High levels of inflation over the past year are starting to have an effect on savings and consumers are feeling some of the pressure. As a result, many lenders are starting to report a rise in loan losses.
The credit card specialist Capital One (COF 0.26%) is not immune. Bank management reported a solid spike in loan losses, as well as a rise in delinquencies in its fourth-quarter earnings results. With the U.S. economy potentially tipping into a recession later this year, should investors be worried? Let's take a look.
Normalization is inevitable
After establishing a benign credit environment when the pandemic started, it was only a matter of time before credit started to normalize to pre-pandemic levels. Thankfully, consumers were in pretty good shape heading into the pandemic.
Image source: Getty Images.
Capital One saw about $1.4 billion of net charge-offs in the fourth quarter, which looks at debt unlikely to be collected and is a good indicator of actual loan losses. The company also built up its reserves for future losses by about $1 billion to account for loan growth and "a modestly worse economic outlook."
The net charge-off rate as a percentage of total loans moved to 3.22%, which is up more than a full percentage point from the third quarter of the year. Most of the losses are from Capital One's credit card portfolio. The 30-plus day delinquency rate in the company's domestic card portfolio also jumped from 2.97% to 3.43% in the fourth quarter.
Keep in mind that Capital One typically sees higher losses because it serves more below-prime customers. In Q4, more than 30% of its domestic credit card borrowers had a FICO score below 660.
Capital One management didn't exactly specify whether or not they see loan loss rates and delinquencies normalizing to pre-pandemic levels in 2023. But on Capital One's earnings call, CEO Richard Fairbank did say that he thought delinquencies "were pretty normalized." He also said that delinquencies on new originations have been pretty flat in recent months, and payment rates are still elevated. So the messaging is a little cryptic, but I took it as generally positive.
Either way, Capital One has a much larger reserve for loan losses than it did prior to the pandemic. The company's total allowance for credit losses sat at 4.24% of total loans at the end of the fourth quarter. At the end of 2019, the allowance was only at about 2.7%.
Should investors be worried about Capital One?
There are certainly broader economic concerns that investors should be aware of, such as if unemployment jumps above 5% and the U.S. economy tips into a more severe recession than some economists expect.
But Capital One has been in the credit card business for decades, as has its management team, so they've been through cycles and are pretty conservative when it comes to reserving for loan losses. They also currently hold a tremendous amount of excess capital above their regulatory capital requirement, which can be used for unexpected loan losses.
With Capital One still trading pretty cheap at less than 8 times forward earnings and about 115% of its tangible book value, or net worth, I would not be worried about the recent spike in loan losses. I think the company (and the stock) is actually pretty well positioned.
