Capital One Financial Corp. (COF)

Capital One has a great big credit card business. Even though the numbers are quite large, this business is remarkably easy to understand. Capital One takes in deposits at its retail and commercial banks and pays a small rate of interest on these "demand deposits." It then uses these deposits and other financing (like $37 billion in long-term debt) to lend to consumers at very high rates of interest via MasterCard- and Visa-branded credit cards. Capital One makes a profit if the money it earns on its loans exceeds what it pays for capital, after all of the other costs of running the business – like the ubiquitous "what's in your wallet" advertising.





Capital One's problems are large and obvious. Its first problem is leverage. The difference between the value of Capital One's investments (~$150 billion in consumer debt) and the value of its obligations (~$80 billion in deposits and $37 billion in long-term loans) is only about $30 billion. That's not much cushion, given the trends in the credit markets. With about 5% of Americans no longer paying their mortgages and piling up record amounts of additional credit-card debt, it's plausible credit-card delinquencies will rise over the next few months. In fact, according to Capital One, that's exactly what's happening. The company recently wrote off $500 million in loans, saying its annualized rate of write-offs had reached 4.11%, up from 3.7% at the end of 2007.





Furthermore, Capital One is particularly vulnerable to a surprising amount of bad debt, simply because it has grown aggressively over the last five years. Loans held from investment have grown from $32 billion to more than $100 billion today. I think the decline in credit quality over that period will prove to be substantial. America has been on an unprecedented credit binge. Like a fireman hosing down a 4 alarm fire -- Capital One has been dumping huge amounts of unsecured credit-card debt on the market. Its loan book grew in excess of 20% every year between 2003 and 2007 – about six times faster than the economy. Meanwhile, the quality of its loans noticeably declined. The company's return on assets back in 2003 was more than 3%. Last year, it was slightly more than half that... 1.79%. Amnazing huh?





As the quality of the company's loans has deteriorated, so has net income... The write-offs have eaten more and more of its profits. Loan losses totaled $1.4 billion in 2006 and $2.6 billion in 2007. How big might these losses grow?





It's predicted (by people smarter then me) that over the next 12 to 18 months, Capital One experiences defaults on more than 10% of its total loan book, resulting in losses of around $15 billion. That would erode a majority of the bank's equity.





This info is enough for me to short this stock. Full disclosure: As of right now, I am not shorting this stock in my regular portfolio.