We've talked about credit card services company Capital One (NYSE: COF) in two recent columns, and today we'll wrap up with a quick look at the risks that financial services companies such as Capital One face.

As with any investment, investors have to go in with their eyes wide open regarding risks related to the specific company, the industry, and the market as a whole.

Banks are a bit unique in that risk is the name of the game. Banks are in business to loan money. Capital One extends loans to its card holders, collects a small fee from merchants, and collects interest on loans that customers revolve month to month. It's been said many times before that banks are in the business of managing risk, and it's no different with Capital One. The more loans a bank issues, the more profits it generates on the spread between its borrowing cost and loaning rates. At the same time, the more loans a bank issues, the more it is exposed to credit risk. Pretty simple.

What's not so simple is getting a mix of loans that are both profitable and reasonable relative to the risk level. Martin Mayer, business journalist and author of The Bankers, wrote that the formula bankers often use to beef up profits when old customer lines are tapped out is to extend loans to customers other bankers had previously denied credit. This can be quite profitable as rates for riskier clients are higher, but the strategy brings high risk. Banks must manage growth with an eye towards sustainability and high asset quality.

There's quite a bit involved in analyzing bank risks, more than we can go into in a short column, but investors must get a feel for a company's loan quality. One of the fastest ways to zero in on this area is to track net charge-offs as a percentage of managed loans. This is kind of the bottom line for asset quality. It's like saying, "Well, all those loans are great, but how many went bad?"

Net charge-offs represent loans delinquent six months, which must be written off as uncollectible. It doesn't mean the loans won't get collected. Banks pursue delinquent creditors with earnest, you can be sure. But the loans can no longer be counted as a portion of the company's performing loan base. The net charge-off figure tells us how good a job the company is doing managing its loan base, a banking company's bread and butter.

In the latest quarter, Capital One's net charge-off rate fell to 3.75%, down from 3.98% in Q4 of last year. Compared to an industry average of about 6%, Capital One leads the pack among major card vendors.  Here's a look at the major card vendors and charge-off rates at the end of 2000:

Citigroup (NYSE: C)            3.85% 
MBNA (NYSE: KRB)               3.94%
Capital One                    3.98%
Morgan Stanley (NYSE: MWD)     4.40%
American Express (NYSE: AXP)   4.40%

What's more, as the company has fine-tuned its information strategy, it's been able to lower the charge-off rate to 3.75% in the latest quarter, from as high as 6.04% in the first quarter of 1998. Considering Capital One's participation in the sub-prime sector -- an area traditional card companies largely avoided before Capital One demonstrated it could be profitably managed -- its low charge-off rate is especially noteworthy. One of the ways it's been able to keep charge-offs low, for example, is by keeping a tight hold on the size of its credit lines, which are about one-third the industry average, according to company executives. This keeps riskier customers in check.

The company doesn't break out the portion of its loans in different sectors -- sub-prime, prime, and super-prime, but it's increasing its loan mix to upper-prime and super-prime to take advantage of new opportunities. The company frequently shifts its loan mix to grab customers where available, but it's typically been pretty cautious about rolling into new sectors -- and it doesn't make any move without extensive testing. For example, it didn't move into the sub-prime sector until 1992, four years after it began testing its secured credit card. With the economic environment rather sour right now, investors shouldn't be surprised to see bankruptcies increase. This would impact the entire sector, albeit on a short-term basis, and Capital One isn't immune.

Much like any financial services company, Capital One's stock is cyclical, moving with business trends. It's particularly sensitive to changes in interest rates since they affect the company's cost of capital. For this reason, the stock tends to ebb when the Federal Reserve raises interest rates, and flow when rates are getting cut. Investors interested in the sector should understand the stock moves with the tide. What it means for the Rule Maker Portfolio is that we may get a chance to purchase shares at a more reasonable price than today's 26x earnings if we're patient. This doesn't mean we will, just that the stock is one to keep on the radar screen.

With less than 5% of the U.S. credit card market's total receivables, and the market consolidating fast, Capital One has an opportunity to grab market share. Further, it's using its information systems to push into markets with room for growth, such as the auto loan business. From 1999 to 2000, Capital One more than doubled its auto loan portfolio, and now manages $1.2 billion in loans. Its installment loan business jumped 33% last year to $1.6 billion (installment loans are just loans for a specific period, where the borrower pays a preset amount each month), and its international loan portfolio grew 25% to $3 billion. The company has just scratched the surface of these new markets. It's a company we'll be watching closely.

Have a great day.

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Richard McCaffery, who, like a good bank, tries to keep his percentage of non-performing assets lower than the industry average, doesn't own shares in any company mentioned in this report. The Motley Fool is investors writing for investors.