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Q&A with Richard
Fairbank
Related
story:
- Changing course
Editor's Note: Richard Fairbank,
chairman and CEO of Capital One Financial Corp., talked
with writer Jack Milligan in late July for our September
cover story on changes at the financial services company.
Here's an edited version of the transcript, which covers
everything from the company's move away from the sub-prime
to its funding and national branding strategy.
Milligan: I'd like you to speak to the shift in business
focus, moving away from sub- prime, emphasizing prime
and super prime more. What are the reasons for the change
and what impact do you think it will have on your growth
in earnings going forward?
Fairbank: A lot has been made
about Capital One's shift up market and it's certainly
a term I have used, but I want to put it in context
because this shift has been going on for years. In fact,
let me go way back to the beginning of Capital One.
The first thing that defined our company is we came
out with an up market product. We came out at 9.9% APR
when the industry was at 19.8% APR, because our view
was credit costs seem to be very high for consumers…Lenders
were taking a one -size-fits-all approach, and we felt
we could de-average the marketplace and identify customers
who deserved prices at half of the prevailing rate.
And that was the centerpiece of our strategy.
Over time our goal was to expand out
to be a full credit spectrum lender, so we began to
become increasingly successful with sub-prime lending
(lending to higher-risk customers with poor credit histories).
We had carefully structured products that both protected
Capital One and also protected the consumer from getting
in over his or her head. By the mid '90s, we started
growing significantly in sub-prime while continuing
our efforts up market.
Meanwhile, the prime marketplace became
a very difficult place to make money with everybody
jumping from one teaser rate to another and very large
credit lines being offered. So we de-emphasized that
segment of the business, but at the same time starting
going after the high end of the prime market. In about
1997 we coined the word that's now became a standard
in the financial services marketplace--the term super
prime to describe the upper end, blue chip segment of
the market --where we began to aggressively market.
When sub-prime became so out of favor a year ago, it
became clear to us that it would serve our interest
well and the interest of our shareholders well if we
adjusted the mix somewhat to do less sub-prime and even
more up market. .. Several of our competitors had melted
down. And so that's what we describe as our quote unquote
"move up market." It's not new in the sense
that we've been doing it for years. However, it does
involve less growth of sub- prime and more rapid growth
in prime and super prime.
Milligan: How will that affect your
growth rate, because your growth rate in the past has
just been stupendous? It would be hard to imagine that
it would continue like that indefinitely.
Fairbank: Yeah, I think you hit the
nail on the head. As we become a Fortune 200 company,
just the sheer mass of our size makes it less realistic
to have 30 and 40 percent earnings per share growth
rate. But also it is the case that sub-prime is a very
profitable business for us. As we slow down the growth
of sub-prime, that will be a contributing factor to
slower earnings growth for the company. Now that's slower
in the context of the 30 and 40 percent earnings growth.
Capital One is still on track to have significant earnings
growth and to be one of the fastest growing large financial
institutions in America.
Remaining a
growth stock
Milligan: Do you still consider yourself to be a growth
stock?
Fairbank: Oh absolutely, yes. It's a
growth stock in the context of large companies.
Evaluating Capital One has been challenging sometimes
because we've gone from basically start up to Fortune
200 company in a very short period of time. I think
both for those who follow the company and also for those
who run it, we have to keep re-grounding our own expectations.
…It doesn't feel like we're growing any slower.
What's happening is our overall growth rate is slowing
down the velocity of growth laterally so to speak. In
terms of diversification, growth is faster than it's
ever been. Whereas we had basically just the credit
card business five years ago, we now have significant
growth and even profits coming from international installment
loan, auto finance, and we've also grown a big deposit
business over the last number of years. So I think very
much Capital One is still a growth company.
Milligan: It's always been my opinion
that the Achilles heel of the specialty finance company
like a Cap One is really on the funding side. Certainly
your stock has been volatile, and that reflects I'm
sure perceptions people have based upon either what's
going on in the economy or what was happening specifically
at Cap One. But your stock can float up and down--that
doesn't necessarily disrupt the way you do business.
If you have problems on the funding side, you can end
up being out of business, and no one would understands
that better than you.
Fairbank: Yes.
Milligan: I'm curious. When the concern
was being expressed 18 months ago about the company's
degree of exposure to sub-prime, were you having any
funding problems?
Fairbank: No, let me explain the context
of the challenge of being what we call a mono line--
what you're calling a specialty finance company. When
you start in financial services you've got to start
somewhere ---- niche --- starts with a single line of
business and goes from there. If you look at the list
of companies that have been specialty finance companies
in the '90s--by our tally there were 50 specialty finance
companies. Today there are very few left. Many are dead.
A lot have been sold. And of the remaining companies,
many of them are hanging by their fingernails.
Drop in number
of competitors
Milligan: There are only three right?
Fairbank: What are the three that you
have in mind?
Milligan: Well, in addition to you,
there's MBNA and there's Countrywide.
Fairbank: I'd like that to be
your list, not mine because I don't want to get myself
in trouble with my competitors and what category I'm
putting them in. But certainly you've named what most
people would put as the three most healthy ones. But
when an industry that's gone from 50 to three so to
speak--and there are others that are alive but they're
sort of operating with difficulty--that's a profound
statement of the challenges that specialty finance companies
face. It gives you profound insight into why there's
so much volatility in stock price and concern in the
constituencies out there, be they regulators, debt markets
or equity markets because they feel like, 'I've seen
this story before and it doesn't have a happy ending.'
And the pattern recognition is rather obvious.
Now long ago we started focusing on
the demise of many of our competitors, our colleagues,
and focused on what's causing this and what can we do
about that. And it's hard, and so I'm going to give
a broader answer to your question, Jack, but funding's
going to be one of the pieces of this thing. Typically
these companies have failed for one or more of three
reasons.
Since specialty finance companies securitize
their assets, they're required by the accounting to
take these assets and take the entire gain of future
earnings from these assets and record them today, even
though the contingent liability still remains. I don't
want to get into a complicated accounting argument,
but what we have done is taken a very conservative approach
to that. In auto finance we deviated from industry practice
by putting these, our securitized loans, on the balance
sheet, causing us not to take any gains but also in
fact to have to build reserves the old fashioned ways.
So without boring you with a lot of detail on that issue,
certainly one of the problems was accounting practices,
but I think over time it's now been cleaned up in the
industry. We just didn't go there and that helped us
avoid some of the problems that our competitors had.
The second problem has been credit problems.
What we have done is implement maniacally conservative
credit practices. For example, in all of our business
decisions we hardwire in a methodology of assuming a
recession starts tomorrow morning. All of the decisions
have to be in the context of an absolute assumption
of a recession instead of 'Gee it might happen and it
might not.' That's forced us to be very conservative.
Through all the years we have really stayed clear of
credit problems that have plagued our competitors.
The third reason, and this is to your
question, that specialty finance companies got problems
is they've had rather flimsy funding and so when they
run into any other problem--like an accounting problem
or a credit problem--the wholesale funding dries up,
and it's the beginning of the end. So what have we done?
We have had a strategy to fortify our funds through
incredibly conservative stockpile funding, having a
big liquidity portfolio, a large capital base, and also
building a deposit business.
Several years ago we went out and built
a large deposit business; whereas the Household's of
the world, Household International - that huge company
that sold out earlier this year - they had never built
a deposit base. That's another whole source of funding
of FDIC insured deposits. We go back to where 27% of
all of our funding now is deposits. So conservative
accounting, conservative credit, conservative funding
have been the cornerstone of making us able to ride
through all the wild fluctuations in the marketplace
still with the wheels intact. However the other part
of our strategy, Jack, is to say that at the end we
don't want to be a specialty finance company; we want
to be a diversified financial services company. So we
have put a lot of energy over time into diversifying
our product line, but that takes some years to get there.
Milligan: If Cap One ever decided to
sell out, I would think it would be not because you
ran out of growth and decided it was time to cash in,
but because your growth was being restrained by either
your ability to fund it--which probably isn't true-or
maybe because you just got tired of living with the
uncertainty of every time the bond market got a case
of the yips you sort of got whipsawed a little bit.
There's a question in there, and I apologize for the
soliloquy.
Fairbank: Well, it's obvious what the
question is. What you're doing is focusing on the risks
that have plagued specialty finance companies, and it's
implicitly a great question. Every one of these areas
we take a risk, we work backwards from what would be
a really bad scenario and then try to protect against
that. You know one can never protect against every conceivable
risk. So therefore in funding we divide our funding
between the easy to get funding, which is the senior
funding. So the A and Triple A funding--that is at the
top of the pecking order so to speak-- there's a whole
bunch of. The bulk of our funding we do is Triple A-rated
and borrowers get first claim. They're highest on the
pecking order for the Triple A- funding. Do you follow
me?
Milligan: Yes
Fairbank: What will typically happen
to specialty finance companies is the lower-rated debt
that's farther down the subordinated chain--that is
more difficult to get. What we've done is just worked
to stockpile that kind of funding. For example, with
our Triple B- funding, which is the lowest level of
asset -backed funding, we are already stockpiled into
the latter part of 2004, and here we're in the middle
of 2003.
Fairbank: There are no guarantees in
this world, but what we try to do is to take extreme
measures to protect ourselves, and collectively what
we've done in terms of financial management, credit
risk management and funding is very much different from
what our competitors have done.
Selling Capital
One?
Milligan: Are you confident right now in your funding
that the sale of the company is not something that would
be necessary to preserve it as an ongoing business operation?
Fairbank: Actually, I think we're probably
in the strongest position we have ever been with respect
to funding right now. Because we're more stockpiled
and more diversified than we have been in the past.
So I think we feel very good about our funding situation.
Milligan: Okay.
Fairbank: In a nutshell this past year, if you're
an outside party, a debt investor, a regulator, an equity
investor, even someone from the media looking at pattern
recognition--it's pretty clear a number of credit card
players got into trouble and particularly sub- prime
credit card players. So the logical thing to do is to
look at who else is out there with the risk factors?
Those risk factors are credit card or a mono line sort
of specialty finance company structure, some degree
of sub-prime in the mix, fast growth and credit cards.
So we had all of the risk factors…They saw all
of those things present at Capital One, and high growth--I
don't know if I mentioned that but that certainly was
one of the factors that was an issue-- so understandably
people got concerned about Capital One.
The good thing was that we had the underlying
financial strength of Capital One and the underlying
credit quality was such that we were able to ride through
this period of uncertainty very much intact without
in fact significantly deviating from the trajectory
our company was on anyway. In the process the regulators,
seeing the pattern, certainly wanted to make sure that
Capital One had the right kind of reserves in capital
to put, in fact even a higher level had been requested
before to make sure that, to protect against the kind
of problems that happened to other companies. We were
very much able to deliver on that because we had a lot
of earnings power and a lot of extra capital. We've
been able to go through this very noisy period and come
out the other side a stronger company for having gone
through it.
Company's new
structure
Milligan: Last thing. The departure of Nigel Morris.
As I understand it, he will not be replaced as chief
operating officer?
Fairbank: Right, we're going to go
to a structure many companies are turning to these days
which is the multi-divisional model with several strong
division presidents. In the past we've sort of had just
one division, the credit card division but now we have
enough mass to really have several substantial divisions.
We have an auto finance business that is really taking
off, and we also have international business and some
other lending businesses. While I'm very sad to see
my colleague leave --and he's a good friend and a very
talented guy-- we're trying to take this opportunity
to restructure the governance of the company to a more
classical governance model with a 10- person executive
committee and the strong divisional presidents model
as opposed to the chief operating office model.
Looking ahead-auto
finance to play bigger role
Some investors who follow Capital One challenge whether
this shift in corporate culture will work. Fairbank
says he's used to naysayers.
Fairbank: What we have always
had is a very bold strategic agenda to get to a destination
that has very much been the same for many, many years--
which is to take our information-based strategy and
build a diversified financial services company that
is able to compete market by market using this methodology
of mass customizing products.
It started in credit cards, and we had
a lot of success in credit cards…We went in the
auto finance business with a belief that people going
into a car dealership and spending a couple of hours
trying to get financing in a world where we're already
sending pre approved financing to folks in credit cards,
you know why not try to reinvent that industry by bringing
simple pre -approved solutions to auto finance consumers
in the same way we've been doing it in credit cards?
That's probably the fastest growing part of Capital
One. I don't know if you saw the earnings in the second
quarter, but take a look at the auto finance number.
It's just turned the corner, and it's going to contribute
significantly to our profitability going forward.
We've gone into the installment loan
business with a focus only on super prime and with the
nation's lowest prices have built a fast- growing business
there. The common theme is to go into markets in which
competitors have used traditional marketing approaches
and to try to bring simple no-hassle and better-priced
solutions to the consumers.
Coming full
circle?
Milligan: If I recall correctly Signet Bank (from which
Capital One spun off in 1994), before it was acquired,
tried to essentially reinvent itself as a good retail
bank that was sort of like a national products company.
Fairbank:
Yes, you have a very good memory.
Milligan: I don't know that they had
your skill set in terms of business information strategies,
so that may have been something beyond their reach,
but could you ever foresee Cap One returning to its
roots in a sense of harnessing some kind of retail on
the ground operation with this skill you have of selling
financial products nationwide and globally?
Fairbank: I think it's in the long
run part of our destiny. You know we have initially
focused on direct marketing, so you'll find that everything
we did for many years was direct to the consumer. But
then we got into indirect auto lending where we were
going through dealers, and that was a new step for Capital
One. I think you know since most retail products in
America are sold through traditional on the ground,
face-to-face distribution networks, I think some involvement
by Capital One in those distribution channels will be
inevitable. By the way Signet, I think, never got a
chance to really get its strategy fully developed before
they in fact sold out to First Union. So we never did
see the end of that chapter.
"What's
in your wallet?"
Fairbank: The last thing I want to say-- although
you didn't ask the question-- is something I think readers
are interested in and that's what's going on with this
brand strategy and the "What's in your wallet?"
campaign? And let me comment because Jack, that's also
part of the grand plan here.
The grand plan of going from a single
specialty finance one-product company to a diversified
financial institution. Part of what enabled us to build
Capital One is that we were able to ride on the back
of two of the world's most well known brands--Visa and
Master Card. We got what we paid for though, which is
we became one of America's largest companies that nobody
had heard of. Many of our customers confused us with
Visa and Master Card. Our view is if we want to build
one of the nation's great financial institutions--particularly
in products beyond credit cards--we're going to need
at some point to develop a brand identity of our own.
Three years ago we made the decision
to embark, with very substantial investment, to go a
different way from most of our credit card competitors
who were still riding in the Visa/Master Card sort of
brand umbrella and go out and create a brand identity
of our own. And so we have stuck with this investment
for several years. We're very pleased with the results,
but I think we're in a very different place now than
we were a few years ago in that I think 96% of Americans
are familiar with Capital One. When you ask Americans
the name of a credit card company, Capital One is the
most commonly named company.
Just being recognized isn't all that
one's trying to achieve in brand, but this is part of
a long process of trying to create a brand identity
with a company that brings simple no- hassle and well-
priced solutions to consumers who are frustrated and
bewildered by the ever more complicated experience of
trying to manage their financial lives. We believe that
is a very big vein to tap into from a brand point of
view. Everything that you will see out of Capital One
will be consistently moving toward that brand identity,
and we hope to stake out that space in a way meaningfully
differentiated from our competitors.
Milligan: Charles Collie isn't
going to want to hear that you think that you've got
the strongest credit card brand in the country.
Fairbank: By the way, I think American
Express has the strongest credit card brand. To be honest
with you, we have great admiration for their brand.
It begins with brand recognition, but in the end one
wants to move to a place where great companies have
gone like Nike and Volvo and many others who, not only
have brand recognition, but also really stand for something
in consumers' eyes that is highly differentiated from
the competition. So we've got a long way to go, and
I don't think MBNA or American Express should be shaking
in their boots thinking about Capital One. But in our
own little way, we continue quietly toward building
what we hope someday will be one of America's great
financial institutions.
Virginia
Business - September 2003
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