Capital One Financial 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2007.
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 June 30, 2007.
Common Stock, $.01 Par Value: $30,338,145,221*
Common Stock, $.01 Par Value: 372,984,407 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 one of the largest banks in the United States, 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 (COB) which currently offers credit and debit card products, other lending products, and deposit products; and Capital One, National Association (CONA) which offers a broad spectrum of banking products and financial services to consumers, small businesses and commercial clients. Another subsidiary of the Corporation, Superior Savings of New England, N.A. (Superior) focuses on telephonic and media-based generation of deposits. 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.
As of January 1, 2008, Capital One Auto Finance Inc. (COAF) moved from a principal subsidiary of the Corporation to become a direct operating subsidiary of CONA. COAF offers automobile and other motor vehicle financing products.
In the third quarter of 2007, the Company shut down the mortgage origination operations of its wholesale mortgage banking unit, GreenPoint Mortgage (GreenPoint), an operating subsidiary of CONA. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 2Discontinued Operations.
As of December 31, 2007, we had $83.0 billion in deposits and $151.4 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 10th 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 COB organized and located in the United Kingdom (the U.K. Bank), and through a branch of COB in Canada. Our U.K. Bank has authority, among other things, to accept deposits and provide credit card and installment loans.
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 of the Board of Directors. 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 to the SEC.
Capital One is one of the largest banks in the United States. We are a diversified banking corporation focused primarily on consumer and commercial lending and deposit origination. Our principal business segments are Local Banking and National Lending. Local Banking includes consumer, small business and commercial deposits and lending conducted within its branch network. The National Lending segment consists of three sub-segments: the U.S. Card sub-segment which consists of domestic consumer credit and debit card activities; the Auto Finance sub-segment which includes automobile and other motor vehicle financing activities; the Global Financial Services sub-segment consisting of international lending activities, small business lending, installment loans, home loans,
healthcare financing and other diversified activities. For further discussion of our segments, see Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsReportable Segment Summary and Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 4.
Local Banking Segment. The Local Banking segment represents the results of the legacy North Fork and Hibernia business lines except for the Hibernia and North Fork indirect auto businesses, which are included in the Auto Finance sub-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. The Banking segment offers traditional banking products through an extensive branch network in Connecticut, Louisiana, New Jersey, New York, and Texas. 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.
U.S. Card Sub-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 products that appeal to different and changing consumer preferences. Our customized products include 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 Sub-segment. We purchase retail installment contracts, secured by new and used 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, 2007, we are the third largest non-captive provider of auto financing in the United States.
Global Financial Services Sub-segment. The Global Financial Services segment consists of international (U.K. 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 methodologies and approaches similar to those we use in the United States.
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 Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 26 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 our management of liquidity, capital and financial risks.
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 (i) identify and assess risk; (ii) analyze and aggregate risk; (iii) facilitate and support mitigation reporting; (iv) and 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 and progress is monitored against the response plans. For significant risks reported to the senior management committees and the
Board, specific executives are designated as accountable for the management and monitoring process. Across the Company, individual business areas utilize Business Risk Offices staffed by business associates to 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 identifies 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. The Credit Policy Committee also has sub-committees which provide credit oversight at the divisional level. The Chief Credit Officers or their staff review and approve all large scale new credit decisions or programs. Smaller credit decisions are made by credit officers approved by the credit committee(s). 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 environments, 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 Credit Risk Management group monitors the overall composition and quality of our credit portfolio.
Our credit risk profile is managed to maintain resilience to factors outside of our control, strong risk-adjusted returns, and 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. 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 ensure 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 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 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 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 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 of 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 company holds operational risk capital, intended to ensure capital adequacy to withstand extreme events, and to create incentives for business areas to improve their control environments. Operational risk capital is determined through a statistical modeling process that leverages internal loss history, self assessment results, external loss data, and structured scenarios.
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 that Capital One fails to achieve short and long term business objectives as a direct result of a failure to develop the products, capabilities and competitive position necessary to attract and profitably serve consumers, be competitive and withstand market volatility, the result being a failure to deliver returns expected by stakeholders. 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, or possible divestitures or exiting of businesses.
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, rulings, regulations and applicable supervisory guidance. Generally, compliance risk occurs when there are errors or omissions in the companys operating processes. Our business area executives are responsible for allocating sufficient resources to ensure the development and maintenance of compliant operating processes. The Chief Compliance Officer is responsible for ensuring that systems, processes, and personnel are in place to provide reasonable assurance we are in substantive compliance on a day to day basis. This includes measuring compliance risk and working with business areas to prevent or mitigate possible compliance issues, errors, or violations. Compliance results and trends are discussed in a variety of management forums such as the Risk Management Committee and its Compliance sub-committee.
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. The subsequent transition of the North American portfolio to the TSYS platform was completed in 2007. Work is now underway to migrate our United Kingdom credit card portfolio to the European version of the
TSYS processing platform during the first quarter of 2008. 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.
Planning is complete for North Fork Banks integration into Capital Ones existing technology infrastructure, and we expect to complete the conversion of the majority of North Forks systems in 2008.
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.
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. In addition, our industry has experienced substantial consolidation and may continue to do so; 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.
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, 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 business.
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.
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 and competition. 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, 2007, we employed approximately 27,000 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 a proper 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 COB, CONA, 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.
COB 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 COBs international operations (discussed below), COB 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. The Corporation plans to convert COB to a national association in the first quarter of 2008. The new name of COB will be Capital One Bank (USA), National Association. As a national association, COB will be regulated primarily by the OCC and its deposits will continue to be insured by the Deposit Insurance Fund of the FDIC up to applicable limits. For further discussion regarding OCC regulation, Item 1 FFIEC Account Management Guidance.
CONA is a national association, the deposits of which are insured by the Deposit Insurance Fund of the FDIC up to applicable limits. On January 1, 2008, COAF, which engages in automobile financing activities, became a wholly owned subsidiary of CONA. In connection with the COAF reorganization, which included the transfer of approximately $10 billion in assets, certain COAF subsidiaries, holding approximately $14 billion in assets, remain subsidiaries of COFC.
Superior is a national association, the deposits of which are insured by the Deposit Insurance Fund of the FDIC up to applicable limits. Subject to receipt of all required approvals, the Corporation plans to merge Superior with and into CONA in the first quarter of 2008.
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 Corporation also faces regulation in the international jurisdictions in which it conducts business (see below under International Regulation).
In addition to the CONA and Superior merger, the Corporation plans additional consolidations to streamline its operations.
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. In addition, under Virginia law, the Bureau of Financial Institutions may limit the payment of dividends by COB if the Bureau of Financial Institutions determines that such a limitation would be in the public interest and necessary for COBs 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 Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsCapital Adequacy and Item 8 Financial Statements and Supplementary DataNote 20Regulatory Matters. The Banks were well capitalized under these guidelines as of December 31, 2007.
In late 2007, the federal banking regulators published their final 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. The new capital regime is not currently mandatory for the Company, but could become so as we grow, in particular as our non-U.S. business grows. Application of the new capital rules could require us to increase the minimum level of capital that we hold. We will continue to closely monitor regulators implementation of the new rules with respect to the large institutions that are subject to it and assess the likely eventual 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, 2007, 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.
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 COB 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, 2007 COB 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 COB or CONA may not be required to hold additional regulatory capital against such assets.
For purposes of the Guidelines, we treat as subprime all loans in COBs programs that are targeted at customers either with a Fair, Isaac and Company (FICO) score of 660 or below or with no FICO score. COB holds on average 200% of the total risk-based capital requirement that would otherwise apply to such assets.
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 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 loans.
We believe that our 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.
Upon conversion of COB to a national association, COB will implement the OCCs minimum payment requirements over the course of this year, which will require COB to utilize a new formula to calculate minimum payment amounts for its credit card customer base. The new formula will increase minimum payment amounts under some circumstances, which could result in an increase in delinquencies and defaults, as well as an increase in the allowance for loan losses, for COBs credit card portfolio. In addition, the new requirements may adversely impact fee revenue.
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. In May 2007, the Federal Reserve issued proposed rules under the Truth-in-Lending Act; there can be no assurance that such regulations, when final, will not have an adverse impact on us.
Privacy and Fair Credit Reporting
The Gramm-Leach-Bliley Act (GLBA) requires a financial institution to describe in a privacy notice certain of its privacy and data collection practices and requires that customers or consumers, before their nonpublic personal information is shared with nonaffiliated third parties, be given a choice (through an opt-out notice) to limit the sharing of such information about them with nonaffiliated third persons unless the sharing is required or permitted under the GLBA as implemented. The Corporation and the Banks have written privacy notices that are available through the web site of the Corporation, the relevant legal entity, or both, and are delivered to consumers and customers when required under the GLBA. In accordance with the privacy notices noted above, the Corporation and the Banks protect the security of information about their customers, educate their employees about the importance of protecting customer privacy, and allow their customers to remove their names from the solicitation lists they use and share with others to the extent they use or share such lists. The Corporation and the Banks require business partners with whom they share such information to have adequate security safeguards and to abide by the redisclosure and reuse provisions of the GLBA. To the extent that the GLBA and the FCRA require the Corporation or one or more of the Banks to provide customers and consumers the opportunity to opt out of sharing information, then the relevant entity or 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 or the OCC, 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, COB 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. Capital One Asset Management, LLC, Capital One Securities, LLC (d/b/a Capital One Investments, LLC), and North Fork Financial Advisors, L.L.C. are registered investment advisers regulated under the Investment Advisers Act of 1940. Capital One Asset Management provides investment advice to investment companies subject to regulation under the Investment Company Act of 1940. Amivest Corporation, a registered investment advisor, ceased operations on December, 31, 2007.
Capital One Securities, LLC, Capital One Southcoast Capital, Inc., and NFB Investment Services Corporation are registered broker-dealers regulated by the Securities and Exchange Commission (the SEC) and the Financial Industry Regulatory Authority. In addition, Capital One Securities, LLC and Capital One 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. As part of our efforts to streamline our operations, we intend to merge Capital One Securities, LLC and NFB Investment Services Corporation later in 2008.
NFB Agency Corporation (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 mechanisms for the U.S. government, including due diligence requirements for financial institutions to detect and report money laundering through private banking and correspondent accounts; 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; reporting requirements applicable to the receipt of coins and currency of more than $10,000 in nonfinancial trades or businesses; and suspicious activities reporting requirements applicable to brokers and dealers.
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 that prohibit correspondent accounts for foreign shell banks at U.S. financial institutions; require financial institutions to maintain certain records relating to correspondent accounts for 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 proposed that could significantly restrict mortgage lending; other legislation has been proposed that could restrict the practice of charging convenience overdraft fees on deposit accounts. Several hearings have been held in Congress on credit card practices which could lead to legislation restricting credit card practices or mandating additional disclosures. Yet other pending legislation could expand the privacy protections afforded to customers of financial institutions. It is unclear at this time whether and in what form any legislation will be adopted or, if adopted, what its impact on COB, CONA, or the Corporation 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 that we believe place 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 our internal control processes, any material weaknesses. 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 that 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.
COB faces regulation in foreign jurisdictions where it currently operates. Those regulations may be similar to or substantially different from the regulatory requirements COB faces in the United States. In the United Kingdom, COB 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 also has 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. Effective January 1, 2008, the U.K. Bank has become subject to new capital adequacy requirements implemented by the FSA as a result of the U.K.s adoption of the European Capital Requirements Directive, itself an implementation of the Basel II Accord. The U.K. Bank obtains capital through earnings or through additional capital infusion from COB, 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 on favorable terms, it may choose to restrict its growth to reduce the regulatory capital required. Following the introduction of the Capital Requirements Directive, the U.K. Bank continues to have a healthy capital surplus and the impact of the new capital regime has been fully factored into the U.K. Banks financial and capital planning. In addition, the U.K. Bank is limited by the U.K. Companies Act1985 in its distribution of dividends to COB 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 us (or the interpretations of existing laws by relevant regulators) may change in ways that adversely impact our business. The OFT is investigating Visas and MasterCards current methods of setting interchange fees applicable to U.K. domestic transactions. Cross-border interchange fees are also coming under scrutiny from the European Commission, which in December 2007 issued a decision notice stating that MasterCards interchange fees applicable to cross border transactions are in breach of European Competition Law. A similar decision is expected in relation to Visas cross border interchange fees. While there is not expected to be a final determination of the OFTs case before the end of 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 present it is not believed that these changes will have a material impact on the U.K. Banks business model.
Finally, we were 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. Following subsequent thematic work in this area, the FSA noted that the U.K. Bank improved significantly in a number of areas and that the FSA did not have any major concerns at this time.
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.
This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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, but are not limited to 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 forward-looking statements. Many of the factors that will determine these results and values are beyond our ability to control or predict. Forward-looking statements speak only as of the date that they are made, and 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. Although we have tried to discuss all material risks, 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 Face Risk From Economic Downturns
Credit markets experienced difficult conditions and volatility during 2007. As a bank, Capital Ones operations and financial condition are affected by general economic and market conditions. Delinquencies and credit losses have risen recently, partially as a result of a weakening economy and more distress among borrowers. Continued economic weakness may hurt our financial performance as customers default on their loans or, in the case of credit card accounts, carry lower balances and reduce credit card purchase activity. A continued economic downturn could have a material adverse effect on our financial condition and results of operations.
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, which may degrade our profitability if we are unable to raise revenue or reduce costs to compensate for higher losses. 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 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 Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsInterest Rate Risk Management for additional information.
We May Fail To Realize All of the Anticipated Benefits of our Merger
The success of our merger with North Fork will depend, in part, on our ability to realize the anticipated benefits from combining the businesses of Capital One (including the legacy business of Hibernia Corporation) and North Fork. If we are not able to achieve the objectives of the North Fork integration, the anticipated benefits of the merger, 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 merger. Integration efforts also may continue to divert management attention and resources. These integration matters may have an adverse effect on the Company 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. We face the risk that we will not be successful in these new businesses in these new markets.
In addition, as we continue the integration of North Fork, we face the challenge of combining the cultural and historical identities of institutions that previously operated independently. We face the risk that we will not be able to successfully integrate their commercial and local retail lending culture 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.
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, 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 the Company 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. Any increase in the amount of our infrastructure that we outsource to third parties may 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. Substantial legal liability against the Company could have a material adverse financial effect or cause significant reputational harm to us, which could seriously harm our business. For a full description of the litigation risks that we face in connection with the structure of our industry, please refer to Industry Litigation in Item 8 Financial Statements and Supplementary DataNotes to the Financial StatementsNote 21.
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 in Item 1. 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. For example, in 2007 the credit card and mortgage industries have faced increased legislative scrutiny. Adverse reputational impacts or events also may increase our litigation risk. See The Credit Card Industry Faces Increased Litigation Risks Relating to Industry Structure.
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 businesses 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 securitize a portion of 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 Item 7 Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity Risk Management.
Our Stock Price May be Volatile
Capital Ones stock price has been volatile in the past and several factors could cause the price to fluctuate significantly in the future. These factors may be unrelated to our performance. General market price declines or market volatility in the future, including the impact of cyclical economic slowdowns, could adversely affect the market price of our stock.
Our real estate portfolio is used to support all of our business segments. We own the 570,000 square foot headquarters building located at 1680 Capital One Drive in McLean, Virginia. The building is located on a 31 acre land parcel and houses our executive offices and Northern Virginia staff.
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. The Company has seven office buildings, a support facility and a training center 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, approximately 450,000 square feet in locations across Richmond, Virginia; Toronto, Canada; and the United Kingdom.
Our Local Banking segments office and branch operations are conducted primarily utilizing approximately 3.4 million square feet in owned properties and 3.7 million square feet in leased locations across Louisiana, New Jersey, New York and Texas. Portions of the office portfolio are sub-leased where internal demand permits. Additionally, to support our mortgage and Home Loan businesses, we lease facilities totaling approximately 310,600 square feet in California and Kansas. We also own a property of approximately 35,000 square feet in Columbus, Georgia.
Within our National Lending segment, our Auto Finance business occupies just over 700,000 square feet of leased office space in various locations including California, Florida, Georgia, Illinois, Louisiana, Michigan, Oklahoma and Pennsylvania, with the majority of such space in Texas. An additional 73,000 square feet of leased space in Boston and Framingham, Massachusetts supports other National Lending businesses.
The information required by Item 3 is included in Item 8, Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 21.
During the fourth quarter of our fiscal year ending December 31, 2007, 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, 2002 to December 31, 2007. 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.
As of January 1, 2008, Capital One Auto Finance (COAF) moved from a principal subsidiary of the Corporation to become a direct operating subsidiary of CONA. COAF offers automobile and other motor vehicle financing products.
During 2007, Capital One F.S.B. and North Fork Bank merged with and into CONA.
In the third quarter of 2007, the Company shut down the mortgage origination operations of its wholesale mortgage banking unit, GreenPoint Mortgage (GreenPoint), an operating subsidiary of CONA. Additional information can be found in Item 8Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 2Discontinued Operations.
The Corporation and its subsidiaries are hereafter collectively referred to as the Company.
The Company continues to deliver on its strategy of combining the power of national scale lending and local scale banking. As of December 31, 2007, the Company had $83.0 billion in deposits and $151.4 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, interest 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.
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.
Commercial and small business loans are considered to be impaired in accordance with the provisions of Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, (SFAS 114) when it is probable that all amounts due in accordance with the contractual terms will not be collected. Specific allowances are determined in accordance with SFAS 114. Impairment is measured based on the present value of the loans expected cash flows, the loans observable market price or the fair value of the loans collateral.
For purposes of determining impairment, consumer loans are collectively evaluated as they are considered to be comprised of large groups of smaller-balance homogeneous loans and therefore are not individually evaluated for impairment under the provisions of SFAS 114.
As of December 31, 2007 and 2006, the balance in the allowance for loan and lease losses was $3.0 billion and $2.2 billion, respectively.
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.
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 amount, including goodwill. If the fair value is less than the carrying amount, 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 amount of goodwill recorded within the reporting unit. If the carrying amount 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.
Other intangible assets having finite useful lives are separately recognized and amortized over their estimated useful lives.
As of December 31, 2007 and 2006, goodwill of $12.8 billion and $13.6 billion and net intangibles of $1.1 billion and $1.3 billion, respectively, were included in the Consolidated Balance Sheet.
The Company recognizes earned finance charges and fee income on credit card 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 credit card finance charge and fee receivables using a formula based on an estimate of future non-principal losses. 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 $1.1 billion and $0.9 billion for the years ended December 31, 2007 and 2006, respectively.
Nonperforming Assets include nonaccrual loans, impaired loans, certain restructured loans on which interest rates or terms of repayment have been materially revised, foreclosed and repossessed assets.
Commercial loans, consumer real estate and auto loans are placed in nonaccrual status at 90 days past due or sooner if, in managements opinion, there is doubt concerning full collectibility of both principal and interest. All other consumer loans and small business credit card loans are not placed in nonaccrual status prior to charge-off.
At the time a loan is placed on nonaccrual status, interest and fees accrued but not collected through the end of the previous quarter are systematically reversed and charged against income. Interest payments received on nonaccrual loans are applied to principal if there is doubt as to the collectibility of the principal; otherwise, these receipts are recorded as interest income. A loan remains in nonaccrual status until it is current as to principal and interest and the borrower demonstrates the ability to fulfill the contractual obligation.
Upon foreclosure or repossession, loans are adjusted, if necessary, to the estimated fair value of the underlying collateral and transferred to other assets, net of a valuation allowance for selling costs. We estimate market values primarily based on appraisals when available or quoted market prices on liquid assets.
Valuation of Mortgage Servicing Rights
Mortgage Servicing Rights (MSRs), are recognized when mortgage loans are sold in the secondary market and the right to service these loans are retained for a fee, and are carried at fair value; changes in fair value are recognized in mortgage servicing and other income. The Company continues to operate the mortgage servicing
business and to report the changes in the fair value of MSRs in continuing operations. To evaluate and measure fair value, the underlying loans are stratified based on certain risk characteristics, including loan type, note rate and investor servicing requirements. 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.
As of December 31 2007 and 2006, the MSR balance was $247.6 million and $252.3 million, respectively.
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. 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 certain 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, actual losses incurred. Quarterly changes to the representation and warranty reserve related to GreenPoint are reported as discontinued operations for all periods presented.
As of December 31, 2007 and 2006, the representation and warranty reserve was $93.4 million and $156.0 million, respectively.
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. Gains on securitization transactions, fair value adjustments related to residual interests and earnings on the Companys securitizations are included in servicing and securitizations income in the Consolidated Statements of Income and amounts due from the trusts are included in accounts receivable from securitizations on the Consolidated Balance Sheets.
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, 2007 and 2006, the retained interest related to securitization transactions totaled $2.3 billion and $2.2 billion, respectively.
Recognition of Customer Rewards Liability
The Company offers products, primarily credit cards, that provide program members with various rewards such as airline tickets, free or deeply discounted products or cash rebates, based on account activity. 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 primarily 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, 2007 and 2006, the rewards liability was $1.3 billion and $1.1 billion, respectively.
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 offsetting the repricing or maturity characteristics of certain balance sheet assets and liabilities, thereby limiting the impact on earnings. The use of derivative instruments does expose the Company to credit and market risk. 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, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities. 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. The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, (FIN 48) effective January 1, 2007. As a result of adoption, the Company recorded a $29.7 million reduction in retained earnings. The reduction in retained earnings upon adoption is the net impact of a $46.5 million increase in the liability for unrecognized tax benefits and a $16.8 million increase in deferred tax assets. In addition, the Company reclassified $471.1 million of unrecognized tax benefits from deferred tax liabilities to current taxes payable to conform to the deferred tax measurement and balance sheet presentation requirements of FIN 48.
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 years ended December 31, 2007 and 2006, the provision for income taxes on continuing operations was $1.3 billion and $1.2 billion, respectively, and as of December 31, 2007 and 2006, the valuation allowance was $21.3 million and $14.6 million, respectively.
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 $48.9 billion and $49.0 billion as of December 31, 2007 and 2006, respectively, 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 2008 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 Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 24 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 Item 8 Financial Statements and Supplementary
DataNotes to the Consolidated Financial StatementsNote 24 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 Company 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, 2007, 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, 2007 that are expected to amortize into the Companys consumer loans, or be otherwise paid over the periods indicated, are summarized in Table 11. Of the Companys total managed loans, 33% and 34% were included in off-balance sheet securitizations for the years ended December 31, 2007 and 2006, respectively.
Letters of Credit
The Company issues letters of credit (financial standby, performance standby and commercial) to meet the financing needs of its customers. Standby letters of credit 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 letters of credit and customer acceptances, and the results of these reviews are considered in assessing the adequacy of the Companys allowance for loan and lease 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.
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, 2007
V. Management Summary and Business Outlook
In the third quarter of 2007, the Company shut down the mortgage origination operations of its wholesale mortgage banking unit, GreenPoint, resulting in an after-tax loss from discontinued operations of $1.0 billion for the year ended December 31, 2007. GreenPoint was acquired by the Company in December 2006 as part of the North Fork Bancorporation acquisition. The results of the mortgage origination operations of GreenPoint have been accounted for as discontinued operations and, accordingly, separately disclosed from the Companys results of continuing operations for 2007 and 2006. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 2Discontinued Operations.
The following discussion provides a summary of 2007 results compared to 2006 results and 2006 results compared to 2005 results on a continuing operations basis, unless otherwise noted. Each component is discussed in further detail in subsequent sections of this analysis.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Net income was $1.6 billion, or $3.97 per share (diluted) for 2007, compared to $2.4 billion, or $7.62 per share (diluted) for 2006. Net income for 2007 included an after-tax loss from discontinued operations of $1.0 billion, or $2.58 per share (diluted), compared to an after-tax loss from discontinued operations of $11.9 million, or $0.03 per share (diluted) in 2006.
Income from continuing operations for 2007 was $2.6 billion, an increase of $165.3 million, or 7% from 2006. Diluted earnings per share from continuing operations for 2007 was $6.55, a decrease of 14% from $7.65 in 2006.
Results from continuing operations for 2007 include:
2007 Summary of Significant Events
Shut down of Mortgage Origination Operations of Wholesale Mortgage Banking Unit
See Discontinued Operations above. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 2Discontinued Operations.
Restructuring Charges Associated with Cost Initiative
During the second quarter of 2007, we announced a broad-based initiative to reduce expenses and improve our competitive cost position. We recognized $138.2 million in restructuring charges in 2007. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 22Restructuring.
During 2007, we executed a $3.0 billion stock repurchase program, resulting in a net share retirement of 43,717,110 shares. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 16Accelerated Share Repurchase Program and Part 2, Item 5. Market for Companys Common Equity and Related Stockholder Matters.
Litigation Settlements and Reserves
During the fourth quarter of 2007, we recognized a pre-tax charge of $79.8 million for liabilities in connection with the antitrust lawsuit settlement with American Express. Additionally, we recorded a legal reserve of $59.1
million for estimated possible damages in connection with other pending Visa litigation, reflecting our share of such potential damages as a Visa member. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 21Commitments, Contingencies and Guarantees and Part 1, Item 3. Legal Proceedings.
Sale of Interest in Spain
During 2007, the Company completed the sale of its interest in a relationship agreement to develop and market consumer credit products in Spain and recorded a net gain related to this sale of $31.3 million consisting of a $41.6 million increase in non-interest income partially offset by a $10.3 million increase in non-interest expense.
Gain on Sale of MasterCard Shares
As a result of MasterCards IPO in 2006, Capital One owned class B shares of MasterCard common stock, with sale restrictions that were originally scheduled to expire on May 31, 2010. In 2007 shareholders approved an amendment to the MasterCard Certificate of Incorporation that provides for an accelerated conversion of class B common stock into class A common stock. The MasterCard Board of Directors approved a conversion window running from August 4 to October 5, 2007, during which time owners of class B shares may voluntarily elect to convert and sell a certain number of their shares. During the conversion period, Capital One elected to convert and sell 300,482 shares of MasterCard class B common stock. The Company recognized gains of $43.4 million on these transactions in non-interest income.
Gain on Sale of Securities
In 2001 we acquired a 7% stake in the privately held company DealerTrack, a leading provider of on-demand software and data solutions for the automotive retail industry. DealerTrack went public in 2005. During the first quarter of 2007 we sold our remaining interest of 1,832,767 shares for $52.2 million resulting in a pre-tax gain of $46.2 million in non-interest income.
Senior Note Issuance
During the third quarter 2007, we closed the public offering of $1.5 billion aggregate principal amount of our Senior Notes Due 2017 (the Notes). The Notes were issued pursuant to a Senior Indenture dated as of November 1, 1996 (the Indenture) between the Corporation and The Bank of New York Trust Company, N.A. (as successor to Harris Trust and Savings Bank), as Indenture Trustee. Proceeds from the sale of the notes will be used for general corporate purposes, which may include repurchases of shares of our common stock. Additional information can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 9Borrowings and Part 2, Item 7, Section VIII. Funding.
Acceleration of Equity Awards
During the second quarter of 2007, a charge of $39.8 million was taken against salaries and associate benefits. This charge was taken as a result of the accelerated vesting of equity awards in conjunction with the transition of the Banking leadership team, consistent with the terms of the awards. This charge is not included as a restructuring charge associated with our 2007 cost initiative.
We recognized a $69.0 million one-time tax benefit in the second quarter of 2007 resulting from previously unrecognized tax benefits related to our international tax position. In addition, we recognized a $29.7 million reduction in retained earnings associated with the adoption of FIN 48 in 2007.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net income was $2.4 billion, or $7.62 per share (diluted) for 2006, compared to $1.8 billion, or $6.73 per share (diluted) for 2005. Net income for 2006 included an after-tax loss from discontinued operations of $11.9 million, or $0.03 per share (diluted).
Income from continuing operations for 2006 was $2.4 billion, an increase of $617.2 million, or 34% from 2005. Diluted earnings per share from continuing operations for 2006 were $7.65, an increase of 14% from 2005.
Results from continuing operations for 2006 include:
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. The total consideration for the acquisition was $13.2 billion.
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 103.8 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 junior subordinated debentures and $3.2 billion of senior and subordinated debt.
Debt Issuance to fund North Fork Acquisition
In June 2006, the Company issued $345.0 million aggregate principal amount of 7.5% junior subordinated debentures that are scheduled to mature on June 15, 2066. For regulatory capital purposes the debentures 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 issued $650.0 million aggregate principal amount of 7.686% junior subordinated debentures that are scheduled to mature on August 15, 2036. For regulatory capital purposes the debentures 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 SFAS 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 2006 the Company sold a number of Treasury and Agency securities realizing a loss of $34.9 million in non-interest expense.
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 discontinued operations. 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 discontinued operations.
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 Local Banking segment include the reversal of this allowance.
The statements contained in this section are based on our current expectations. Certain statements are forward looking statements within the meaning of the Private Securities Litigation Reform Act. Actual results could differ materially from those in our forward looking statements. Factors that could materially influence results are set forth throughout this section and in Item 1A Risk Factors.
Like all banks, Capital One faces continuing cyclical challenges in 2008. The Company believes that its strong balance sheet and experience in managing through prior economic cycles position the Company to successfully navigate the current challenges. Expectations for 2008 results include:
The Company expects that returns in 2008 will likely be pressured by credit headwinds as the economy weakens. The Company believes that its strong balance sheet, resilient businesses, and actions to navigate the current challenges will position the Company for a strong rebound when economic and credit cycles turn favorable.
In the Local Banking segment, the Company expects to maintain caution in underwriting both consumer and commercial loans in the current economic cycle. The Company also expects the intense competitive environment for deposits to continue in 2008. As a result, the Company expects loan growth rate and deposit growth rate in the low single digits in its Local Banking segment in 2008.
Planning is complete for North Fork Banks integration into Capital Ones existing technology infrastructure, and we expect to complete the conversion of the majority of North Forks systems in 2008. The Local Banking business is on track to convert to a single deposit platform and brand in the first quarter of 2008. While, integration and systems conversions may result in an elevation in Local Banking operating expense in the first half of 2008, the Company expects that the longer term trend of improving operating efficiency will resume in the second half of 2008.
In the National Lending businesses, the Company faces several challenges that may pressure results, including weakening consumer credit and uncertainty regarding the consumer economy.
In the U.S. Card sub-segment, the Company expects the competitive environment to remain challenging. The Company expects U.S. Card revenue margins to decline from 4th quarter levels in the first quarter of 2008, and to be in the high-teens throughout 2008. There are several reasons for the expected decline. First, the Company expects to assess fewer fees as customers continue to adjust to pricing and fee policies implemented in the second half of 2007. Also, the Company plans to implement additional fee policy adjustments in the first quarter, such as a more generous and targeted fee waiver policy, which will reduce fee revenues somewhat. Finally, the Company expects an increase in introductory rate assets in the U.S. Card portfolio as it pursues targeted opportunities with superprime revolver customers. Despite the modestly lower revenue margins which result from these factors, the Company remains confident that continued strong revenue margins well enable the U.S. Card business to weather cyclical economic pressures.
The Company expects the U.S. Card managed charge-off rate to be in the mid-6% range in the first half of 2008, consistent with delinquencies through the latter half of 2007.
The Company continues to take actions to further strengthen resiliency and sustain well-above hurdle financial returns in the face of cyclical credit challenges. For example, the Company specifically designs product structures and tightly manages credit lines appropriate to each part of the credit risk spectrum. The Company maintains a prudent and measured approach to underwriting and marketing. In 2008, the Company expects little to no loan growth in U.S. Card, and no material change in the mix of the U.S. Card portfolio. The Company has increased collections capacity and intensity early in the current credit cycle. Finally, the Company continues to pursue process and efficiency improvements, leveraging the new infrastructure platform implemented successfully in 2007.
In the Auto Finance sub-segment, the Company has started to scale back lending across the credit spectrum. In the dealer prime business, the Company is focusing on a selective network of dealers with whom it has established deep relationships and who have historically produced better credit and profit performance.
The Auto Finance business is focused on originating loans with better credit characteristics by tightening underwriting and steering originations upmarket within both the subprime and prime parts of the market. In subprime, the Company has stopped originating loans to the riskiest sub-segments, essentially exiting the riskiest
25% of subprime. In prime, the Company has largely exited the so-called near prime space, which has resulted in an improvement in the average FICO scores of prime originations. Today, the average FICO scores of prime originations are 30 points better than prime originations from the fourth quarter of 2006, and 70 points better than prime originations from the fourth quarter of 2005.
The Company believes that significantly reduced originations, a smaller portfolio with better credit characteristics, improved pricing, and aggressive management of operating expenses should combine to help the auto finance business achieve better financial returns in 2008. Lower loan balances, however, may temporarily put upward pressure on metrics like charge-off and delinquency rates, even if actual trends in charge-off and delinquency dollars are improving. The Company will continue to monitor the performance of the auto finance business carefully, and expects to adjust quickly in line with rapidly changing market conditions.
In the Global Financial Services (GFS) sub-segment, North American GFS businesses are generally expected to experience similar trends as in the U.S. Card sub-segment. The Company remains cautious in its outlook for the U.K. and Canada, given the risk that U.S. economic pressures could spread to other parts of the world.
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, 2007, 2006 and 2005.
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.
The following discussion provides a summary of 2007 results compared to 2006 results and 2006 results compared to 2005 results on a continuing operations basis, unless otherwise noted. Each component is discussed in further detail in subsequent sections of this analysis.
Net interest income
Net interest income is comprised of interest income earned on securities and interest income and past-due fees earned and deemed collectible from the Companys loans, less interest expense on interest-bearing deposits, senior and subordinated notes, and other borrowings.
For the year ended December 31, 2007, reported net interest income increased 28%, or $1.4 billion. The increase in net interest income was driven by the acquisition of North Fork, modest loan growth, and increased margins in the U.S. Card sub-segment due to selective pricing changes implemented after the completion of our card holder system conversion in 2007. Net interest margin decreased 68 basis points for the year ended December 31, 2007, primarily due to the addition of the lower net interest margin North Fork business.
For the year ended December 31, 2006, reported net interest income increased 38%, or $1.4 billion, compared to 2005 inclusive of $135.1 million from the North Fork acquisition. The increase was due to a 51% increase in reported average earning assets driven by a full year of Hibernia activity and the December 2006 North Fork acquisition. Net interest margin decreased 57 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 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 servicing and other, service charges and other customer-related fees, interchange income and other non-interest income.
For the year ended December 31, 2007 and 2006, reported non-interest income increased 15% and 10%, respectively. 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 15% for the year ended December 31, 2007. This increase was attributable to higher net gains on sales resulting from higher revenue generated from selective pricing and fee changes in the U.S. card portfolio offset somewhat by higher charge-offs in the securitized portfolio resulting from continued normalization of credit losses and a 7% increase in average securitized loans year over year. Average securitized loans were $51.2 billion for 2007 compared to $47.8 billion in 2006.
Servicing and securitizations income increased 7% for the year ended December 31, 2006, compared to 2005. This increase was primarily the result of a 7% increase in the average off-balance sheet loan portfolio.
Service Charges and Other Customer-Related Fees
For 2007, service charges and other customer-related fees grew 16% due to the inclusion of North Fork and selective pricing changes in the U.S. Card sub-segment.
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, 2006 service charges and other customer-related fee income declined $84.5 million or 6% from 2005. This was reflective of the reported loan growth being concentrated in the Auto Finance and Global Financial Services sub-segments that generate lower fee income and lower fee revenue from U.S. Card.
Mortgage Servicing and Other Income
Mortgage servicing and other is comprised of non-interest income related to our continuing mortgage servicing business and other mortgage related income. For the year ended December 31, 2007, Mortgage servicing and other income decreased 6% from prior year due to the changes in fair value of the mortgage servicing rights attributable to the run-off of the portfolio and lack of originations subsequent to the shutdown of GreenPoints mortgage origination business in 2007.
Interchange income, net of rewards expense, decreased 9% for the year ended December 31, 2007 due to decreases in reported purchase volume of 3% and higher costs associated with our rewards programs of 3%. Managed U.S. Card purchase volume increased 3% compared to 2006. Costs associated with the Companys rewards programs were $182.9 million in 2007.
Interchange income, net of rewards expense, increased 7% for the year ended December 31, 2006, compared to 2005. This increase is primarily related to a 13% increase in purchase volume. 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.
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, revenue generated by our healthcare finance business and income earned from purchased charged-off loan portfolios.
Other non-interest income for the year ended December 31, 2007, increased $194.4 million or 66%. The increase is primarily due to the North Fork acquisition. Other non-interest income for 2007 also includes a $46.2 million gain from the sale of a stake in DealerTrack Holding Inc., a $41.6 million gain on sale of our interest in a relationship agreement to develop and market consumer credit products in Spain and gains from sales of MasterCard stock of $43.4 million.
Other non-interest income for the year ended December 31, 2006, increased $31.9 million from 2005. The increase was 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 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.
Provision for loan and lease losses
Provision for loan and lease losses increased $1.2 billion, or 79% for the year ended December 31, 2007. The increase in provision is a result of the continued normalization of consumer credit following the unusually favorable credit environment in 2006, adverse charge-off and delinquency trends in our National Lending businesses and the increase in our coverage ratio of allowance to loans held for investment as a result of economic weakening in the latter part of 2007 as evidenced by increased delinquency rates and consistent with recently released economic indicators.
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 compared to 2005 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.
Non-interest expense consists of marketing, restructuring and operating expenses.
For the year ended December 31, 2007, non-interest expense increased 16%, reflecting a 22% increase in operating expenses and a 7% decrease in marketing expense. Non-interest expense increased $1.1 billion to $8.1 billion for the year ended December 31, 2007. The increase in operating expense was driven by the addition of North Forks operating expenses, CDI amortization and integration expenses associated with our bank acquisitions, litigation accruals related to industry litigation, restructuring charges associated with our 2007 cost initiative, and the accelerated vesting of restricted stock related to the transition to new management in our Local Banking business.
Non-interest expense increased 21% for the year ended December 31, 2006 compared to 2005, reflecting a 5% increase in marketing spend and a 27% increase in operating expenses. Non-interest expense increased $1.2 billion in 2006, of which $0.9 billion reflected a full years worth of Hibernias operations and $100 million from the North Fork acquisition.
The Companys effective tax rate was 33.0%, 33.9% and 36.1% for the years ended December 31, 2007, 2006 and 2005, respectively. The effective rate includes federal, state, and international tax components. The decrease in the 2007 rate compared to the 2006 rate was primarily due to changes in the Companys international tax position recognized in the second quarter 2007 in the amount of $69.0 million and increases in certain tax credits. 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 2006 income tax expense.
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 from continuing operations grew $33.4 billion, or 30%, and $26.1 billion, or 31%, for the year ended December 31, 2007 and December 31, 2006, respectively. The increases in average managed loans held for investment were driven by loan growth in the Local Banking segment as a result of the North Fork acquisition in 2006 and the Hibernia acquisition in 2005.
For additional information, see section XII, Tabular Summary, Table C (Managed 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 30-plus day delinquency rate for the reported and managed consumer loan portfolio increased 92 and 85 basis points to 3.66% and 3.87%, respectively, from December 31, 2006 to December 31, 2007. The acquisition of the lower loss North Fork loan portfolio reduced reported and managed delinquency rates. The decrease was offset by normalization of credit following the unusually favorable credit environment in 2006, selective pricing and fee policy moves in the U.S. Card sub-segment, the significant pull back from prime revolver marketing in the U.S. Card sub-segment, continued elevated losses in the Auto Finance sub-segment, and from economic weakening evidenced by increased delinquencies and consistent with recently released economic indicators.
The 30-plus day delinquency rate for the reported and managed consumer loan portfolio decreased 40 and 22 basis points to 2.74% and 3.02%, respectively, at December 31, 2006, compared to 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 $31.7 billion loans added through the acquisition of North Fork).
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. We charge off credit card loans at 180 days past the statement cycle date and generally charge off other consumer loans at 120 days past the due date or upon repossession of collateral. Bankruptcies charge-off within 30 days of notification and deceased accounts charge-off within 60 days of notification. 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.
Year-to-date 2007 reported and managed net charge-off rates decreased 11 basis points to 2.10% and increased 4 basis points to 2.88%, respectively. The decrease in the reported charge-off rate was impacted by the higher credit quality North Fork loan portfolio for a full year 2007 which more than offset the effects of continued consumer credit normalization and economic weakness during the latter part of 2007. The impacts of the continued credit normalization and economic weakness also had a significant impact on the managed charge-off rate for the Companys credit card securitization programs. Year-to-date reported and managed net charge-off dollars increased 39% and 32%, respectively, compared to the prior year.
Year-to-date 2006 reported and managed net charge-off rates decreased 134 and 141 basis points, respectively, with net charge-off dollars decreasing 3% and 13% on a reported and managed basis, respectively, for the year ended December 31, 2006 compared to the prior year. The decrease in net charge-off rates was 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 acquisitions.
For additional information, see section XII, Tabular Summary, Table F (Net Charge-offs).
Nonperforming loans as a percentage of total loans held for investment were 0.82% and 0.43% at December 31, 2007 and 2006, respectively.
For additional information, see section XIII, Tabular Summary, Table G (Nonperforming Assets).
Allowance for loan and lease losses
The allowance for loan and lease losses related to loans held for investment increased $783.0 million, or 36% to $3.0 billion at December 31, 2007. The increase is driven primarily by an increase in our coverage ratio of allowance to loans held for investment as a result of delinquencies and economic weakening in the latter part of 2007 as evidenced by increased delinquencies and consistent with recently released economic indicators.
The allowance for loan losses was $2.2 billion at December 31, 2006, an increase of $390.0 million from December 31, 2005. The increase was 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.
For additional information, see section XII, Tabular Summary, Table H (Summary of Allowance for Loan and Lease Losses).
VII. Reportable Segment Summary for Continuing Operations
We manage our business as two distinct operating segments: Local Banking and National Lending. The Local Banking and National Lending 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 basis within each segment, information about reportable segments is provided on a managed basis.
In the third quarter of 2007, the Company shut down mortgage origination operations of its wholesale mortgage banking unit, GreenPoint. The results of the mortgage origination operations are being reported as discontinued operations for each period presented, and are not included in segment results of the Company. The results of GreenPoints mortgage servicing business continue to be reported as part of the Companys continuing operations. The mortgage servicing function was moved into the Local Banking segment in conjunction with the shutdown of the mortgage origination operation, and the results of the Local Banking segment were restated to include the mortgage servicing results for each period of 2007. During the fourth quarter of 2007, GreenPoints held for investment commercial mortgage portfolio results were moved into the Local Banking segment. GreenPoints held for investment consumer portfolio results were moved into the Other category for the fourth quarter of 2007.
We maintain our 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 our internal management information system, which is maintained on a line of business level through allocations from legal entities.
Local Banking Segment
Table 2: Local Banking
Beginning in 2006, we added a Local Banking segment. The Local Banking segment represents the results of the legacy Hibernia and North Fork business lines, except for the indirect auto business and the investment portfolio results, and our branchless deposit business. The legacy indirect auto businesses of both Hibernia and North Fork are included in the Auto Finance sub-segment results, and the respective investment portfolio results are included in the Other category. The impacts of the North Fork acquisition for the year ended December 31, 2006 are included in the Other category.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
The Local Banking segment contributed $574.2 million of net income to the Company during 2007, compared to $178.6 million during 2006. At December 31, 2007, loans outstanding in the Local Banking segment totaled $44.0 billion while deposits outstanding totaled $73.3 billion. The increases in loans and deposits outstanding are due primarily to the addition of the loan and deposit portfolios of North Fork Bank, along with modest growth in loans and deposits during 2007. As of December 31, 2006, North Fork loan and deposit balances of $30.1 billion and $37.8 billion, respectively, were included in the Other category.
Local 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 2007, the Local Banking segment generated net interest income of $2.3 billion compared to $996.9 million during 2006. The increase is due to the increase in loan and deposit outstandings mentioned above. The net interest margin on loans was lower in 2007 than 2006 because of the addition of the North Fork loan portfolio, which contained a higher percentage of lower yielding loans than the Hibernia portfolio. Net interest margins on deposits are higher in 2007 than in 2006 because of the addition of the lower cost North Fork deposit portfolio to the existing Hibernia and Capital One deposits.
The provision for loan losses increased to $32.1 million in 2007 from $0.4 million in 2006. The increase is primarily the result of the addition of the North Fork loan portfolios in 2007, offset by a $91.4 million reduction in the allowance for loan losses to conform the allowance for loan losses methodology of the Local Banking segment to the Companys established methodology. In addition, during 2006, $25.7 million of allowance for loan losses previously established to cover expected losses in the portion of the loan portfolio impacted by Hurricanes Katrina and Rita was no longer needed and these amounts reduced the overall provision expense in 2006.
Non-interest expenses were $2.2 billion in 2007, compared to $1.2 billion in 2006. The primary reason for the increase is the addition of North Fork to the Local Banking segment results in 2007. In addition, during 2007 the Local Banking segment continued to incur costs associated with the integration of Hibernia and North Fork. These activities progressed as planned during the year and all Hibernia related integration activities were completed. In 2007, the Company opened 39 new banking locations across Louisiana, New Jersey, New York, Texas and Virginia. The costs of operating these branches, including lease costs, depreciation and personnel, is included in non-interest expense.
National Lending Segment
Table 3: National Lending
The National Lending segment consists of three sub-segments: U.S. Card, Auto Finance and Global Financial Services. The National Lending segment contributed $2.4 billion of net income during 2007, compared to $2.3 billion during 2006. At December 31 2007, loans outstanding in the National Lending segment totaled $106.5 billion while deposits outstanding totaled $2.1 billion. Profits are primarily generated from net interest income and past-due fees earned and deemed collectible from our loans, income earned on securities, and non-interest income including the sale and servicing of loans and fee-based services to customers. Total revenue increased 12% during 2007 primarily due to growth in the average managed loans held for investment portfolio of 7% and selective pricing and fee changes following conversion of our cardholder system. Provision for loan and lease losses increased $1.5 billion, or 46%, during 2007, compared to 2006 due to normalization of credit following the unusually favorable credit environment in 2006, selective pricing and fee policy moves in the U.S. Card sub-segment, the significant pull back from prime revolver marketing in the U.S. Card sub-segment, continued elevated losses in the Auto Finance sub-segment, and from economic weakening consistent with recently released economic indicators.
U.S. Card Sub-Segment
Table 4: U.S. Card
The U.S. Card sub-segment consists of domestic consumer credit card lending activities.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
The U.S. Card sub-segment had earnings of $2.1 billion, an increase of 16% year over year due to higher revenue generation and increased operational efficiency, partially offset by the worsening credit environment and associated reserve build.
Period end loans outstanding decreased $1.5 billion, or 3%, during 2007 mainly driven by a portfolio sale related to the exit of a co-branded credit card partnership at the end of the first quarter of 2007 and our prime revolver marketing pull-back. We are also experiencing a modest increase in asset attrition as compared to 2006, resulting from repricing parts of the portfolio where original terms had expired. Asset attrition remains at lower levels than those experienced in 2005 and earlier periods. Managed purchase volume increased by 3% over the prior year. Purchase volume growth was muted by a deceleration in retail sales growth, the sale of the co-branded credit card partnership and the impact of other deliberate strategy choices.
Total revenues increased by 11% over prior year, as our margins expanded due to product and marketing strategy changes implemented in 2007. Primary drivers of the increase in revenue margin include selective pricing and fee changes, pull-back from prime revolver space as well as other strategy changes.
The provision for loan losses increased 43% to $2.4 billion during 2007. The increase is partly driven by normalization of credit in 2007 following the unusually favorable credit environment in 2006 and by economic weakening consistent with recently released economic indicators. The increased charge-off rate in 2007 was exacerbated by the pull back from the prime revolver space throughout the year, and by the pricing and fee moves in the second and third quarters. Non-interest expenses for 2007 decreased by 6%, due to lower marketing spend as a result of the Companys evolving marketing strategy and increased operational efficiency.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
U.S. Card sub-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.
Period end loans held for investment 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 2006, U.S. Card had increasingly focused on transactor products, shifted more upmarket in subprime cards and modestly increased the volume of assets at introductory rates.
The provision for loan losses decreased 28% during 2006. The decrease is attributable to the favorable credit environment in 2006, offset by loan growth. Non-interest expenses for 2006 increased 5%, primarily driven by infrastructure improvements and investments.
Auto Finance Sub-Segment
Table 5: Auto Finance
The Auto Finance sub-segment consists of automobile and other motor vehicle financing activities.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
The Auto Finance sub-segment recognized a net loss of $33.8 million during 2007, compared with net income of $233.5 million during 2006, as revenue generated from portfolio growth was more than offset by worsening credit performance.
The loan portfolio increased 16% year over year as a result of the transfer of $1.8 billion of North Fork Banks auto loans to the Auto Finance sub-segment on January 1, 2007 and strong organic originations growth within our dealer and direct marketing channels. Originations in 2007 were $13.2 billion, 7% higher than prior year. As a result of this portfolio growth, net interest income increased 10% during 2007 compared to 2006.
Non-interest income for 2007 included a one-time gain of $46.2 million related to the sale of 1.8 million shares of DealerTrack.
During 2007, the Auto Finance sub-segments net charge-off rate was 3.06%, up 78 basis points from 2.28% during 2006. Net charge-offs of loans outstanding increased $272.8 million, or 58%, while average loans
outstanding during 2007 grew $3.7 billion, or 18%, compared to 2006. The 30-plus day delinquency rate was up 149 basis points at December 31, 2007. The adverse credit performance is mainly driven by credit normalization following the unusually favorable credit environment in 2006 and elevated losses from the recent Dealer Prime originations and the Dealer Subprime business. While the Dealer Prime loans being originated today have better credit characteristics compared to loans originated a year ago, loss levels from loans originated in 2006 will remain elevated until the loans amortize. Elevated losses in the Dealer Subprime business are a result of industry-wide risk and underwriting expansions of the past several years. While losses on these loans have increased, the business remains profitable and risk adjusted returns remain within the Companys expectations. The provision for loan losses increased $561.3 million, or 113% during 2007. This increase was driven by a weakening U.S. economy, growth in the loan portfolio, and elevated losses from discontinued programs in our Prime segment, as well as moderately worse credit quality in Subprime.
Non-interest expense increased 3% during 2007, compared to 12% revenue growth for 2006. Operating costs as a percent of loans have declined from 2.8% during the first quarter of 2007 to 2.3% during the fourth quarter of 2007 as the Auto Finance sub-segment realized the benefits of the integration of the dealer programs of the legacy Capital One, Onyx, Hibernia, and North Fork auto lending businesses.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net income for the Auto Finance sub-segment increased $101.5 million, or 77% during 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, heightened competition, and the acquisition of Hibernias indirect auto loans, which increased the Auto Finance sub-segment mix of prime loans.
The Auto Finance sub-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.
For 2006, the net charge-off rate was 2.28%, down 42 basis points from 2.70% in 2005. Net charge-offs of loans outstanding increased $84.4 million, or 22%, while average loans grew $6.3 billion, or 45%, during 2006 compared to 2005. 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 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% during 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% during 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 sub-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 sub-segment was up 64 basis points to 6.35% 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.
Global Financial Services Sub-Segment
Table 6: Global Financial Services
The Global Financial Services sub-segment consists of international (U.K. 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.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Net income for the Global Financial Services sub-segment increased 9% during 2007. Excluding the $31.3 million net gain on the sale of Spain, net income increased 1% from 2006. Profitability improved year-over-year in the U.K. due primarily to an improved credit outlook, however, domestic businesses are facing more challenges due to worsening customer credit outlook in the U.S.
Revenue growth in 2007, excluding the Spain gain on sale, was 10% and was in line with growth in average loans of 9%. Non-interest expense grew more modestly at 7%, resulting in improvement in the efficiency ratio from 50% in 2006 to 48% in 2007.
The provision for loan losses increased 20% during 2007, as a result of growth in the loan portfolio combined with deteriorating credit quality metrics in U.S. Global Financial Services. The net charge-off rate for 2007 was 4.09%, an increase of 31 basis points compared to 3.78% for 2006. The increase in the net charge-off rate is largely the result of worsening U.S. credit quality trends, offset by recovery in the U.K.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net income for the Global Financial Services sub-segment increased 47% during 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% during 2006, slightly below the 14% growth in average loans outstanding for the same period.
The provision for loan losses increased 15% during 2006, as a result of growth in the loan portfolio combined with deteriorating credit quality metrics in the U.K. The net charge-off rate for 2006 was 3.78%, a decline of 19 basis points compared to 3.97 for 2005. 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% during 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% during 2006, well below the growth in revenue of 11% and average loans of 14%.
The Company has established access to a variety of funding sources. Table 7 illustrates the Companys unsecured funding sources and its two auto securitization warehouses.
Table 7: Funding Availability
The Senior and Subordinated Global Bank Note Program gives COB 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, COB issued senior unsecured debt through an $8.0 billion Senior Domestic Bank Note Program. COB 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. On April 30, 2007 the Credit Facility was terminated.
Collateralized Revolving Credit Facilities
In March 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, 2007, the Capital One Auto Loan Facility I had the capacity to issue up to $4.1 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. The Capital One Auto Loan Facility I was paid down in January 2008.
In March 2005, COAF entered into a second 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, 2007, the Capital One Auto Loan Facility II had the capacity to issue up to $1.3 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. The Capital One Auto Loan Facility II was paid down in January 2008.
Corporation Shelf Registration Statement
As of December 31, 2007, 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.
In September 2007, the Company issued $1.5 billion aggregate principal amount of 6.75% Senior Notes due September 15, 2017.
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, the Company 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, 2007, the Company had $83.0 billion in deposits of which $3.6 billion were held in foreign banking offices and $10.0 billion represented large domestic denomination certificates of $100 thousand or more.
Table 8 shows the maturities of domestic time certificates of deposit in denominations of $100 thousand or greater (large denomination CDs) as of December 31, 2007.
Table 8: Maturities of Large Denomination Certificates$100,000 or More
Table 9 shows the composition of average deposits for the periods presented.
Table 9: Deposit Composition and Average Deposit Rates
Additional information regarding funding can be found in Item 8 Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 9.
Table 10 reflects the costs of other borrowings of the Company as of and for each of the years ended December 31, 2007, 2006 and 2005.
Table 10: Short Term Borrowings
Table 11 summarizes the amounts and maturities of the contractual funding obligations of the Company, including off-balance sheet funding.
Table 11: Funding Obligations