Wednesday, May 7, 2008

No credit for Capital One

The Quote of the Month

““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.

The Position of the Month

Stock: COF
Position: Short

Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract

The Summary

Capital One is a leveraged lender with high percentage of low quality cardholders.

The Story

Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.

Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”

Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”

COF insiders are selling

(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”

Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”

The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.

To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.

Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion

This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.

(1) Andrew Horowitz,

(2) Andrew Horowitz,

(3) Andrew Horowitz

(4), 4/25/08,

(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters,