Last week, Capital One Financial (COF) announced that is was formally withdrawing from the residential mortgage loan market. Some observers mistook this announcement for news, thinking that COF had actually been engaged in residential lending in a serious way. Housing Wire, for example, reported that COF had “suddenly” exited the mortgage and home equity business.
In fact, despite several acquisitions, these motivated mostly by a desire to accumulate deposits, COF had never really cared about mortgage lending or anything other than credit cards and consumer loans. “The challenging rate environment and marketplace … do not allow us to be both competitive and profitable for the foreseeable future,” Sanjiv Yajnik, the president of financial services at COF, said in an internal memo.
At the end of Q2 ’17, COF had about 21% of its loan book in all real estate loans, including residential at 8% and about 12% commercial real estate loans. Almost 60% of the balance sheet is “loans to individuals,” including credit cards, auto loans and other consumer revolvers. Most large banks that inhabit Peer Group 1 have a third of their balance sheet in real estate exposures of one sort or another. COF owns a big slug of mortgage backed securities, however, something to ponder as the Treasury yield curve slowly inverts under the weight of the Yellen Put.
The reason that COF looks askance at asset classes such as resi comes down to simple returns. COF’s margin on net interest income is almost 7% on a tax equivalent basic compared with an average of 3% for Peer Group 1. That’s more than 2x JPM, BAC, WFC, etc. That fat spread comes from consumer loans. Indeed, the yield on earning assets for COF was over 400bp higher than its asset peers at the end of Q3 ’17.
Even with all that yield, however, COF still delivers high single digit equity returns overall. Or put more bluntly, things like residential mortgages were dragging down the overall equity returns for the bank. Indeed, real estate loans including residential and CRE, are currently the lowest yielding loan category on COF’s book at 418bp.
Credit cards comes in at a handsome 1,400bp and consumer loans is 725bp, according to the FDIC. With fees and other goodies added in, total net revenue margin for the cards business rises to almost 17%. Commercial & Industrial loans at 560bp are actually quite respectable for the large banks, with the weaker players such as Citigroup (C) laboring at less than half of that spread for C&I loans.
Real estate loans at COF have been falling as a percentage of total loans for the past five years. During this same period, COF’s total assets have grown and its deposit base has essentially doubled. The bank securitizes about $1 billion per quarter, including about $400 million in residential mortgage loan production that will gradually go away. But this is actually a positive for COF, since the risk-adjusted return on residential lending is probably negative anyway. Note that the bank is actually pursuing retail investment advisory business alongside the consumer credit products.
Thanks to the blessing of the Dodd-Frank law and the constant intercessions of the folks at the Consumer Finance Protection Bureau, who have turned extortion into a form of public policy, residential mortgage lending is now a loss leader for most of the US banking industry. COF is merely the latest commercial bank to make the obvious decision, namely that residential lending is not a business worth doing – at least without significant scale. And in any event, the double digit return available from credit cards is pretty hard to argue with any day of the week.
Last thought. COF is the largest monoline consumer credit card issuer, but Citi is the largest credit card shop in the industry. Given that the latter has already bailed out of asset management and residential mortgages, may be time to slam these two consumer credit shops together and call it a day. There may not be much organic growth in the banking industry and even less alpha, but there is always M&A.