The bank can make a lot of money when times are good, but when tough times come around, it can get ugly fast.
Capital One Financial (COF -5.40%) is an interesting bank. Unlike most banks, it hasn’t focused on building out a branch network. It has instead built out a credit card business.
This is a very different model from the banking industry giants, and investors need to fully appreciate the risks involved. Here’s what you need to know, and why investors might want to tread with caution today.
Capital One is not your typical bank
The basic bank model is pretty simple: It takes in cash from customers in the form of deposits (think savings and checking accounts). It then uses that cash to lend to other customers (think mortgages). The bank will usually pay less interest to bank account holders than it charges for the mortgages it issues, with the difference representing its profit. Banking today is a lot more complex than that, but traditional banking is still a core part of most large banks.
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Capital One doesn’t really do this. Instead, its focus has been on issuing credit cards. The bank’s credit card business generated $961 million in income from operations in the first quarter of 2024 compared to $381 million for consumer banking and $280 million for commercial banking. Its credit card business is huge, and there are a large number of customers with lower credit ratings in the mix.
Adding to this fairly aggressive business model, the bank is also a material player in auto loans. These tend to be on the risky side, with Capital One again taking on extra risk by being willing to work with borrowers with lower credit ratings. There’s a good reason for this aggressive stance: It can be highly profitable.
Such customers often have to pay higher interest rates and usually make greater use of debt. And many carry credit card balances from month to month instead of paying off the balance to avoid the huge interest costs of carrying a balance. As long as these Capital One customers keep paying their bills, it can be highly profitable to lend aggressively.
The problem is when things go south
The key to the last sentence is “as long as these Capital One customers keep paying their bills.” Anybody who has lived through a recession knows that it can quickly turn people’s financial lives upside down. The worst hit are usually those with lower credit quality, who were perhaps already having trouble making ends meet. Some of the first bills that get ignored are credit cards and auto loans.
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This is why Capital One’s stock fell well more than 80% during the Great Recession. And why it lost over 40% of its value during the recession in the early days of the coronavirus. When inflation started to rise after the pandemic, the stock fell sharply, too.
All of these moves in its share price were because investors were worried that the bank’s high-risk business model wouldn’t hold up to the economic weakness that was testing it.
And yet the stock has managed to come back from its recent lows, which were driven by rising interest rates. Indeed, investors seem to be betting that Capital One is on solid ground even as there are signs of weakness starting to show up in its portfolio.
For example, in the U.S. credit card business, the delinquency rate for loans that are late by 30 days or more rose 82 basis points year over year in the first quarter to 4.48%. That’s a 22% rise year over year in the delinquency rate. This isn’t to suggest that the bottom has dropped out, which it hasn’t, but to highlight that customers appear to be dealing with more financial strain today than they were a year ago.
Meanwhile, in the consumer banking business, the company is writing more auto loans (up 21% year over year) but setting aside more money for bad loans. It’s notable that the bank’s provision for credit losses rose $151 million in the first quarter of 2024 to $426 million, which is a huge 55% year-over-year increase.
Again, the bottom isn’t falling out, but it does look like the economy is more worrying. And that’s when things can get bad for Capital One and its shareholders.
Capital One has survived this cycle before
To be fair, management is very aware of what it is doing. It has muddled through economic weakness before and continued to thrive over the long term. It will probably do the same again.
But investors are boosting the stock while there are signs of increasing weakness in the company’s high-risk business model and in the economy at large. If you are looking at Capital One, you might want to tread carefully. The next recession will probably offer up a much better opportunity to buy the stock.
