Capital One, What’s in Your Wallet?

Not as much as you thought.

Consumer credit, the engine that drives the mammoth U.S. economy, is developing a few knocks. Home-mortgage delinquencies are rising. Retailers such as Sears that finance significant portions of the purchases made at their stores are writing off larger chunks of outstanding credit as uncollectable. Providian, a credit card company that lends primarily to borrowers with tarnished credit histories, has lost 90 percent of its market value since the summer of 2001.

Such deterioration shouldn’t come as any shock. For years, consumer finance companies have indiscriminately blanketed the nation with credit card offers, seemingly heedless of recipients’ capacity to service the debt. And when the economy slows, people have more difficulty paying their bills.

But the tough sledding at Capital One Financial has been a surprise. The formerly high-flying credit card company has lost half its value since July and earlier this month warned investors of escalating bad debts and slower future growth. Until recently 14-year-old Capital One has led a charmed life, lionized in the press—and in the stock market—for being a fundamentally different company. Capital One’s shtick is that it is in the information business more than it is in the banking business.

Most credit card marketers have all the subtlety of an offensive lineman. Some 5 billion solicitations pile up in U.S. mailboxes annually, according to Mail Monitor, a unit of BAIGlobal Inc. The carpet-bombing strategy was first pursued with success by Bank of America in California in the 1960s, and it has been replicated by banks and consumer finance companies in the decades since.

From the beginning, Capital One pursued a different strategy. Co-founders Richard Fairbank and Nigel Morris, former management consultants, had concluded from their work with banks that credit cards didn’t focus on individual customer needs: Citibank tended to offer the same product at the same terms to millions of potential users. Nor did card issuers use information technology well, employing it only to process payments, not to mine data for better credit decisions. What’s more, most credit card companies separated their marketing, credit risk, and IT departments.

Years before the Internet made it easier, Fairbank and Morris believed that uniting the three disciplines would allow credit card companies efficiently to realize the Holy Grail of financial services: mass customization. Through shrewd marketing and savvy database management, the company could eschew mail drops in favor of the scientific method. It could carefully test to determine which credit card products would appeal to which customers.

Twenty banks rejected their idea. In 1988, Signet Bank of Richmond, Va., saw the light and brought on Fairbank and Morris. Their unit grew slowly, but in 1995, Signet spun off the credit card division. Capital One became a publicly held company with Fairbank as chairman and chief executive officer, and Morris as president and chief operating officer.

Since them, Capital One has conducted hundreds of thousands of card tests—46,000 in 2001 alone. The tests allowed it to determine who reacts most favorably to slight adjustments in interest rates, maximum balances, or fees; who prefers to sign up via the Internet; and who responds to telephone solicitations (Who? Please tell me who responds to telephone solicitations!). When Capital One figured out how to sell to the small group of targeted test customers, it looked for similar customers throughout the United States. The sensibility at Capital One was more like the Human Genome Project than a cold-calling operation. “We’re creating a massive scientific lab where everything can be tested,” Fairbank told U.S. Banker last year. The company became first an object of curiosity and then a legend. It was all very New Economy and not at all easily imitated.

Since 1995, Capital One has notched stunning growth. The number of card-holders has grown from 6 million in 1995 to 48.2 million today; loans have risen from $95 million to $56.9 billion. It is now one of the Top 10 issuers of bank credit cards. As it grew, Capital One continued to post industry-leading numbers. Compared with older and less technologically sophisticated credit card companies, it had lower charge-off rates—3.92 percent in 2000, compared with 5.6 percent industrywide—lower delinquency rates, and higher spreads. In the marketplace, and on the stock market, it was slaughtering its competitors.

And while other companies focused on particular niches—American Express targeted the high-end, Citigroup the middle market, Providian the subprime market, and companies like MBNA pursued affiliate cards (Slate Visa, anyone?)—Capital One could profitably range across all these niches.

So, what went wrong? In order to maintain its 30 percent annual growth, Capital One in recent years had to range where the profitable borrowers were. And increasingly that was in the subprime market. Subprime lending isn’t exactly haute finance. When it’s good, it’s very good—you can lend money at double-digit rates when your borrowing costs are in the low single digits. But when it’s bad, it’s very bad. In personal bankruptcy filings, for example, unsecured debts like credit card balances are frequently wiped out.

Capital One thought its superior technology and customization would allow it to dive deeper into the subprime pool without danger. “I’d be disappointed if we’re not able to push right through a recession,” Fairbank told U.S. Banker.

That didn’t happen. It’s true that Capital One has not cratered like Providian. And it has never been accused of crossing the line that separates subprime lending and usury. (Subprime lender Household International Inc. in early October paid $484 million to settle predatory lending charges.) But, in part because it tilted into the low-end business at the wrong time, Capital One is looking less like a whiz-bang outfit and more like a stodgy old bank. In July 2002, Moody’s concluded that Capital One’s charge-off rate was 5.49 percent. That’s still better than the industry average—6.26 percent in that month—but the gap between Capital One and the field seems to be closing. In its most recent quarter, Capital One also had to adjust reserves—and hence lower profits—in anticipation of new government regulations regarding subprime loans. More troubling, the company last week said its charge-off rate would rise sharply to more than 6 percent in the fourth quarter and into the “high-6 percent range in the first half of 2003.”

Capital One seems finally to have admitted that the business cycle still rules even those who know their way around servers and databases. To protect profits, and hence its credit rating, the company slashed marketing costs by 42 percent in the most recent quarter. That translates into many fewer of its vaunted tests and a lower growth rate going forward—more like 20 percent than 30 percent.

Of course, 20 percent is nothing to sneeze at. The company is still making good spreads and ample profits, and it’s worth $6.6 billion. But increasingly Capital One is behaving—and being valued—more like its less sophisticated peers.