An Important Lesson About Capital One and Discover Financial

If you had to guess which major banks would suffer the most meaningful loan losses in a downturn similar to the financial crisis, which banks would you pick?

If you said Capital One Financial (COF -0.32%) and Discover Financial Services (DFS 0.33%), you'd be right. This is one of the many takeaways from this year's stress tests, the results of which were released by the Federal Reserve over the past two weeks.

To be clear, Capital One and Discover don't have the largest loan losses when measured by sheer size. That distinction goes to JPMorgan Chase (JPM 0.06%) and Wells Fargo (WFC 0.89%).

Source: Federal Reserve.

The Fed estimated in this year's test that JPMorgan Chase would suffer $54 billion in loan losses over a nine-quarter stretch in which the economy plunges into a deep recession, the unemployment rate reaches 10%, and asset values plummet across the board. Wells Fargo's projected loan losses come in at $50 billion.

It should be little surprise that JPMorgan Chase and Wells Fargo top this list, as they're the first and third biggest banks in America, respectively, when measured by total assets. And when measured by loans alone, Wells Fargo is the biggest bank.

But if you're not looking at sheer size, and are instead focused on the percent of a bank's loan portfolio that would be written off in a deep downturn -- this is the measure that should matter most to investors in a particular bank -- that's where Capital One and Discover rank at the top (or, I suppose, bottom) of the 34 banks that took this year's tests.

Source: Federal Reserve.

The Fed estimated that Capital One would charge off 12.2% of its loan portfolio in a deep downturn, while Discover Financial would charge off 13% of its loans. These were the only double-digit loan losses, and both are more than double the 5.8% average among the banks tested this year.

Why Capital One and Discover? Is it because they're worse at managing credit risk than other banks? Or is something else at play here?

The answer to this has to do with their business models. As you probably know, Capital One and Discover are best known for being credit card issuers. And while other banks issue credit cards, none are as concentrated in the business as Capital One and Discover.

At the end of the first quarter, 79% of Discover's loan portfolio consisted of credit card loans. The same percentage at Capital One was 44%. To put these in perspective, credit card loans represented only 3.6% of Wells Fargo's loan portfolio, 15% at JPMorgan Chase, and 10% at Bank of America (BAC 0.45%).

Credit card loans are the riskiest types of loans that banks make. Image source: Getty Images.

The reason this matters is because credit card loans default at a higher rate than other types of loans. According to the Fed's math, 13.7% of credit card loans at the nation's biggest banks would be written off in a hypothetical financial crisis. Ranking second are commercial real estate loans at 7%, or roughly half that of credit card loans.

The best performing category consists of first-lien residential mortgages, only 2.2% of which are expected to default. And the average for all types of loans, as I've already noted, is 5.8%.

None of this means that Capital One and Discover Financial are bad or especially risky investments -- that depends on how they manage the elevated risk associated with their heavy concentration in credit card loans. But either way, this is an important distinguishing characteristic that investors in these banks should keep in the back of their minds.