addition, we make available free of charge through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after electronic filing or furnishing of such material with the SEC.
Capital One is one of the largest financial services franchises in the United States. We are a diversified financial services corporation focused primarily on consumer and commercial lending and deposit origination. Our principal business segments are domestic credit card lending, automobile and other motor vehicle financing, global financial services and banking. For further discussion of our segments, see pages 48-54 in
Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsReportable Segment Summary and pages 92-95 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 3.
U.S. Card Segment. We offer a wide variety of credit card products throughout the United States, which we customize to appeal to different consumer preferences and needs. Our product offerings are supported by extensive brand advertising. We routinely test new products to develop ones that appeal to different and changing consumer preferences. Our customized products include both products offered to a wide range of consumer credit risk profiles, as well as products aimed at special consumer interests. Our pricing strategies are risk-based; lower risk customers may likely be offered products with more favorable pricing and we expect these products to yield lower delinquencies and credit losses. On products offered to higher risk customers, however, we are likely to experience higher delinquencies and losses, and we price these products accordingly.
Auto Finance Segment. We purchase retail installment contracts, secured by automobiles or other motor vehicles, through dealer networks throughout the United States. Additionally, we utilize direct marketing, including the internet, to offer automobile financing directly to consumers. Our direct marketed products include financing for the purchase of new and used vehicles, as well as refinancing of existing motor vehicle loans. As of December 31, 2006, we are the third largest non-captive provider of auto financing in the United States. One of our competitive advantages is that we are able to provide credit to customers with a wide range of credit profiles.
Global Financial Services Segment. The Global Financial Services segment consists of international (UK and Canada) lending, small business lending, installment loans, home loans, healthcare finance and other consumer financial service activities, extending Capital Ones national scale lending franchise and providing geographic diversification. In our international businesses, we utilize the methodologies and approaches similar to those we use in the United States.
Banking Segment. The Banking segment represents the results of the legacy Hibernia business lines except for the indirect auto business, which is included in the Auto Finance segment results, and the investment portfolio results which are included in the Other category. In addition, the Banking segment includes the results of the Companys branchless deposit business which were previously included as part of the Other category. The Banking segment offers traditional banking products through an extensive branch network. Products include commercial and consumer loans, commercial and consumer deposit account services, commercial credit cards, treasury management services, trust services and other banking related products, such as insurance, brokerage services, merchant services, and investment banking. In addition, the Banking segment offers money market (liquid accounts) and certificate of deposit accounts (time deposits) through internet channels.
Acquisition of North Fork Bancorporation
On December 1, 2006, we completed our acquisition of North Fork Bancorporation, a financial holding company that provides a wide array of financial products and services through its bank and non-bank subsidiaries. Under the merger agreement, North Fork merged with and into the Corporation, and Capital One continued as the surviving corporation. We are focused on successfully integrating North Fork Bancorporation into the Corporation, and beginning with the first quarter of 2007, we will begin reporting its activities in our business segments. For the year ended December 31, 2006, North Forks financial results are included in the Other category in our financial statements.
Loan portfolio concentration within a specific geographic region may be regarded differently based upon the current and expected credit characteristics and performance of the portfolio. Our loan portfolio is geographically diverse, although we do have commercial lending concentrations in the New York metropolitan area and Louisiana. See page 130 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 24 of this form.
Enterprise Risk Management
Risk is an inherent part of our business and activities. We have an Enterprise Risk Management (ERM) program designed to ensure appropriate and comprehensive oversight and management of risk. The ERM program has three components. First, the Board of Directors and senior management committees oversee risk and risk management practices. Second, the centralized department headed by the Chief Risk Officer establishes risk management methodologies, processes and standards. Third, the individual business areas throughout the Company are responsible for managing risk in their businesses and performing ongoing identification, assessment and response to risks. Our ERM framework includes eight categories of risk: credit, liquidity, market, operational, legal, strategic, reputation, and compliance.
Board and Senior Management Oversight
A combination of the Board and senior management committees is used to oversee the management of risk. The Audit and Risk Committee of the Board of Directors oversees our accounting, financial reporting, internal controls and risk assessment and management processes. The Audit and Risk Committee also reviews periodic reporting on significant risks and mitigation activities and compliance with corporate risk policies. The Board Finance and Trust Oversight Committee oversees liquidity and market risk. The Executive Committee, a committee of senior management chaired by the Chief Executive Officer, provides guidance to senior executives regarding strategic risk and provides an integrated view of risk through reports by our other senior management committees:
Integrity, Ethical Values and Risk Management Culture
We maintain our risk management culture through various mechanisms designed to bring the consideration of risk into daily decision making. We have a corporate Code of Business Conduct and Ethics, available on the Corporate Governance page of our website at www.capitalone.com/about, under which each associate is obligated to behave with integrity in dealing with customers and business partners and to comply with applicable laws and regulations. We also have a compliance training program and an associate performance management process that emphasize achieving business results while ensuring integrity, legal compliance and sound business management. Our risk management culture is also encouraged through frequent direction and communications from the Board of Directors, senior leadership, corporate and departmental risk management policies, risk management and compliance training programs and on-going risk assessment activities in the business.
Organizational Structure for Risk Identification, Monitoring and Reporting
Our organizational structure supports consideration of risk in decision making. We monitor our key risks, mitigation plans and our risk management capability through a system of on-going measurement and reporting to business area management, the Chief Risk Officer, senior management committees and the Board and its committees. The corporate Risk Management department designs and facilitates the implementation of methodologies to identify and assess risk, analyze and aggregate risk and mitigation reporting and to evaluate and enhance the risk management culture. Each business area uses these methodologies to identify key risk exposures which are assessed according to potential likelihood and impact, as well as, the quality of the related controls. If appropriate, risk response plans are developed for risks and the business tracks progress against the plans. For significant risks reported to the senior management committees and the Board, specific executives are designated as accountable for the management and monitoring of each such risk. Across the Company, individual business areas utilize Business Risk Offices staffed by associates from the business who oversee implementation of methodologies and tools for risk identification, assessment and reporting. Our Corporate Audit Services department also assesses risk and the related quality of internal controls and risk management through its audit activities. Corporate Audit Services reports on the scope and results of its work to the Audit and Risk Committee of the Board of Directors.
Credit Risk Management
Successful management of credit risk, the risk that borrowers may default on their financial obligations to us, is critical to our success. There are four primary sources of credit risk: (1) changing economic conditions, which affect customers ability to pay and the value of any collateral; (2) changing competitive environment, which affects customer debt loads, borrowing patterns and loan terms; (3) our underwriting strategies and standards, which determine to whom we offer credit and on what terms; and (4) the quality of our internal controls, which establish a process to test that underwriting conforms to our standards and identify credit quality issues so we can act upon them in a timely manner. We are focused on managing each of these sources of credit risk.
The overall management of credit risk is the responsibility of the Chief Risk Officer who is supported by a Commercial Chief Credit Officer and a Consumer Chief Credit Officer. The goal of the Chief Credit Officers is to provide strong central oversight of credit policy and credit programs in the consumer and commercial lending businesses while maintaining the ability of operating units to respond flexibly to changing market and competitive conditions. The Chief Credit Officers are assisted by the Credit Policy Committee, a committee of senior management that oversees and approves corporate credit policy and credit performance. Its members include the Chief Risk Officer, the Chief Credit Officers, the Deputy Chief Risk Officer, the Controller, the Presidents of U.S. Card, Auto Finance and Global Financial Services segments and the head of Commercial Banking. The Credit Policy Committee also has sub-committees which provide credit oversight at the divisional level. The Chief Credit Officers, their staff, or the appropriate credit committee review and approve all large scale new credit decisions or programs. Smaller credit decisions are approved by credit officers appointed by the credit committee(s) and supervised by the Credit Risk Management organization. It is expected that all credit programs and major credit decisions will also be approved by the appropriate operating executives. These organizational structures are designed so that each of our business units applies standardized practices in measuring and managing credit risk, and that all relevant factors, such as credit outlook, profitability, and the competitive, economic, and regulatory environment, are considered in making credit decisions.
The Board of Directors has established policies that govern credit administration and limit the level and composition of risk in the total lending portfolio. The centralized Credit Risk Management group monitors overall composition and quality of the credit portfolio.
Our credit risk profile is managed to maintain resilience to factors outside of our control, strong risk-adjusted returns, and increased diversification.
Our guiding principles, strong central governance, and Board-directed credit risk tolerances are designed to keep senior executives well-informed of credit trends so they can make appropriate credit and business decisions for
us. We preserve day-to-day market responsiveness and flexibility by empowering our business line managers to develop credit strategies and programs aligned with our credit risk policies and objective of long-term business profitability. The credit program development process considers the evolving needs of the target market, the competitive environment, and the economic outlook.
Most of our consumer credit strategies rely heavily on the use of sophisticated proprietary scoring models. These models consider many variables, including credit scores developed by nationally recognized scoring firms. The models are validated, monitored and maintained in accordance with detailed policies and procedures to help maintain their continued validity. Our Chief Scoring Officer, a member of the Chief Risk Officers staff, oversees the development, implementation and maintenance of key statistical models.
Liquidity Risk Management
Liquidity risk refers to exposures generated from the use and availability of various funding sources to meet our current and future operating needs. The management of liquidity risk is overseen by the Chief Financial Officer with advice and guidance from the Asset and Liability Management Committee and its sub-committee on funding chaired by the Treasurer. We currently manage and mitigate our liquidity risk through the use of a variety of funding sources to establish a maturity pattern that provides a prudent mixture of short-term and long-term funds. See page 58 in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity Risk Management for additional information.
Market Risk Management
Market risk refers to exposures generated from changes in interest rates and foreign currency exchange rates. The management of market risk is overseen by the Chief Financial Officer with the advice and guidance from the Asset and Liability Management Committee. We currently manage and mitigate our interest rate sensitivity through several techniques, which include, but are not limited to, managing the maturity and repricing characteristics of assets and liabilities and by entering into interest rate derivatives. We currently manage and mitigate our exposure to foreign currency exchange risk by entering into forward foreign currency exchange contracts and cross currency swaps. The hedging of foreign currency exchange rates is limited to certain intercompany obligations related to international operations. See page 60 in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsMarket Risk Management for additional information.
Operational Risk Management
Operational risk is the risk of direct or indirect loss resulting from inadequate or failed processes, systems, people, or exposure to external events. The management of operational risk is overseen by the Chief Risk Officer with the advice and guidance of the Risk Management Committee.
Operational risk is a normal part of business for any financial services firm. It may manifest itself in many ways, including business interruptions, errors related to processing and systems, or fraud by employees or persons outside the Company. The risk of loss includes the potential for legal actions arising as a result of an operational deficiency or as a result of noncompliance with applicable laws or regulatory standards. We could also suffer financial loss, face regulatory action, not be able to service customers and suffer damage to our reputation.
The Risk Management Committee reviews our operational risk profile, which includes assessment of the operational controls, significant operational risks and mitigation plans and loss event experience across the enterprise. Operational risk information is also reported to the Audit and Risk Committee of the Board of Directors. Corporate Audit Services also assesses operational risk and the related quality of internal controls and quality of risk management through our audit activities.
The key tools used in operational risk management are a risk self assessment process, operational loss event management and economic capital quantification. Key risk exposures are identified by each business area and
evaluated according to potential impact and likelihood, as well as the quality of the related controls. If appropriate, risk response plans are developed for certain identified risks and progress is tracked against the plans. Business units are required to conduct self assessments at least annually. Internal loss histories, self assessment results, and data from industry sources are combined with senior managements assessments of future loss rates in a structured scenario approach to quantify economic capital for operational risk. The capital methodology is intended to ensure capital adequacy to withstand extreme events, and to create incentives for business areas to improve their control environments.
There are many specialized activities designed to mitigate key operational risks facing us. These include dedicated fraud management departments, programs for third party supplier risk management, information security, business continuity planning and data risk management. We incorporate the output of these functions with our analysis and reporting to senior management to achieve a broad assessment of operational risk levels and trends.
Legal Risk Management
Legal risk represents the risk of loss related to (i) new and changed laws and regulations, (ii) interpretations of law, (iii) our legal entity structure and (iv) the drafting of contracts. The management of legal risk, domestically and internationally, is overseen by our General Counsel. We operate in a heavily regulated industry, have an evolving corporate structure and rely significantly on certain contractual relationships, all of which contribute to the level of risk we face. We also face risk of loss from litigation, which is primarily managed by our legal department.
Strategic Risk Management
Strategic risk is the risk to earnings or capital from operating in a competitive environment. The Executive Committee, described above, is the principal management forum for discussion of strategic risk. We assess strategic risk in our annual planning process, which includes both a top-down process set by senior management and a bottom-up process led by the business lines. Consideration of strategic risk is also a vital component of due diligence when evaluating acquisitions or new products, ventures or markets.
Reputation Risk Management
Reputation risk represents the risk to: (i) market value; (ii) recruitment and retention of associates; and (iii) maintenance of a loyal customer base due to negative perceptions of our internal and external stakeholders regarding our business strategies and activities. The management of reputation risk is overseen by the General Counsel and Corporate Secretary with advice and guidance from Corporate Affairs. We use qualitative criteria to assess reputation risk. Various measures, both internal and external, are considered to gauge changes to our reputation and overall reputation risk and include brand market research, customer studies, internal operational loss event data and external measures.
Compliance Risk Management
Compliance risk is the risk of non-conformance to laws, rules and regulations. The management of compliance risk is overseen by the Chief Compliance Officer who reports to the Chief Risk Officer, with the oversight and guidance of the Audit and Risk Committee as well as the Risk Management Committee and its compliance sub-committee. The Corporate Compliance organization provides the business areas with consulting, training and assistance in the implementation of business processes to ensure compliance with applicable laws and regulations. The business areas, in conjunction with corporate compliance, assess and mitigate compliance risk through our enterprise risk self assessment process. Compliance monitoring and associated exception remediation activities are conducted jointly between Corporate Compliance and the business areas. Corporate Compliance is also responsible for independent reporting with respect to compliance risk activities to the Board and executive management.
Technology / Systems
We leverage information technology to achieve our business objectives and to develop and deliver products and services that satisfy our customers needs. A key part of our strategic focus is the development of efficient, flexible computer and operational systems to support complex marketing and account management strategies and the development of new and diversified products. Our commitment to managing risk and ensuring effective controls is built into all of our strategies. We believe that the continued development and integration of these systems is an important part of our efforts to reduce costs, improve quality and provide faster, more flexible technology services. Consequently, we continuously review capabilities and develop or obtain systems, processes and competencies to meet our unique business requirements. As part of our continuous efforts to review and improve our technologies, we may either develop such capabilities internally or rely on third party outsourcers who have the ability to deliver technology that is of higher quality, lower cost, or both. Over time, we have increasingly relied on third party outsourcers to help us deliver systems and operational infrastructure. Consistent with this approach, in August 2005 Capital One and Total System Services Inc. (TSYS ) finalized a five year definitive agreement for TSYS to provide processing services for Capital Ones North American portfolio of consumer and small business credit card accounts. This transition is largely complete, and is scheduled to be finalized in the first half of 2007. We believe that over time our transfer to this new technology platform will allow us to achieve cost savings, increase speed to market, expand product and service flexibility, and enhance our ability to innovate while reducing operational risk.
As a part of the North Fork integration, planning is well underway to determine preferred systems and platforms for our banking businesses.
Funding and Liquidity
A discussion of our funding programs and liquidity has been included in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsFunding on pages 54-60.
As a marketer of credit card, consumer and commercial financial products and services, we face intense competition in all aspects of our business from numerous bank and non-bank providers of financial services. Some of these companies are substantially larger and have more resources than we do. Our industry has experienced substantial consolidation and may continue to do so; this consolidation continues to create competitors who are larger and have more resources than we do. In addition, such consolidated and/or larger competitors may have a more diversified product and customer base, operational efficiencies and more versatile technology platforms than we do. Consolidation has and may continue to increase competitive pressures on both us and other companies in our industry.
Each of our financial products is marketed to specific consumer populations across the credit spectrum. The terms of each product are actively managed to achieve a balance between risk and expected performance. For example, credit card product terms typically include the ability to reprice individual accounts upwards or downwards based on the customers payment and other performance. In addition, since 1998, we have marketed low non-introductory rate cards to consumers with low-risk and established credit profiles to take advantage of the favorable risk return characteristics of this consumer type. Industry competitors have continuously solicited our customers with these and other interest rate strategies. Management believes the competition has put, and will continue to put, additional pressure on our pricing and general product feature strategies.
We compete with international, national, regional and local issuers of Visa® and MasterCard® credit cards, as well as with American Express®, Discover Card® and, to a certain extent, smart cards and debit cards. In general, customers are attracted to credit card issuers largely on the basis of price, credit limit and other product features, and customer loyalty is often limited.
We compete with national and state banks for deposits, commercial loans and trust accounts and with savings and loan associations and credit unions for loans and deposits. We also compete with other financial services providers for loans, deposits, investments, insurance and other services and products. In addition, we compete against non-depository institutions that are able to offer products and services that were typically banking products and services. Finally, we compete against other lending institutions in our healthcare financing and mortgage lending businesses.
In motor vehicle finance, we face competition from banks and non-bank lenders who provide financing for dealer-originated loans. We also face competition from a small, but growing number of online automobile finance providers.
We believe that we are able to compete effectively in both our current and new markets. There can be no assurance, however, that our ability to market products and services successfully or to obtain adequate returns on our products and services will not be impacted by the nature of the competition that now exists or may later develop. For a discussion of the risks related to our competitive environment, please refer to Risk FactorsWe Face Intense Competition in All of Our Markets on page 19.
As part of our overall and ongoing strategy to protect and enhance our intellectual property, we rely on a variety of protections, including copyrights, trademarks, trade secrets, patents and certain restrictions on disclosure. We also undertake other measures to control access to and distribution of our other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use certain intellectual property or proprietary information without authorization. Our precautions may not prevent misappropriation or infringement of our intellectual property or proprietary information. In addition, our competitors also file patent applications for innovations that are used in our industry. The ability of our competitors to obtain such patents may adversely affect our ability to compete. Conversely, our ability to obtain such patents may increase our competitive advantage. There can be no assurance that we will be successful in such efforts, or that the ability of our competitors to obtain such patents may not adversely impact our financial results.
As of December 31, 2006, we employed approximately 31,800 employees whom we refer to as associates. A central part of our philosophy is to attract and maintain a highly capable staff. We view current associate relations to be satisfactory. None of our associates is covered under a collective bargaining agreement.
The Corporation is a bank holding company (BHC) under Section 3 of the Bank Holding Company Act of 1956, as amended (the BHC Act) (12 U.S.C. § 1842). The Corporation is subject to the requirements of the BHC Act, including its capital adequacy standards and limitations on the Corporations nonbanking activities, and to supervision, examination and regulation by the Federal Reserve Board (the Federal Reserve). Permissible activities for a BHC include those activities that are so closely related to banking as to be incident thereto such as consumer lending and other activities that have been approved by the Federal Reserve by regulation or order. Certain servicing activities are also permissible for a BHC if conducted for or on behalf of the BHC or any of its affiliates. Impermissible activities for BHCs include activities that are related to commerce such as retail sales of nonfinancial products. Under Federal Reserve policy, the Corporation is expected to act as a source of financial and managerial strength to any banks that it controls, including the Bank, CONA, the Savings Bank, North Fork Bank and Superior (the Banks), and to commit resources to support them.
On May 27, 2005, the Corporation became a financial holding company under the Gramm-Leach-Bliley Act amendments to the BHC Act (the GLBA). The GLBA removed many of the restrictions on the activities of BHCs that become financial holding companies. A financial holding company, and the non-bank companies under its control, are permitted to engage in activities considered financial in nature (including, for example, insurance underwriting, agency sales and brokerage, securities underwriting, dealing and brokerage and merchant banking activities); incidental to financial activities; or complementary to financial activities if the Federal Reserve determines that they pose no risk to the safety or soundness of depository institutions or the financial system in general.
The Corporations election to become a financial holding company under the GLBA certifies that the depository institutions the Corporation controls meet certain criteria, including capital, management and Community Reinvestment Act requirements. If the Corporation were to fail to continue to meet the criteria for financial holding company status, it could, depending on which requirements it failed to meet, face restrictions on new financial activities or acquisitions and/or be required to discontinue existing activities that are not generally permissible for bank holding companies.
The Bank is a banking corporation chartered under Virginia law and a member of the Federal Reserve System, the deposits of which are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (the FDIC) up to applicable limits. In addition to regulatory requirements imposed as a result of the Banks international operations (discussed below), the Bank is subject to comprehensive regulation and periodic examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission (the Bureau of Financial Institutions), the Federal Reserve, the Federal Reserve Bank of Richmond (FRB-R) and the FDIC.
CONA is a national association, the deposits of which are insured by the Deposit Insurance Fund of the FDIC up to applicable limits.
The Savings Bank is a federal savings bank chartered by the Office of Thrift Supervision (the OTS) and is a member of the Federal Home Loan Bank System. Its deposits are insured by the Deposit Insurance Fund of the FDIC up to applicable limits. The Savings Bank is subject to comprehensive regulation and periodic examination by the OTS and the FDIC.
North Fork Bank is a banking corporation chartered under New York law, the deposits of which are insured by the Deposit Insurance Fund of the FDIC up to applicable limits. North Fork Bank is subject to comprehensive regulation and period examination by the New York State Banking Department (NYSBD) of the FDIC.
Superior is a national association, the deposits of which are insured by the Deposit Insurance Fund of the FDIC up to applicable limits.
The Corporation is also registered as a financial institution holding company under Virginia law and as such is subject to periodic examination by Virginias Bureau of Financial Institutions. The Corporations automobile financing activities, conducted by COAF and its subsidiaries, fall under the scrutiny of the Federal Reserve and the state agencies having supervisory authority under applicable sales finance laws or consumer finance laws in most states. The Corporation also faces regulation in the international jurisdictions in which it conducts business.
The Corporation has filed applications with the Office of the Comptroller of the Currency to consolidate several of its banking subsidiaries into a single national bank, to be known as Capital One, N.A. This consolidation would include CONA, the Savings Bank and North Fork Bank. As part of this consolidation, the Corporation would also establish COAF and GreenPoint Mortgage Funding, Inc. (GreenPoint), which offers residential and commercial mortgages, as operating subsidiaries of the new national bank.
Dividends and Transfers of Funds
Dividends to the Corporation from its direct and indirect subsidiaries represent a major source of funds for the Corporation to pay dividends on its stock, make payments on corporate debt securities and meet its other obligations. There are various federal and state law limitations on the extent to which the Banks can finance or otherwise supply funds to the Corporation through dividends, loans or otherwise. These limitations include minimum regulatory capital requirements, federal and state banking law requirements concerning the payment of dividends out of net profits or surplus, Sections 23A and 23B of the Federal Reserve Act and Regulation W governing transactions between an insured depository institution and its affiliates, and general federal and state regulatory oversight to prevent unsafe or unsound practices. In general, federal and applicable state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as the Banks, from making dividend distributions if such distributions are not paid out of available earnings or would cause the institution to fail to meet applicable capital adequacy standards. Under OTS regulations, other limitations apply to the Savings Banks ability to pay dividends, the magnitude of which depends upon the extent to which the Savings Bank meets its regulatory capital requirements. In addition, under Virginia law, the Bureau of Financial Institutions may limit the payment of dividends by the Bank if the Bureau of Financial Institutions determines that such a limitation would be in the public interest and necessary for the Banks safety and soundness.
The Banks are subject to capital adequacy guidelines adopted by federal banking regulators. For a further discussion of the capital adequacy guidelines, see pages 62-63 in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsCapital Adequacy and pages 119-121 in Item 8 Financial Statements and Supplementary DataNote 19Regulatory Matters. The Banks were well capitalized under these guidelines as of December 31, 2006.
On September 25, 2006, the federal banking regulators published their proposed regulations to implement the international accord on revised risk-based capital rules known as Basel II, a capital regime that would apply to the largest and most complex institutions. Three months later, the regulators proposed revisions to the capital regime applicable to all the other banks, in an attempt to address perceived disparities, this new proposal referred to as Basel IA. Neither proposed regime would currently be mandatory for Capital One, but either could become so.
Although the Committees stated intent is that Basel II will not change the amount of overall capital in the global banking system, adoption of the proposed new capital rules could require us to increase the minimum level of capital held. We will continue to closely monitor regulatory action on Basel II and Basel IA and assess the potential impact to us.
Among other things, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires federal bank regulatory authorities to take prompt corrective action (PCA) with respect to insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital ratio levels: well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2006, each of the Banks met the requirements for a well-capitalized institution. The well-capitalized classification is determined solely for the purposes of applying FDICIAs PCA provisions, as discussed below, and should not be viewed as describing the condition or future prospects of a depository institution, including the Banks. Were any of the Banks to lose their status as well-capitalized they could be required to increase capital or lose access to deposits.
The Banks may accept brokered deposits as part of their funding. Under FDICIA, only well-capitalized and adequately-capitalized institutions may accept brokered deposits. Adequately-capitalized institutions, however, must first obtain a waiver from the FDIC before accepting brokered deposits, and such deposits may not pay rates that significantly exceed the rates paid on deposits of similar maturity from the institutions normal market area or the national rate on deposits of comparable maturity, as determined by the FDIC, for deposits from outside the institutions normal market area.
Liability for Commonly-Controlled Institutions
Under the cross-guarantee provision of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), insured depository institutions such as the Banks may be liable to the FDIC with respect to any loss incurred or reasonably anticipated to be incurred, by the FDIC in connection with the default of, or FDIC assistance to, any commonly controlled insured depository institution. The Banks are commonly controlled within the meaning of the FIRREA cross-guarantee provision.
Investment Limitation and Qualified Thrift Lender Test
Federally-chartered savings banks such as the Savings Bank are subject to certain investment limitations. For example, federal savings banks are not permitted to make consumer loans (i.e., certain open-end or closed-end loans for personal, family or household purposes, excluding credit card loans) in excess of 35% of the savings banks assets. Federal savings banks are also required to meet the QTL Test, which generally requires a savings bank to maintain at least 65% portfolio assets (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill and (iii) property used to conduct business) in certain qualified thrift investments (residential mortgages and related investments, including certain mortgage backed and mortgage related investments, small business related securities, certain state and federal housing investments, education loans and credit card loans) on a monthly basis in nine out of every twelve months. Failure to qualify under the QTL Test could subject the Savings Bank to substantial restrictions on its activities, including the activity restrictions that apply generally to bank holding companies and their affiliates and potential loss of grandfathered rights under the GLBA. As of December 31, 2006, 76% of the Savings Banks portfolio assets were held in qualified thrift investments, and the Savings Bank was in compliance with the QTL Test.
Subprime Lending Guidelines
On January 31, 2001, the federal banking agencies issued Expanded Guidance for Subprime Lending Programs (the Guidelines). The Guidelines, while not constituting a formal regulation, provide guidance to the federal bank examiners regarding the adequacy of capital and loan loss reserves held by insured depository institutions engaged in subprime lending. The Guidelines adopted a broad definition of subprime loans which likely covers more than one-third of all consumers in the United States. Because our business strategy is to provide credit card products and other consumer loans to a wide range of consumers, we believe that a portion of our loan assets are viewed by the examiners as subprime. Thus, under the Guidelines, bank examiners could require the Bank or the Savings Bank to hold additional capital (from one and one-half to three times the minimally required level of capital, as set forth in the Guidelines), or additional loan loss reserves, against such assets. As described above, as of December 31, 2006 the Bank and the Savings Bank each met the requirements for a well-capitalized institution. Federal examiners, however, have wide discretion as to how to apply the Guidelines and there can be no assurances that the Bank or the Savings Bank may not be required to hold additional regulatory capital against such assets.
For purposes of the Subprime Guidelines, we treat as subprime all loans in the Banks and the Savings Banks programs that are targeted at customers either with a Fair, Isaac and Company (FICO) score of 660 or below or with no FICO score. The Bank and the Savings Bank hold on average 200% of the total risk-based capital requirement that would otherwise apply to such assets.
Non-Traditional Mortgage Products Guidance
In September 2006, the Federal Financial Institutions Examinations Council (FFIEC) issued new guidance (the Guidance) with respect to non-traditional mortgage products. Non-traditional mortgage products are generally defined as residential mortgage loans that allow borrowers to defer repayment of principal or interest, such as interest-only loans and payment-option adjustable rate mortgages. The Guidance places new restrictions and requirements on the origination and servicing of non-traditional mortgage products, including heightened loan underwriting standards. These restrictions and requirements may adversely affect our mortgage operations.
FFIEC Account Management Guidance
On January 8, 2003, the Federal Financial Institutions Examination Council (FFIEC) released Account Management and Loss Allowance Guidance (the Guidance). The Guidance applies to all credit lending of regulated financial institutions and generally requires that banks properly manage several elements of their credit card lending programs, including line assignments, over-limit practices, minimum payment and negative amortization, workout and settlement programs, and the accounting methodology used for various assets and income items related to credit card loans.
We believe that our credit card account management and loss allowance practices are prudent and appropriate and, therefore, consistent with the Guidance. We caution, however, that similar to the subprime Guidelines, the Guidance provides wide discretion to bank regulatory agencies in the application of the Guidance to any particular institution and its account management and loss allowance practices. Accordingly, under the Guidance, bank examiners could require changes in our account management or loss allowance practices in the future, and such changes could have an adverse impact on our financial condition or results of operation.
Regulation of Lending Activities
The activities of the Banks as consumer lenders also are subject to regulation under various federal laws, including the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act (the FCRA), the Community Reinvestment Act and the Service members Civil Relief Act, as well as under various state laws. Depending on the underlying issue and applicable law, regulators are often authorized to impose penalties for violations of these statutes and, in certain cases, to order the Banks to compensate injured borrowers. Borrowers may also have a private right of action to bring actions for certain violations. Federal bankruptcy and state debtor relief and collection laws also affect the ability of the Banks to collect outstanding balances owed by borrowers. These laws plus state sales finance laws also affect the ability of our automobile financing business to collect outstanding balances.
Privacy and Fair Credit Reporting
entities provide such options in the privacy notice. In addition to adopting federal requirements regarding privacy, the GLBA also permits individual states to enact stricter laws relating to the use of customer information. To date, at least California, Vermont and North Dakota have done so by statute, regulation or referendum, and other states may consider proposals which impose additional requirements or restrictions on the Corporation and/or the Banks. If the federal or state regulators of the financial subsidiaries establish further guidelines for addressing customer privacy issues, the Corporation and/or one or more of the Banks may need to amend their privacy policies and adapt their internal procedures.
Like other lending institutions, the Banks utilize credit bureau data in their underwriting activities. Use of such data is regulated under the FCRA on a uniform, nationwide basis, including credit reporting, prescreening, sharing of information between affiliates, and the use of credit data. The Fair and Accurate Credit Transactions Act of 2003 (the FACT Act), which was enacted by Congress and signed into law in December 2003, extends the federal preemption of the FCRA permanently, although the law authorizes states to enact identity theft laws that are not inconsistent with the conduct required by the provisions of the FACT Act. If financial institutions and credit bureaus fail to alleviate the costs and consumer frustration associated with the growing crime of identity theft, financial institutions could face increased legislative/regulatory and litigation risks. In addition, federal regulators are still in the process of promulgating regulations under the FACT Act; there can be no assurance that such regulations, when enacted, will not have an adverse impact on us.
Investment in the Corporation and the Banks
Certain acquisitions of capital stock may be subject to regulatory approval or notice under federal or state law. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of capital stock of the Corporation in excess of the amount which can be acquired without regulatory approval. Each of the Banks is an insured depository institution within the meaning of the Change in Bank Control Act. Consequently, federal law and regulations prohibit any person or company from acquiring control of the Corporation without, in most cases, prior written approval of the Federal Reserve, the OCC or the OTS, as applicable. Control is conclusively presumed if, among other things, a person or company acquires more than 25% of any class of voting stock of the Corporation. A rebuttable presumption of control arises if a person or company acquires more than 10% of any class of voting stock and is subject to any of a number of specified control factors as set forth in the applicable regulations. Additionally, the Bank is a bank within the meaning of Chapter 13 of Title 6.1 of the Code of Virginia governing the acquisition of interests in Virginia financial institutions (the Financial Institution Holding Company Act). The Financial Institution Holding Company Act prohibits any person or entity from acquiring, or making any public offer to acquire, control of a Virginia financial institution or its holding company without making application to, and receiving prior approval from, the Bureau of Financial Institutions.
The Corporations non-bank subsidiaries are subject to supervision and regulation by various other federal and state authorities. Insurance agency subsidiaries are regulated by state insurance regulatory agencies in the states in which they operate. Hibernia Asset Management, L.L.C., Hibernia Investments, L.L.C., Amivest Corporation and North Fork Financial Advisors, L.L.C. are registered investment advisers regulated under the Investment Advisers Act of 1940. Hibernia Asset Management provides investment advice to investment companies subject to regulation under the Investment Company Act of 1940.
Hibernia Investments, Hibernia Southcoast Capital, Inc., and NFB Investment Services Corporation are registered broker-dealers regulated by the Securities and Exchange Commission (the SEC) and the National Association of Securities Dealers, Inc. In addition, Hibernia Investments and Hibernia Southcoast Capital, Inc. are regulated by the Louisiana Office of Financial Institutions through the Deputy Commissioner of Securities. The Companys broker-dealer subsidiaries are subject to, among other things, net capital rules designed to measure the general financial condition and liquidity of a broker-dealer. Under these rules, broker-dealers are required to maintain the minimum net capital deemed necessary to meet their continuing commitments to
customers and others, and are required to keep a substantial portion of their assets in relatively liquid form. These rules also limit the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Broker-dealers are also subject to other regulations covering their business operations, including sales and trading practices, public offerings, publication of research reports, use and safekeeping of client funds and securities, capital structure, record-keeping and the conduct of directors, officers and employees.
NFB Agency Corp. (NFB Agency) is a New York State licensed insurance agency that is regulated by the state insurance regulatory agencies in the states in which it operates. NFB Agency provides both personal and business insurance services to retail and commercial clients.
USA PATRIOT Act of 2001
On October 26, 2001, the President signed into law the USA PATRIOT Act of 2001 (the Patriot Act). The Patriot Act contains sweeping anti-money laundering and financial transparency laws as well as enhanced information collection tools and enforcement mechanics for the U.S. government, including: due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; standards for verifying customer identification at account opening; rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; reports by nonfinancial trades and businesses filed with the Treasury Departments Financial Crimes Enforcement Network for transactions exceeding $10,000; and filing suspicious activities reports by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.
The Department of Treasury in consultation with the Federal Reserve and other federal financial institution regulators has promulgated rules and regulations implementing the Patriot Act which: prohibit U.S. correspondent accounts with foreign banks that have no physical presence in any jurisdiction; require financial institutions to maintain certain records for correspondent accounts of foreign banks; require financial institutions to produce certain records relating to anti-money laundering compliance upon request of the appropriate federal banking agency; require due diligence with respect to private banking and correspondent banking accounts; facilitate information sharing between government and financial institutions; require verification of customer identification; and require financial institutions to have in place an anti-money laundering program.
Several states have passed legislation which attempts to tax the income from interstate financial activities, including credit cards, derived from accounts held by local state residents. Based on the volume of our business in these states and the nature of the legislation passed to date, we currently believe that this development will not materially affect our financial condition.
Legislation has been enacted requiring additional disclosures for credit cards and other types of consumer lending. Such legislation places additional restrictions on the practices of credit card issuers and consumer lenders generally. In addition to the FCRA and FACT Act provisions discussed above, Congress has enacted broad changes to the federal Bankruptcy code, including a sweeping reform of the consumer bankruptcy provisions which, while instituting a means test for individuals filing under Chapter 13 and enacting other reforms, also requires credit card issuers to provide regular disclosures to customers of the financial effect of regularly making only the minimum required payment on their accounts. Also, proposals have been made to restrict certain consumer lending practices and expand the privacy protections afforded to customers of financial institutions. The current Congress is holding hearings on credit card practices of various kinds, including fees, marketing practices, and changing customers interest rates, but most analysts believe the prospects for broad
legislation range from uncertain to unlikely. Consequently it remains unclear whether and in what form any legislation will be adopted or, if adopted, what its impact on us would be. Congress or individual states may in the future consider other legislation that would materially and/or adversely affect the banking or consumer lending industries.
Sarbanes-Oxley Act Compliance
On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) was passed into law. The Sarbanes-Oxley Act applies to all companies that are required to file periodic reports with the Securities and Exchange Commission (SEC) and contains a number of significant changes relating to the responsibilities of directors and officers and reporting and governance obligations of SEC reporting companies. In addition, the Sarbanes-Oxley Act also created the Public Company Accounting Oversight Board (the PCAOB), a private sector, non-profit corporation whose mission is to oversee the auditors of public companies. The PCAOB recommends rulemaking to the SEC and sets certain standards for the auditors which it oversees. Since the passage of the Sarbanes-Oxley Act, we have taken a variety of steps which we believe places us in substantial compliance with the effective provisions of the Sarbanes-Oxley Act. We continue to monitor SEC rulemaking and PCAOB activities to determine if additional changes are needed to comply with provisions that may become effective in the future. Furthermore, our management has supervised the design of, or has designed, internal controls and procedures to provide reasonable assurances regarding the reliability of its financial reporting and disclosure controls and procedures to ensure that material information regarding the Company is made known to them, particularly during the period in which this Annual Report on Form 10-K is being prepared and has evaluated the effectiveness of those controls as more fully set forth in Controls and Procedures below. We have, in compliance with Section 404 of the Sarbanes-Oxley Act, certified, in connection with this Annual Report on Form 10-K, that we did not discover, during the execution of its internal control processes, any material weaknesses. Managements assessment of the effectiveness of internal control over financial reporting excludes the evaluation of the internal controls over financial reporting of North Fork Bancorporation and its subsidiaries, which were acquired on December 1, 2006. In addition, our management policy is to disclose to our auditors and the Audit and Risk Committee of the Board of Directors significant deficiencies, if any, in the design or operation of our internal control over financial reporting, which are reasonably likely to adversely affect our ability to record, process, summarize and report financial information, as well as any fraud, whether or not material, by those that have a significant role in these processes.
The Bank faces regulation in foreign jurisdictions where it currently operates, and may, in the future, operate. Those regulations may be similar to or substantially different from the regulatory requirements the Bank faces in the United States. In the United Kingdom, the Bank operates through the U.K. Bank, which was established in 2000. The U.K. Bank is regulated by the Financial Services Authority (FSA) and licensed by the Office of Fair Trading (OFT). The U.K. Bank is an authorized deposit taker and thus is able to take consumer deposits in the U.K. The U.K. Bank has also been granted a full license by the OFT to issue consumer credit under the U.K.s Consumer Credit Act1974. The FSA requires the U.K. Bank to maintain certain regulatory capital ratios at all times, and it may modify those requirements at any time. The U.K. Bank obtains capital through earnings or through additional capital infusion from the Bank, subject to approval under Regulation K of the rules administered by the Federal Reserve. If the U.K. Bank is unable to generate or maintain sufficient capital in favorable terms, it may choose to restrict its growth to maintain its required capital levels. In addition, the U.K. Bank is limited by the U.K. Companies Act1985 in its distribution of dividends to the Bank in that such dividends may only be paid out of the U.K. Banks distributable profits.
As in the U.S., in non-U.S. jurisdictions where we operate, we face a risk that the laws and regulations that are applicable to it (or the interpretations of existing laws by relevant regulators) may change in ways that adversely impact our business. The OFT has concluded the initial part of its industry wide investigation into alleged unfair contract terms in lending agreements and to how credit card companies calculate default charges, such as late,
overlimit and returned check fees, in the U.K. The OFT has set out guidance on its view that default charges should cover only certain specified costs and it has issued guidance on what those costs may be. Specifically, the OFT has requested that the industry limit default fees to a maximum of twelve pounds sterling. The U.K. industry was given until June 28, 2006 to implement the OFTs guidance. Capital One, as well as other U.K. card issuers, has complied with such request. The impact on the U.K. Bank depends on the success of actions we have taken and plans to take to mitigate the impact of this reduction. In addition, the OFT has confirmed that it will continue with its investigation into Visas and MasterCards current method of setting interchange fees applicable to U.K. domestic transactions. Cross-border interchange fees are also coming under scrutiny from the European Commission with the European Commission issuing a Statement of Objections in relation to MasterCards cross border interchange fees. While a final decision from the OFT is not expected before early 2009, the most likely outcome is that interchange fees will be reduced and this could adversely affect the yield on U.K. credit card portfolios, including ours, and could therefore adversely impact our earnings. Finally, in the United Kingdom, the Consumer Credit Act 2006 received Royal Assent on March 30, 2006 and has an implementation timetable extending from 2006 to 2008. The purpose of the Act is to reform the Consumer Credit Act1974. The key areas covered by the Act are as follows: the creation of an unfair relationship test to enable debtors to challenge unfair relationships with creditors, the creation of alternative dispute resolution options for credit agreements, a requirement on lenders to provide additional information to debtors after the agreement is made, and a stricter licensing regime that will give the OFT new powers to fine lenders for their behavior. At this time, we cannot predict the extent to which the changes in the Act and Regulations will impact us.
Finally, we were recently cited by the FSA following an investigation into the sale of payment protection insurance (PPI). PPI is a cross-sell product which protects a borrowers ability to keep up the payments on their credit card or loan in case of an accident, sickness or unemployment for a period of up to 12 months. In relation to our sale of PPI, we were fined by the FSA for failing to have adequate systems and controls and for failing to treat our customers fairly. Prior to the FSAs investigation, Capital One had started a project to implement a number of significant improvements to its sales and administrative processes concerning PPI with a focus on customer communications. Capital One proactively worked with the FSA and has addressed all of its concerns. The fine did not have a material adverse effect on our results of operations or financial condition, and was significantly lower than other recent fines the FSA have imposed on other providers for failings in this area.
The statistical information required by Item 1 can be found in Item 6 Selected Financial Data, Item 7 Management Discussion and Analysis of Financial Condition and Results of Operations and in Item 8, Financial Statements and Supplementary Data, as follows:
This Annual Report on Form 10-K contains forward-looking statements. We also may make written or oral forward-looking statements in our periodic reports to the Securities and Exchange Commission on Forms 10-Q and 8-K, in our annual report to shareholders, in our proxy statements, in our offering circulars and prospectuses,
in press releases and other written materials and in statements made by our officers, directors or employees to third parties. Statements that are not about historical facts, including statements about our beliefs and expectations, are forward-looking statements. Forward-looking statements include information relating to our future earnings per share, growth in managed loans outstanding, product mix, segment growth, managed revenue margin, funding costs, operations costs, employment growth, marketing expense, delinquencies and charge-offs. Forward-looking statements also include statements using words such as expect, anticipate, hope, intend, plan, believe, estimate or similar expressions. We have based these forward-looking statements on our current plans, estimates and projections, and you should not unduly rely on them.
Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, including the risks discussed below. Our future performance and actual results may differ materially from those expressed in these forward-looking statements. Many of the factors that will determine these results and values are beyond our ability to control or predict. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. You should carefully consider the factors discussed below in evaluating these forward-looking statements.
This section highlights specific risks that could affect our business and us. Although we have tried to discuss key factors, please be aware that other risks may prove to be important in the future. In addition to the factors discussed elsewhere in this report, among the other factors that could cause actual results to differ materially are the following:
We Face Intense Competition in All of Our Markets
We operate in a highly competitive environment, and we expect competitive conditions to continue to intensify as merger activity in the financial services industry continues to produce larger, better capitalized and more geographically diverse companies that are capable of offering a wider array of financial products and services at better prices. In such a competitive environment, we may lose entire accounts, or may lose account balances, to competing financial institutions, or find it more costly to maintain our existing customer base. Customer attrition from any or all of our lending products, together with any lowering of interest rates or fees that we might implement to retain customers, could reduce our revenues and therefore our earnings. Similarly, customer attrition from our deposit products, in addition to an increase in rates and/or services that we may offer to retain those deposits, may increase our expenses and therefore reduce our earnings. We expect that competition will continue to grow more intensely with respect to most of our products. Some of our competitors may be substantially larger than we are, which may give those competitors advantages, including a more diversified product and customer base, the ability to reach out to more customers and potential customers, operational efficiencies, more versatile technology platforms, broad-based local distribution capabilities, lower-cost funding, and larger existing branch networks. These competitors may also consolidate with other financial institutions in ways that enhance these advantages and intensify our competitive environment.
With respect to our credit card business, we compete primarily with respect to price (primarily interest rates and fees), credit limit and other product features. Larger, better capitalized companies may be able to offer credit cards at better rates and with more attractive features than we can offer. Our other consumer lending businesses, including auto lending, small business lending, home loan lending, installment lending, our commercial lending businesses, and our businesses in international markets also compete on a similar variety of factors, including price, loan terms, product features and customer service.
Our banking business competes with national and state banks for deposits, loans, and trust accounts, and also competes with other financial services companies in offering various types of financial services. In addition, technological advances and the growth of e-commerce have made it possible for non-depository institutions to offer products and services that traditionally were banking products and services. Deposit customers are also sensitive to price and service level competition.
In addition, we compete on the basis of transaction execution, innovation and technology. Our industry is subject to rapid and significant technological changes. In order to compete in our industry, we must continue to invest in technologies across all of our businesses, including transaction processing, data management, customer interactions and communications and risk management and compliance systems. We expect that new technologies will continue to emerge, and these new services and technologies could be superior to or render our technologies obsolete. Our future success will depend in part on our ability to continue to develop and adapt to technological changes and evolving industry standards. If we are not able to invest successfully in and compete at the leading edge of technological advances across all of our businesses, our revenues and profitability could suffer.
We May Experience Increased Delinquencies and Credit Losses
Like other lenders, we face the risk that our customers will not repay their loans. Rising losses or leading indicators of rising losses (higher delinquencies, non-performing loans, or bankruptcy rates; lower collateral values) may require us to increase our allowance for loan losses and may degrade our profitability if we are unable to raise revenue or reduce costs to compensate for higher losses. The favorable credit environment we have experienced may not continue. In particular, we face the following risks in this area:
We Face Risk of Interest Rate Fluctuations
Like other financial institutions, we borrow money from other institutions and depositors, which we use to make loans to customers and invest in debt securities and other earning assets. We earn interest on these loans and assets and pay interest on the money we borrow from institutions and depositors. Changes in interest rates, including changes in the relationship between short term rates and long term rates, may have negative impacts on our net interest income and therefore our earnings. If the rate of interest we pay on our borrowings and deposits increases more than the rate of interest we earn on our assets, our net interest income, and therefore our earnings, would fall. Our earnings could also be negatively impacted if the interest rates we charge on our earning assets fall more quickly than the rates we pay on our borrowings and deposits. Changes in interest rates and competitor responses to those changes may affect the rate of customer pre-payments for mortgages and auto and other term loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on our earning asset portfolio. Changes in interest rates and competitor responses to these changes may also impact customer decisions to maintain balances in the deposit accounts they have with us. These changes may require us to replace withdrawn balances with higher cost alternative sources of funding.
We assess our interest rate risk by estimating the effect on our earnings under various scenarios that differ based on assumptions about the direction and the magnitude of interest rate changes. We take risk mitigation actions based on those assessments. We face the risk that changes in interest rates could reduce our net interest income and our earnings in material amounts, especially if actual conditions turn out to be materially different than those we assumed.
See pages 60-62 in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsInterest Rate Risk Management contained in this Annual Report on Form 10-K for the year ended December 31, 2006.
We May Fail To Realize All of the Anticipated Benefits of our Mergers with Hibernia Corporation and North Fork Bancorporation
The success of our mergers with Hibernia and North Fork will depend, in part, on our ability to realize the anticipated benefits from combining the businesses of Capital One, Hibernia and North Fork. However, to realize these anticipated benefits, we must successfully combine these businesses. While we have successfully completed the integration of Hibernia, we are in the early stages of the North Fork integration. If we are not able to achieve the objectives of the North Fork integration, the anticipated benefits of the mergers, such as cost savings and other synergies, may not be realized fully or at all or may take longer to realize than expected. In addition, it is possible that the ongoing integration process could result in the loss of key employees, the disruption of each companys ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the mergers. Integration efforts also will divert management attention and resources. These integration matters could have an adverse effect on Capital One during such transition period.
Our recent acquisitions also involve our entry into new businesses and new geographic or other markets which present risks resulting from our relative inexperience in these new areas and these new businesses. Historically,
our business has not focused on retail and commercial banking. These new businesses change the overall character of our consolidated portfolio of businesses and react differently to economic and other external factors. While we have senior managers with experience in the banking industry, we may not be able to retain our experienced banking personnel to develop such expertise internally or to recruit it externally. If we are unable to retain or develop such personnel, our business will suffer.
In addition, as with many integration efforts, the integrations of Hibernia and North Fork face the challenges of combining the cultural and historical identities of institutions that previously operated independently. Particularly with respect to the acquisition of North Fork, we face the risk that we will not be able to successfully integrate their commercial and local retail lending cultures with our national scale lending culture. Furthermore, we may be unable to appreciate the cultural factors that drive these new businesses. If we are unable to successfully adapt our unique cultural perspectives, our integration efforts and our overall business could suffer.
Finally, North Fork entered into an informal memorandum of understanding with the bank regulatory authorities pursuant to which it is required to take certain actions regarding its anti-money laundering compliance program. We are responsible for fulfilling the obligations of this informal memorandum of understanding, which may be more costly or take more time than we initially anticipated.
We Face Risk From Economic Downturns
Delinquencies and credit losses in the consumer finance industry generally increase during economic downturns or recessions. Likewise, consumer demand may decline during an economic downturn or recession. In the United States, we face the risk that the effects of higher interest rates, higher energy costs and pressure on housing prices may place added strain on consumers ability to make purchases and repay their loans. Accordingly, an economic downturn in the United States (either local or national), can hurt our financial performance as accountholders default on their loans or, in the case of credit card accounts, carry lower balances and reduce credit card purchase activity. Furthermore, because our business model is to lend across the credit spectrum, we make loans to lower credit quality customers. These customers generally have higher rates of charge-offs and delinquencies than do higher credit quality customers.
Finally, the credit environment in certain geographic areas may continue to worsen, which also could hurt our financial performance. Although we are geographically diversified, we have concentrations of our commercial loans in the New York metropolitan area and Louisiana. The regional economic conditions in these areas affect the demand for our products and services as well as the ability of our customers to repay loans and the value of the collateral securing these loans. A significant decline in the general economic conditions in these regional economies could have a material adverse effect on our financial condition and results of operations.
We Face Risk Related to the Strength of our Operational, Technological and Organizational Infrastructure
Our ability to grow and compete is dependent on our ability to build or acquire the necessary operational and technological infrastructure and to manage the cost of that infrastructure while we expand and as we integrate acquired businesses. Similar to other large corporations, in our case, operational risk can manifest itself in many ways, such as errors related to failed or inadequate processes, faulty or disabled computer systems, fraud by employees or persons outside of Capital One and exposure to external events. We are dependent on our operational infrastructure to help manage these risks. From time to time, we may need to change or upgrade our technology infrastructure. We may experience disruption, and we may face additional exposure to these risks during the course of making such changes. In addition, as we acquire other institutions, we face additional challenges when integrating different operational platforms. Such integration efforts may be more disruptive to the business and/or more costly than we anticipate.
In some cases, we outsource the maintenance and development of our operational and technological functionality to third parties. These third parties may experience errors or disruptions that could adversely impact us and over which we may have limited control. As we increase the amount of our infrastructure that we outsource to third parties, we increase our exposure to this risk.
In addition, we are heavily dependent on the strength and capability of our technology systems which we use both to interface with our customers and to manage our internal financial and other systems. Our ability to develop and deliver new products that meet the needs of our existing customers and attract new ones depends on the functionality of our technology systems. Our ability to develop and implement effective marketing campaigns also depends on our technology. Additionally, our ability to run our business in compliance with applicable laws and regulations is dependent on these infrastructures.
Finally, in addition to maintaining a solid infrastructure platform, we are also dependent on recruiting management and operations personnel with the experience to run an increasingly large and complex business. Although we take steps to retain our existing management talent and recruit new talent as needed, we face a competitive market for such talent and there can be no assurance that we will continue to be able to maintain and build a management team capable of running our increasingly large and complex business. Also, we may acquire key personnel in connection with the acquisition of businesses. While we strive to retain such personnel, there can be no assurance that we will be able to do so.
The Credit Card Industry Faces Increased Litigation Risks Relating to Industry Structure
We face risks from the outcomes of certain credit card industry litigation. Over the past several years, MasterCard International and Visa U.S.A., Inc., as well as several of their member banks have been involved in several different lawsuits challenging various practices of MasterCard and Visa and their member banks. In November 2004, American Express filed an antitrust lawsuit against MasterCard and Visa and several member banks, alleging, among other things, that the defendants implemented practices that prevented member banks from issuing American Express cards. The Corporation, the Bank and the Savings Bank are named defendants in this lawsuit. Separately, a number of entities, each purporting to represent a class of retail merchants, also have filed antitrust lawsuits against MasterCard, Visa and several member banks, including the Corporation and certain of its subsidiaries.
Given the complexity of the issues raised by these lawsuits and the uncertainty regarding: (i) the outcome of these suits; (ii) the likelihood and amount of any possible judgments; (iii) the likelihood, amount and validity of any claim against MasterCard and Visas member banks, including us; (iv) changes in industry structure that may result from the suits; and (v) the effects of these suits, in turn, on competition in the industry, member banks, as well as interchange and association fees, we cannot determine at this time the long-term effects that these suits may have on us. For a full description of the litigation risks that we face in connection with the structure of our industry, please refer to Industry Litigation on page 123 in Item 8 Financial Statements and Supplementary DataNotes to the Financial StatementsNote 20.
We Face the Risk of a Complex and Changing Regulatory and Legal Environment
We operate in a heavily regulated industry and are therefore subject to a wide array of banking, consumer lending and deposit laws and regulations that apply to almost every element of our business. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations, may increase our costs and/or limit our ability to pursue certain business opportunities. As our business grows in size and complexity, establishing systems and processes to achieve compliance may become more difficult and costly. We face additional compliance challenges as a result of our acquisition of North Fork, which may be more costly and/or require more management attention than we anticipate. In addition, we face similar risks with respect to our international businesses, where changing laws and regulations may have an adverse impact on our results. For a description of the laws and regulations to which we are subject, please refer to Supervision and
Regulation, pages 10-18. The regulatory environment in which we operate could have a negative impact on our business and our financial results.
We Face the Risk of Fluctuations in Our Expenses and Other Costs that May Hurt Our Financial Results
Our expenses and other costs, such as operating, labor and marketing expenses, directly affect our earnings results. In light of the extremely competitive environment in which we operate, and because the size and scale of many of our competitors provide them with increased operational efficiencies, it is important that we are able to successfully manage our expenses. Many factors can influence the amount of our expenses, as well as how quickly they may increase. Investments in infrastructure, which may be necessary to maintain a competitive business, may increase operational expenses in the short-run. As our business develops, changes or expands, additional expenses can arise from management of outsourced services, asset purchases, structural reorganization, a reevaluation of business strategies and/or expenses to comply with new or changing laws or regulations. Integration of acquired entities may also increase our expenses, and we may be less able to predict the operational expenses of newly acquired businesses. If we are unable to successfully manage our expenses, our financial results will suffer.
Reputational Risk and Social Factors May Impact our Results
Our ability to originate and maintain accounts is highly dependent upon the perceptions of consumer and commercial borrowers and deposit holders and other external perceptions of our business practices and/or our financial health. Adverse perceptions regarding our reputation in the consumer, commercial and funding markets could lead to difficulties in generating and maintaining accounts as well as in financing them. Particularly, negative perceptions regarding our reputation could lead to decreases in the levels of deposits that consumer and commercial customers and potential customers choose to maintain with us. In addition, adverse developments or perceptions regarding the practices of our competitors, or our industry as a whole, may also negatively impact our reputation. Finally, negative perceptions regarding the reputations of third parties with whom we have important relationships, such as our independent auditors, also may adversely impact our reputation. Adverse impacts on our reputation, or the reputation of our industry, could result in greater regulatory and/or legislative scrutiny, which may lead to laws or regulations that may change or constrain the manner in which we engage with our customers and the products we offer them. Adverse reputational impacts or events also may increase our litigation risk. See The Credit Card Industry Faces Increased Litigation Risks Relating to Industry Structure on page 23.
In addition, a variety of social factors may cause changes in credit card and other consumer finance use, payment patterns and the rate of defaults by accountholders and borrowers domestically and internationally. These social factors include changes in consumer confidence levels, the publics perception of the use of credit cards and other consumer debt, and changing attitudes about incurring debt and the stigma of personal bankruptcy.
We May Face Limited Availability of Financing, Variation in Our Funding Costs and Uncertainty in Our Securitization Financing
In general, the amount, type and cost of our funding, including financing from other financial institutions, the capital markets and deposits, directly impact our expenses in operating our business and growing our assets and therefore, can positively or negatively affect our financial results.
A number of factors could make such financing more difficult, more expensive or unavailable on any terms both domestically and internationally (where funding transactions may be on terms more or less favorable than in the United States), including, but not limited to, financial results and losses, specific events that adversely impact our reputation, disruptions in the capital markets, specific events that adversely impact the financial services industry, counter-party availability, interest rate fluctuations, rating agencies actions, and the general state of the U.S. and world economies. Also, because we depend on the capital markets for funding and capital, we could
experience reduced availability and increased cost of funding if our debt ratings were lowered. Also, we compete for funding with other banks, savings banks and similar companies, some of which are publicly traded. Many of these institutions are substantially larger, may have more capital and other resources and may have better debt ratings than we do. In addition, as some of these competitors consolidate with other financial institutions, these advantages may increase. Competition from these institutions may increase our cost of funds.
As part of our capital markets financing, we actively securitize our consumer loans. The occurrence of certain events may cause the securitization transactions to amortize earlier than scheduled, which would accelerate the need for additional funding. This early amortization could, among other things, have a significant effect on the ability of certain of our business entities to meet the capital adequacy requirements as all off-balance sheet loans experiencing such early amortization would have to be recorded on the balance sheet. See pages 58-60 in Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity Risk Management contained in this Annual Report on Form 10-K for the year ended December 31, 2006.
In March, 2006, we completed the purchase of the previously leased, 570,000 square foot headquarters building located at 1680 Capital One Drive, McLean, Virginia. The building is located on a 31 acre parcel of land and houses our executive offices and Northern Virginia staff. Generally, we use our properties to support all of our business segments.
We own approximately 316 acres of land in Goochland County, Virginia purchased for the construction of an office campus (the West Creek Campus) to consolidate certain operations in the Richmond area. Between 2002 and 2005, seven office buildings, a support facility and a training center were constructed and occupied at the West Creek Campus. Totaling nearly 1.2 million square feet, the West Creek Campus houses multiple business and staff groups. Ample land availability provides the flexibility for further expansion should business demand increase. Another 460,000 square feet in office, data and production space is owned in Richmond, Virginia, along with a 344,075 square foot facility in Nottingham, United Kingdom, from which we conduct credit, collections, customer service and other operations. Our businesses also occupy leased space totaling, in the aggregate, about 720,000 square feet in locations across Richmond, Virginia; Boston and Framingham, MA; Tampa, FL; and Toronto, Canada.
For our mortgage business, we own a 35,000 square foot loan servicing center in Columbus, Georgia, and we otherwise occupy leased office and warehouse space totaling nearly 335,000 square feet in California. In addition, we lease an additional 290,000 square feet across Georgia, Washington, Minnesota, Idaho, North Carolina, Florida, Colorado, Illinois, Virginia, New Jersey, Texas, Oregon, Nevada, Pennsylvania, New York, Maryland, Arizona, Utah, Michigan, Connecticut, Massachusetts, and Ohio.
Our Banking segment and North Fork Banks office and branch operations are conducted primarily utilizing about 3.5 million square feet in owned properties and 3.6 million square feet in leased locations in Louisiana, New Jersey, New York and Texas. Portions of the office portfolio are sub-leased where internal demand permits.
Our Auto Finance segment occupies approximately 640,000 square feet of leased space, with the majority in Texas, and other locations across California, Maine, Massachusetts, Washington, Missouri, Arizona, Michigan, North Carolina, Nevada, New Jersey, Illinois, Virginia, Florida, Pennsylvania, Texas, Oklahoma and Georgia.
Our Global Financial Services segment occupies leased offices of 147,000 square feet in Overland Park, Kansas and about 39,500 square feet in the United Kingdom. GFS also occupies a portion of the Companys leased space in Toronto, Canada and Boston and Framingham, Massachusetts.
The information required by Item 3 is included in Item 8, Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 20 on pages 121-124.
During the fourth quarter of our fiscal year ending December 31, 2006, no matters were submitted for a vote of our stockholders.
Cumulative Shareholder Return
The following graph compares cumulative total stockholder return on our common stock with the S&P Composite 500 Stock Index (S&P 500 Index) and an industry index, the S&P Financial Composite Index (S&P 500 Financials Index), for the period from December 31, 2001 to December 31, 2006. The graph assumes an initial investment of $100 in common stock of the specified securities. The cumulative returns include stock price appreciation and assume full reinvestment of dividends. The stock price performance on the graph below is not necessarily indicative of future performance.
The remaining information required by Item 5 is included under the following:
Capital One Financial Corporation (the Corporation) is a diversified financial services company whose banking and non-banking subsidiaries market a variety of financial products and services. The Corporations principal subsidiaries are:
Another subsidiary of the Corporation, Superior Savings of New England, N.A. (Superior) focuses on telephonic and media-based generation of deposits. In addition, a subsidiary of North Fork Bank, GreenPoint Mortgage Funding, Inc. (GreenPoint) offers residential and commercial mortgages.
The Corporation and its subsidiaries are hereafter collectively referred to as the Company. The Company is delivering on its strategy of combining the power of national scale lending and local scale banking. As of December 31, 2006, the Company had $85.8 billion in deposits and $146.2 billion in managed loans outstanding.
The Companys earnings are primarily driven by lending to consumers and commercial customers and by deposit-taking activities which generate net interest income, and by activities that generate non-interest income, including the sale and servicing of loans and providing fee-based services to customers. Customer usage and payment patterns, credit quality, levels of marketing expense and operating efficiency all affect the Companys profitability.
The Companys primary expenses are the costs of funding assets, provision for loan losses, operating expenses (including associate salaries and benefits, infrastructure maintenance and enhancements, and branch operations and expansion costs), marketing expenses, and income taxes.
II. Critical Accounting Estimates
The Notes to the Consolidated Financial Statements contain a summary of the Companys significant accounting policies, including a discussion of recently issued accounting pronouncements. Several of these policies are considered to be more critical to the portrayal of the Companys financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Areas with significant judgment and/or estimates or that are materially dependent on management judgment include: determination of the level of allowance for loan and lease losses, valuation of goodwill and other intangibles, finance charge and fee revenue recognition, valuation of mortgage servicing rights, valuation of representation and warranty reserves, valuation of retained interests from securitization transactions, recognition of customer reward liability, treatment of derivative instruments and hedging activities, and accounting for income taxes.
Additional information about accounting policies can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 1 on pages 81-89.
Determination of Allowance for Loan and Lease Losses
The allowance for loan and lease losses is maintained at the amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing reported loan portfolios. The provision for loan losses is the periodic cost of maintaining an adequate allowance. The amount of allowance necessary is based on distinct allowance methodologies depending on the type of loans which include specifically identified criticized loans, migration analysis, forward loss curves and historical loss trends. In evaluating the sufficiency of the allowance for loan and lease losses, management takes into consideration the following factors: recent trends in delinquencies and charge-offs including bankrupt, deceased and recovered amounts; forecasting uncertainties and size of credit risks; the degree of risk inherent in the composition of the loan portfolio; economic conditions; legal and regulatory guidance; credit evaluations and underwriting policies; seasonality; and the value of collateral supporting the loans. To the extent credit experience is not indicative of future performance or other assumptions used by management do not prevail, loss experience could differ significantly, resulting in either higher or lower future provision for loan losses, as applicable. The evaluation process for determining the adequacy of the allowance for loan and lease losses and the periodic provisioning for estimated losses is undertaken on a quarterly basis, but may increase in frequency should conditions arise that would require the Companys prompt attention. Conditions giving rise to such action are business combinations or other acquisitions or dispositions of large quantities of loans, dispositions of non-performing and marginally performing loans by bulk sale or any development which may indicate an adverse trend.
As of December 31, 2006, the balance in the Allowance for loan and lease losses was $2.18 billion.
Valuation of Goodwill and Other Intangible Assets
Goodwill and other intangible assets (primarily core deposit intangibles) reflected on the Consolidated Balance Sheets arose from previous acquisitions. At the date of acquisition, the Company recorded the assets acquired and liabilities assumed at fair value. The excess of cost over the fair value of the net assets acquired is recorded on the balance sheet as goodwill. The cost includes the consideration paid and all direct costs associated with the acquisition. Indirect costs relating to the acquisition are expensed when incurred based on the nature of the item.
In accordance with the requirements specified in Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets, goodwill must be allocated to reporting units and tested for impairment. The Company tests goodwill for impairment at least annually or more frequently if events or circumstances such as adverse changes in the business, indicate that there may be justification for conducting an interim test. Impairment testing is performed at the reporting unit level (which is the same level as the Companys four operating segments identified in Note 3 to the Consolidated Financial Statements).
The first part of the test is a comparison at the reporting unit level, of the fair value of each reporting unit to its carrying value, including goodwill. If the fair value is less than the carrying value, then the second part of the test is needed to measure the amount of potential goodwill impairment. The implied fair value of the reporting unit goodwill is calculated and compared to the actual carrying value of goodwill recorded within the reporting unit. If the carrying value of reporting unit goodwill exceeds the implied fair value of that goodwill, then the Company would recognize an impairment charge for the amount of the difference.
The fair values of reporting units are determined primarily using discounted cash flow models based on each reporting units internal forecasts.
Intangible assets having an estimated useful life are separately recognized and amortized over their estimated useful lives.
As of December 31, 2006, goodwill of $13.6 billion and net intangibles of $1.3 billion were included in the Consolidated Balance Sheet.
Finance Charge and Fee Revenue Recognition
The Company recognizes earned finance charges and fee income on open ended loans according to the contractual provisions of the credit arrangements. When the Company does not expect full payment of finance charges and fees, it does not accrue the estimated uncollectible portion as income (hereafter the suppression amount). To calculate the suppression amount, the Company first estimates the uncollectible portion of finance charge and fee receivables using a formula based on historical account migration patterns and current delinquency status. This formula is consistent with that used to estimate the allowance related to expected principal losses on reported loans. The suppression amount is calculated by adding any current period change in the estimate of the uncollectible portion of finance charge and fee receivables to the amount of finance charges and fees charged-off (net of recoveries) during the period. The Company subtracts the suppression amount from the total finance charges and fees billed during the period to arrive at total reported revenue.
The amount of finance charges and fees suppressed were $0.9 billion for the year ended December 31, 2006.
Valuation of Mortgage Servicing Rights
The right to service mortgage loans for others, or Mortgage servicing rights (MSRs), is recognized when mortgage loans are sold in the secondary market and the rights to service these loans are retained for a fee. The MSRs initial carrying value is determined by allocating the recorded investment in the underlying mortgage loans between the assets sold and the interest retained based on their relative fair values at the date of transfer. Fair value of the MSRs is determined using the present value of the estimated future cash flows of net servicing income. The Company uses assumptions in the valuation model that market participants use when estimating future net servicing income, including prepayment speeds, discount rates, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income and late fees. This model is highly sensitive to changes in certain assumptions. Different anticipated prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSRs. If actual prepayment experience differs from the anticipated rates used in the Companys model, this difference could result in a material change in MSR value.
MSRs are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of MSRs is analyzed quarterly and adjusted to reflect changes in prepayment speeds.
The MSR balance is $252.3 million at December 31, 2006.
Valuation of Representation and Warranty Reserve
The representation and warranty reserve is available to cover probable losses inherent with the sale of mortgage loans in the secondary market by GreenPoint. In the normal course of business, certain representations and warranties are made to investors at the time of sale, which permit the investor to return the loan to the seller or require the seller to indemnify the investor for losses incurred by the investor while the loan remains outstanding. The evaluation process for determining the adequacy of the representation and warranty reserve and the periodic provisioning for estimated losses is performed for each product type on a quarterly basis. Factors considered in the evaluation process include historical sales volumes, aggregate repurchase and indemnification activity and actual losses incurred.
As of December 31, 2006, the representation and warranty reserve carried a balance of $156.0 million.
Valuation of Retained Interests from Securitization Transactions
Loan securitization involves the transfer of a pool of loan receivables to a trust or other special purpose entity. The trust sells an undivided interest in the pool of loan receivables to third-party investors through the issuance of asset backed securities and distributes the proceeds to the Company as consideration for the loans transferred.
The Company removes loan receivables from the Consolidated Balance Sheets for securitizations that qualify as sales in accordance with Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilitiesa Replacement of FASB Statement No. 125 (SFAS 140). The trusts are qualified special purpose entities as defined by SFAS 140 and are not subsidiaries of the Company and are not included in the Companys consolidated financial statements. The gain on sale recorded from off-balance sheet securitizations is based on the estimated fair value of the assets sold and retained and liabilities incurred, and is recorded at the time of sale, net of transaction costs. The related receivable is the interest-only strip, which is based on the present value of the estimated future cash flows from excess finance charges and past-due fees over the sum of the return paid to security holders, estimated contractual servicing fees and credit losses.
Certain estimates inherent in the determination of the fair value of the retained interests are influenced by factors outside the Companys control, and as a result, such estimates could materially change and actual results could be materially different from such estimates. Any future gains that will be recognized in accordance with SFAS 140 will be dependent on the timing and amount of future securitizations. The Company intends to continuously assess the performance of new and existing securitization transactions, and therefore the valuation of retained interests, as estimates of future cash flows change.
As of December 31, 2006, the retained interest on the Consolidated Balance sheet was $2.2 billion.
Recognition of Customer Rewards Liability
The Company offers credit cards that provide program members with various rewards such as airline tickets, free or deeply discounted products or cash rebates, based on purchase volume. The Company establishes a rewards liability based on points earned which are ultimately expected to be redeemed and the average cost per point redemption. As points are redeemed, the rewards liability is relieved. The cost of reward programs is reflected as a reduction to interchange income. The rewards liability will be affected over time as a result of changes in the number of account holders in the reward programs, the actual amount of points earned and redeemed, general economic conditions, the actual costs of the rewards, changes made by reward partners and changes that the Company may make to the reward programs in the future. To the extent assumptions used by management do not prevail, rewards costs could differ significantly, resulting in either a higher or lower future rewards liability, as applicable.
As of December 31, 2006, the rewards liability was $1.1 billion.
Treatment of Derivative Instruments and Hedging Activities
The Company utilizes certain derivative instruments to minimize significant unplanned fluctuations in earnings caused by interest rate and foreign exchange rate volatility. The Companys goal is to manage sensitivity to changes in rates by modifying the repricing or maturity characteristics of certain balance sheet assets and liabilities, thereby limiting the impact on earnings. By using derivative instruments, the Company is exposed to credit and market risk. The Company manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken in conjunction with the risks which are being hedged. The Company manages credit risk through strict counterparty credit risk limits and/or collateralization agreements.
At inception, the Company determines if a derivative instrument meets the criteria for hedge accounting under SFAS No. 133. Ongoing effectiveness evaluations are made for instruments that are designated and qualify as hedges. If the derivative is free standing, no assessment of effectiveness is needed by management.
Accounting for Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, recognizing the current and deferred tax consequences of all transactions that have been recognized in the
financial statements using the provisions of the enacted tax laws. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are recorded to reduce deferred tax assets to an amount that is more likely than not to be realized.
The calculation of the Companys income tax provision is complex and requires the use of estimates and judgments. When analyzing business strategies, the Company considers the tax laws and regulations that apply to the specific facts and circumstances for any transaction under evaluation. This analysis includes the amount and timing of the realization of income tax provisions or benefits. Management closely monitors tax developments in order to evaluate the effect they may have on its overall tax position and the estimates and judgments utilized in determining the income tax provision and records adjustments as necessary.
The Company records valuation allowances to reduce deferred tax assets to the amount that is more likely than not to be realized. In making this assessment, management analyzes future taxable income, reversing temporary differences and ongoing tax planning strategies. Should a change in circumstances lead to a change in judgment about the realizability of deferred tax assets in future years, the Company would adjust related valuation allowances in the period that the change in circumstances occurs, along with a corresponding increase or charge to income.
For the year ended December 31, 2006, the provision for income taxes was $1.2 billion, and as of December 31, 2006, the valuation allowance was $15.5 million.
III. Off-Balance Sheet Arrangements
Off-Balance Sheet Securitizations
The Company actively engages in off-balance sheet securitization transactions of loans for funding purposes. The Company receives the proceeds from third party investors for securities issued from the Companys securitization vehicles which are collateralized by transferred receivables from the Companys portfolio. Securities outstanding totaling $49.0 billion as of December 31, 2006, represent undivided interests in the pools of consumer loan receivables that are sold in underwritten offerings or in private placement transactions.
The securitization of consumer loans has been a significant source of liquidity for the Company. Maturity terms of the existing securitizations vary from 2007 to 2025 and, for revolving securitizations, have accumulation periods during which principal payments are aggregated to make payments to investors. As payments on the loans are accumulated and are no longer reinvested in new loans, the Companys funding requirements for such new loans increase accordingly. The Company believes that it has the ability to continue to utilize off-balance sheet securitization arrangements as a source of liquidity; however, a significant reduction or termination of the Companys off-balance sheet securitizations could require the Company to draw down existing liquidity and/or to obtain additional funding through the issuance of secured borrowings or unsecured debt, the raising of additional deposits or the slowing of asset growth to offset or to satisfy liquidity needs.
The credit quality of the receivables transferred is supported by credit enhancements, which may be in various forms including interest-only strips, subordinated interests in the pool of receivables, cash collateral accounts, cash reserve accounts and accrued interest and fees on the investors share of the pool of receivables. Some of these credit enhancements are retained by the seller and are referred to as retained residual interests. The Companys retained residual interests are generally restricted or subordinated to investors interests and their value is subject to substantial credit, repayment and interest rate risks on transferred assets if the off-balance sheet loans are not paid when due. Securitization investors and the trusts only have recourse to the retained
residual interests, not the Companys assets. See pages 124-127 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 22 for quantitative information regarding retained interests.
Collections and Amortization
Collections of interest and fees received on securitized receivables are used to pay interest to investors, servicing and other fees, and are available to absorb the investors share of credit losses. For revolving securitizations, amounts collected in excess of that needed to pay the above amounts are remitted, in general, to the Company. Under certain conditions, some of the cash collected may be retained to ensure future payments to investors. For amortizing securitizations, amounts collected in excess of the amount that is used to pay the above amounts are generally remitted to the Company, but may be paid to investors in further reduction of their outstanding principal. See pages 124-127 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 22 for quantitative information regarding revenues, expenses and cash flows that arise from securitization transactions.
Securitization transactions may amortize earlier than scheduled due to certain early amortization triggers, which would accelerate the need for funding. Additionally, early amortization would have a significant impact on the ability of the Bank and Savings Bank to meet regulatory capital adequacy requirements as all off-balance sheet loans experiencing such early amortization would be recorded on the balance sheet and accordingly would require incremental regulatory capital. As of December 31, 2006, no early amortization events related to the Companys off-balance sheet securitizations have occurred.
The amounts of investor principal from off-balance sheet consumer loans as of December 31, 2006 that are expected to amortize into the Companys consumer loans, or be otherwise paid over the periods indicated, are summarized in Table 10. Of the Companys total managed loans, 34% and 43% were included in off-balance sheet securitizations for the years ended December 31, 2006 and 2005, respectively.
Letters of Credit and Financial Guarantees
The Company issues letters of credit (both standby and commercial) and financial guarantees to meet the financing needs of its customers. Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party in a borrowing arrangement. Commercial letters of credit are short-term commitments issued primarily to facilitate trade finance activities for customers and are generally collateralized by the goods being shipped to the client. Collateral requirements are similar to those for funded transactions and are established based on managements credit assessment of the customer. Management conducts regular reviews of all outstanding standby letters of credit and commercial letters of credit, and the results of these reviews are considered in assessing the adequacy of the Companys allowance for loan losses.
Loan and Line of Credit Commitments
For credit extended through credit cards, only drawn and outstanding loan balances are recorded on the Consolidated Balance Sheet. The Company has unused available credit card lines and does not anticipate that all of its customers will exercise their entire available line at any given point in time. The Company generally has the right to increase, reduce, cancel, alter or amend the terms of these available lines of credit at any time.
The Company enters into commitments to extend credit other than credit card lines that are legally binding conditional agreements having fixed expirations or termination dates and specified interest rates and purposes. These commitments generally require customers to maintain certain credit standards. Collateral requirements and loan-to-value ratios are the same as those for funded transactions and are established based on managements credit assessment of the customer. Commitments may expire without being drawn upon. Therefore, the total commitment amount does not necessarily represent future requirements.
In connection with certain installment loan securitization transactions, the transferee (off-balance sheet special purpose entity receiving the installment loans) entered into interest rate hedge agreements (the swaps) with a counterparty to reduce interest rate risk associated with the transactions. In connection with the swaps, the Corporation entered into letter agreements guaranteeing the performance of the transferee under the swaps. If at anytime the Class A invested amount equals zero and the notional amount of the swap is greater than zero resulting in an Early Termination Date (as defined in the securitization transactions Master Agreement), then (a) to the extent that, in connection with the occurrence of such Early Termination Date, the transferee is obligated to make any payments to the counterparty pursuant to the Master Agreement, the Corporation shall reimburse the transferee for the full amount of such payment and (b) to the extent that, in connection with the occurrence of an Early Termination Date, the transferee is entitled to receive any payment from the counterparty pursuant to the Master Agreement, the transferee will pay to the Corporation the amount of such payment.
IV. Reconciliation to GAAP Financial Measures
The Companys consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) are referred to as its reported financial statements. Loans included in securitization transactions which qualify as sales under GAAP have been removed from the Companys reported balance sheet. However, servicing fees, finance charges, and other fees, net of charge-offs, and interest paid to investors of securitizations are recognized as servicing and securitizations income on the reported income statement.
The Companys managed consolidated financial statements reflect adjustments made related to effects of securitization transactions qualifying as sales under GAAP. The Company generates earnings from its managed loan portfolio which includes both the on-balance sheet loans and off-balance sheet loans. The Companys managed income statement takes the components of the servicing and securitizations income generated from the securitized portfolio and distributes the revenue and expense to appropriate income statement line items from which it originated. For this reason, the Company believes the managed consolidated financial statements and related managed metrics to be useful to stakeholders.
As of and for the year Ended December 31, 2006
V. Management Summary
The following discussion provides a summary of 2006 results compared to 2005 results and 2005 results compared to 2004 results. Each component is discussed in further detail in subsequent sections of this analysis.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net income increased 33% to $2.4 billion for the year ended December 31, 2006. The Company reported 13% diluted earnings per share growth in 2006, while achieving a number of significant milestones, including the successful integration of Hibernia, the acquisition of North Fork, upgraded credit ratings, and a significant upgrade of the systems infrastructure.
Diluted earnings per share were $7.62 for the full year, which included a $0.32 dilutive impact from the North Fork acquisition.
Revenue growth was fueled by managed loan growth in the Auto Finance and Global Financial Services segments and a full year of Hibernia results, offset by declining revenues in U.S. Card driven by ongoing changes in product strategy. The provision for loan losses slightly declined year over year, despite reported loan growth, due to the continued increase in the concentration of higher credit quality loans in the reported loan portfolio combined with a continued favorable loss environment resulting from, in part, a slower than expected return of bankruptcy related charge-offs to historical levels, and the alignment of allowance methodologies across acquired businesses.
Non-interest expense increased $1.2 billion in 2006 driven by increases in operating expense. The increase in operating expense was driven primarily by a full year of Hibernias results which contributed $951.3 million (which includes integration costs and costs to support the branch expansion efforts) of the overall increase, the one month impact of the North Fork acquisition which added $97.4 million of operating expense, and increased costs for infrastructure investments, including the conversion of the Companys cardholder transaction and account processing platform. Although operating expenses increased for the year, operating expense as a percentage of average managed assets continued to decline, reflecting the Companys improved operating efficiency. The Companys return on managed assets of 1.69% is consistent with prior years and reflects the sustainability and diversification of the Companys earnings stream.
Managed loans as of December 31, 2006 were $146.2 billion, up 39% from 2005. Excluding the $31.7 billion of loans from the North Fork acquisition, managed loans grew to $114.4 billion, with organic loan growth at 10% year over year. The Company ended the year with $85.8 billion in deposits which included $38.5 billion of deposits from the acquisition of North Fork. These deposits represent approximately 50% of 2006 total managed liabilities.
In 2006, the Company made additional progress to become a diversified financial services company. The successful integration of Hibernia and the acquisition of North Fork have expanded the Companys local banking presence. Strong growth in Auto Finance and domestic Global Financial Services segments and the addition of GreenPoints nationwide mortgage business bolster the Companys national lending position. The Company delivered solid results and built a strong balance sheet.
As a result of the corporate strategies and banking acquisitions, the Companys debt ratings were upgraded during 2006. Moodys raised its rating to A2 and A3 at the Bank and the Corporation respectively. Two Standard & Poor upgrades now have the Company rated A- at the Bank entities and BBB+ at the Corporation.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Net income increased 17% to $1.8 billion for the year ended December 31, 2005, while diluted earnings per share increased 8% compared to the prior year. The growth in earnings for 2005 was driven by growth in the managed loan portfolio and contributions from 2005 acquisitions. Earnings per share growth was constrained by the increase in share count as a result of the issuance of shares in connection with the execution of the forward purchase contracts related to the mandatory convertible debt securities and stock option exercise activity.
Revenue growth was driven by growth in the managed loan portfolio and contributions from 2005 acquisitions. Provision for loan losses increased due to growth in the reported loan portfolio, estimated losses from the Gulf Coast Hurricanes, and an increase in net charge-offs resulting from the enactment of the Bankruptcy Abuse Prevention and Consumer Act of 2005 (new bankruptcy legislation). Non-interest expense increased in 2005 driven by increases in operating expense. The increase in operating expense was driven primarily by the 2005 acquisitions, which contributed 86% of the overall increase, and slightly higher one-time charges in 2005, offset by lower 2005 charges related to the corporate-wide cost initiatives. Although operating expenses increased for the year, operating expense as a percentage of average managed assets continued to decline, reflecting the Companys improved operating efficiency. The Companys return on managed assets of 1.72% was consistent with prior years and reflected the sustainability and diversification of the Companys earnings stream.
The Company continued to achieve strong loan growth in its Auto Finance and Global Financial Services segments, which accounted for 91% of the loan growth in 2005 and represented 45% of managed loans at December 31, 2005, excluding $16.3 billion in loans added through the Hibernia acquisition. This growth was achieved through organic originations and the acquisition of Onyx Acceptance Corporation (Onyx), a specialty auto loan originator and the Key Bank portfolio which were included in the Auto Finance segment.
In 2005, the Company expanded its lending and deposit products and its distribution channels while delivering strong results and maintaining a strong balance sheet. Total assets continued to grow and the Company continued to maintain significant levels of liquidity. Capital ratios remained well above the regulatory well capitalized thresholds following the acquisition of Hibernia.
2006 Significant Events
Acquisition of North Fork Bancorporation
On December 1, 2006, Capital One acquired 100% of the outstanding common stock of North Fork Bancorporation, a bank holding company with more than 350 bank branches in the New York metropolitan area and a nationwide mortgage business. Pursuant to the Merger Agreement, each share of North Fork common stock outstanding at the effective time of the merger was converted into the right to receive either $28.144 in cash or 0.3692 of a share of Capital One common stock, at the election of each North Fork stockholder, subject to proration due to limitations on the aggregate amount of cash to be paid by Capital One in the merger and depending on the election of other North Fork stockholders, as specified in the Merger Agreement. Capital One paid $13.2 billion in cash and Capital One common stock to North Fork stockholders.
The average of the closing prices of Capital One common stock on the NYSE for the five trading days ending the day before the completion of the merger was $76.24. The total consideration of $13.2 billion included the value of outstanding stock options and was paid with the issuance of 104.0 million shares of Capital Ones common stock and $5.2 billion in cash consideration. Upon completion of the merger, outstanding options of North Fork were exchanged for options of Capital One with the number of options and option price adjusted for the exchange ratio. Capital One financed the cash portion of the acquisition through a combination of short term liquidity conversions and debt offerings. Specifically, Capital One acquired the common shares by liquidating $1.0 billion of federal funds sold and resale agreements and by issuing $995.0 million of trust preferred capital securities and $3.2 billion of senior and subordinated debt.
Debt Issuance to fund North Fork Acquisition
In June 2006, the Company and Capital One Capital II, a subsidiary of the Company created as a Delaware statutory business trust, issued $345.0 million aggregate principal amount of 7.5% Enhanced Trust Preferred Securities (the Enhanced TRUPS®) that are scheduled to mature on June 15, 2066. The securities represent a preferred beneficial interest in the assets of the trust and are recorded in other borrowings in the balance sheet. For regulatory capital purposes the securities are treated as equity and serve to increase Tier 1 and Total Risk Based Capital at the holding company level.
In July 2006, the Company and Capital One Capital III, a subsidiary of the Company created as a Delaware statutory business trust, issued $650.0 million aggregate principal amount of 7.686% Capital Securities that are scheduled to mature on August 15, 2036. The securities represent a preferred beneficial interest in the assets of the trust and are recorded in other borrowings in the balance sheet. For regulatory capital purposes the securities are treated as equity and serve to increase Tier 1 and Total Risk Based Capital at the holding company level.
In August 2006, the Company issued $1.0 billion aggregate principal amount of 6.150% Subordinated Notes due September 1, 2016.
In September 2006, the Company issued $1.1 billion of Floating Rate Senior Notes due September 10, 2009 and $1.1 billion of 5.7% Senior Notes due September 15, 2011.
North Fork Balance Sheet Derivative
In April 2006, the Company entered into derivative instruments to mitigate certain exposures it faced as a result of the expected acquisition of North Fork. The position was designed to protect the Companys tangible capital ratios from falling below a desired level in the event that subsequent increases in interest rates had reduced the mark-to-market value of North Forks balance sheet prior to closing. The Companys maximum negative exposure was expected to be no more than approximately $50 million. The derivative instruments were not treated as designated hedges under Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, and as such were marked to market through the income statement until the derivatives were terminated. The derivative instruments expired out of the money and unexercised on October 2, 2006 with a $50.1 million reduction to non-interest income.
Loss on Sale of Securities
Subsequent to the North Fork acquisition, in December the Company sold a number of Treasury and Agency securities realizing a loss of $34.9 million.
Sale of Mortgage Loans
During the fourth quarter, the Company entered agreements and established the price with third parties to sell $1.5 billion of CONAs residential mortgage portfolio and $4.2 billion of North Fork Banks mortgage portfolio as part of a balance sheet downsizing related to the acquisition of North Fork. In December 2006, $0.2 billion of loans were sold, resulting in a loss of $9.2 million. The Company recognized a loss of $21.4 million resulting from the mark to lower of cost or market on the remaining $5.5 billion of mortgage loans held for sale which was recorded in mortgage banking operations income. The Company entered into freestanding interest rate swaps to mitigate the interest rate exposure on the mortgage loans held for sale. The Company recognized a mark-to-market gain on the freestanding interest rates swaps of $35.7 million in mortgage banking operations income.
MasterCard, Inc. Initial Public Offering
In May 2006, MasterCard, Inc. completed an initial public offering of its stock. In connection with this transaction the Company received 2,305,140 Class B shares of which 1,360,032 Class B shares were immediately redeemed by
MasterCard, Inc. The Company recognized a $20.5 million gain from the share redemption, which was recorded in other non-interest income. The Class B shares carry certain trading restrictions which lapse in 2010.
Charged-Off Loan Portfolio Sale
In February 2006, the Company recognized $83.8 million of income from the sale of a combination of previously purchased charged-off loan portfolios and Company originated charged-off loans. The sale resulted in the acceleration of certain future portfolio returns. The pre-tax income is reflected in the following income statement line items: an increase of $66.4 million to various revenue line items, the majority of which was recorded to other non-interest income for the portion related to purchased charged-off loan portfolios; a $7.0 million reduction in the provision for loan losses through an increase in recoveries for the portion of charged-off loans originated by the Company and not securitized; and an increase of $10.4 million to servicing and securitizations income for the portion of charged-off loans originated by the Company and securitized.
Resolution of Tax Issues
During 2006, the Companys income tax expense was reduced by $70.7 million due to the resolution of certain tax issues and audits for prior years with the Internal Revenue Service. This reduction represented the release of previous accruals for potential audit adjustments which were subsequently settled or eliminated and further refinement of existing tax exposures.
Release of Hurricane Reserve
During 2006, the Company determined that $25.7 million of allowance for loan losses previously established to cover expected losses in the portion of the loan portfolio impacted by the 2005 hurricanes was no longer needed. This determination was driven by improvements in credit performance of the impacted portfolios since the time those reserves were established. As a result, results for the Banking segment include the reversal of this allowance.
VI. Financial Summary
Table 1 provides a summary view of the consolidated income statement and selected metrics at and for the years ended December 31, 2006, 2005 and 2004.
CAPITAL ONE FINANCIAL CORPORATION
Table 1: Financial Summary
Summary of the Reported Income Statement
The following is a detailed description of the financial results reflected in Table 1 Financial Summary. Additional information is provided in Section XII, Tabular Summary as detailed in sections below.
All 2006 comparisons are made between the year ended December 31, 2006 and the year ended December 31, 2005. All 2005 comparisons are made between the year ended December 31, 2005 and the year ended December 31, 2004.
Net interest income
Net interest income is comprised of interest income and past-due fees earned and deemed collectible from the Companys loans and income earned on securities, less interest expense on interest-bearing deposits, senior and subordinated notes and other borrowings.
For the year ended December 31, 2006, reported net interest income increased 39%, or $1.4 billion, inclusive of $135.1 million from the North Fork acquisition. The increase was due to a 52% increase in reported average earning assets driven by a full year of Hibernia activity and the recent North Fork acquisition. Net interest margin decreased 60 basis points from 6.63% in 2005 due to spread compression driven primarily by a focus on higher credit quality and a shift in asset mix through recent acquisitions.
For the year ended December 31, 2005, reported net interest income increased 23%. The increase was primarily due to significant growth in reported average earning assets. The yield on earning assets and cost of funds remained relatively stable year over year.
For additional information, see section XII, Tabular Summary, Table A (Statements of Average Balances, Income and Expense, Yields and Rates) and Table B (Interest Variance Analysis).
Non-interest income is comprised of servicing and securitizations income, mortgage banking operations income, service charges and other customer-related fees, interchange income and other non-interest income.
For the year ended December 31, 2006 and 2005, reported non-interest income increased 10% and 8%, respectively. The 2006 and 2005 increases were both due to year over year increases in servicing and securitizations income, service charges and other customer-related fees, interchange income, mortgage banking operations income and other non-interest income. See detailed discussion of the components of non-interest income below.
Servicing and Securitizations Income
Servicing and securitizations income represents servicing fees, excess spread and other fees derived from the off-balance sheet loan portfolio, adjustments to the fair value of retained interests derived through securitization transactions, as well as gains and losses resulting securitization and other sales transactions.
Servicing and securitizations income increased 7% for the year ended December 31, 2006. This increase was primarily the result of a 7% increase in the average off-balance sheet loan portfolio.
Servicing and securitizations income increased 9% for the year ended December 31, 2005. This increase was primarily the result of a 13% increase in the average off-balance sheet loan portfolio offset by losses from the Gulf Coast hurricanes and bankruptcy charge-offs resulting from the new bankruptcy legislation.
Service Charges and Other Customer-Related Fees
For 2006, Service charges and other customer-related fees grew 19% or $276.7 million, inclusive of $344.2 million from a full year of Hibernia activity and $16.8 million from the North Fork acquisition. Excluding the impact of acquisitions, service charges and other customer-related fee income declined $84.5 million or 6%. This is reflective of the reported loan growth being concentrated in the Auto Finance and Global Financial Services segments that generate lower fee income and continued declining fee revenue from U.S. Card.
Excluding $44.7 million contributed by businesses acquired in 2005, service charges and other customer-related fees decreased 2% for the year ended December 31, 2005, while the average reported loan portfolio, exclusive of
the 2005 acquisitions, grew 7%. The lower growth in service charges and other customer-related fee income when compared to average reported loan growth is reflective of the reported loan growth being concentrated in the Auto Finance and Global Financial Services segments that generate lower fee income.
Mortgage Banking Operations Income
Mortgage banking operations income includes commission and fees earned by the Companys mortgage businesses, gains and losses associated with hedging transactions, gains and losses on sale of mortgage loans held for sale, and lower of cost or market adjustments to the held for sale loan portfolio. Mortgage banking operations income increased 21% from prior year due to the acquisition of North Fork.
Interchange income, net of rewards expense, increased 7% for the year ended December 31, 2006. This increase is primarily related to a 13% increase in purchase volumes. Costs associated with the Companys rewards programs were $176.3 million and $176.9 million for the years ended December 31, 2006 and 2005, respectively.
Interchange income, net of rewards expense, increased 8% for the year ended December 31, 2005. This increase is primarily related to a 15% increase in purchase volumes. Costs associated with the Companys rewards programs was $176.9 million and $128.2 million for the years ended December 31, 2005 and 2004, respectively. The 38% increase in the rewards expense is due to an increase in purchase volumes and the continued expansion of the rewards program during 2005.
Other Non-Interest Income
Other non-interest income includes, among other items, gains and losses on sales of securities, gains and losses associated with hedging transactions, service provider revenue generated by the Companys healthcare finance business, gains on the sale of auto loans and income earned related to purchased charged-off loan portfolios.
Other non-interest income for the year ended December 31, 2006, increased $32.2 million. The increase is primarily the result of a $59.8 million gain from the sale of purchased charged-off loan portfolios, a $20.5 million gain from the share redemption in connection with the MasterCard, Inc. initial public offering, a $28.6 million increase in the revenue related to back end performance bonuses related to prior period auto loan sales compared to same periods in prior years, offset by a $50.1 million negative fair value adjustment on the derivatives instruments entered into in anticipation of the North Fork Bank acquisition, and a $12.4 million loss recorded in connection with the extinguishment of senior notes during the first quarter of 2006, and $12.4 million income recognized in the prior year from the Companys charged off loan portfolio which was disposed of in February 2006.
Other non-interest income for the year ended December 31, 2005, included $160.0 million of income related to businesses acquired during 2005. Exclusive of the income generated from businesses acquired, other non-interest income decreased 20% from the prior year. This decrease is primarily the result of gains recognized in 2004, including a $31.5 million gain from the sale of the Companys joint venture investment in South Africa and a $41.1 million gain from the sale of the French loan portfolio, as well as, a $26.3 million reduction in gains recognized from the sale of auto loans in 2005 due to lower volume of whole loan sales. These reductions in 2005 in other non-interest income were partially offset by a $34.0 million gain from the sale of previously purchased charged-off loan portfolios during 2005.
Provision for loan losses
Exclusive of the North Fork acquisition, the provision for loan losses decreased 1% for the year ended December 31, 2006, compared to the prior year. The decrease in the provision is as a result of a continued
increase in the concentration of higher credit quality loans in the reported loan portfolio combined with a continued favorable loss environment resulting from, in part, a slower than expected return of bankruptcy related charge-offs to historical levels. During 2006, the Company determined that $25.7 million of allowance for loan losses previously established to cover expected losses in the portion of the loan portfolio impacted by the 2005 hurricanes was no longer needed.
The provision for loan losses increased 22% for the year ended December 31, 2005 compared to the prior year. This increase was driven by 14% growth in the reported loan portfolio, exclusive of Hibernia loans acquired, estimated losses resulting from the Gulf Coast hurricanes, and an increase in net charge-offs resulting from the enactment of the new bankruptcy legislation. Exclusive of the estimated losses from the Gulf Coast Hurricanes and the increase in bankruptcy related charge-offs in 2005 compared to 2004, the provision for loan losses would have increased 8% from the prior year. This provision for loan losses increase relative to the 14% growth in the reported loan portfolio reflects a continued increase in the concentration of higher credit quality loans in the reported loan portfolio
Non-interest expense consists of marketing and operating expenses.
Non-interest expense increased 22% for the year ended December 31, 2006, reflecting a 5% increase in marketing spend and a 27% increase in operating expenses. Non-interest expense increased $1.2 billion for the year, of which $0.9 billion reflected a full years worth of Hibernias operations and $0.1 billion from the North Fork acquisition. In addition, the Company made infrastructure investments which include the successful conversion to a new installment loan platform in July 2006, the ongoing conversions to the Companys new card holder platform, and branch expansion in the Banking segment.
Non-interest expense increased 7% for the year ended December 31, 2005, reflecting flat marketing spend and a 9% increase in operating expenses. The increase in operating expenses was driven primarily by the 2005 acquisitions and slightly higher 2005 one-time charges, offset by lower 2005 charges related to the companys corporate-wide cost reduction initiatives announced in 2004. Companies acquired in 2005 contributed $303.8 million in operating expenses or 86% of the overall increase. In addition, the company recognized a $20.6 million pre-payment penalty related to the refinancing of the McLean headquarters facility and a $28.2 million impairment charge related to its Global Financial Services segment insurance brokerage business compared to a total of $36.4 million in 2004 one-time charges detailed below. 2005 operating expenses were positively impacted by a $67.3 million reduction in employee termination benefits and facility consolidation costs related to corporate-wide cost reduction initiatives. Excluding the aforementioned items, operating expenses increased 2% for the year ended December 31, 2005. This increase was the result of 7% managed loan growth, excluding 2005 acquisitions, and reflects improved operating efficiencies. Operating expenses as a percentage of average managed assets for the year ended December 31, 2005 fell 33 basis points to 4.12% from 4.45% for the prior year.
The Companys effective tax rate was 33.9%, 36.1%, and 34.6% for the years ended December 31, 2006, 2005, and 2004, respectively. The effective rate includes federal, state, and international tax components. The decrease in the 2006 rate compared to 2005 was primarily due to the resolution of certain tax issues and audits for prior years with the Internal Revenue Service resulting in $70.7 million reduction to provision. The increase in the 2005 rate compared to 2004 was primarily due to changes in the Companys international tax positions.
Loan Portfolio Summary
The Company analyzes its financial performance on a managed loan portfolio basis. The managed loan portfolio is comprised of on-balance sheet and off-balance sheet loans. The Company has retained servicing rights for its
securitized loans and receives servicing fees in addition to the excess spread generated from the off-balance sheet loan portfolio.
Average managed loans held for investment grew 31%, or $26.1 billion and 16%, or $11.6 billion for the years ended December 31, 2006 and 2005, respectively. The increase in average managed loans held for investment included $2.7 billion from the North Fork acquisition in 2006, and $16.1 billion from the Hibernia acquisition in 2005.
For additional information, see section XII, Tabular Summary, Table C (Managed Consumer Loan Portfolio) and Table D (Composition of Reported Loan Portfolio).
The Company believes delinquencies to be an indicator of loan portfolio credit quality at a point in time. The entire balance of an account is contractually delinquent if the minimum payment is not received by the payment due date. Delinquencies not only have the potential to impact earnings if the account charges off, but they also result in additional costs in terms of the personnel and other resources dedicated to resolving the delinquencies.
The 30-plus day delinquency rate for the reported and managed consumer loan portfolio decreased 40 and 22 basis points, respectively, at December 31, 2006. The reduction in the reported and managed consumer loan 30-plus day delinquency rates reflect a higher concentration of lower loss assets in the respective loan portfolios (including $31.7 billion loans added through the acquisition of North Fork).
The 30-plus day delinquency rate for the reported and managed consumer loan portfolio decreased 71 and 58 basis points, respectively, at December 31, 2005. The reduction in the reported and managed consumer loan 30-plus day delinquency rates reflect a higher concentration of lower loss assets in the respective loan portfolios (including $16.3 billion loans added through the acquisition of Hibernia), the clearing out of delinquencies related to recent bankruptcy related charge-offs and overall improved collections experience.
For additional information, see section XII, Tabular Summary, Table E (Delinquencies).
Net charge-offs include the principal amount of losses (excluding accrued and unpaid finance charges and fees and fraud losses) less current period principal recoveries. The Company charges off credit card loans at 180 days past the due date and generally charges off other consumer loans at 120 days past the due date or upon repossession of collateral. Non-collateralized consumer bankruptcies are typically charged-off within 2-7 days upon notification and in any event within 30 days. Commercial loans are charged-off when the amounts are deemed uncollectible. Costs to recover previously charged-off accounts are recorded as collection expenses in other non-interest expense.
The reported and managed net charge-off rates decreased 134 and 141 basis points, respectively, with net charge-off dollars decreasing 1% on a reported and managed basis, for the year ended December 31, 2006 compared to the prior year. The decrease in net charge-off rates is due to historically low levels of bankruptcies following the change in bankruptcy legislation in the fourth quarter of 2005 and an increase in the concentration of higher credit quality loans in the reported loan portfolio driven by recent acquisitions.
The reported and managed net charge-off rates decreased 23 and 16 basis points, respectively, while net charge-off dollars increased 12% and 11% on a reported and managed basis, respectively, for the year ended December 31, 2005 compared to the prior year. The decrease in net charge-off rates principally relates to the Companys continued asset diversification within and beyond U.S. consumer credit cards. The increase in the net
charge-off dollars was driven by growth in the reported and managed loan portfolios combined with the incremental increase of bankruptcy charge-offs resulting from the enactment of the new bankruptcy legislation. Reported and managed bankruptcy charge-offs increased $146.8 million and $394.8 million, respectively, for the year ended December 31, 2005 when compared to the prior year.
For additional information, see section XII, Tabular Summary, Table F (Net Charge-offs).
The Company assumed nonperforming assets in connection with the acquisitions of Hibernia and North Fork.
Nonperforming loans consist of nonaccrual loans (loans on which interest income is not currently recognized) and restructured loans (loans with below-market interest rates or other concessions due to the deteriorated financial condition of the borrower). Commercial, small business and some auto loans are placed in nonaccrual status at 90 days past due or sooner if, in managements opinion, there is doubt concerning the ability to fully collect both principal and interest.
For additional information, see section XII, Tabular Summary, Table G (Nonperforming Assets).
Allowance for loan and lease losses
The allowance for loan and lease losses is maintained at the amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing reported loan portfolios. The provision for loan losses is the periodic cost of maintaining an adequate allowance. The amount of allowance necessary is based on distinct allowance methodologies depending on the type of loans which include specifically identified criticized loans, migration analysis, forward loss curves and historical loss trends. In evaluating the sufficiency of the allowance for loan and lease losses, management takes into consideration the following factors: recent trends in delinquencies and charge-offs including bankrupt, deceased and recovered amounts; forecasting uncertainties and size of credit risks; the degree of risk inherent in the composition of the loan portfolio; economic conditions; legal and regulatory guidance; credit evaluations and underwriting policies; seasonality; and the value of collateral supporting the loans. To the extent credit experience is not indicative of future performance or other assumptions used by management do not prevail, loss experience could differ significantly, resulting in either higher or lower future provision for loan and lease losses, as applicable. The evaluation process for determining the adequacy of the allowance for loan losses and the periodic provisioning for estimated losses is undertaken on a quarterly basis, but may increase in frequency should conditions arise that would require the Companys prompt attention. Conditions giving rise to such action are business combinations or other acquisitions or dispositions of large quantities of loans, dispositions of non-performing and marginally performing loans by bulk sale or any development which may indicate an adverse trend.
The allowance for loan losses increased $390.0 million from December 31, 2005 driven primarily by the acquisition of North Fork which added $222.2 million of allowance for loan losses at December 31, 2006. The remaining increase was the result of 8% growth in the reported loan portfolio, exclusive of the North Fork loans portfolio.
During 2006, the Company determined that $25.7 million of allowance for loan losses previously established by Hibernia to cover expected losses in the portion of the loan portfolio impacted by the 2005 hurricanes was no longer needed. This determination was driven by improvements in credit performance of the impacted portfolios since the time those reserves were established. As a result, results for the Banking segment include the reversal of this allowance. In addition, during the fourth quarter the Company aligned the allowance for loss methodology for CONAs indirect auto portfolio with the Capital One legacy auto portfolio. The resulting impact of the methodology alignment was a decrease to the allowance for loan losses of $36.8 million.
During the fourth quarter, the Company completed a review of the loan portfolios deemed to be impaired in accordance with SOP 03-3 associated with the acquisition of Hibernia National Bank. Based upon the information available at the time of this review, the majority of the consumer portfolio and a portion of the commercial portfolio were determined not to have been impaired at the acquisition date. Therefore, the related SOP 03-3 contra accounts were adjusted, with reclassifications of approximately $30.8 million of contra asset balances to increase the allowance for loan losses, and approximately $68.8 million to decrease Goodwill.
For additional information, see section XII, Tabular Summary, Table H (Summary of Allowance for Loan Losses).
VII. Reportable Segment Summary
The Company manages its business as four distinct operating segments: U.S. Card, Auto Finance, Global Financial Services and Banking. The U.S. Card, Auto Finance, Global Financial Services and Banking segments are considered reportable segments based on quantitative thresholds applied to the managed loan portfolio for reportable segments provided by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.
As management makes decisions on a managed portfolio basis within each segment, information about reportable segments is provided on a managed basis.
The Company maintains its books and records on a legal entity basis for the preparation of financial statements in conformity with GAAP. The following table presents information prepared from the Companys internal management information system, which is maintained on a line of business level through allocations from legal entities.
US Card Segment
Table 2: U.S. Card
The U.S. Card segment consists of domestic consumer credit card lending activities.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
U.S. Card segment earnings increased year over year primarily due to the favorable credit environment. Throughout 2006, charge-offs remained at historically low levels following the change in bankruptcy legislation in the fourth quarter of 2005.
Ending Loans increased year over year by 8% and was driven by a combination of both new customer acquisitions as well as growth and retention of balances from existing customers. Purchase Volume growth of 13% shows continued growth within the rewards business along with healthy retail sales growth.
Total revenues declined 2% for the year, primarily driven by changes in product strategy. In the past year, U.S. Card has increasingly focused on transactor products, shifted more upmarket in subprime cards and increased the volume of assets at introductory rates.
The provision for loan losses decreased 28% for the year ended December 31, 2006. The decrease is attributable to the favorable credit environment in 2006 and outlook for losses in 2007, offset by loan growth. Non-interest expenses for 2006 increased 5%, primarily driven by infrastructure improvements and investments.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
The U.S. Card segment provided earnings growth primarily as a result of year over year loan growth and improved operating efficiencies. U.S. Card segment net income for 2005 grew as a result of higher revenue and lower non-interest expense, offset by higher provision for loan losses. Total revenues grew 3% for the year, as a result of 2% growth in the average loan portfolio coupled with higher purchase volumes. Current period earnings reflect the Companys choice not to engage in certain repricing practices prevalent in the industry that focus on short-term growth at the expense of customer loyalty and generating long-term profitability.
The provision for loan losses increased 3% for the year ended December 31, 2005. The increase is due to an increase in 2005 bankruptcy related charge-offs resulting from the enactment of new bankruptcy legislation, $10.0 million in estimated future losses resulting from the Gulf Coast Hurricanes and growth in the loan portfolio.
Non-interest expense for 2005 included a $16.8 million expense allocation related to the prepayment penalty for the refinancing of the McLean Headquarters facility and an $85.3 million reduction in charges associated with the Companys continued cost reduction initiatives compared to 2004. Exclusive of these charges, non-interest expense decreased 2%, reflecting improved operating efficiencies.
Auto Finance Segment
Table 3: Auto Finance
The Auto Finance segment consists of automobile and other motor vehicle financing activities.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
The Auto Finance segments loan portfolio increased 33% year over year as a result of the 2006 addition of Hibernias indirect auto loan portfolio, as well as strong organic originations growth within the dealer marketing channels.
Auto Finance net income increased $101.5 million, or 77% for the year ended December 31, 2006, as a result of portfolio growth, improvement in loan loss performance and additional scale gained in non interest expense. The increase was partially offset by margin compression due to the increasing rate environment and heightened competition.
For the year ended, December 31, 2006, the Auto Finance segments net charge-off rate was down 42 basis points from the prior year. Net charge-offs of Auto Finance segment loans increased $84.4 million, or 22%, while average Auto Finance loans for the year ended December 31, 2006 grew $6.3 billion, or 45%, compared to the prior year. The decrease in the charge-off rate was primarily driven by improved loan quality through the acquisition of Hibernias indirect auto loans, which increased the Auto Finance segment mix of prime loans, and decreases in bankruptcy related charge-offs which were lower than historical levels following the bankruptcy filing spike experienced in the fourth quarter of 2005. The provision for loan losses increased $35.3 million, or 8% for the year ended December 31, 2006. This increase was driven by growth in the loan portfolio, partially
offset by a reduction in allowance for loan losses as a result of implementing a consistent reserve policy on the Hibernia indirect auto portfolio.
Non-interest expense increased 18% for the year ended December 31, 2006, due to growth in the loan portfolio. However, loan growth versus prior year outpaced the increase in non-interest expense as the Auto Finance segment experienced greater cost efficiency, while 2005 included incremental operating and integration expenses related to the 2005 acquisitions.
The 30-plus day delinquency rate for the Auto Finance segment was up 64 basis points at December 31, 2006. The increase in delinquencies was the result of the gradual normalization of delinquencies following the 2005 bankruptcy spike and targeted risk expansion in non-prime markets.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
The Auto Finance segments loan portfolio increased 64% year over year as a result of 2005 acquisitions of Onyx Acceptance Corporation and the Key Bank non-prime auto loan portfolio, as well as, strong organic originations growth aided, in part, by auto manufacturers employee-pricing initiatives and other discount programs in 2005.
Auto Finance net income decreased for the year ended December 31, 2005, as a result of increases in the provision for loan losses and non-interest expense, as well as lower gains from the sale of auto loans.
Growth in the loan portfolio also resulted in a significant increase in revenue. However, this increase was offset by a decrease in non-interest income primarily related to $24.7 million reduction in gains from the sale of auto loans, inclusive of allocations related to funds transfer pricing, compared to the prior year.
For the year ended, December 31, 2005, the Auto Finance segments net charge-off rate was down 58 basis points from the prior year. Net charge-offs of Auto Finance segment loans increased $77.1 million, or 25%, while average Auto Finance loans for the year ended December 31, 2005 grew $4.9 billion, or 52%, compared to the prior year. The decrease in the charge-off rate was primarily driven by the acquisition of Onyx Acceptance Corporation, which originates and services a portfolio of mostly prime auto receivables, improved loan quality, collections performance and favorable industry trends, and a $20.4 million one-time acceleration of charge-offs in 2004 related to a change in the charge-off recognition process for auto loans in bankruptcy. The provision for loan losses increased 64% for the year ended December 31, 2005, as a result of significant organic loan growth, $16.0 million of estimated future incremental losses resulting from the Gulf Coast Hurricanes, and losses related to the enactment of the new bankruptcy legislation.
Non-interest expense increased 48% for the year ended December 31, 2005, driven by growth in the loan portfolio and incremental operating and integration expenses related to the 2005 acquisitions.
The 30-plus day delinquency rate for the Auto Finance segment was up 21 basis points at December 31, 2005. The increase in delinquencies was the result of a spike in bankruptcy filings prior to the enactment of the new bankruptcy legislation in October 2005 and the $20.4 million one-time acceleration of charge-offs in December 2004, which moved delinquent accounts to charge-off status in that year.
Global Financial Services Segment
Table 4: Global Financial Services
The Global Financial Services segment consists of international (UK and Canada) lending, small business lending, installment loans, home loans, healthcare finance and other consumer financial service activities, extending Capital Ones national scale lending franchise and providing geographic diversification. Global Financial Services represents a growing earnings contributor for the Company with a greater than 60% compound annual growth rate since 2003.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Global Financial Services net income increased 47% for the year ended December 31, 2006 as a result of strong growth and profitability across all North American businesses. Strong 2006 growth in North America was offset by challenges in Europe. Total revenue increased 11% for the year ended December 31, 2006, slightly below the 14% growth in average loans for the same period.
The provision for loan losses increased 15% for the year ended December 31, 2006, as a result of growth in the loan portfolio combined with deteriorating credit quality metrics in the U.K. during 2006. Global Financial Services net charge-off rate declined 19 basis points for 2006 compared to the prior year. The decrease in the net charge-off rate is largely the result of the 2005 U.S. bankruptcy legislation changes and continued stability in North American credit quality trends, offset by continued worsening in the U.K.
Non-interest expense increased 1% for the year ended December 31, 2006. Non-interest expense in 2005 included a $28.2 million impairment charge related to the write-off of goodwill and other charges related to the Companys insurance brokerage business. Exclusive of the one time charge, non-interest expense increased 3% for the year ended December 31, 2006, well below the growth in revenue of 11% and average loans of 14%.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Global Financial Services segments loan portfolio increased 10% year over year as a result of the underlying performance of our North American businesses.
Global Financial Services net income decreased 13% for the year ended December 31, 2005 as a result of increases in provision for loan losses and non-interest expense and one-time gains on the sales of the Companys joint venture investment in South Africa and French loan portfolio that occurred during 2004, offset by increases in revenue. Total revenue increased 19% for the year ended December 31, 2005 as a result of a 19% growth in average loans for the same period and contributions from the Global Financial Services businesses acquired in 2005.
The provision for loan losses increased 35% for the year ended December 31, 2005, as a result of growth in the loan portfolio combined with deteriorating credit quality metrics in the U.K. during 2005.
Non-interest expense in 2005 included a $28.2 million impairment charge related to the write-off of goodwill and other charges related to the Companys insurance brokerage business. Non-interest expense in 2004 included expense associated with a change in fixed asset capitalization thresholds and impairment of internally developed software. Exclusive of these one time charges and a $20.5 million reduction in employee termination and facility consolidation charges, non-interest expense for the year ended December 31, 2005, increased 18% in line with the 19% growth in average managed loans.
Table 5: Banking
Beginning in 2006, Capital One added a Banking segment. The Banking segment represents the results of the legacy Hibernia business lines except for the indirect auto business, which is included in the Auto Finance segment results, and the investment portfolio results which are included in the Other category. In addition, the Banking segment includes the results of the Companys branchless deposit business which were previously included as part of the Other category. On December 1, 2006, the Company completed its acquisition of North Fork Bancorporation. The impacts of the North Fork acquisition for the one month ended December 31, 2006 are included in the Other category.
Year Ended December 31, 2006
The Banking segment contributed $178.6 million of income to the Company during 2006. At December 31, 2006, loans outstanding in the Banking segment totaled $12.1 billion while deposits outstanding totaled $35.3 billion. Banking segment profits are primarily generated from net interest income, which represents the spread between loan yields and the internal cost of funds charged to the business for those loans, plus the spread between deposit interest costs and the funds transfer price credited to the business for those deposits. During 2006, the Banking segment generated net interest income of $996.9 million.
During 2006, overall loan growth was relatively flat as new loan originations were offset by significant loan repayments in the areas most impacted by Hurricanes Katrina and Rita. In addition, during the fourth quarter the Company decided to sell $1.5 billion of the Banking segments residential mortgage portfolio as part of the balance sheet downsizing related to the acquisition of NFB.
For the year, average branch-based deposits increased approximately $1.3 billion. Deposit growth was the result of an increase in deposits in the hurricane impacted areas during the first few months of the year. This growth was the continuation of a surge in deposits experienced in the fourth quarter of 2005 after the hurricanes. Deposit growth in the second half of the year primarily came from Texas, where the Company continued to open new branches. Deposits decreased in the fourth quarter as new growth in Texas was offset by attrition in the hurricane impacted areas.
During 2006, the Company determined that $25.7 million of allowance for loan losses previously established to cover expected losses in the portion of the loan portfolio impacted by the hurricanes was no longer needed. This determination was driven by improvements in credit performance of the impacted portfolios since the time those reserves were established. As a result, results for the Banking segment include the reversal of this allowance.
During 2006, the Company opened 33 new branches in Texas, with 14 opened in the fourth quarter. An additional 6 branches opened during the first two weeks of January 2007. These new branches contributed to the deposit growth mentioned above. The costs of operating these branches, including lease costs, depreciation and personnel, is included in non-interest expense. Also included in non-interest expense are costs associated with the integration of Hibernia into the Company. Substantially all integration activities related to Hibernia have been or will be completed by the end of the first quarter of 2007.
The Company has established access to a variety of funding sources. Table 6 illustrates the Companys unsecured funding sources and its two auto securitization warehouses.
Table 6: Funding Availability
The Senior and Subordinated Global Bank Note Program gives the Bank the ability to issue securities to both U.S. and non-U.S. lenders and to raise funds in U.S. and foreign currencies, subject to conditions customary in transactions of this nature.
Prior to the establishment of the Senior and Subordinated Global Bank Note Program, the Bank issued senior unsecured debt through an $8.0 billion Senior Domestic Bank Note Program. The Bank did not renew the Senior Domestic Bank Note Program for future issuances following the establishment of the Senior and Subordinated Global Bank Note Program.
In June 2004, the Company terminated its Domestic Revolving and Multicurrency Credit Facilities and replaced them with a new revolving credit facility (Credit Facility) providing for an aggregate of $750.0 million in unsecured borrowings from various lending institutions to be used for general corporate purposes. The Credit Facility is available to the Corporation, the Bank, the Savings Bank, and Capital One Bank (Europe), plc, subject to covenants and conditions customary in transactions of this type. The Corporations availability has been increased to $500.0 million under the Credit Facility. All borrowings under the Credit Facility are based upon varying terms of London Interbank Offering Rate (LIBOR).
In April 2002, COAF entered into a revolving warehouse credit facility collateralized by a security interest in certain auto loan assets (the Capital One Auto Loan Facility I). As of December 31, 2006, the Capital One Auto Loan Facility I had the capacity to issue up to $3.3 billion in secured notes. The Capital One Auto Loan Facility I has multiple participants each with separate renewal dates. The facility does not have a final maturity date. Instead, each participant may elect to renew the commitment for another set period of time. Interest on the facility is based on commercial paper rates.
In March 2005, COAF entered into a revolving warehouse credit facility collateralized by a security interest in certain auto loan assets (the Capital One Auto Loan Facility II). As of December 31, 2006, the Capital One Auto Loan Facility II had the capacity to issue up to $1.8 billion in secured notes. The facility does not have a final maturity date. Instead, the participant may elect to renew the commitment for another set period of time. Interest on the facility is based on commercial paper rates.
In May 2006, the Company entered into a syndicated bridge loan facility (the Facility). The Facility was available to the Company to finance, on an interim basis, the cash consideration payable to shareholders of North Fork in connection with the acquisition. On September 29, 2006 the Facility was terminated.
As of December 31, 2006, the Corporation had an effective shelf registration statement under which the Corporation from time to time may offer and sell an indeterminate aggregate amount of senior or subordinated debt securities, preferred stock, depositary shares representing preferred stock, common stock, trust preferred securities, junior subordinated debt securities, guarantees of trust preferred securities and certain back-up obligations, purchase contracts and units. There is no limit under this shelf registration statement to the amount or number of such securities that the Corporation may offer and sell.
The Company continues to expand its retail deposit gathering efforts through its direct marketing channels, the existing branch network and through De Novo branch expansion. Deposits from the direct marketing business continued to grow due to expansion in marketed channels, such as the internet.
With the acquisitions of North Fork and Hibernia, Capital One acquired new channels for deposit growth. The branch network offers a broad set of deposit products that include demand deposits, money market deposits, NOW accounts, and certificates of deposits (CDs).
As of December 31, 2006, the Company had $85.8 billion in deposits of which $4.0 billion were held in foreign banking offices and $12.0 billion represented large domestic denomination certificates of $100 thousand or more.
Table 7 shows the maturities of domestic time certificates of deposit in denominations of $100 thousand or greater (large denomination CDs) as of December 31, 2006.
Table 7: Maturities of Large Denomination Certificates$100,000 or More
Table 8 shows the composition of average deposits for the periods presented.
Table 8: Deposit Composition and Average Deposit Rates
Table 9 reflects the costs of other borrowings of the Company as of and for each of the years ended December 31, 2006, 2005 and 2004.
Table 9: Short Term Borrowings
Additional information regarding funding can be found on pages 101-104 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 9.
Table 10 summarizes the amounts and maturities of the contractual funding obligations of the Company, including off-balance sheet funding.
Table 10: Funding Obligations
The terms of the lease and credit facility agreements related to certain other borrowings and operating leases in Table 10 require several financial covenants (including performance measures and equity ratios) to be met. If these covenants are not met, there may be an acceleration of the payment due dates noted above. As of December 31, 2006, the Company was not in default of any such covenants.
Liquidity Risk Management
Liquidity risk management refers to the way the Company manages the use and availability of various funding sources to meet its current and future operating needs. These needs are largely a result of asset growth, securitization, debt and deposit maturities, and payments of other corporate obligations.
To facilitate liquidity risk management, the Company uses a variety of funding sources to establish a maturity pattern that provides a prudent mixture of short-term and long-term funds. The Company obtains funds through the gathering of deposits, issuing debt and equity, and securitizing assets. Further liquidity is provided to the Company through committed facilities. As of December 31, 2006, the Corporation, the Bank, the Savings Bank, CONA and COAF collectively had over $ 12.1 billion in unused commitments under various credit facilities (including the Collateralized Revolving Credit Facility) and unused conduit capacity available for liquidity needs.
Additionally, the Company maintains a portfolio of highly rated and highly liquid securities in order to provide adequate liquidity and to meet its ongoing cash needs. As of December 31, 2006, the Company had $10.7 billion of such securities, cash and cash equivalents, net of pledged securities of $9.5 billion.
As discussed in Off-Balance Sheet Arrangements, a significant source of liquidity for the Company has been the securitization of consumer loans. As of December 31, 2006 the Company funded approximately 34% of its managed loans through on and off-balance sheet securitizations. The Company expects to securitize additional loan principal receivables during 2007. The Companys securitization program has maturities in 2007 and through 2025. The revolving securitizations have accumulation periods during which principal payments are aggregated to make payments to investors. As payments on the loans are accumulated and are no longer reinvested in new loans, the Companys funding requirements for such new loans increase accordingly. The occurrence of certain events may cause the securitization transactions to amortize earlier than scheduled, which would accelerate the need for funding. Additionally, this early amortization could have a significant effect on the ability of the Bank and the Savings Bank to meet the capital adequacy requirements as all off-balance sheet loans experiencing such early amortization would have to be recorded on the balance sheet and accordingly would require incremental regulatory capital. As such amounts mature or are otherwise paid, the Company believes it can securitize additional consumer loans, gather deposits, purchase federal funds and establish other funding sources to fund new loan growth, although no assurance can be given to that effect.
The Company is a leading issuer in the securitization markets. If these markets experience difficulties the Company may be unable to securitize its loan receivables or to do so at favorable pricing levels. Factors affecting the Companys ability to securitize its loan receivables or to do so at favorable pricing levels include the overall credit quality of the Companys securitized loans, the stability of the market for securitization transactions, and the legal, regulatory, accounting and tax environments governing securitization transactions. If the Company was unable to continue to securitize its loan receivables at current levels, the Company would use its investment securities and money market instruments in addition to alternative funding sources to fund increases in loan receivables and to meet its other liquidity needs. The resulting change in the Companys current liquidity sources could potentially subject the Company to certain risks. These risks would include an increase in the Companys cost of funds, an increase in the allowance and the provision for loan losses as more loans would remain on the Companys consolidated balance sheet, and limited or no loan growth, if the Company were unable to find alternative and cost-effective funding sources. In addition, if the Company could not continue to remove the loan receivables from the balance sheet the Company would possibly need to raise additional capital to support asset growth.
Based on past deposit activity, the Company expects to retain a portion of its deposit balances as they mature. Therefore, the Company anticipates the net cash outflow related to deposits within the next year will be significantly less than reported in Table 8. The Company utilizes deposits to fund loan and other asset growth and to diversify funding sources.
Core deposits are comprised of domestic non-interest bearing deposits, NOW accounts, money market deposit accounts, savings accounts, certificates of deposit of less than $100,000 and other consumer time deposits. The Company maintains a Grand Cayman branch for issuing Eurodollar time deposits.
The Company has deposits that are obtained through the use of a third-party intermediary. Included in these deposits at December 31, 2006, were brokered deposits of $12.0 billion, compared to $11.4 billion at December 31, 2005. These deposits represented 14% and 24% of total deposits at December 31, 2006 and 2005, respectively. If these brokered deposits are not renewed at maturity, the Company would use its investment securities and money market instruments in addition to alternative funding sources to fund increases in loan receivables and meet its other liquidity needs. The Federal Deposit Insurance Corporation Improvement Act of 1991 limits the use of brokered deposits to well-capitalized insured depository institutions and, with a waiver from the Federal Deposit Insurance Corporation, to adequately capitalized institutions. At December 31, 2006, the Bank, the Savings Bank, CONA, North Fork Bank, and Superior and the Corporation were well-capitalized as defined under the federal bank regulatory guidelines. Based on the Companys historical access to the brokered deposit market, it expects to replace maturing brokered deposits with new brokered deposits or with the Companys direct deposits.
Other funding programs established by the Company include senior and subordinated notes. At December 31, 2006, the Company had $9.7 billion in senior and subordinated notes outstanding that mature in varying amounts from 2007 to 2027, as compared to $6.7 billion at December 31, 2005.
Included in senior and subordinated notes on the Companys balance sheet, the Bank has a global bank note program. Notes may be issued under this program with maturities of thirty days or more from the date of issue. At December 31, 2006, the Bank had $3.4 billion in bank notes outstanding.
Subsidiary banks are members of various Federal Home Loan Banks (FHLB) that provide a source of funding through advances. These advances carry maturities from one month to 30 years. At December 31, 2006, the Company had $2.6 billion of advances from the FHLBs. All FHLB borrowings are collateralized with mortgage-related assets which may include residential and commercial mortgages and home equity loans.
The Company also held $6.0 billion in available-for-sale investment securities, net of $9.5 billion in pledged available-for-sale investment securities and $4.7 billion of cash and cash equivalents at December 31, 2006, compared to $9.2 billion in available-for-sale investment securities, net of $5.1 billion in pledged available-for-sale investment securities and $4.1 billion of cash and cash equivalents at December 31, 2005. As of December 31, 2006, the weighted average life of the investment securities was approximately 3.6 years. These investment securities, along with cash and cash equivalents, provide increased liquidity and flexibility to support the Companys funding requirements.
The Company has a $750.0 million credit facility committed through June 2007. The Company may take advances under the facility subject to covenants and conditions customary in a transaction of this nature. This facility may be used for general corporate purposes and was not drawn upon at December 31, 2006.
On June 6, 2006, August 1, 2006 and February 5, 2007, the Corporation and certain of its subsidiary trusts (Capital One Capital II, Capital One Capital III and Capital One Capital IV, respectively) completed offerings of trust preferred securities, representing preferred beneficial interests in the assets of the subsidiary trusts. The proceeds from the sale of the trust preferred securities to investors, and of certain common trust securities to the Corporation, were invested by the subsidiary trusts in junior subordinated debt securities of the Corporation.
Simultaneously with the closing of each of these offerings of trust preferred securities, the Corporation entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of long-term
indebtedness of the Corporation or certain of its depositary institution subsidiaries. The Company will provide a copy of the replacement capital covenant to holders of the covered debt upon request made to Investor Relations.
The replacement capital covenants provide that the Corporation will not repay, redeem or purchase, and will cause its subsidiaries not to repay, redeem or purchase, all or any part of the relevant trust preferred securities or junior subordinated debt securities prior to a defined termination date except, with certain limited exceptions, to the extent that, during the 180 days prior to the date of that repayment, redemption or purchase, the Corporation or its subsidiaries have received proceeds from the sale of qualifying securities that (i) have equity-like characteristics that are the same as, or more equity-like than, the applicable characteristics of the relevant junior subordinated debt securities at the time of redemption or repurchase, and (ii) the Corporation has obtained prior approval of the Federal Reserve Board, if such approval is then required by the Federal Reserve Board.
As of the date of this Annual Report, the Corporations 5.35% Subordinated Notes, due May 1, 2014, is the series of long-term indebtedness whose holders are entitled to the benefits of the replacement capital covenants.
The Company enters into interest rate swap agreements in order to manage interest rate exposure. In most cases, this exposure is related to the funding of fixed rate assets with floating rate obligations, including off-balance sheet securitizations. The Company also enters into forward foreign currency exchange contracts to reduce sensitivity to changing foreign currency exchange rates. The hedging of foreign currency exchange rates is limited to certain intercompany obligations related to international operations. These derivatives expose the Company to certain credit risks. The Company has established policies and limits, as well as collateral agreements, to manage credit risk related to derivative instruments.
In April 2006, the Company entered into derivative instruments to mitigate certain exposures it faced as a result of the expected acquisition of North Fork. The position was designed to protect the Companys tangible capital ratios from falling below a desired level. The Companys maximum negative exposure was expected to be no more than approximately $50 million. The derivative instruments expired out of the money and unexercised on October 2, 2006.
Additional information regarding derivative instruments can be found on pages 127-130 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 23.
IX. Market Risk Management
Interest Rate Risk
The management of interest rate risk, or the risk that earnings will be diminished by changes in interest rates, is fundamental for banking institutions. Like other banks, the Company borrows money from other institutions and depositors, which it uses to make loans to customers and invest in debt securities and other earning assets. The Company earns interest on these loans and assets and pays interest on the money it borrows from institutions and depositors. If the rate of interest it pays on its borrowings and deposits increases more than the rate of interest it earns on its assets, the Companys net interest income, and therefore its earnings, will be diminished. The Companys earnings could also be negatively impacted if the interest rates it charges on its earning assets fall more quickly than the rates it pays on its borrowings and deposits. Changes in interest rates and competitor responses to those changes may affect the rate of customer pre-payments for mortgages and auto and installment loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on its earning asset portfolio. Changes in interest rates and competitor responses to these changes may also impact customer decisions to maintain balances in the deposit accounts they have with the Company. These changes may require the Company to replace withdrawn balances with higher cost alternative sources of funding.
In addition to the impact to current earnings, interest rate risk also refers to changes in the net present value of assets and off-balance sheet positions less liabilities (termed economic value of equity) due to interest rate changes. Economic value of equity could be affected to the extent that the market value of the Companys assets, liabilities and off-balance sheet positions do not respond equally to changes in interest rates.
The Companys measurement of interest rate risk considers both earnings and market value exposures. The consolidated balance sheet and all off-balance sheet positions are included in the analysis. The analysis reflects known balances and contractual maturities when available. Balance sheet positions lacking contractual maturities and those with a likelihood of maturity prior to their contractual term are assumed to mature consistent with business line expectations or, when available in the case of marketable securities, market expectations. As of December 31, 2006, the Companys Asset/Liability Management Policy limited the change in projected 12-month net interest income due to instantaneous parallel rate shocks of +/-200 basis points to less than 3% of base net interest income. As of December 31, 2006 the Company estimated a 1.6% reduction in 12-month net interest income for an immediate 200 basis point rate increase and a 0.5% reduction in 12-month net interest income for an immediate 200 basis point rate decline.
In addition to limits related to possible changes in 12-month net interest income, as of December 31, 2006 the Asset/Liability Management Policy limited the pre-tax change in economic value of equity due to instantaneous parallel rate shocks of 200 basis points to less than 12%. As of December 31, 2006, the estimated reduction in economic value of equity due to an adverse 200 basis point rate shock was 3.9%.
The Company has revised its Asset/Liability Management Policy effective January 31, 2007. The Company has broadened its measure of interest rate risk to include the impact to current earnings of changes in the valuation of mortgage servicing rights as a result of changes in interest rates. The Company continues to limit the decline in 12-month earnings due to an instantaneous parallel interest rate shock to less than 3% of base net interest income.
The precision of the measures used to manage interest rate risk is limited due to the inherent uncertainty of the underlying forecast assumptions. These measures do not consider the impact of the effects of changes in the overall level of economic activity associated with various interest rate scenarios. In addition, the measurement of interest rate sensitivity does not reflect the ability of management to take action to mitigate further exposure to changes in interest rates, including, within legal and competitive constraints, the repricing of interest rates on outstanding credit card loans and deposits.
The Company manages and mitigates its interest rate sensitivity through several techniques, which include, but are not limited to, changing the maturity and repricing characteristics of various balance sheet categories and by entering into interest rate derivatives.
Table 11 reflects the interest rate repricing schedule for earning assets and interest-bearing liabilities as of December 31, 2006.
Table 11: Interest Rate Sensitivity
Foreign Exchange Risk
The Company is exposed to changes in foreign exchange rates which may impact translated income and expense associated with foreign operations. In order to limit earnings exposure to foreign exchange risk, the Companys Asset/Liability Management Policy requires that material foreign currency denominated transactions be hedged. As of December 31, 2006, the estimated reduction in 12-month earnings due to adverse foreign exchange rate movements corresponding to a 95% probability is less than 1%. The precision of this estimate is also limited due to the inherent uncertainty of the underlying forecast assumptions.
The Company and the Bank are subject to capital adequacy guidelines adopted by the Federal Reserve Board (the Federal Reserve), the Savings Bank is subject to capital adequacy guidelines adopted by the Office of Thrift Supervision (the OTS), CONA and Superior are subject to capital adequacy guidelines adopted by the Office of the Comptroller of the Currency (the OCC), and North Fork Bank is subject to capital adequacy guidelines adopted by the Federal Deposit Insurance Corporation (the FDIC) (collectively the regulators). The capital adequacy guidelines require the Company, the Bank, the Savings Bank, CONA, Superior and North Fork Bank to maintain specific capital levels based upon quantitative measures of their assets, liabilities and off-balance sheet items. In addition, the Bank, Savings Bank, CONA, Superior and North Fork Bank must also adhere to the regulatory framework for prompt corrective action.
The most recent notifications received from the regulators categorized the Bank, the Savings Bank, CONA, Superior and North Fork Bank as well-capitalized. As of December 31, 2006, the Companys, the Banks, the Savings Banks, CONAs, Superiors and North Fork Banks capital exceeded all minimum regulatory requirements to which they were subject, and there were no conditions or events since the notifications discussed above that management believes would have changed either the Companys, the Banks, the Savings Banks, CONAs, Superiors or North Fork Banks capital category.
The Bank and Savings Bank treat a portion of their loans as subprime under the Expanded Guidance for Subprime Lending Programs (the Subprime Guidelines) issued by the four federal banking agencies that comprise the Federal Financial Institutions Examination Council (FFIEC), and have assessed their capital and allowance for loan losses accordingly. Under the Subprime Guidelines, the Bank and Savings Bank each exceed the minimum capital adequacy guidelines as of December 31, 2006. Failure to meet minimum capital requirements can result in mandatory and possible additional discretionary actions by the regulators that, if undertaken, could have a material effect on the Companys consolidated financial statements.
For purposes of the Subprime Guidelines, the Company has treated as subprime all loans in the Banks and the Savings Banks targeted subprime programs to customers either with a FICO score of 660 or below or with no FICO score. The Bank and the Savings Bank hold on average 200% of the total risk-based capital charge that would otherwise apply to such assets. This results in higher levels of regulatory capital at the Bank and the Savings Bank.
Additionally, regulatory restrictions exist that limit the ability of the Bank, Savings Bank, CONA, North Fork Bank and Superior to transfer funds to the Corporation. As of December 31, 2006, retained earnings of the Bank, the Savings Bank, CONA, North Fork Bank and Superior of $142.2 million, $362.0 million, $101.2 million, $37.5 million and $0.4 million, respectively, were available for payment of dividends to the Corporation without prior approval by the regulators.
Additional information regarding capital adequacy can be found on pages 119-121 in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 19.
Although the Company expects to reinvest a substantial portion of its earnings in its business, the Company also intends to continue to pay regular quarterly cash dividends on its common stock. The declaration and payment of dividends, as well as the amount thereof, are subject to the discretion of the Board of Directors of the Company and will depend upon the Companys results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. Accordingly, there can be no assurance that the Corporation will declare and pay any dividends. As a holding company, the ability of the Corporation to pay dividends is dependent upon the receipt of dividends or other payments from its subsidiaries. Applicable banking regulations and provisions that may be contained in borrowing agreements of the Corporation or its subsidiaries may restrict the ability of the Corporations subsidiaries to pay dividends to the Corporation or the ability of the Corporation to pay dividends to its stockholders.
XI. Business Outlook
This business outlook section summarizes the Companys expectations for earnings for 2007, and its primary goals and strategies for continued growth. The statements contained in this section are based on managements current expectations and do not take into account any acquisitions that might occur during the year. Certain statements are forward looking, and therefore actual results could differ materially from those in the Companys forward looking statements. Factors that could materially influence results are set forth throughout this section and in Item 1A BusinessRisk Factors.
The Company expects to deliver diluted earnings per share between $7.40 and $7.80 in 2007. This guidance includes the expected impact of about $140 million in intangibles amortization and about $100 million of integration expenses both related to the acquisitions of both Hibernia and North Fork.
Inclusive in this guidance is the assumption that unsecured credit in the U.S. returns to more normal levels in 2007. In addition, the Company expects that the yield curve will remain inverted early in the year and stay relatively flat through the balance of 2007. Finally, the Company assumes that the cyclical downturn in the residential mortgage market continues into 2007, and is likely to be further impacted by the recently issued federal regulatory guidance on non-traditional mortgages.
The Companys 2007 results will also be impacted by the targeted $275 million pre-tax in net synergies, consistent with the announcement of the deal in March 2006. The Company now expects the full run-rate synergies will be realized later in 2008, and there is a reduced level of opportunity to achieve cost and revenue synergies in 2007. This is partially a result of the impact of the expected yield curve environment on near-term balance sheet synergies. It also results from the scheduling of the conversion to a single deposit platform and brand in the first quarter of 2008. This timing is driven by the interest of a smooth and effective integration.
The share count used to translate the Companys expected GAAP NIAT to earnings per share assumes the beginning of the previously announced $3 billion in share buy-backs in the second quarter of 2007. The Company previously announced its intention to execute $3 billion in share buy-backs, split evenly between the second half of 2007 and the first half of 2008. The Company now expects to start the program in the second quarter of 2007, and increase the expected portion of the share buy-back, which will occur in 2007, to approximately $2.25 billion.
The Companys earnings are a function of its revenues (net interest income and non-interest income), consumer usage, payment and attrition patterns, the credit quality and growth rate of its earning assets (which affect fees, charge-offs and provision expe