Capital One's Biggest Strength Is Also Its Biggest Weakness

By Markets Fool.com

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Over the past two decades, Capital One Financial has been one of the nation's best-performing bank stocks, and there's little reason to believe that it won't continue to have similar success in the future.

But there's one thing about the McLean, Va.-based lender that prospective investors need to know: The main reason Capital One has been so successful in the past -- namely, its $86 billion portfolio of high-yielding credit card loans -- is also the biggest risk to the bank's ongoing profitability.

A credit card company first
Capital One is a genuine oddity when it comes to banks. I say that because most banks -- including Bank of America and JPMorgan Chase, among others -- either acquire credit card companies or originate their own credit card operations to supplement their existing lines of business.

Capital One, on the other hand, evolved in the opposite direction. Instead of being a bank that expands into credit cards, it was a credit card company that expanded into banking. It did so by buying a collection of traditional lenders, beginning with its 2005 acquisition of New Orleans-based Hibernia National Bank.

The lasting influence on Capital One's business model may not be evident at first glance, but it becomes so when you dig into its numbers. Most notably, a full 41% of its loan portfolio consists of consumer credit card loans. This is an unusually large proportion when you consider that most banks, particularly within Capital One's immediate peer group, allocate less than 10% of their loan portfolios to credit card loans.

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The risk and reward of credit card lending
Up until now, Capital One's heavy concentration in credit cards has been more of a benefit to its shareholdersthan a detriment. This is because credit card loans generate significantly more interest income than, say, residential mortgage loans or most types of commercial loans.

In its latest earning release, Capital One's $273 billion in earning assets yielded 7.38%. That's more than twice the average earning-asset yield of the nation's 10 biggest traditional banks, which was 3.14% in the most recent quarter.

But the flip side is that credit card loans, from a lender's perspective, are riskier than most other types of debt. In the first case, credit card loans are unsecured -- that is, they aren't backed by specific collateral that can be readily seized and sold in the event of a default. Secondly, even borrowers with less-than-ideal credit histories can often be approved for a credit card. Finally, credit card default rates are highly correlated with unemployment, which, in turn, fluctuates with the business cycle.

In the financial crisis of 2008-2009, for instance, credit card loans were one of the primary sources of problems for the nation's biggest banks. Bank of America, the largest credit card lender at the time, serves as a case in point. Between 2008 and 2010, it wrote off $72 billion in toxic credit card loans alone. "In the boom we pushed cards through the branches and in mass mailings," Bank of America CEO Brian Moynihan said in 2011. "To drive growth we gave cards to people who couldn't afford them."

To be clear, Capital One has been much more disciplined than Bank of America when it comes to handing out cards. As a result, even at the nadir of the financial crisis, it lost only $46 million on an annual basis. That's an impressive feat, considering both Capital One's heavy concentration in credit cards and the unusual depth of the downturn and the resulting impact on unemployment.

But the point remains: Capital One is in a risky business. This is true even in the context of banking, which is an inherently risky industry. Thus, for current and prospective investors alike, it's important to keep in mind that Capital One's biggest strength could, under less adroit risk-management, become its biggest weakness.

The article Capital One's Biggest Strength Is Also Its Biggest Weakness originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Capital One Financial., and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.