The one metric that stuck out like a sore thumb in Capital One's (COF 0.20%) third-quarter earnings release was its net charge-offs, the amount of money it loses from delinquent loans, which increased by 18% on a year-over-year basis. The good news is that this otherwise disturbing trend is less about credit quality and more about loan growth, as faster loan growth necessarily entails higher charge-offs.
Capital One CEO Richard Fairbank calls this "growth math" and spent much of the company's third-quarter conference call discussing it. "Two factors are driving our current credit trends and expectations," Fairbank noted. "The first is growth math, which is the upward pressure on delinquencies [and] charge-offs as new loan balances season and become a larger proportion of our overall portfolio."
Data source: Capital One's 3Q15 financial supplement, page 3. Chart by author.
No matter how good a bank is at managing credit risk, and Capital One has proven to be adept at this in the past, even the best underwrite loans that default. As a result, the objective isn't to eliminate charge-offs entirely because that would unduly suffocate loan origination volumes, which in turn would weigh on revenue. The objective is instead to minimize net charge-offs to the greatest extent reasonably possible.
It's worth keeping in mind that revenue generation and risk management must be balanced to achieve sustainable and outstanding long-term profitability. A myopic focus on revenue generation will produce the desired results in the short run since it's easy to find people and businesses that want to borrow money. But this strategy comes apart when the credit cycle takes a turn for the worse, as it frequently does, punishing overly liberal lenders with higher default rates compared to their more conservative counterparts.
Still, regardless of the strength of a particular bank's risk culture, because it must be balanced against the need to grow revenue, it's unavoidable that an increase in loan volumes will be followed by an increase in net charge-offs. This is particularly true with credit card loans, which must charged-off within six months after entering delinquency.
On top of this, new credit card accounts tend to default at a higher rate than old, or "seasoned," accounts. Bill Carcache, an analyst at Normura Securities, teased this out on the conference call, noting that a company like Capital One is likely to experience peak default rates within the first 18 to 30 months after accounts are opened.
So if we just draw a line in the sand that looks [out], say, 36 months, then anything older than that is past peak losses and you have declining charge-off rates relating to anything that's older than 36 months. And anything younger than that is experiencing arguably rising charge-offs.
When you couple this with Capital One's rapid loan growth last quarter -- average loans in its domestic credit card segment were up 12% compared to the same period last year -- this explains not only why charge-offs increased at the McLean, Virginia-based lender, but also why its net charge-off ratio did as well. This ratio reflects net charge-offs as percentage of a bank's total loan portfolio. Thus, if a larger share of a bank's loan portfolio is made up of new loans, which is a consequence of rapid loan growth, then the net charge-off rate will increase.
In sum, while less-experienced investors and analysts may be concerned about the 18% increase in Capital One's net charge-offs last quarter, you now know that there's more to this story than meets the eye.
