FORM 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended June 30, 2007.

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED).

For the transition period from              to             

Commission File No. 1-13300

 


CAPITAL ONE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Delaware   54-1719854

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

1680 Capital One Drive McLean, Virginia   22102
(Address of Principal Executive Offices)   (Zip Code)

(703) 720-1000

Registrant’s telephone number, including area code:

(Not applicable)

(Former name, former address and former fiscal year, if changed since last report)

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b of the Exchange Act. (Check One):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)    Yes  ¨    No  x

As of July 31, 2007 there were 417,685,490 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 



Table of Contents

CAPITAL ONE FINANCIAL CORPORATION

FORM 10-Q

INDEX

June 30, 2007

 

          Page
PART 1. FINANCIAL INFORMATION    1
Item 1    Reported Financial Statements (unaudited):    1
            Condensed Reported Consolidated Balance Sheets    1
            Condensed Reported Consolidated Statements of Income    2
            Condensed Reported Consolidated Statements of Changes in Stockholders’ Equity    3
            Condensed Reported Consolidated Statements of Cash Flows    4
            Notes to Condensed Reported Consolidated Financial Statements    5
Item 2    Management’s Discussion and Analysis of Financial Condition and Results of Operations    18
Item 3    Quantitative and Qualitative Disclosure of Market Risk    47
Item 4    Controls and Procedures    47
PART 2. OTHER INFORMATION    48
Item 1    Legal Proceedings    48
Item 1A    Risk Factors    48
Item 2    Unregistered Sales of Equity Securities and Use of Proceeds    48
Item 6    Exhibits    48
   Signatures    52


Table of Contents

Part 1. Financial Information

Item 1. Financial Statements

CAPITAL ONE FINANCIAL CORPORATION

Condensed Reported Consolidated Balance Sheets (unaudited)

(Dollars in thousands, except share and per share data)

 

    

June 30

2007

   

December 31

2006

 

Assets:

    

Cash and due from banks

   $ 2,354,393     $ 2,817,519  

Federal funds sold and resale agreements

     3,940,269       1,099,156  

Interest-bearing deposits at other banks

     753,160       743,821  
                

Cash and cash equivalents

     7,047,822       4,660,496  

Securities available for sale

     20,407,932       15,452,047  

Mortgage loans held for sale

     2,732,044       10,435,295  

Loans held for investment

     91,617,353       96,512,139  

Less: Allowance for loan and lease losses

     (2,120,000 )     (2,180,000 )
                

Net loans held for investment

     89,497,353       94,332,139  

Accounts receivable from securitizations

     5,481,686       4,589,235  

Premises and equipment, net

     2,260,928       2,203,280  

Interest receivable

     768,617       816,426  

Goodwill

     13,612,005       13,635,435  

Other

     4,129,570       3,614,932  
                

Total assets

   $ 145,937,957     $ 149,739,285  
                
Liabilities:     

Non-interest-bearing deposits

   $ 11,236,110     $ 11,648,070  

Interest-bearing deposits

     74,444,345       74,122,822  
                

Total Deposits

     85,680,455       85,770,892  

Senior and subordinated notes

     9,222,506       9,725,470  

Other borrowings

     20,681,289       24,257,007  

Interest payable

     543,805       574,763  

Other

     4,623,241       4,175,947  
                

Total liabilities

     120,751,296       124,504,079  
                
Stockholders’ Equity:     

Preferred Stock, par value $.01 per share; authorized 50,000,000 shares, none issued or outstanding

     —         —    

Common stock, par value $.01 per share; authorized 1,000,000,000 shares, 417,354,776 and 412,219,973 issued as of June 30, 2007 and December 31, 2006, respectively

     4,174       4,122  

Paid-in capital, net

     15,682,009       15,333,137  

Retained earnings

     11,141,194       9,760,184  

Cumulative other comprehensive income

     245,431       266,180  

Less: Treasury stock, at cost; 25,914,653 and 2,294,586 shares as of June 30, 2007 and December 31, 2006, respectively

     (1,886,147 )     (128,417 )
                

Total stockholders’ equity

     25,186,661       25,235,206  
                

Total liabilities and stockholders’ equity

   $ 145,937,957     $ 149,739,285  
                

See Notes to Condensed Reported Consolidated Financial Statements.

 

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Table of Contents

CAPITAL ONE FINANCIAL CORPORATION

Condensed Reported Consolidated Statements of Income

(Dollars in thousands, except per share data) (unaudited)

 

    

Three Months Ended

June 30

  

Six Months Ended

June 30

     2007    2006    2007    2006
Interest Income:            

Loans held for investment, including past-due fees

   $ 2,266,898    $ 1,616,937    $ 4,593,578    $ 3,229,559

Securities available for sale

     237,978      167,352      442,058      331,462

Mortgage loans held for sale

     71,149      4,714      215,908      8,813

Other

     137,036      108,154      249,530      205,905
                           

Total interest income

     2,713,061      1,897,157      5,501,074      3,775,739
Interest Expense:            

Deposits

     749,603      416,232      1,480,086      819,841

Senior and subordinated notes

     134,061      84,707      272,607      179,061

Other borrowings

     269,303      199,136      565,441      372,878
                           

Total interest expense

     1,152,967      700,075      2,318,134      1,371,780
                           
Net interest income      1,560,094      1,197,082      3,182,940      2,403,959

Provision for loan and lease losses

     401,035      362,445      751,080      532,715
                           

Net interest income after provision for loan and lease losses

     1,159,059      834,637      2,431,860      1,871,244
Non-Interest Income:            

Servicing and securitizations

     1,226,896      1,025,506      2,214,978      2,179,110

Service charges and other customer-related fees

     482,979      413,398      962,446      849,129

Mortgage banking operations

     102,855      41,973      189,398      73,859

Interchange

     125,979      131,538      244,090      251,029

Other

     67,456      97,498      205,778      215,037
                           

Total non-interest income

     2,006,165      1,709,913      3,816,690      3,568,164
Non-Interest Expense:            

Salaries and associate benefits

     713,242      536,465      1,437,501      1,052,609

Marketing

     326,718      356,695      658,267      680,466

Communications and data processing

     196,172      172,734      382,160      341,938

Supplies and equipment

     116,043      113,028      250,645      211,212

Restructuring expense

     101,142      —        101,142      —  

Occupancy

     85,085      52,753      170,930      102,130

Other

     574,451      449,222      1,157,609      866,021
                           

Total non-interest expense

     2,112,853      1,680,897      4,158,254      3,254,376
                           

Income before income taxes

     1,052,371      863,653      2,090,296      2,185,032

Income taxes

     301,999      311,066      664,874      749,106
                           

Net income

   $ 750,372    $ 552,587      1,425,422    $ 1,435,926
                           

Basic earnings per share

   $ 1.92    $ 1.84    $ 3.57    $ 4.79
                           

Diluted earnings per share

   $ 1.89    $ 1.78    $ 3.51    $ 4.64
                           

Dividends paid per share

   $ 0.03    $ 0.03    $ 0.05    $ 0.05
                           

See Notes to Condensed Reported Consolidated Financial Statements.

 

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CAPITAL ONE FINANCIAL CORPORATION

Condensed Reported Consolidated Statements of Changes in Stockholders’ Equity

(Dollars in thousands, except share and per share data) (unaudited)

 

     Common Stock    

Paid-In

Capital, Net

   

Retained

Earnings

   

Cumulative

Other

Comprehensive

Income (Loss)

   

Treasury

Stock

   

Total

Stockholders’

Equity

 

(In thousands, except share and per share data)

   Shares     Amount            
Balance, December 31, 2005    302,786,444     $ 3,028     $ 6,848,544     $ 7,378,015     $ 6,129     $ (106,802 )   $ 14,128,914  

Comprehensive income:

              

Net income

   —         —         —         1,435,926       —         —         1,435,926  

Other comprehensive income, net of income tax:

              

Unrealized losses on securities, net of income taxes benefit of $59,673

   —         —         —         —         (103,968 )     —         (103,968 )

Foreign currency translation adjustments

   —         —         —         —         131,661       —         131,661  

Unrealized gains on cash flow hedging instruments, net of income taxes of $15,788

   —         —         —         —         26,305       —         26,305  
                                                      

Other comprehensive income

   —         —         —         —         53,998       —         53,998  
                                                      

Comprehensive income

                 1,489,924  

Cash dividends - $.05 per share

   —         —         —         (16,105 )     —         —         (16,105 )

Purchase of treasury stock

   —         —         —         —         —         (8,534 )     (8,534 )

Issuances of common stock and restricted stock, net of forfeitures

   639,993       6       16,425       —         —         —         16,431  

Exercise of stock options and related tax benefits

   2,580,829       26       199,780       —         —         —         199,806  

Compensation expense for restricted stock awards and stock options

   —         —         86,627       —         —         —         86,627  
                                                      
Balance, June 30, 2006    306,007,266     $ 3,060     $ 7,151,376     $ 8,797,836     $ 60,127     $ (115,336 )   $ 15,897,063  
                                                      
Balance, December 31, 2006    412,219,973     $ 4,122     $ 15,333,137     $ 9,760,184     $ 266,180     $ (128,417 )   $ 25,235,206  

Cumulative effect from adoption of FIN 48

           (31,830 )         (31,830 )

Cumulative effect from adoption of FAS 156, net of income taxes of $6,378

           8,809           8,809  

Comprehensive income:

              

Net income

           1,425,422           1,425,422  

Other comprehensive income, net of income tax:

              

Unrealized loss on securities, net of income taxes benefit of $62,652

             (107,818 )       (107,818 )

Defined benefit pension plans

             (1,352 )       (1,352 )

Foreign currency translation adjustments

             73,298         73,298  

Unrealized gains on cash flow hedging instruments, net of income tax of $9,090

             15,123         15,123  
                                                      

Other comprehensive income

   —         —         —         —         (20,749 )     —         (20,749 )
                                                      

Comprehensive income

                 1,404,673  
                 —    

Cash dividends - $.03 per share

           (21,391 )         (21,391 )

Purchase of treasury stock

               (1,757,730 )     (1,757,730 )

Issuances of common stock and restricted stock, net of forfeitures

   1,063,803       11       18,618             18,629  

Exercise of stock options and related tax benefits of exercises and restricted stock vesting

   4,207,243       42       229,320             229,362  

Compensation expense for restricted stock awards and stock options

         108,159             108,159  

Adjustment to issuance of common stock for acquisition

   (136,243 )     (1 )     (10,386 )           (10,387 )

Allocation of ESOP shares

         3,161             3,161  
                                                      

Balance, June 30, 2007

   417,354,776     $ 4,174     $ 15,682,009     $ 11,141,194     $ 245,431     $ (1,886,147 )   $ 25,186,661  
                                                      

See Notes to Condensed Reported Consolidated Financial Statements.

 

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CAPITAL ONE FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

(Dollars in thousands) (unaudited)

 

    

Six Months Ended

June 30,

 
     2007     2006  

Operating Activities:

    

Net Income

   $ 1,425,422     $ 1,435,926  

Adjustments to reconcile net income to cash provided by operating activities:

    

Provision for loan and lease losses

     751,080       532,715  

Depreciation and amortization, net

     329,856       254,220  

(Gains) losses on sales of securities available for sale

     (66,857 )     25,596  

Gains on sales of auto loans

     (10,285 )     (22,875 )

Gains on extinguishment of debt

     (17,444 )     —    

Mortgage loans held for sale:

    

Transfers in and originations

     (10,999,318 )     (120,555 )

Loss on sales

     38,650       —    

Proceeds from sales

     18,628,775       —    

Stock plan compensation expense

     258,515       102,707  

Changes in assets and liabilities, net of effects from purchase of companies acquired:

    

Decrease in interest receivable

     47,809       37,275  

(Increase) decrease in accounts receivable from securitizations

     (895,299 )     89,502  

Increase in other assets

     (463,439 )     (65,607 )

Increase (decrease) in interest payable

     450,434       (20,484 )

Decrease in other liabilities

     (30,958 )     (242,546 )
                

Net cash provided by operating activities

     9,446,941       2,005,874  
                
Investing Activities:     

Purchases of securities available for sale

     (9,329,173 )     (4,462,735 )

Proceeds from maturities of securities available for sale

     3,672,539       1,797,173  

Proceeds from sales of securities available for sale

     544,449       1,523,455  

Proceeds from securitizations of loans

     7,060,100       6,903,738  

Net increase in loans held for investment

     (3,336,612 )     (8,521,384 )

Principal recoveries of loans previously charged off

     321,430       274,929  

Additions of premises and equipment, net

     (211,404 )     (398,864 )

Net payments for companies acquired

     (14,787 )     (22,923 )
                

Net cash used in investing activities

     (1,293,458 )     (2,906,611 )
                
Financing Activities:     

Net decrease in deposits

     (90,437 )     (754,316 )

Net (decrease) increase in other borrowings

     (3,557,059 )     1,304,288  

Maturities of senior notes

     (462,500 )     (1,224,731 )

Repurchases of senior notes

     —         (31,296 )

Purchases of treasury stock

     (1,757,730 )     (8,534 )

Dividends paid

     (21,391 )     (16,105 )

Net proceeds from issuances of common stock

     21,790       16,431  

Proceeds from share based payment activities

     101,170       141,779  
                

Net cash used in financing activities

     (5,766,157 )     (572,484 )
                

Increase in cash and cash equivalents

     2,387,326       (1,473,221 )

Cash and cash equivalents at beginning of year

     4,660,496       4,071,267  
                

Cash and cash equivalents at end of period

   $ 7,047,822     $ 2,598,046  
                

See Notes to Condensed Reported Consolidated Financial Statements.

 

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CAPITAL ONE FINANCIAL CORPORATION

Notes to Condensed Reported Consolidated Financial Statements

(in thousands, except per share data) (unaudited)

Note 1

Summary of Significant Accounting Policies

Business

Capital One Financial Corporation (the “Corporation”) is a diversified financial services company whose banking and non-banking subsidiaries market a variety of financial products and services. The Corporation’s principal subsidiaries are:

 

   

Capital One Bank (the “Bank”) which currently offers credit and debit card products, deposit products, and also engages in a wide variety of lending and other financial activities.

 

   

Capital One, F.S.B. (the “Savings Bank”) which offers consumer and commercial lending and consumer deposit products. Effective July 1, 2007, the Savings Bank merged with and into CONA.

 

   

Capital One, National Association (“CONA”) which offers a broad spectrum of financial products and services to consumers, small businesses and commercial clients.

 

   

Capital One Auto Finance, Inc. (“COAF”) which offers automobile and other motor vehicle financing products.

 

   

North Fork Bank (“North Fork Bank”) which offers a full range of banking products and financial services, to both consumer and commercial customers. Effective August 1, 2007, North Fork Bank merged with and into CONA.

Another subsidiary of the Corporation, Superior Savings of New England, N.A. (“Superior”) focuses on telephonic and media-based generation of deposits. In addition, a subsidiary of North Fork Bank, GreenPoint Mortgage Funding, Inc. (“GreenPoint”) offers residential and commercial mortgages. Effective August 1, 2007, GreenPoint became an operating subsidiary of CONA.

The Corporation and its subsidiaries are hereafter collectively referred to as the “Company”.

Basis of Presentation

The accompanying unaudited condensed reported consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.

All significant intercompany balances and transactions have been eliminated. Certain prior years’ amounts have been reclassified to conform to the 2007 presentation. All amounts in the following notes, excluding share and per share data, are presented in thousands.

The notes to the reported consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2006 should be read in conjunction with these condensed reported consolidated financial statements.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Liabilities, (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value with changes in fair value included in current earnings. The election is made on specified election dates, can be made on an instrument by instrument basis, and is irrevocable. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Management is currently evaluating the impact of adoption of SFAS 159 on the consolidated earnings and financial position of the Company.

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, Fair Value Measurements (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Management is currently evaluating the impact of adoption of SFAS 157 on the consolidated earnings and financial position of the Company.

 

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In September 2006, the FASB issued Statement of Financial Accounting Standard No. 156, Accounting for Servicing of Financial Assets, and (“SFAS 156”), which amends Statement of Financial Accounting Standards No. 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”). SFAS 156 changes the accounting for, and reporting of, the recognition and measurement of separately recognized servicing assets and liabilities. Effective January 1, 2007, the Company adopted SFAS 156 resulting in an $8.8 million cumulative effect, net of taxes of $6.4 million, increase to the beginning balance of retained earnings.

In February 2006, the FASB issued Statement of Financial Accounting Standard No. 155, Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140, (“SFAS 155”). SFAS 155 amends FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, (“SFAS 133”) and SFAS 140. SFAS 155 resolves issues addressed in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The adoption of SFAS 155 did not have a material impact on the consolidated earnings or financial position of the Company.

Adoption of FIN 48

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

The Company adopted the provisions of FIN 48 effective January 1, 2007. As a result of adoption, the Company recorded a $31.8 million reduction in retained earnings. The reduction in retained earnings upon adoption is the net impact of a $48.7 million increase in the liability for unrecognized tax benefits and a $16.8 million increase in deferred tax assets. In addition, the Company reclassified $471.1 million of unrecognized tax benefits from deferred tax liabilities to current taxes payable to conform to the deferred tax measurement and balance sheet presentation requirements of FIN 48.

The balance of unrecognized tax benefits at January 1, 2007 is $661.6 million. Included in the balance at January 1, 2007, are $83.5 million of tax positions which, if recognized, would affect the effective tax rate and $58.0 million of tax positions which, if recognized, would result in a reduction in goodwill. Also included in the balance is $466.4 million of tax positions related to items of income and expense for which the ultimate taxability or deductibility is highly certain, but for which there is uncertainty about the timing of recognition. Because of the impact of deferred tax accounting, other than interest and penalties, the acceleration of taxability or deferral of deductibility of these items would not affect the annual effective tax rate but may accelerate the payment of taxes to an earlier period.

The Company continues to recognize accrued interest and penalties related to unrecognized tax benefits as a component of income tax expense, consistent with its policy prior to adoption of FIN 48. The accrued balance of interest and penalties related to unrecognized tax benefits at January 1, 2007 is $119.1 million.

The Company is subject to examination by the Internal Revenue Service (“IRS”) and other tax authorities in certain countries and states in which the Company has significant business operations. The tax years subject to examination vary by jurisdiction. The IRS is currently examining the Company’s federal income tax returns for the years 2003 and 2004 as well as the tax returns of certain acquired subsidiaries for the year 2004. During 2006, the IRS concluded its examination of the Company’s federal income tax returns for the years 2000-2002. Tax issues for years 1995-1999 are pending in the U.S. Tax Court, and the conclusion of those matters could impact tax years after 1999.

As of June 30, 2007, the IRS has proposed adjustments with respect to the timing of recognition of items of income and expense derived from the Company’s credit card business in various tax years. The ultimate resolution of these issues is not

 

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expected to have a material effect on the Company’s operations or financial condition. However, the Company anticipates that it is reasonably possible that a payment of up to $250 million, principally related to these timing issues, will be made within twelve months of the reporting date resulting in a significant reduction to the Company’s liability for unrecognized tax benefits.

Significant Accounting Policies

See the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, Item 8 “Notes to Condensed Reported Financial Statements – Note 1 – Summary of Significant Accounting Policies” for a summary of the Company’s accounting policies. Refer also to the discussion below for accounting policies that may supplement or modify the discussion of accounting policies in the Company’s Form 10-K for the year December 31, 2006.

Consumer Loan Securitizations

The Company primarily securitizes credit card loans, auto loans and installment loans. Securitization provides the Company with a significant source of liquidity and favorable capital treatment for securitizations accounted for as off-balance sheet arrangements. See Item 8 “Notes to Condensed Reported Financial Statements – Note 22 – Off-Balance Sheet Securitizations” in the Company’s Form 10-K for the year ended December 31, 2006 for additional detail.

Loan securitization involves the transfer of a pool of loan receivables to a trust or other special purpose entity. The trust sells an undivided interest in the pool of loan receivables to third-party investors through the issuance of asset backed securities and distributes the proceeds to the Company as consideration for the loans transferred. The Company removes loan receivable from the Reported Consolidated Balance Sheets for securitizations that qualify as sales in accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities – a Replacement of SFAS No. 125 (“SFAS 140”). Alternatively, when the transfer would not be considered a sale but rather a financing, the assets will remain on the Company’s Reported Consolidated Balance Sheet with an offsetting liability recognized in the amount of proceeds received.

Interests in the securitized and sold loans may be retained in the form of subordinated interest-only strips, subordinated tranches, cash collateral and spread accounts. The Company also retains a seller’s interest in the credit card receivables transferred to the trusts which is carried on a historical cost basis and classified as loans held for investment on the Reported Consolidated Balance Sheet.

Gains on securitization transactions, fair value adjustments related to residual securitizations income in the Consolidated Statements of Income and amounts due from the trusts are included in accounts receivable from securitizations on the Reported Consolidated Balance Sheets. As of June 30, 2007 and December 31, 2006, the retained interest on the Reported Consolidated Balance Sheet was $2.5 billion and $2.2 billion, respectively. See Note 22 in the Company’s Form 10-K for the year December 31, 2006 for additional detail.

The gain on sale recorded from off-balance sheet securitizations is recorded based on the estimated fair value of the assets sold and retained and liabilities incurred, and is recorded at the time of sale, net of transaction costs, in Servicing and securitizations income on the Reported Consolidated Statements of Income. The related receivable is the interest-only strip, which is based on the present value of the estimated future cash flows from excess finance charges and past-due fees over the sum of the return paid to security holders, estimated contractual servicing fees and credit losses. The interest-only strip is accounted for as a trading security with changes in the estimated fair value recorded in Servicing and securitizations income. To the extent assumptions used by management do not prevail, fair value estimates of the interest-only strip could differ significantly, resulting in either higher or lower future servicing and securitization income, as applicable.

The Company does not recognize servicing assets or servicing liabilities for servicing rights retained from consumer loan securitizations since the servicing fee approximates just adequate compensation to the Company for performing the servicing.

Loans Held for Investment

Loans held for investment include consumer and commercial loans. Consumer loans include credit card, installment, auto and mortgage loans. Credit card loans are reported at their principal amounts outstanding and include uncollected billed interest and fees. All other loans are reported at their principal amounts outstanding.

 

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All new originations of consumer loans, except for mortgage loans, are deemed to be held for investment at origination because management has the intent and ability to hold them for the foreseeable future or until maturity or payoff. See Item 8 “Notes to Condensed Reported Financial Statements—Note 1—Summary of Significant Accounting Policies,” in the Company’s Form 10-K for the year ended December 31, 2006 for additional detail on Mortgage Loans Held for Sale. Management believes the foreseeable future is relatively short based on the weighted average life of the consumer loans and the homogeneous nature of the receivables. In determining the amount of Loans held for investment, management makes judgments about the Company’s ability to fund these loans through means other than securitization, such as deposits and other borrowings. Management assesses whether loans can continue to be held for investment on a quarterly basis by considering capital levels and scheduled maturities of funding instruments used.

Consumer loan balances that are expected to be securitized in the next three months are reclassified as held for sale. Management believes its ability to reasonably forecast the amount of existing consumer loans that should be reclassified as held for sale is limited to three months from the balance sheet date because of the short-term nature of the assets, the revolving nature of the securitization structures and the fact that securitizations that occur beyond three months will involve a significant proportion of consumer loans that have not yet been originated. The Company continues to include these loans in loans held for investment because separate classification in the Reported Consolidated Balance Sheets and related impacts to the Reported Consolidated Statements of Income is considered immaterial to the Company’s financial statements. The loans that have been identified as held for sale are carried at the lower of aggregate cost or fair value and an allowance for loan losses is not provided for these loans.

Cash flows associated with loans that are originated with the intent to hold for investment are classified as investing cash flow, regardless of a subsequent change of intent.

Note 2

Business Combinations

North Fork Bancorporation

On December 1, 2006, the Company acquired 100% of the outstanding common stock of North Fork Bancorporation (“North Fork”), a regional bank holding company headquartered in New York conducting commercial and retail banking from branch locations in New York, New Jersey, and Connecticut, with a complementary national mortgage banking business.

The acquisition was accounted for under the purchase method of accounting, and, as such, the assets and liabilities of North Fork were recorded at their respective fair values as of December 1, 2006. The results of North Fork’s operations were included in the Company’s Consolidated Reported Statement of Income commencing December 1, 2006.

The total consideration of $13.2 billion, which includes the value of outstanding stock options, was settled through the issuance of 103.8 million shares of the Company’s common stock and payment of $5.2 billion in cash. Under the terms of the transaction, each share of North Fork common stock was exchanged for $28.14 in cash or 0.3692 shares of the Company’s common stock or a combination of common stock and cash based on the aforementioned conversion rates, based on the average of the closing prices on the NYSE of the Company’s common stock during the five trading days ending the day before the completion of the merger, which was $76.24.

 

Costs to acquire North Fork:

  

Capital One common stock issued

   $ 7,914,463

Cash consideration paid

     5,200,500

Fair value of employee stock options

     83,633

Investment banking, legal, and consulting fees

     31,547
      

Total consideration paid for North Fork

   $ 13,230,143

The allocation of the final purchase price is still subject to refinement as the integration process continues and additional information becomes available.

The following unaudited pro forma condensed statements of income assume that the Company and North Fork were combined at the beginning of 2006.

 

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Table of Contents
    

Three Months Ended

June 30 2006

  

Six Months Ended

June 30 2006

Net interest income

   $ 1,555,638    $ 3,107,487

Non-interest income

     1,866,008      3,891,305

Provision for loan and lease losses

     371,445      550,715

Non-interest expense

     2,000,523      3,893,510

Income taxes

     369,584      868,668
             

Net income

   $ 680,094    $ 1,685,899
             

Basic earnings per share

   $ 1.68    $ 4.17

Diluted earnings per share

   $ 1.64    $ 4.06
             

(1) Pro forma adjustments include the following adjustments: accretion for loan fair value discount, reduction of interest income for amounts used to fund the acquisition, amortization for interest-bearing deposits fair value premium, accretion for subordinated notes fair value premium, addition of interest expense for borrowings used to fund the acquisition, and related amortization for intangibles acquired, net of North Fork’s historical intangible amortization expense.

Note 3

Segments

With the Company’s diversification into banking through the acquisition of Hibernia Corporation in late 2005 and the acquisition of North Fork in fourth quarter 2006, the Company strategically manages its business at two operating segment levels: Local Banking and National Lending. Local Banking includes consumer, small business and commercial deposits and lending conducted within its branch network. The National Lending segment consists of the following four sub-segments:

 

   

U.S. Card sub-segment which consists of domestic consumer credit and debit card activities.

 

   

Auto Finance sub-segment which includes automobile and other motor vehicle financing activities.

 

   

Global Financial Services sub-segment consisting of international lending activities, small business lending, installment loans, home loans, healthcare financing and other diversified activities.

 

   

Mortgage Banking sub-segment which consists primarily of residential and commercial mortgages originated for sale into the secondary market.

The Local Banking and National Lending Banking segments are considered reportable segments based on quantitative thresholds applied to the managed loan portfolio for reportable segments provided by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, and are disclosed separately. The Other category includes the Company’s liquidity portfolio, emerging businesses not included in the reportable segments, and various non-lending activities. The Other category also includes the net impact of transfer pricing, certain unallocated expenses, gains/losses related to the securitization of assets, and restructuring charges related to the Company’s 2007 cost initiative.

The Company maintains its books and records on a legal entity basis for the preparation of financial statements in conformity with GAAP. The following tables present information prepared from the Company’s internal management information system, which is maintained on a line of business level through allocations from the consolidated financial results.

See Note 1, Summary of Significant Accounting Policies in the Annual Report on Form 10-K for the accounting policies of the reportable segments.

 

Total Company

   Three Months Ended June 30, 2007
  

National

Lending

  

Local

Banking

   Other    

Total

Managed

  

Securitization

Adjustments (1)

   

Total

Reported

Net interest income

   $ 2,085,449    $ 584,465    $ (35,056 )   $ 2,634,858    $ (1,074,764 )   $ 1,560,094

Non-interest income

     1,247,343      174,691      (249 )     1,421,785      584,380       2,006,165

Provision for loan and lease losses

     873,471      23,929      (5,981 )     891,419      (490,384 )     401,035

Restructuring expenses

     —        —        101,142       101,142      —         101,142

Other non-interest expenses

     1,449,697      533,297      28,717       2,011,711      —         2,011,711

Income tax provision (benefit)

     347,916      69,464      (115,381 )     301,999      —         301,999
                                           

Net income (loss)

   $ 661,708    $ 132,466    $ (43,802 )   $ 750,372      —       $ 750,372
                                           

Loans held for investment

   $ 102,277,827    $ 41,919,645    $ (11,928 )   $ 144,185,544    $ (52,568,191 )   $ 91,617,353

Total deposits

   $ 2,411,435    $ 74,482,705    $ 8,786,315     $ 85,680,455      —       $ 85,680,455

 

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Total Company

   Three Months Ended June 30, 2006
  

National

Lending

  

Local

Banking

   Other    

Total

Managed

  

Securitization

Adjustments (1)

   

Total

Reported

Net interest income

   $ 1,906,108    $ 249,228    $ (14,507 )   $ 2,140,829    $ (943,747 )   $ 1,197,082

Non-interest income

     1,130,005      114,039      (44,712 )     1,199,332      510,581       1,709,913

Provision for loan and lease losses

     785,029      6,632      3,950       795,611      (433,166 )     362,445

Restructuring expenses

     —        —        —         —        —         —  

Other non-interest expenses

     1,375,138      289,996      15,763       1,680,897      —         1,680,897

Income tax provision (benefit)

     307,925      23,324      (20,183 )     311,066      —         311,066
                                           

Net income (loss)

   $ 568,021    $ 43,315    $ (58,749 )   $ 552,587      —       $ 552,587
                                           

Loans held for investment

   $ 95,230,654    $ 13,189,112    $ 13,673     $ 108,433,439    $ (47,830,636 )   $ 60,602,803

Total deposits

   $ 2,434,679    $ 35,281,970    $ 9,470,164     $ 47,186,813      —       $ 47,186,813

 

National Lending sub-segment detail

   Three Months Ended June 30, 2007
   U.S. Card   

Auto

Finance

  

Global

Financial

Services

  

Mortgage

Banking

  

Total

National

Lending

Net interest income

   $ 1,189,434    $ 374,038    $ 500,464    $ 21,513    $ 2,085,449

Non-interest income

     842,428      23,273      311,438      70,204      1,247,343

Provision for loan and lease losses

     402,589      182,278      284,282      4,322      873,471

Non-interest expenses

     808,769      157,044      400,469      83,415      1,449,697

Income tax provision

     282,253      19,948      44,346      1,369      347,916
                                  

Net income

   $ 538,251    $ 38,041    $ 82,805    $ 2,611    $ 661,708
                                  

Loans held for investment

   $ 50,032,530    $ 24,067,760    $ 27,489,749    $ 687,788    $ 102,277,827
     Three Months Ended June 30, 2006

National Lending sub-segment detail

   U.S. Card   

Auto

Finance

  

Global

Financial

Services

  

Mortgage

Banking

  

Total

National

Lending

Net interest income

   $ 1,120,422    $ 340,234    $ 445,452    $ —      $ 1,906,108

Non-interest income

     803,083      29,842      297,080      —        1,130,005

Provision for loan and lease losses

     413,701      74,714      296,614      —        785,029

Non-interest expenses

     860,874      149,115      365,149      —        1,375,138

Income tax provision

     227,125      51,186      29,614      —        307,925
                                  

Net income

   $ 421,805    $ 95,061    $ 51,155    $ —      $ 568,021
                                  

Loans held for investment

   $ 48,736,483    $ 20,558,455    $ 25,935,716    $ —      $ 95,230,654

(1) Income statement adjustments for the three months ended June 30, 2007 reclassify the net of finance charges of $1,564.3 million, past due fees of $221.7 million, other interest income of $(44.3) million and interest expense of $666.9 million; and net charge-offs of $490.4 million to non-interest income from net interest income and provision for loan and lease losses, respectively.

 

   Income statement adjustments for the three months ended June 30, 2006 reclassify the net of finance charges of $1,341.8 million, past due fees of $237.1 million, other interest income of $(61.6) million and interest expense of $573.5 million; and net charge-offs of $433.2 million to non-interest income from net interest income and provision for loan losses, respectively.

 

10


Table of Contents

Total Company

   Six Months Ended June 30, 2007
  

National

Lending

  

Local

Banking

   Other    

Total

Managed

  

Securitization

Adjustments (1)

   

Total

Reported

Net interest income

   $ 4,174,064    $ 1,158,034    $ (76,483 )   $ 5,255,615    $ (2,072,675 )   $ 3,182,940

Non-interest income

     2,435,265      361,564      (44,813 )     2,752,016      1,064,674       3,816,690

Provision for loan and lease losses

     1,722,687      47,705      (11,311 )     1,759,081      (1,008,001 )     751,080

Restructuring expenses

     —        —        101,142       101,142      —         101,142

Other non-interest expenses

     2,958,754      1,072,361      25,997       4,057,112      —         4,057,112

Income tax provision (benefit)

     664,201      137,439      (136,766 )     664,874      —         664,874
                                           

Net income (loss)

   $ 1,263,687    $ 262,093    $ (100,358 )   $ 1,425,422    $ —       $ 1,425,422
                                           

Loans held for investment

   $ 102,277,827    $ 41,919,645    $ (11,928 )   $ 144,185,544    $ (52,568,191 )   $ 91,617,353

Total deposits

   $ 2,411,435    $ 74,482,705    $ 8,786,315     $ 85,680,455      —       $ 85,680,455

Total Company

   Six Months Ended June 30, 2006
  

National

Lending

  

Local

Banking

   Other    

Total

Managed

  

Securitization

Adjustments (1)

   

Total

Reported

Net interest income

   $ 3,898,461    $ 494,152    $ (16,814 )   $ 4,375,799    $ (1,971,840 )   $ 2,403,959

Non-interest income

     2,204,988      218,524      (1,986 )     2,421,526      1,146,638       3,568,164

Provision for loan and lease losses

     1,334,637      16,453      6,827       1,357,917      (825,202 )     532,715

Restructuring expenses

     —        —        —         —        —         —  

Other non-interest expenses

     2,684,694      562,983      6,699       3,254,376      —         3,254,376

Income tax provision (benefit)

     730,384      46,634      (27,912 )     749,106      —         749,106
                                           

Net income (loss)

   $ 1,353,734    $ 86,606    $ (4,414 )   $ 1,435,926    $ —       $ 1,435,926
                                           

Loans held for investment

   $ 95,230,654    $ 13,189,112    $ 13,673     $ 108,433,439    $ (47,830,636 )   $ 60,602,803

Total deposits

   $ 2,434,679    $ 35,281,970    $ 9,470,164     $ 47,186,813    $ —       $ 47,186,813

 

National Lending sub-segment detail

   Six Months Ended June 30, 2007
   U.S. Card   

Auto

Finance

  

Global

Financial

Services

  

Mortgage

Banking

   

Total

National

Lending

Net interest income

   $ 2,400,775    $ 746,091    $ 987,382    $ 39,816     $ 4,174,064

Non-interest income

     1,621,034      83,859      610,745      119,627       2,435,265

Provision for loan and lease losses

     776,425      382,336      559,604      4,322       1,722,687

Non-interest expenses

     1,669,789      321,992      796,670      170,303       2,958,754

Income tax provision (benefit)

     542,004      43,214      84,206      (5,223 )     664,201
                                   

Net income (loss)

   $ 1,033,591    $ 82,408    $ 157,647    $ (9,959 )   $ 1,263,687
                                   

Loans held for investment

   $ 50,032,530    $ 24,067,760    $ 27,489,749    $ 687,788     $ 102,277,827

National Lending sub-segment detail

   Six Months Ended June 30, 2006
   U.S. Card   

Auto

Finance

  

Global

Financial

Services

  

Mortgage

Banking

   

Total

National

Lending

Net interest income

   $ 2,341,523    $ 673,237    $ 883,701    $ —       $ 3,898,461

Non-interest income

     1,578,496      46,060      580,432      —         2,204,988

Provision for loan and lease losses

     638,139      182,519      513,979      —         1,334,637

Non-interest expenses

     1,705,603      283,770      695,321      —         2,684,694

Income tax provision

     551,698      88,552      90,134      —         730,384
                                   

Net income

   $ 1,024,579    $ 164,456    $ 164,699    $ —       $ 1,353,734
                                   

Loans held for investment

   $ 48,736,483    $ 20,558,455    $ 25,935,716    $ —       $ 95,230,654

(1) Income statement adjustments for the six months ended June 30, 2007 reclassify the net of finance charges of $3,026.7 million, past due fees of $440.3 million, other interest income of $(77.9) million and interest expense of $1,316.4 million; and net charge-offs of $1,008.0 million to non-interest income from net interest income and provision for loan and lease losses, respectively.

Income statement adjustments for the six months ended June 30, 2006 reclassify the net of finance charges of $2,705.3 million, past due fees of $493.5, other interest income of $(123.3) million and interest expense of $1,103.7 million; and net charge-offs of $825.2 million to non-interest income from net interest income and provision for loan losses, respectively.

 

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Note 4:

Comprehensive Income

Comprehensive income for the three months ended June 30, 2007 and 2006, respectively was as follows:

 

     Three Months Ended
June 30
     2007     2006

Comprehensive Income:

    

Net income

   $ 750,372     $ 552,587

Other comprehensive (loss) income, net of tax

     (38,027 )     68,275
              

Total comprehensive income

   $ 712,345     $ 620,862
              

Note 5

Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share:

 

    

Three Months Ended

June 30

  

Six Months Ended

June 30

     2007    2006    2007    2006
Numerator:            

Net income

   $ 750,372    $ 552,587    $ 1,425,422    $ 1,435,926
                           
Denominator:            

Denominator for basic earnings per share - Weighted-average shares

     390,847      300,829      399,735      300,047
Effect of dilutive securities:            

Stock options

     5,379      7,987      5,746      8,324

Contingently issuable shares

     766      —        383      —  

Restricted stock

     481      1,172      595      1,188
                           

Dilutive potential common shares

     6,626      9,159      6,724      9,512
                           

Denominator for diluted earnings per share - Adjusted weighted-average shares

     397,473      309,988      406,459      309,559
                           
Basic earnings per share    $ 1.92    $ 1.84    $ 3.57    $ 4.79
                           
Diluted earnings per share    $ 1.89    $ 1.78    $ 3.51    $ 4.64
                           

Note 6

Goodwill and Other Intangible Assets

The following table provides a summary of goodwill.

 

Total Company

  

National

Lending

  

Local

Banking

    Other     Total  

Balance at December 31, 2006

   $ 2,278,880    $ 1,623,928     $ 9,732,627     $ 13,635,435  

Transfers

     5,454,007      4,278,620       (9,732,627 )     —    

Additions

     —        —         —         —    

Adjustments

     35,632      (53,014 )     —         (17,382 )

Disposals

     —        (9,151 )     —         (9,151 )

Foreign Currency Translation

     3,103      —         —         3,103  
                               

Balance at June 30, 2007

   $ 7,771,622    $ 5,840,383     $ —       $ 13,612,005  
                               

 

National Lending Detail

   U.S. Card   

Auto

Finance

  

Global

Financial

Services

  

Mortgage

Banking

   National
Lending Total

Balance at December 31, 2006

   $ 762,284    $ 763,648    $ 752,948    $ —      $ 2,278,880

Transfers

     2,368,716      1,341,339      1,093,952      650,000      5,454,007

Additions

     —        —        —        —        —  

Adjustments

     —        —        —        35,632      35,632

Disposals

     —        —        —        —        —  

Foreign Currency Translation

     —        —        3,103      —        3,103
                                  

Balance at June 30, 2007

   $ 3,131,000    $ 2,104,987    $ 1,850,003    $ 685,632    $ 7,771,622
                                  

 

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As of December 1, 2006, the Company acquired North Fork Bancorporation, Inc., a commercial and retail bank in New York, which created $9.7 billion of goodwill. The goodwill associated with the acquisition of North Fork was held in the Other category at December 31, 2006. The North Fork acquisition goodwill was allocated across the operating segments during the first quarter of 2007, based on an increase in the relative fair value of each respective segment resulting from the acquisition.

For the six months ended June 30, 2007, purchase accounting adjustments on loans held for sale of $35.6 million associated with the acquisition of North Fork were made to the Mortgage Banking sub-segment. Purchase accounting adjustments to assets of $(4.1), liabilities of $(36.0) and to equity of $(10.4) associated with the acquisition of North Fork in 2006, and adjustments to liabilities of $(1.2) and to equity of $(1.3) associated with the acquisition of Hibernia in 2005, were made to the Local Banking segment. In addition, $9.2 million of goodwill associated with the divestiture of one its subsidiaries, Hibernia Insurance Agency, was removed from the Local Banking segment.

Goodwill impairment is tested at the reporting unit level or one level below on an annual basis in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. For the six months ended June 30, 2007, no impairment on goodwill was required to be recognized.

In connection with the acquisitions of Hibernia and North Fork, the Company recorded intangible assets that consisted of core deposit intangibles, trust intangibles, lease intangibles, and other intangibles, which are subject to amortization. The core deposit and trust intangibles reflect the estimated value of deposit and trust relationships. The lease intangibles reflect the difference between the contractual obligation under current lease contracts and the fair market value of the lease contracts at the acquisition date. The other intangible items relate to customer lists, brokerage relationships and insurance contracts. The following table summarizes the Company’s purchase accounting intangible assets subject to amortization.

 

     June 30, 2007
    

Gross

Carrying

Amount

  

Accumulated

Amortization

   

Net Carrying

Amount

  

Amortization

Period

Core deposit intangibles

   $ 1,320,000    $ (202,119 )   $ 1,117,881    10.6 years

Lease intangibles

     46,903      (6,859 )     40,044    8.0 years

Trust intangibles

     10,500      (1,808 )     8,692    16.5 years

Other intangibles

     8,641      (2,255 )     6,386    10.5 years
                          

Total

   $ 1,386,044    $ (213,041 )   $ 1,173,003   
                          

Intangibles are amortized on an accelerated basis over their respective estimated useful lives. Intangible assets are recorded in Other assets on the balance sheet. Amortization expense related to purchase accounting intangibles totaled $54.9 million and $111.1 million for the three months and six months ended June 30, 2007. Amortization expense for intangibles is recorded to non-interest expense. The weighted average amortization period for all purchase accounting intangibles is 10.6 years.

For the six months ended June 30, 2007, no impairment on intangibles was required to be recognized.

Note 7

Mortgage Servicing Rights

Mortgage Servicing Rights (“MSRs”), are recognized when mortgage loans are sold in the secondary market and the right to service these loans are retained for a fee, and are carried at fair value; changes in fair value are recognized in mortgage banking operations. To evaluate and measure fair value, the underlying loans are stratified based on certain risk characteristics, including loan type, note rate and investor servicing requirements. The following table sets forth the changes in the fair value of mortgage servicing rights:

 

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Mortgage Servicing Rights:

 

Three Months Ended

June 30, 2007

   

Six Months Ended

June 30, 2007

 

Balance, Beginning of period

  $ 267,554     $ 252,295  

Cumulative effect adjustment for the adoption of FAS 156

    —         15,187  

Originations

    22,413       46,161  

Sales

    (930 )     (1,715 )

Change in fair value

    26,994       4,103  
               

Balance at June 30, 2007

  $ 316,031     $ 316,031  
               

Ratio of Mortgage Servicing Rights to Related Loans Serviced for Others

    1.07 %     1.07 %

Weighted Average Service Fee

    0.28       0.28  

The significant assumptions used in estimating the fair value of the servicing assets at June 30, 2007 were as follows:

 

    

June 30,

2007

 

Weighted average prepayment rate (includes default rate)

   24.42 %

Weighted average life (in years)

   4.0  

Discount rate

   10.50 %

At June 30, 2007, the sensitivities to immediate 10% and 20% increases in the weighted average prepayment rates would decrease the fair value of mortgage servicing rights by $28.3 million and $52.7 million, respectively.

As of June 30, 2007, the Company’s mortgage loan servicing portfolio consisted of mortgage loans with an aggregate unpaid principal balance of $47.8 billion, of which $32.2 billion was serviced for investors other than the Company.

Note 8

Commitments, Contingencies and Guarantees

Letters of Credit and Financial Guarantees

The Company issues letters of credit (both standby and commercial) and financial guarantees to meet the financing needs of its customers. Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party in a borrowing arrangement. Commercial letters of credit are short-term commitments issued primarily to facilitate trade finance activities for customers and are generally collateralized by the goods being shipped to the client. Collateral requirements are similar to those for funded transactions and are established based on management’s credit assessment of the customer. Management conducts regular reviews of all outstanding standby letters of credit and customer acceptances, and the results of these reviews are considered in assessing the adequacy of the Company’s allowance for loan and lease losses.

The Company had contractual amounts of standby letters of credit, commercial letters of credit, and financial guarantees of $1.3 billion at June 30, 2007. As of June 30, 2007, financial guarantees had expiration dates ranging from 2007 to 2009. The fair value of the guarantees outstanding at June 30, 2007 that have been issued since January 1, 2003, was $4.4 million and was included in other liabilities.

Industry Litigation

Over the past several years, MasterCard International and Visa U.S.A., Inc., as well as several of their member banks, have been involved in several different lawsuits challenging various practices of MasterCard and Visa.

In 1998, the United States Department of Justice filed an antitrust lawsuit against the MasterCard and Visa membership associations composed of financial institutions that issue MasterCard or Visa credit or debit cards (“associations”), alleging, among other things, that the associations had violated antitrust law and engaged in unfair practices by not allowing member banks to issue cards from competing brands, such as American Express and Discover Financial Services. In 2001, a New York district court entered judgment in favor of the Department of Justice and ordered the associations to repeal these policies. The United States Court of Appeals for the Second Circuit affirmed the district court and, on October 4, 2004, the United States Supreme Court denied certiorari in the case. In November 2004, American Express filed an antitrust lawsuit (the “Amex lawsuit”) against MasterCard and Visa and several member banks alleging, among other things, that the

 

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defendants jointly and severally implemented and enforced illegal exclusionary agreements that prevented member banks from issuing American Express cards. The complaint requests civil monetary damages, which could be trebled. The Corporation, the Bank, and the Savings Bank are named defendants in this lawsuit.

Separately, a number of entities, each purporting to represent a class of retail merchants, have also filed antitrust lawsuits (the “Interchange lawsuits”) against MasterCard and Visa and several member banks, including the Corporation and its subsidiaries, alleging among other things, that the defendants conspired to fix the level of interchange fees. The complaints request civil monetary damages, which could be trebled. In October 2005, the Interchange lawsuits were consolidated before the United States District Court for the Eastern District of New York for certain purposes, including discovery.

Finally, a number of individual plaintiffs, each purporting to represent a class of cardholders, have filed antitrust lawsuits (the “Fee Antitrust lawsuits”) against several issuing banks, including the Corporation, alleging among other things that the defendants conspired to fix the level of late fees and over-limit fees charged to cardholders, and that these fees are excessive. The complaint requests civil monetary damages, which could be trebled.

We believe that we have meritorious defenses with respect to these cases and intend to defend these cases vigorously. At the present time, management is not in a position to determine whether the resolution of these cases will have a material adverse effect on either the consolidated financial position of the Corporation or the Corporation’s results of operations in any future reporting period.

In addition, several merchants filed class action antitrust lawsuits, which were subsequently consolidated, against the associations relating to certain debit card products. In April 2003, the associations agreed to settle the lawsuit in exchange for payments to plaintiffs and for changes in policies and interchange rates for debit cards. Certain merchant plaintiffs have opted out of the settlements and have commenced separate lawsuits. Additionally, consumer class action lawsuits with claims mirroring the merchants’ allegations have been filed in several courts. Finally, MasterCard and Visa, as well as certain member banks, continue to face additional lawsuits regarding policies, practices, products and fees.

With the exception of the Fee Antitrust lawsuits, the Interchange lawsuits and the Amex lawsuit, the Corporation and its subsidiaries are not parties to the lawsuits against MasterCard and Visa described above and therefore will not be directly liable for any amount related to any possible or known settlements of such lawsuits. However, the Corporation’s subsidiary banks are member banks of MasterCard and Visa and thus may be affected by settlements or lawsuits relating to these issues, including changes in interchange payments. In addition, it is possible that the scope of these lawsuits may expand and that other member banks, including the Corporation’s subsidiary banks, may be brought into the lawsuits or future lawsuits. In part as a result of such litigation, MasterCard and Visa are expected to continue to evolve as corporate entities, including by changing their governance structures as previously announced. During the second quarter of 2006, MasterCard successfully completed its initial public offering and Visa revised its governance structure. Both entities now rely upon independent directors for certain decisions, including the setting of interchange rates.

Given the complexity of the issues raised by these lawsuits and the uncertainty regarding: (i) the outcome of these suits, (ii) the likelihood and amount of any possible judgments, (iii) the likelihood, amount and validity of any claim against the member banks, including the Corporation and its subsidiary banks, (iv) changes in industry structure that may result from the suits and (v) the effects of these suits, in turn, on competition in the industry, member banks, and interchange fees, the Company cannot determine at this time the long-term effects of these suits.

Other Pending and Threatened Litigation

In addition, the Company is commonly subject to various pending and threatened legal actions relating to the conduct of its normal business activities. In the opinion of management, the ultimate aggregate liability, if any, arising out of any such pending or threatened legal actions will not be material to its consolidated financial position or its results of operations.

Tax issues for years 1995-1999 are pending in the U.S. Tax Court. The ultimate resolution of these issues is not expected to have a material effect upon the Company’s operations or financial condition.

Note 9

Restructuring

During the second quarter of 2007, the Company announced a broad-based initiative to reduce expenses and improve the competitive cost position of the Company. The 2007 cost initiative includes actions already taken during the second quarter of 2007 in the Company’s US Card, Auto Finance, Mortgage Banking, and UK businesses.

 

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Many of the planned actions leverage the capabilities of recently completed infrastructure projects in several of the Company’s businesses. The scope and timing of the expected cost reductions are the result of an ongoing, comprehensive review of operations within and across the Company’s businesses, which began several months ago.

The Company anticipates recording charges of approximately $300 million pre-tax over the course of the cost reduction initiative. Approximately $150 million of these charges are related to severance benefits, while the remaining charges are associated with items such as contract and lease terminations and consolidation of facilities and infrastructure.

In 2007, expected pre-tax charges related to the cost restructuring initiative are approximately $200 million.

Expenses related to the Company’s 2007 cost initiative for the three months ended June 30, 2007 were recorded in non-interest expense as restructuring expense and were comprised of the following:

 

    

Three months

ended

June 30,

2007

Restructuring Expenses:

  

Employee termination benefits

   $ 53,479

Occupancy

     8,427

Supplies and equipment

     18,224

Marketing

     1,372

Other

     19,640
      

Total Restructuring Expenses

   $ 101,142
      

Employee termination benefits received by executives and associates of the Company for the three months ended June 30, 2007 were $8.6 million and $44.9 million, respectively.

Included in the $19.6 million of other restructuring expenses are $15.0 million of contract termination costs and $4.6 million of software impairment.

The Company made $3.7 million in cash payments for restructuring charges in the second quarter of 2007 that related to employee termination benefits. Restructuring accrual activity associated with the Company’s 2007 cost initiative for the three months ended June 30, 2007 was as follows:

 

     2007  

Restructuring accrual activity:

  

Balance, March 31

   $ —    

Restructuring charges

     101,142  

Cash payments

     (3,706 )

Noncash write-downs and other adjustments

     (27,499 )
        

Balance, June 30

   $ 69,937  
        

Note 10

Accelerated Share Repurchase Program

On March 12, 2007, the Company entered into a $1.5 billion accelerated share repurchase (“ASR”) agreement with Credit Suisse, New York Branch (“CSNY”). The ASR agreement was entered into pursuant to the Company’s $3.0 billion stock repurchase program announced on January 25, 2007. Under the ASR agreement, the Company purchased $1.5 billion dollars of its $.01 par value common stock at an initial price of $73.57 per share, the closing price of the Company’s common stock on the New York Stock Exchange on April 2, 2007, the effective date of the agreement. The ASR program is accounted for as an initial treasury stock transaction and a forward stock purchase contract. The initial repurchase of shares resulted in an immediate reduction of the outstanding shares used to calculate the weighted-average common shares outstanding for basic and diluted EPS on the effective date of the agreement. The forward stock purchase contract is classified as an equity instrument and was deemed to have a fair value of $0 at the effective date. The impact of the ASR on basic and diluted EPS for the three months ended June 30, 2007 was $0.09. The impact on basic and diluted EPS for the six months ended June 30, 2007 was $0.09 and $0.08, respectively.

 

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An ASR combines the immediate share retirement benefits of a tender offer with the market impact and pricing benefits of an open stock repurchase program. The ASR agreement provides that the Company or CSNY may be obligated to make certain additional payments upon final settlement of the ASR agreement. Most significantly, the Company may receive from, or be required to pay, CSNY a purchase price adjustment based on the daily volume weighted average market price of the Company’s common stock over a period beginning after the effective date of the agreement through on or around August 22, 2007. The maximum number of shares to be received or delivered under the contract is 50,971,863. These additional payments will be satisfied in shares of the Company’s common stock. As of June 30, 2007, based on the daily volume weighted average market price of the Company’s common stock since the effective date of the agreement, the Company would be required to deliver 765,831 shares to CSNY. Increases in the daily volume weighted average market price of the Company’s common stock would increase the amount of shares the Company would be required to deliver to CSNY. Decreases in the daily volume weighted average market price of the Company’s common stock would decrease the amount of shares the Company would be required to deliver to CSNY.

The arrangement is intended to comply with Rules 10b5-1(c)(1)(i) and 10b-18 of the Securities Exchange Act of 1934, as amended.

In addition to the $1.5 billion ASR, the Company also purchased $0.25 billion of shares in an open market repurchase. Additional share repurchase information is included in Part 1, Item 2. Section V, Management Summary, Q2 2007 Significant Events and Part 2, Item 2. “Unregistered Sales of Equity Securities and Uses of Proceeds.”

Note 11

Subsequent Events

Fair Value of Retained Interests

Effective July 1, 2007, certain of the Company’s retained interests that, under the guidance provided by Derivatives Implementation Group Issue B40, were previously exempted from the scope of SFAS 155, Accounting for Certain Hybrid Financial Instruments, through June 30, 2007, have been determined to be hybrid financial instruments containing embedded derivatives that otherwise would require bifurcation. The Company has elected to record these retained interests at fair value with changes in fair value recorded in earnings. This change did not have a material impact on the consolidated earnings or financial position of the Company.

Pending Acquisition of NetSpend Holdings, Inc.

On August 7, 2007, the Company entered into a definitive agreement to acquire NetSpend Holdings, Inc., the parent company of NetSpend Corporation, a retail marketer of prepaid debit cards. The purchase price is $700 million in an all-cash transaction. Under the terms of the agreement, NetSpend will become a subsidiary of Capital One, N.A. The transaction is subject to customary regulatory approvals and notifications and is expected to close in the fourth quarter of 2007.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Dollars in thousands) (yields and rates presented on an annualized basis)

I. Introduction

We are a diversified financial services company whose banking and non-banking subsidiaries market a variety of financial products and services.

We are delivering on our strategy of combining the power of national scale lending and local scale banking. As of June 30, 2007, we had $85.7 billion in deposits and $144.2 billion in managed loans held for investment.

Our earnings are primarily driven by lending to consumers, small business and commercial customers and by deposit-taking activities which generate net interest income, and by activities that generate non-interest income, including the sale and servicing of loans and providing fee-based services to customers. Customer usage and payment patterns, credit quality, levels of marketing expense, operating efficiency all affect our profitability.

Our primary expenses are the costs of funding assets, provision for loan and lease losses, operating expenses (including associate salaries and benefits, infrastructure maintenance and enhancements, and branch operations and expansion costs), marketing expenses, and income taxes.

II. Critical Accounting Estimates

See our Annual Report on Form 10-K for the year ended December 31, 2006, Part I, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a summary of our critical accounting estimates.

The methodology applied to our estimate for income taxes has changed due to the implementation of a new accounting pronouncement as described below.

Income Taxes

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”), which we adopted on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.

Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The impact of the reassessment of our tax positions in accordance with FIN 48 did not have a material impact on the results of operations, financial position, or liquidity.

Additional information is included in this Quarterly Report under the heading “Notes to Condensed Reported Consolidated Financial Statements – Note 1 – Summary of Significant Accounting Policies.”

III. Off-Balance Sheet Arrangements

See our Annual Report on Form 10-K for the year ended December 31, 2006, Part III, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a summary of our off-balance sheet arrangements.

Of our total managed loans, 36% and 44% were included in off-balance sheet securitizations for the periods ended June 30, 2007 and June 30, 2006, respectively.

IV. Reconciliation to GAAP Financial Measures

Our consolidated reported financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) are referred to as our “reported” financial statements. Loans included in securitization transactions which qualify as sales under GAAP have been removed from our “reported” balance sheet. However, servicing fees, finance charges, and other fees, net of charge-offs, and interest paid to investors of securitizations are recognized as servicing and securitizations income on the “reported” income statement.

 

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Our “managed” consolidated financial statements reflect adjustments made related to effects of securitization transactions qualifying as sales under GAAP. We generate earnings from our “managed” loan portfolio which includes both the on-balance sheet loans and off-balance sheet loans. Our “managed” income statement takes the components of the servicing and securitizations income generated from the securitized portfolio and distributes the revenue and expense to appropriate income statement line items from which it originated. For this reason, we believe the “managed” consolidated financial statements and related managed metrics to be useful to stakeholders.

 

     As of and for the three months ended June 30, 2007

(Dollars in thousands)

   Total Reported   

Securitization

Adjustments(1)

    Total Managed(2)

Income Statement Measures

       

Net interest income

   $ 1,560,094    $ 1,074,764     $ 2,634,858

Non-interest income

   $ 2,006,165    $ (584,380 )   $ 1,421,785
                     

Total revenue

   $ 3,566,259    $ 490,384     $ 4,056,643

Provision for loan losses

   $ 401,035    $ 490,384     $ 891,419

Net charge-offs

   $ 400,814    $ 490,384     $ 891,198
                     
Balance Sheet Measures        

Loans

   $ 91,617,353    $ 52,568,191     $ 144,185,544

Total assets

   $ 145,937,957    $ 51,765,199     $ 197,703,156

Average loans

   $ 91,619,955    $ 51,471,273     $ 143,091,228

Average earning assets

   $ 123,209,216    $ 49,411,309     $ 172,620,525

Average total assets

   $ 147,758,243    $ 50,756,562     $ 198,514,805

Delinquencies

   $ 2,387,155    $ 1,742,239     $ 4,129,394
                     

(1) Income statement adjustments reclassify the net of finance charges of $1,564.3 million, past-due fees of $221.7 million, other interest income of $(44.3) million and interest expense of $666.9 million; and net charge-offs of $490.4 million from non-interest income to net interest income and provision for loan losses, respectively.
(2) The managed loan portfolio does not include auto loans which have been sold in whole loan sale transactions where we have retained servicing rights.

V. Management Summary

The following discussion provides a summary of the second quarter of 2007 results compared to the same period in the prior year.

Three Months Ended June 30, 2007 Compared to Three Months Ended June 30, 2006

Our net income for the quarter was $750.4 million, an increase of 36% from the second quarter of 2006. Diluted EPS increased 6% to $1.89 per share. 2007 results include the impact of the North Fork Bank acquisition that was completed on December 1, 2006.

Key factors in the second quarter 2007 results compared to the second quarter of 2006 include:

 

   

Net interest income grew 30% or $363.0 million as a result of modest loan volume growth across all segments, the acquisition of North Fork in 2006 and increased margins in the U.S. Card sub-segment due to a reduction in the amount of teaser based acquisitions and selective pricing changes implemented after the completion of our card holder system conversion.

 

   

Provision for loan and lease losses increased by 11%, due primarily to the continued normalization of charge-offs post-bankruptcy spike.

 

   

Non interest income for the quarter increased 17%, driven by a combination of increases in servicing and securitization income, service charges and other customer-related fees, and mortgage banking operations, offset by a decrease in other non interest income.

 

   

Non-interest expense increased $432.0 million for the three months ended June 30, 2007. The increase in operating expense was driven by the addition of North Fork Bank’s operating expenses, CDI amortization and integration expenses associated with our bank acquisitions, restructuring charges associated with our 2007 cost initiative, and the accelerated vesting of restricted stock related to the transition to new management in our Banking business.

 

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We incurred lower than normal taxes in the second quarter of 2007 driven by changes in our international tax position.

 

   

The change in EPS was positively impacted by an increase in net income and the $1.75 billion of share repurchases that was executed in the second quarter of 2007 offset by the net of the incremental shares that were issued as part of the North Fork Bank acquisition.

Managed loans held for investment as of June 30, 2007 were $144.2 billion, up 33% or $35.8 billion from June 30, 2006. This increase in loan growth is primarily attributable to the North Fork acquisition in 2006. Excluding the impact of the North Fork acquisition, loans held for investment grew 4%.

We ended the second quarter of 2007 with $85.7 billion in total deposits, up $38.5 billion, or 82% from June 30, 2006. These deposits represent approximately 50% of the total managed liabilities.

Q2 2007 Significant Events

Restructuring Associated with 2007 Cost Initiative

During the second quarter of 2007, we announced a broad-based initiative to reduce expenses and improve our competitive cost position. We recognized $101.1 MM in restructuring charges in the second quarter of 2007. Additional information is included in this Quarterly Report under the heading “Notes to Condensed Reported Consolidated Financial Statements – Note 9 – Restructuring”.

Acceleration of Equity Awards

During the second quarter of 2007, a charge of $39.8 million was taken against salaries and associate benefits as a result of the accelerated vesting of equity awards made in connection with the transition of the management team for our Banking business following the North Fork acquisition in the fourth quarter of 2006. This charge is not included as a restructuring charge associated with our 2007 cost initiative.

Share Repurchase

During the second quarter of 2007, we executed $1.75 billion of share repurchases, including the $1.50 billion Accelerated Share repurchase program and $0.25 billion of shares in an open market repurchase.

On March 12, 2007, we entered into a $1.5 billion accelerated share repurchase (“ASR”) agreement with Credit Suisse, New York Branch (“CSNY”). The ASR agreement was entered into pursuant to our $3.0 billion stock repurchase program announced on January 25, 2007. Under the ASR agreement, we purchased $1.5 billion dollars of its $.01 par value common stock at an initial price of $73.57 per share, the closing price of our common stock on the New York Stock Exchange on April 2, 2007, the effective date of the agreement. Additional information is included in this Quarterly Report under the heading “Notes to Condensed Reported Consolidated Financial Statements – Note 10 – Accelerated Share Repurchase Program” and Part 2, Item 2. “Unregistered Sales of Equity Securities and Uses of Proceeds”.

Tax Position

We recognized a $69.0 million one-time tax benefit in the second quarter of 2007 resulting from previously unrecognized tax benefits related to our international tax position.

25 Day Grace Implementation

Net charge-off rate for the second quarter 2007 was positively impacted by the implementation of a 25 day grace period for our credit card customers. A cardholder’s grace period is defined as the time between the customer’s statement being generated and their payment being due without incurring additional interest or penalty. The Company had been offering grace periods up to 30 days. Effective June 2006 the Company moved all cardholders to a 25 day grace period. Implementation of 25 Day Grace did not have a material impact on Net Provision for the quarter.

 

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Summary of the Reported Income Statement

The following is a detailed description of the financial results reflected in Table 1 – Financial Summary. Additional information is provided in section XIII, Tabular Summary as detailed in sections below.

All quarterly comparisons are made between the three month period ended June 30, 2007 and the three month period ended June 30, 2006, unless otherwise indicated.

All year to date comparisons are made between the six month period ended June 30, 2007 and the six month period ended June 30, 2006, unless otherwise indicated.

Net interest income

Net interest income is comprised of interest income and past-due fees earned and deemed collectible from loans and income earned on securities, less interest expense on interest-bearing deposits, senior and subordinated notes and other borrowings.

For the three months ended June 30, 2007, reported net interest income increased 30%, or $363.0 million. For the six months ended June 30, 2007, reported net interest income increased 32%, or $779.0 million. The increase in Net Interest Income was driven by the acquisition of North Fork Bank, modest loan growth, and increased margins in the U.S. Card sub-segment due to a reduction in teaser based acquisitions and selective pricing changes implemented after the completion of our card holder system conversion. Net interest margin decreased 98 basis points for both the three and six months ended June 30, 2007 primarily due to the addition of the North Fork portfolio. For the three and six months ended June 30, 2007, interest income to average earning assets decreased 76 and 72 basis points, respectively.

For additional information, see section XIII, Tabular Summary, Table A (Statements of Average Balances, Income and Expense, Yields and Rates) and Table B (Interest Variance Analysis).

Non-interest income

Non-interest income is comprised of servicing and securitizations income, service charges and other customer-related fees, mortgage banking operations income, interchange income and other non-interest income.

For the three and six months ended June 30, 2007, reported non-interest income increased 17% and 7%, respectively. See detailed discussion of the components of non-interest income below.

Servicing and Securitizations Income

Servicing and securitizations income represents servicing fees, excess spread and other fees resulting from the off-balance sheet loan portfolio, adjustments to the fair value of retained interests resulting from securitization transactions, as well as gains and losses resulting from securitization and other sales transactions.

Servicing and securitizations income increased 20% and 2%, respectively, for the three and six months ended June 30, 2007. For the three months ended June 30, 2007, the increase was primarily driven by an increase in off-balance sheet funding activity partially offset by an increase in charge-offs. The increase of servicing and securitizations income for the six months ended June 30, 2007 was due to gains due to an increase in off-balance sheet funding activity and an increase of finance charge income offset by continued normalization of credit losses.

Service Charges and Other Customer-Related Fees

For the three and six months ended June 30, 2007, service charges and other customer-related fees grew 17% and 13%, respectively, due to the inclusion of North Fork and pricing changes in the U.S. Card sub-segment.

Mortgage Banking Operations

Mortgage banking operations is comprised of non-interest income related to our mortgage banking activities across all reportable segments including, but not limited to, our Mortgage Banking sub-segment. For the three months ended June 30, 2007, mortgage banking operations income grew 145%, or $60.9 million. For the six months ended June 30, 2007, mortgage banking operations income grew 156%, or $115.5 million. Included in this activity for the three months ended June 30, 2007, were mortgage fees of $ 47.8 million, derivative income of $26.7 million and a loss on sales of mortgage loans held for sale of $29.4 million. The activity for the six months ended June 30, 2007 included mortgage fees of $94.6 million, derivative income of $17.6 million and a loss on sales of mortgage loans held for sale of $38.7 million.

 

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Interchange

Interchange income, net of rewards expense, decreased 4% and 3%, respectively, for the three and six months ended June 30, 2007. Costs associated with our rewards programs decreased 37% and 25%, respectively, for the three and six months ended June 30, 2007. Purchase volumes increased 4% and 6% for the three and six months ended June 30, 2007, respectively. The decrease in rewards expense and the revenue generated on the purchase volumes was more than offset by a shift in the purchase transaction mix.

Other Non-Interest Income

Other non-interest income includes, among other items, gains and losses on sales of securities, gains and losses associated with hedging transactions, service provider revenue generated by our healthcare finance business, gains on the sale of auto loans and income earned related to purchased charged-off loan portfolios.

Other non-interest income for the three and six months ended June 30, 2007, decreased 31% and 4%, respectively. The decrease is as a result of one time gains recognized for the three and six months ended June 30, 2006 related to the MasterCard, Inc. initial public offering and a $59.8 million gain from the sale of purchased charged-off loan portfolios, respectively.

Provision for loan and lease losses

Provision for loan and lease losses increased 11% and 41%, respectively, for the three and six months ended June 30, 2007. The increases in the provision are as a result of the normalization of credit in U.S. consumer lending as well as an increase in loans held for investment.

Non-interest expense

Non-interest expense consists of marketing, operating, and restructuring expenses.

For the three months ended June 30, 2007, non-interest expense increased 26%, reflecting a 35% increase in operating expenses and an 8% decrease in marketing expense. Non-interest expense increased $432.0 million to $2.1 billion for the three months ended June 30, 2007. For the six months ended June 30, 2007, non-interest expense increased 28%, reflecting a 36% increase in operating expenses and a 3% decrease in marketing expenses. Non-interest expense increased $903.9 million to $4.2 billion for the six months ended June 30, 2007. The increase in operating expense was driven by the addition of North Fork Bank’s operating expenses, CDI amortization and integration expenses associated with our bank acquisitions, restructuring charges associated with our 2007 cost initiative, and the accelerated vesting of restricted stock related to the transition to new management in our Banking business.

Income taxes

Our effective income tax rate was 28.7% and 36.0% for the three months ended June 30, 2007 and 2006, respectively. The effective rate includes federal, state, and international tax components. The decrease in our effective tax rate for the three months ended June 30, 2007 was primarily attributable to a $69.0 million one-time tax benefit related to our international tax position.

Loan Portfolio Summary

We analyze our financial performance on a managed loan portfolio basis. The managed loan portfolio is comprised of on-balance sheet and off-balance sheet loans. We have retained servicing rights for our securitized loans and receive servicing fees in addition to the excess spread generated from the off-balance sheet loan portfolio.

Average managed loans held for investment grew 35% and 36%, respectively, for the three and six months ended June 30, 2007. The increases in average managed loans held for investment for the three and six months ended June 30, 2007 was driven by modest loan growth across all segments and the North Fork acquisition in 2006.

For additional information, see section XIII, Tabular Summary, Table C (Managed Consumer Loan Portfolio) and Table D (Composition of Reported Loan Portfolio).

Delinquencies

We believe delinquencies to be an indicator of loan portfolio credit quality at a point in time. The entire balance of an account is contractually delinquent if the minimum payment is not received by the payment due date. Delinquencies not only have the potential to impact earnings if the account charges off, but they also result in additional costs in terms of the personnel and other resources dedicated to resolving the delinquencies.

 

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For additional information, see section XIII, Tabular Summary, Table E (Delinquencies).

Net Charge-Offs

Net charge-offs include the principal amount of losses (excluding accrued and unpaid finance charges and fees and fraud losses) less current period principal recoveries. We charge off credit card loans at 180 days past the due date and generally charge off other consumer loans at 120 days past the due date or upon repossession of collateral. Non-collateralized consumer bankruptcies are typically charged-off within 2-7 days upon notification and in any event within 30 days. Commercial loans are charged-off when the amounts are deemed uncollectible. Costs to recover previously charged-off accounts are recorded as collection expenses in other non-interest expense.

For the three months ended June 30, 2007, both the reported and managed net charge-off rates decreased 26 basis points, with net charge-off dollars increasing 35% and 22% on a reported and managed basis, respectively, compared to the same period in the prior year. For the six months ended June 30, 2007, the reported and managed net charge-off rates decreased 25 and 14 basis points, respectively, with net charge-off dollars increasing 39% and 29% on a reported and managed basis, respectively, compared to the same period in the prior year. The decreases in net charge-off rates are due to the acquisition of North Fork’s higher credit quality loans; the implementation of 25 day grace period for our credit card customers as described in Section V, Management Summary, Q2 2007 Significant Events; offset by the normalization of credit in U.S. consumer lending.

For additional information, see section XIII, Tabular Summary, Table F (Net Charge-offs).

Nonperforming Assets

Nonperforming loans consist of nonaccrual loans (loans on which interest income is not currently recognized) and restructured loans (loans with below-market interest rates or other concessions due to the deteriorated financial condition of the borrower). Commercial, small business, mortgage and some auto loans are generally placed in nonaccrual status at 90 days past due or sooner if, in management’s opinion, there is doubt concerning the ability to fully collect both principal and interest.

For additional information, see section XIII, Tabular Summary, Table G (Nonperforming Assets).

Allowance for loan and lease losses

The allowance for loan and lease losses is maintained at the amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing reported loan portfolios. The provision for loan and lease losses is the periodic cost of maintaining an adequate allowance. The amount of allowance necessary is based on distinct allowance methodologies depending on the type of loans which include specifically identified criticized loans, migration analysis, forward loss curves and historical loss trends. In evaluating the sufficiency of the allowance for loan and lease losses, management takes into consideration the following factors: recent trends in delinquencies and charge-offs including bankrupt, deceased and recovered amounts; forecasting uncertainties and size of credit risks; the degree of risk inherent in the composition of the loan portfolio; economic conditions; legal and regulatory guidance; credit evaluations and underwriting policies; seasonality; and the value of collateral supporting the loans. To the extent credit experience is not indicative of future performance or other assumptions used by management do not prevail, loss experience could differ significantly, resulting in either higher or lower future provision for loan and lease losses, as applicable. The evaluation process for determining the adequacy of the allowance for loan and lease losses and the periodic provisioning for estimated losses is undertaken on a quarterly basis, but may increase in frequency should conditions arise that would require our prompt attention. Conditions giving rise to such action are business combinations or other acquisitions or dispositions of large quantities of loans, dispositions of non-performing and marginally performing loans by bulk sale or any development which may indicate an adverse trend.

The allowance for loan and lease losses increased $15.0 million since March 31, 2007, driven primarily by an increase in Loans held for investment. The coverage ratio of allowance to loans held for investment has decreased 1 basis point as U.S. consumer credit continues to normalize.

For additional information, see section XIII, Tabular Summary, Table H (Summary of Allowance for Loan and Lease Losses).

 

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VI. Financial Summary

Table 1 provides a summary view of the consolidated income statement and selected metrics for us at and for the three and six month periods ended June 30, 2007 and 2006. Impacts of the North Fork acquisition are included in the Q2 2007 balances.

Table 1: Financial Summary

 

    

As of and for the Three Months Ended

June 30

   

As of and for the Six Months Ended

June 30

 

(Dollars in thousands)

   2007     2006     Change     2007     2006     Change  

Earnings (Reported):

            

Net interest income

   $ 1,560,094     $ 1,197,082     $ 363,012     $ 3,182,940     $ 2,403,959     $ 778,981  

Non-interest income:

            

Servicing and securitizations

     1,226,896       1,025,506       201,390       2,214,978       2,179,110       35,868  

Service charges and other customer-related fees

     482,979       413,398       69,581       962,446       849,129       113,317  

Mortgage banking operations

     102,855       41,973       60,882       189,398       73,859       115,539  

Interchange

     125,979       131,538       (5,559 )     244,090       251,029       (6,939 )

Other

     67,456       97,498       (30,042 )     205,778       215,037       (9,259 )
                                                

Total non-interest income

     2,006,165       1,709,913       296,252       3,816,690       3,568,164       248,526  
                                                

Total Revenue(1)

     3,566,259       2,906,995       659,264       6,999,630       5,972,123       1,027,507  

Provision for loan and lease losses

     401,035       362,445       38,590       751,080       532,715       218,365  

Marketing

     326,718       356,695       (29,977 )     658,267       680,466       (22,199 )

Restructuring expenses

     101,142       —         101,142       101,142       —         101,142  

Operating expenses

     1,684,993       1,324,202       360,791       3,398,845       2,573,910       824,935  
                                                

Income before taxes

     1,052,371       863,653       188,718       2,090,296       2,185,032       (94,736 )

Income taxes

     301,999       311,066       (9,067 )     664,874       749,106       (84,232 )
                                                

Net income

   $ 750,372     $ 552,587     $ 197,785     $ 1,425,422     $ 1,435,926     $ (10,504 )
                                                
Common Share Statistics:             

Basic EPS

   $ 1.92     $ 1.84     $ 0.08     $ 3.57     $ 4.79     $ (1.22 )

Diluted EPS

   $ 1.89     $ 1.78     $ 0.11     $ 3.51     $ 4.64     $ (1.13 )
                                                
Selected Balance Sheet Data:             

Reported loans held for investment (period end)

   $ 91,617,353     $ 60,602,803     $ 31,014,550     $ 91,617,353     $ 60,602,803     $ 31,014,550  

Managed loans held for investment (period end)

     144,185,544       108,433,439       35,752,105       144,185,544       108,433,439       35,752,105  

Reported loans held for investment (average)

     91,619,955       58,833,376       32,786,579       92,537,815       58,489,806       34,048,009  

Managed loans held for investment (average)

     143,091,228       106,089,894       37,001,334       143,599,187       105,354,135       38,245,052  

Allowance for loan and lease losses (period end)

     (2,120,000 )     (1,765,000 )     (355,000 )     (2,120,000 )     (1,765,000 )     (355,000 )

Interest Bearing Deposits (period end)

     74,444,345       42,698,976       31,745,369       74,444,345       42,698,976       31,745,369  

Total Deposits (period end)

     85,680,455       47,186,813       38,493,642       85,680,455       47,186,813       38,493,642  

Interest Bearing Deposits (average)

     75,218,488       42,796,715       32,421,773       75,043,748       43,075,070       31,968,678  

Total Deposits (average)

     86,718,996       47,208,970       39,510,026       86,377,377       47,542,277       38,835,100  
                                                

Selected Company Metrics (Reported):

            

Return on average assets (ROA)

     2.03 %     2.47 %     -0.44 %     1.93 %     3.22 %     -1.29 %

Return on average equity (ROE)

     11.95 %     14.19       -2.24 %     11.24 %     19.02       -7.78 %

Net charge-off rate(2)

     1.75 %     2.01       -0.26 %     1.79 %     2.04       -0.25 %

Net interest margin

     5.06 %     6.04       -0.98 %     5.13 %     6.11       -0.98 %

Revenue margin

     11.58 %     14.67       -3.09 %     11.29 %     15.17       -3.88 %
                                                

Selected Company Metrics (Managed):

            

Return on average assets (ROA)

     1.51 %     1.62 %     -0.11 %     1.44 %     2.12 %     -0.68 %

Net charge-off rate(2)

     2.49 %     2.75       -0.26 %     2.56 %     2.70       -0.14 %

Net interest margin

     6.11 %     6.89       -0.78 %     6.08 %     7.09       -1.01 %

Revenue margin

     9.40 %     10.75       -1.35 %     9.26 %     11.02       -1.76 %
                                                

(1) In accordance with the Company’s finance charge and fee revenue recognition policy, the amounts billed to customers but not recognized as revenue were $236.3 million and $215.0 million for the three months ended June 30, 2007 and 2006, respectively, and $450.0 million and $385.9 million for the six months ended June 30, 2007 and 2006, respectively.
(2) Managed and reported net charge-off rate for the second quarter of 2007 was positively impacted 11 and 17 basis points due to the implementation of a change in customer statement generation from a 30 day to a 25 day grace period. This change did not have a material impact on net provision for the quarter.

 

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VII. Reportable Segment Summary

We manage our business as two distinct operating segments: Local Banking and National Lending. The Local Banking and National Lending segments are considered reportable segments based on quantitative thresholds applied to the managed loan portfolio for reportable segments provided by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information.

As management makes decisions on a managed basis within each segment, information about reportable segments is provided on a managed basis.

We maintain our books and records on a legal entity basis for the preparation of financial statements in conformity with GAAP. The following table presents information prepared from our internal management information system, which is maintained on a line of business level through allocations from legal entities.

Local Banking Segment

Table 2: Local Banking

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 

(Dollars in thousands)

   2007     2006     2007     2006  
Earnings (Managed Basis)         

Interest income

   $ 1,724,239     $ 682,679     $ 3,464,371     $ 1,333,664  

Interest expense

     1,139,774       433,451       2,306,337       839,512  
                                

Net interest income

     584,465       249,228       1,158,034       494,152  

Non-interest income

     174,691       114,039       361,564       218,524  
                                

Total revenue

     759,156       363,267       1,519,598       712,676  

Provision for loan and lease losses

     23,929       6,632       47,705       16,453  

Restructuring expense

     —         —         —         —    

Other non-interest expense

     533,297       289,996       1,072,361       562,983  
                                

Income before taxes

     201,930       66,639       399,532       133,240  

Income taxes

     69,464       23,324       137,439       46,634  
                                

Net income

   $ 132,466     $ 43,315     $ 262,093     $ 86,606  
                                
Selected Metrics (Managed Basis)         

Period end loans held for investment

   $ 41,919,645     $ 13,189,112     $ 41,919,645     $ 13,189,112  

Average loans held for investment

   $ 42,110,537     $ 13,115,534     $ 41,979,336     $ 13,199,548  

Core deposits(1)

   $ 63,828,306     $ 27,857,265     $ 63,828,306     $ 27,857,265  

Total deposits

   $ 74,482,705     $ 35,281,970     $ 74,482,705     $ 35,281,970  

Loans held for investment yield

     7.03 %     7.63 %     7.01 %     7.50 %

Net interest margin - loans

     1.88 %     3.18 %     1.89 %     3.22 %

Net interest margin - deposits

     2.01 %     1.59 %     1.99 %     1.56 %

Net charge-off rate

     0.19 %     0.45 %     0.17 %     0.41 %

Non performing loans

   $ 80,781     $ 90,508     $ 80,781     $ 90,508  

Non performing loans as a % of loans held of investment

     0.19 %     0.69 %     0.19 %     0.69 %

Number of active ATMs

     1,253       586       1,253       586  

Number of locations

     724       325       724       325  
                                

(1) Includes domestic non-interest bearing deposits, NOW accounts, money market deposit accounts, savings accounts, certificates of deposit of less than $100,000 and other consumer time deposits.

 

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Beginning in 2006, we added a Banking segment following the acquisition of Hibernia Corporation in late 2005. Banking segment results for the period ended June 30, 2006 include the results of the legacy Hibernia business lines except for the indirect auto business, and the results of our branchless deposit business which were previously included as part of the Other segment. On December 1, 2006, we completed our acquisition of North Fork. Beginning with the results for the quarter ended March 31, 2007, the Banking segment also includes the results of the legacy North Fork business lines except for the indirect auto business and GreenPoint.

The Banking segment contributed $132.5 million and $262.1 million of income for the three and six months ended June 30, 2007, respectively, compared to $43.3 million and $86.6 million in the comparable periods of the prior year. At June 30, 2007, Loans held for investment in the Banking segment totaled $41.9 billion while deposits outstanding totaled $74.5 billion. Banking segment profits are primarily generated from net interest income, which represents the spread between loan yields and the internal cost of funds charged to the business for those loans, plus the spread between deposit interest costs and the funds transfer price credited to the business for those deposits. Increases in loans held for investment, deposits and banking segment income over the prior year are a result of the acquisition of North Fork. Loans held for investment interest margins have remained flat during 2007, and are down from comparable periods in 2006 due primarily to the addition of the North Fork loan portfolio, which contained a higher percentage of lower yielding mortgage loans than the Hibernia portfolio. Deposit interest margins also have been stable during 2007 and are up over comparable periods in 2006 due to the addition of the lower cost North Fork deposits to the existing Hibernia and Capital One deposits.

Non-interest expenses for the three and six months ended June 30, 2007 were $533.3 million and $1,072.4 million, respectively, compared to $290.0 million and $563.0 million in the comparable periods of the prior year. Banking segment non-interest expenses include the costs of operating the branch network and commercial and consumer loan businesses, marketing expenses, and certain Company wide expenses allocated to the banking segment. In addition, banking segment non-interest expenses include the amortization of core deposit intangibles related to the acquisitions of both Hibernia and North Fork, as well as the costs of integrating banking segment activities.

National Lending Segment

Table 3: National Lending

 

     Three Months Ended     Six Months Ended  
     June 30,     June 30,  

(Dollars in thousands)

   2007     2006     2007     2006  
Earnings (Managed Basis)         

Interest income

   $ 3,335,417     $ 2,901,131     $ 6,665,717     $ 5,828,766  

Interest expense

     1,249,968       995,023       2,491,653       1,930,305  
                                

Net interest income

     2,085,449       1,906,108       4,174,064       3,898,461  

Non-interest income

     1,247,343       1,130,005       2,435,265       2,204,988  
                                

Total revenue

     3,332,792       3,036,113       6,609,329       6,103,449  

Provision for loan and lease losses

     873,471       785,029       1,722,687       1,334,637  

Restructuring expense

     —         —         —         —    

Other non-interest expense

     1,449,697       1,375,138       2,958,754       2,684,694  
                                

Income before taxes

     1,009,624       875,946       1,927,888       2,084,118  

Income taxes

     347,916       307,925       664,201       730,384  
                                

Net income

   $ 661,708     $ 568,021     $ 1,263,687     $ 1,353,734  
                                
Selected Metrics (Managed Basis)         

Period end loans held for investment

   $ 102,277,827     $ 95,230,654     $ 102,277,827     $ 95,230,654  

Average loans held for investment

   $ 100,995,167     $ 92,954,555     $ 101,632,334     $ 92,144,478  

Core deposits(1)

   $ 1,124     $ 138,984     $ 1,124     $ 138,984  

Total deposits

   $ 2,411,435     $ 2,434,679     $ 2,411,435     $ 2,434,679  

Loans held for investment yield

     13.03 %     12.47 %     12.87 %     12.63 %

Net charge-off rate (2)

     3.45 %     3.07 %     3.56 %     3.03 %

30+ day delinquency rate

     3.86 %     3.44 %     3.86 %     3.44 %

Number of accounts (000s)

     48,548       48,854       48,548       48,854  
                                

(1) Includes domestic non-interest bearing deposits, NOW accounts, money market deposit accounts, savings accounts, certificates of deposit of less than $100,000 and other consumer time deposits.
(2) Net charge-off rate for the second quarter of 2007 was positively impacted by 16 basis points due to the implementation of a change in customer statement generation from a 30 day to a 25 day grace period. This change did not have a material impact on net provision for the quarter.

 

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The National Lending segment consists of four sub-segments: U.S. Card, Auto Finance, Global Financial Services, and Mortgage Banking. In the first quarter 2007, we added the Mortgage Banking sub-segment which consists primarily of residential and commercial mortgages originated for sale into the secondary market.

The National Lending segment contributed $661.7 million and $1,263.7 million of income for the three and six months ended June 30, 2007, respectively, compared to $568.0 million and $1,353.7 million in the corresponding prior year periods ended June 30, 2006. At June 30, 2007, loans held for investment in the National Lending segment totaled $102.3 billion while deposits outstanding totaled $2.4 billion. Profits are primarily generated from net interest income and past-due fees earned and deemed collectible from our loans, income earned on securities, and non-interest income including the sale and servicing of loans and fee-based services to customers. Total revenue increased 10% for the three months ended June 30, 2007 primarily due to growth in the average managed loans held for investment portfolio of 9% and selective pricing and fee changes following conversion of our cardholder system. For the six months ended June 30, 2007 revenue increased 8%. Credit normalization drove the increase in provision for loan and lease losses for the National Lending segment.

Non-interest expenses for the three and six months ended June 30, 2007 were $1.4 billion and $3.0 billion, respectively, compared to $1.4 billion and $2.7 billion in the corresponding prior year periods ended June 30, 2006. The increase was largely driven by additional expenses to support managed loan growth.

U.S. Card Sub-Segment

Table 4: U.S. Card

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 

(Dollars in thousands)

   2007     2006     2007     2006  
Earnings (Managed Basis)         

Interest income

   $ 1,779,670     $ 1,628,144     $ 3,593,516     $ 3,342,703  

Interest expense

     590,236       507,722       1,192,741       1,001,180  
                                

Net interest income

     1,189,434       1,120,422       2,400,775       2,341,523  

Non-interest income

     842,428       803,083       1,621,034       1,578,496  
                                

Total revenue

     2,031,862       1,923,505       4,021,809       3,920,019  

Provision for loan and lease losses

     402,589       413,701       776,425       638,139  

Non-interest expense

     808,769       860,874       1,669,789       1,705,603  
                                

Income before taxes

     820,504       648,930       1,575,595       1,576,277  

Income taxes

     282,253       227,125       542,004       551,698  
                                

Net income

   $ 538,251     $ 421,805     $ 1,033,591     $ 1,024,579  
                                
Selected Metrics (Managed Basis)         

Period end loans held for investment

   $ 50,032,530     $ 48,736,483     $ 50,032,530     $ 48,736,483  

Average loans held for investment

   $ 49,573,957     $ 47,856,045     $ 50,719,665     $ 48,035,986  

Loans held for investment yield

     14.36 %     13.61 %     14.17 %     13.92 %

Net charge-off rate (2)

     3.73 %     3.29 %     3.87 %     3.11 %

30+ day delinquency rate

     3.41 %     3.30 %     3.41 %     3.30 %

Purchase volume(1)

   $ 21,781,462     $ 20,878,732     $ 41,128,274     $ 38,894,401  

Number of total accounts (000s)

     36,608       37,199       36,608       37,199  
                                

(1) Includes purchase transactions net of returns and excludes cash advance transactions.
(2) Net charge-off rate for the second quarter of 2007 was positively impacted by 31 basis points due to the implementation of a change in customer statement generation from a 30 day to a 25 day grace period. This change did not have a material impact on net provision for the quarter.

 

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The U.S. Card sub-segment consists of domestic consumer credit and debit card activities.

Managed loans increased 3% compared to June 30, 2006. Year-over-year growth was negatively impacted by portfolio sale of a co-branded credit card partnership at the end of the first quarter of 2007 and a reduction in our already-low marketing of balance transfer teaser products. In the second quarter, we experienced heightened asset attrition as a result of repricing parts of the portfolio where original funding had expired. Purchase volume increased 4% over the prior year, while account attrition decreased during the three months ended June 30, 2007. The purchase volume increase was negatively impacted by the co-branded credit card partnership sale in the first quarter of 2007 as well as deliberate strategy choices. Additionally, retail sales have been soft in recent months, adding to the pressure on purchase volume growth.

For the three months ended June 30, 2007, net income was $538.3 million, an increase of $116.4 million, or 28%, compared to the three months ended June 30, 2006. The increase was mainly a result of a 6%, or $108.4 million increase in revenues, driven by higher asset and purchase volumes, as well as increased margins. Primary drivers of the increase in revenue margin include reductions in the amount of teaser-based acquisitions as well as selective pricing and fee changes following the conversion of our card holder system. For the six months ended June 30, 2007, U.S. Card sub-segment net income increased 1% compared to the same period last year as higher revenues were off-set by higher net provision due to the normalization of consumer credit.

Net provision decreased $11.1 million for the three months ended June 30, 2007 compared to the three months ended June 30, 2006, reflecting higher securitization levels. For the six months ended June 30, 2007 net provision increased by $138.3 million driven by continued normalization of U.S. Consumer credit following the bankruptcy legislation impact. The net charge-off rate for the three and six months ending June 30, 2007 increased 44 basis points and 76 basis points, respectively, from same period last year, reflecting the above mentioned credit normalization effect. The net charge-off rate for the three months ended June 30, 2007 decreased 31 basis points due to the implementation of a change in customer statement generation from a 30 day to a 25 day grace period. This change did not have a material impact on net provision for the quarter.

During the three months ended June 30, 2007, we realized $26.0 million of gain on sale of charged-off debt. The proceeds of this sale were applied against the net charge-offs and reduced the net charge-off rate by 21 basis points.

Non-interest expenses decreased 6% and 2%, respectively, for three and six months periods ending June 30, 2007 due to lower marketing spend as a result of our evolving marketing strategy and lower operational expenses. This is in line with our recent 8-K filing indicating that we are taking actions to reduce our operating expenses and we expect to generally see continued improvement over the course of 2007 and 2008 with some quarterly volatility.

 

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Auto Finance Sub-Segment

Table 5: Auto Finance

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 

(Dollars in thousands)

   2007     2006     2007     2006  

Earnings (Managed Basis)

        

Interest income

   $ 651,821     $ 547,731     $ 1,289,430     $ 1,068,561  

Interest expense

     277,783       207,497       543,339       395,324  
                                

Net interest income

     374,038       340,234       746,091       673,237  

Non-interest income

     23,273       29,842       83,859       46,060  
                                

Total revenue

     397,311       370,076       829,950       719,297  

Provision for loan and lease losses

     182,278       74,714       382,336       182,519  

Non-interest expense

     157,044       149,115       321,992       283,770  
                                

Income before taxes

     57,989       146,247       125,622       253,008  

Income taxes

     19,948       51,186       43,214       88,552  
                                

Net income

   $ 38,041     $ 95,061     $ 82,408     $ 164,456  
                                

Selected Metrics (Managed Basis)

        

Period end loans held for investment

   $ 24,067,760     $ 20,558,455     $ 24,067,760     $ 20,558,455  

Average loans held for investment

   $ 23,898,070     $ 20,187,631     $ 23,748,702     $ 19,815,457  

Loans held for investment yield

     10.91 %     10.85 %     10.86 %     10.79 %

Net charge-off rate

     2.35 %     1.54 %     2.32 %     1.94 %

30+ day delinquency rate

     6.00 %     4.55 %     6.00 %     4.55 %

Auto loan originations(1)

   $ 2,992,427     $ 3,107,409     $ 6,304,295     $ 6,047,949  

Number of total accounts (000s)

     1,771       1,525       1,771       1,525  
                                

(1) Includes all organic auto loan originations and excludes auto loans added through acquisitions.

The Auto Finance sub-segment consists of automobile and other motor vehicle financing activities.

Auto Finance sub-segment’s loans held for investment portfolio increased 17% over prior year quarter as a result of the transfer of $1.8 billion of North Fork Bank’s auto loans to the Auto Finance sub-segment on January 1, 2007, and strong organic originations growth within our dealer and direct marketing channels. As a result of this portfolio growth, net interest income increased 10% in the three months ended June 30, 2007 compared to the same period in the prior year, and 11% in the six months ended June 30, 2007 compared to the same period prior year.

Non-interest income for the six months ended June 30, 2007 included a one-time gain of $46.2 million related to the sale of 1.8 million shares of DealerTrack stock during the first quarter.

For the three and six month periods ended June 30, 2007, the Auto Finance sub-segment’s net charge-off rate was up 81 basis points and 38 basis points, respectively, compared with the all-time low charge off rates seen in the same periods in the prior year. Net charge-offs of auto loans increased $62.7 million and $83.3 million for the three and six month periods ended June 30, 2007, respectively. The provision for loan and lease losses increased $107.6 million and $199.8 million for the three and six month periods ended June 30, 2007, respectively, primarily driven by portfolio growth, credit normalization following the historic low loss rates seen in the first half of 2006, targeted risk expansion, and declining credit performance for the prime loan portfolio.

The 30-plus day delinquency rate for the Auto Finance sub-segment increased 145 basis points at June 30, 2007. The increase in delinquencies was the result of the normalization of delinquencies following the 2005 bankruptcy spike, which lowered 2006 delinquency rates, targeted risk expansion, and declining credit performance in the dealer prime portfolio.

Non-interest expense increased 5% and 13%, respectively for the three and six months ended June 30, 2007 when compared to the same periods in the prior year. Operating costs on a percent of loan basis have declined versus prior year as the Auto Finance sub-segment begins to realize the initial benefits of the integration of the dealer programs of the legacy Capital One, Onyx, Hibernia, and North Fork auto lending businesses.

 

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Global Financial Services Sub-Segment

Table 6: Global Financial Services

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 

(Dollars in thousands)

   2007     2006     2007     2006  

Earnings (Managed Basis)

        

Interest income

   $ 829,551     $ 725,256     $ 1,632,692     $ 1,417,502  

Interest expense

     329,087       279,804       645,310       533,801  
                                

Net interest income

     500,464       445,452       987,382       883,701  

Non-interest income

     311,438       297,080       610,745       580,432  
                                

Total revenue

     811,902       742,532       1,598,127       1,464,133  

Provision for loan and lease losses

     284,282       296,614       559,604       513,979  

Non-interest expense

     400,469       365,149       796,670       695,321  
                                

Income before taxes

     127,151       80,769       241,853       254,833  

Income taxes

     44,346       29,614       84,206       90,134  
                                

Net income

   $ 82,805     $ 51,155     $ 157,647     $ 164,699  
                                

Selected Metrics (Managed Basis)

        

Period end loans held for investment

   $ 27,489,749     $ 25,935,716     $ 27,489,749     $ 25,935,716  

Average loans held for investment

   $ 27,048,111     $ 24,910,879     $ 26,925,140     $ 24,293,035  

Loans held for investment yield

     12.16 %     11.58 %     12.02 %     11.61 %

Net charge-off rate

     3.98 %     3.90 %     4.08 %     3.77 %

30+ day delinquency rate

     2.93 %     2.82 %     2.93 %     2.82 %

Number of total accounts (000s)

     10,157       10,130       10,157       10,130  
                                

Global Financial Services businesses extend Capital One’s national scale lending franchise and provide geographic diversification. The sub-segment consists of international (Europe and Canada) lending, small business lending, installment loans, home loans, healthcare finance and other consumer financial service activities.

Global Financial Services net income increased 62% for the three months ended June 30, 2007 largely driven by strong revenue growth in North America and a favorable credit outlook in the U.K. Net income decreased 4% for the six months ended June 30, 2007 as a result of higher non-interest expense and increased provision for loan and lease losses.

Total revenue increased 9% for the three and six months ended June 30, 2007, in line with the 9% growth in average loans held for investment for the three months ended June 30, 2007 and lower than the 11% growth in average loans for the six months ended June 30, 2007. Strong North American growth was largely offset by the implementation of a £12 fee cap for default charges (late and overlimit fees) in Europe in September 2006.

The provision for loan losses decreased 4% for the three months ended June 30, 2007 and increased 9% for the six months ended June 30, 2007. Current period charge-offs and allowance for loan and lease losses expected in the future were impacted by the normalization of credit following the impact of the U.S. bankruptcy legislation implemented in 2005.

Non-interest expense increased 10% and 15% for the three and six months ended June 30, 2007, respectively. Marketing was flat for the three months ended June 30, 2007 and 9% higher for the six months ended June 30, 2007 as a result of continued investment. Operating costs were higher for the three and six months ended June 30, 2007 reflecting asset growth.

 

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Mortgage Banking Sub-Segment

Table 7: Mortgage Banking

 

(Dollars in thousands)

  

Three Months Ended

June 30, 2007

   

Six Months Ended

June 30, 2007

 

Earnings (Managed Basis)

    

Interest income

   $ 74,375     $ 150,079  

Interest expense

     52,862       110,263  
                

Net interest income

     21,513       39,816  

Non-interest income

     70,204       119,627  
                

Total revenue

     91,717       159,443  

Provision for loan and lease losses

     4,322       4,322  

Non-interest expense

     83,415       170,303  
                

Income before taxes

     3,980       (15,182 )

Income taxes (benefit)

     1,369       (5,223 )
                

Net income (loss)

   $ 2,611     $ (9,959 )
                

Selected Metrics (Managed Basis)

    

Period end loans held for investment

   $ 687,788     $ 687,788  

Average loans held for investment

   $ 475,029     $ 238,827  

Net gain on sale margin

     56 bps       53 bps  

Efficiency ratio

     91 %     107 %

Mortgage Loan Originations

   $ 5,499,306     $ 12,294,774  
                

The Mortgage Banking sub-segment consists of mortgage origination, whole loan sales and servicing.

Originations were $5.5 billion for the three months ended June 30, 2007, compared to $6.8 billion in the prior quarter. The decline in originations was related to an overall weakness in the mortgage market, as well as the ongoing impact of the underwriting tightening that occurred during the first quarter of 2007.

The Mortgage Banking sub-segment recorded net income of $2.6 million for the quarter ended June 30, 2007, compared to a net loss of $12.6 million in the prior quarter. A $20.8 million increase in non-interest income was largely driven by market value adjustments on the mortgage servicing rights as a result of slower prepayment assumptions.

During the quarter, mortgage loans with an unpaid principal balance of $701 million were transferred from loans held for sale to loans held for investment. As a result, a $4.3 million provision for loan and lease losses was recognized in the current quarter.

Net interest income increased $3.2 million over the previous quarter due to an increase in higher yielding assets. The higher yields were offset by a slight decrease in the average balance of interest earning assets compared to the prior quarter.

Non-interest expense decreased $3.5 million compared to the prior quarter, as lower originations resulted in lower salary and incentive expense.

VIII. Funding

Funding Availability

We have established access to a variety of funding sources.

Table 8 illustrates our unsecured funding sources and our two auto loan secured warehouses.

Table 8: Funding Availability

 

(Dollars or dollar equivalents in millions)

  

Effective/

Issue Date

   Availability (1)(6)    Outstanding (4)   

Final

Maturity(5)

Senior and Subordinated Global Bank Note Program(2)

   1/03    $ 1,800    $ 3,188    —  

Senior Domestic Bank Note Program(3)

   4/97      —        167    —  

Capital One Auto Loan Facility I

   3/02      1,937      1,363    —  

Capital One Auto Loan Facility II

   3/05      1,642      108    —  

Corporation Automatic Shelf Registration Statement

   5/06      *      N/A    **
                       

(1) All funding sources are non-revolving except for the Credit Facility and the Capital One Auto Loan Facilities. Funding availability under the credit facilities and auto loan secured warehouses is subject to compliance with certain representations, warranties and covenants. Funding availability under all other sources is subject to market conditions.
(2) The notes issued under the Senior and Subordinated Global Bank Note Program may have original terms of thirty days to thirty years from their date of issuance. This program was updated in June 2005.
(3) The notes issued under the Senior Domestic Bank Note Program have original terms of one to ten years. The Senior Domestic Bank Note Program is no longer available for issuances.

 

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(4) Amounts outstanding are as of June 30, 2007.
(5) Maturity date refers to the date the facility terminates, where applicable.
(6) Availability does not include unused conduit capacity related to off-balance sheet securitization structures of $7.8 billion at June 30, 2007.
* The Corporation and certain of its subsidiaries have registered an indeterminate amount of securities pursuant to the Automatic Shelf Registration Statement that are available for future issuance.
** Under SEC rules, the Automatic Shelf Registration Statement expires three years after filing. Accordingly, the Corporation must file a new Automatic Shelf Registration Statement at least once every three years.

Senior and Subordinated Notes

The Senior and Subordinated Global Bank Note Program gives the Bank the ability to issue securities to both U.S. and non-U.S. lenders and to raise funds in U.S. and foreign currencies, subject to conditions customary in transactions of this nature.

Prior to the establishment of the Senior and Subordinated Global Bank Note Program, the Bank issued senior unsecured debt through its $8.0 billion Senior Domestic Bank Note Program, of which $167.1 million was outstanding at June 30, 2007. The Bank did not renew the Senior Domestic Bank Note Program for future issuances following the establishment of the Senior and Subordinated Global Bank Note Program.

Other Short-Term Borrowings

Revolving Credit Facility

In June 2004, we terminated our Domestic Revolving and Multicurrency Credit Facilities and replaced them with a new revolving credit facility (“Credit Facility”) providing for an aggregate of $750.0 million in unsecured borrowings from various lending institutions to be used for general corporate purposes. On April 30, 2007 the Credit Facility was terminated.

Collateralized Revolving Credit Facilities

In March 2002, COAF entered into a revolving warehouse credit facility collateralized by a security interest in certain auto loan assets (the “Capital One Auto Loan Facility I”). As of June 30, 2007, the Capital One Auto Loan Facility I had the capacity to issue up to $3.3 billion in secured notes. The Capital One Auto Loan Facility I has multiple participants each with separate renewal dates. The facility does not have a final maturity date. Instead, each participant may elect to renew the commitment for another set period of time. Interest on the facility is largely based on commercial paper rates.

In March 2005, COAF entered into a second revolving warehouse credit facility collateralized by a security interest in certain auto loan assets (the “Capital One Auto Loan Facility II”). As of June 30, 2007, the Capital One Auto Loan Facility II had the capacity to issue up to $1.8 billion in secured notes. The facility does not have a final maturity date. Instead, the participant may elect to renew the commitment for another set period of time. Interest on the facility is based on commercial paper rates.

Corporation Shelf Registration Statement

As of June 30, 2007, we had an effective shelf registration statement under which we from time to time may offer and sell an indeterminate aggregate amount of senior or subordinated debt securities, preferred stock, depositary shares representing preferred stock, common stock, trust preferred securities, junior subordinated debt securities, guarantees of trust preferred securities and certain back-up obligations, purchase contracts and units. There is no limit under this shelf registration statement to the amount or number of such securities that we may offer and sell.

Table 9 shows the maturities of domestic time certificates of deposit in denominations of $100 thousand or greater (large denomination CDs) as of June 30, 2007.

Table 9: Maturities of Large Denomination Certificates—$100,000 or More

 

     June 30, 2007  

(Dollars in thousands)

   Balance    Percent  

Three months or less

   $ 3,526,582    32.32 %

Over 3 through 6 months

     1,760,608    16.13 %

Over 6 through 12 months

     1,955,546    17.92 %

Over 12 months through 10 years

     3,669,118    33.63 %
             

Total

   $ 10,911,854    100.00 %
             

 

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Table 10 shows the composition of average deposits for the periods presented.

Table 10: Deposit Composition and Average Deposit Rates

 

     Three Months Ended June 30,     Six Months Ended June 30,  
    

Average

Balance

  

% of

Deposits

   

Average

Deposit

Rate

   

Average

Balance

  

% of

Deposits

   

Average

Deposit

Rate

 

Non-interest bearing - domestic

   $ 11,470,020    13.23 %   N/A     $ 11,304,591    13.09 %   N/A  

NOW accounts

     5,115,994    5.90 %   2.87 %     5,091,195    5.89 %   2.84 %

Money market deposit accounts

     27,612,189    31.84 %   4.00 %     26,555,379    30.74 %   3.96 %

Savings Accounts

     8,409,684    9.70 %   1.73 %     8,397,407    9.72 %   1.71 %

Other consumer time deposits

     18,494,150    21.33 %   4.71 %     19,040,267    22.04 %   4.52 %
                                      

Total core deposits

     71,102,037    82.00 %   3.19 %     70,388,839    81.48 %   3.13 %

Public fund certificate of deposits of $100,000 or more

     1,981,883    2.28 %   4.90 %     2,010,178    2.33 %   4.89 %

Certificates of deposit of $100,000 or more

     9,609,949    11.08 %   4.47 %     9,972,936    11.55 %   4.61 %

Foreign time deposits - non-interest bearing

     4,025,127    4.64 %   5.07 %     4,005,424    4.64 %   5.01 %
                                      

Total deposits

   $ 86,718,996    100.00 %   3.46 %   $ 86,377,377    100.00 %   3.43 %
                                      

IX. Capital

Capital Adequacy

The Company and the Bank are subject to capital adequacy guidelines adopted by the Federal Reserve Board (the “Federal Reserve”), the Savings Bank is subject to capital adequacy guidelines adopted by the Office of Thrift Supervision (the “OTS”), CONA and Superior are subject to capital adequacy guidelines adopted by the Office of the Comptroller of the Currency (the “OCC”), and North Fork Bank is subject to capital adequacy guidelines adopted by the Federal Deposit Insurance Corporation (the “FDIC”) (collectively the “regulators”). The capital adequacy guidelines set minimum risk-based and leverage capital requirements that are based upon quantitative and qualitative measures of their assets and off-balance sheet items. The Federal Reserve holds the Corporation to similar minimum capital requirements.

As of June 30, 2007, the Bank, the Savings Bank, CONA, Superior and North Fork Bank (collectively the “Banks”) each exceeded the minimum regulatory requirements to which it was subject. The Banks all were considered “well-capitalized” under applicable capital adequacy guidelines. Also as of June 30, 2007, the Corporation was considered “well-capitalized” under Federal Reserve capital standards for bank holding companies and, therefore, exceeded all minimum capital requirements. There have been no conditions or events since that we believe would have changed the capital category of the Corporation or any of the Banks.

The Bank and Savings Bank treat a portion of their loans as “subprime” under the “Expanded Guidance for Subprime Lending Programs” (the “Subprime Guidelines”) issued by the four federal banking agencies that comprise the Federal Financial Institutions Examination Council (“FFIEC”), and have assessed their capital and allowance for loan and lease losses accordingly. Under the Subprime Guidelines, the Bank and Savings Bank each exceed the minimum capital adequacy guidelines as of June 30, 2007. Failure to meet minimum capital requirements can result in mandatory and possible additional discretionary actions by the regulators that, if undertaken, could have a material effect on the Corporation’s consolidated financial statements.

For purposes of the Subprime Guidelines, the Corporation has treated as subprime all loans in the Bank’s and the Savings Bank’s targeted “subprime” programs to customers either with a FICO score of 660 or below or with no FICO score. The Bank and the Savings Bank hold on average 200% of the total risk-based capital charge that would otherwise apply to such assets. This results in higher levels of regulatory capital at the Bank and the Savings Bank.

 

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Additionally, regulatory restrictions exist that limit the ability of the Bank, Savings Bank, CONA, North Fork Bank and Superior to transfer funds to the Corporation. As of June 30, 2007, retained earnings of the Bank, the Savings Bank, CONA, North Fork Bank and Superior of $199.2 million, $436.0 million, $11.8 million, $115.5 million and $4.0 million, respectively, were available for payment of dividends to the Corporation without prior approval by the regulators.

Table 11 – REGULATORY CAPITAL RATIOS

 

    

Regulatory

Filing

Basis

Ratios

   

Applying

Subprime

Guidance

Ratios

   

Minimum for

Capital

Adequacy

Purposes

   

To Be

“Well Capitalized”

Under

Prompt Corrective

Action

Provisions

 

June 30, 2007

        

Capital One Financial Corp.

        

Tier 1 Capital

   10.87 %   10.09 %   4.00 %   N/A  

Total Capital

   13.99     13.07     8.00     N/A  

Tier 1 Leverage

   9.33     9.33     4.00     N/A  

Capital One Bank

        

Tier 1 Capital

   16.40 %   12.76 %   4.00 %   6.00 %

Total Capital

   20.39     16.07     8.00     10.00  

Tier 1 Leverage

   13.34     13.34     4.00     5.00  

Capital One F.S.B.

        

Tier 1 Capital

   13.21 %   10.87 %   4.00 %   6.00 %

Total Capital

   14.49     12.14     8.00     10.00  

Tier 1 Leverage

   13.55     13.55     4.00     5.00  

Capital One National Bank

        

Tier 1 Capital

   10.51 %   N/A     4.00 %   6.00 %

Total Capital

   11.50     N/A     8.00     10.00  

Tier 1 Leverage

   7.53     N/A     4.00     5.00  

North Fork Bank

        

Tier 1 Capital

   10.85 %   N/A     4.00 %   6.00 %

Total Capital

   11.88     N/A     8.00     10.00  

Tier 1 Leverage

   7.70     N/A     4.00     5.00  

Superior Bank

        

Tier 1 Capital

   13.96 %   N/A     4.00 %   6.00 %

Total Capital

   14.26     N/A     8.00     10.00  

Tier 1 Leverage

   5.45     N/A     4.00     5.00  
                        
June 30, 2006         

Capital One Financial Corp. (1)

        

Tier 1 Capital

   16.10 %   14.44 %   4.00 %   N/A  

Total Capital

   18.30     16.53     8.00     N/A  

Tier 1 Leverage

   14.22     14.22     4.00     N/A  

Capital One Bank

        

Tier 1 Capital

   14.42 %   11.41 %   4.00 %   6.00 %

Total Capital

   18.53     14.88     8.00     10.00  

Tier 1 Leverage

   11.51     11.51     4.00     5.00  

 

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Capital One, F.S.B.

        

Tier 1 Capital

   13.68 %   11.33 %   4.00 %   6.00 %

Total Capital

   14.95     12.59     8.00     10.00  

Tier 1 Leverage

   13.65     13.65     4.00     5.00  

Capital One, National Association

        

Tier 1 Capital

   10.44 %   N/A     4.00 %   6.00 %

Total Capital

   11.68     N/A     8.00     10.00  

Tier 1 Leverage

   7.3     N/A     4.00     5.00  

(1) The regulatory framework for prompt corrective action is not applicable for bank holding companies.

Dividend Policy

Although we expect to reinvest a substantial portion of our earnings in our business, we also intend to continue to pay regular quarterly cash dividends on our common stock. The declaration and payment of dividends, as well as the amount thereof, are subject to the discretion of the Board of Directors of the Company and will depend upon our results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. Accordingly, there can be no assurance that we will declare and pay any dividends. As a holding company, our ability to pay dividends is dependent upon the receipt of dividends or other payments from our subsidiaries. Applicable banking regulations and provisions that may be contained in our borrowing agreements or the borrowing agreements of our subsidiaries may limit our subsidiaries’ ability to pay dividends to us or our ability to pay dividends to our stockholders.

X. Business Outlook

This business outlook section summarizes our expectations for earnings for 2007, and our primary goals and strategies for continued growth. The statements contained in this section are based on our current expectations and do not take into account any acquisitions that might occur during the year. Certain statements are forward looking. Actual results could differ materially from those in our forward looking statements. Factors that could materially influence results are set forth throughout this section and in Item 1A “Risk Factors.”

Expected Earnings

On July 19, 2007, we announced that we expect earnings per share for the full year to be between $7.00 to $7.40, with non-operating items moving us to the lower end of that range. This guidance was as of the date it was given. This guidance is inclusive of $200M of restructuring charges incurred as a result of our 2007 cost initiative that we announced in the second quarter. Also included in this guidance is the completion of a $3 billion share repurchase program, to be completed by the end of 2007.

In addition to the restructuring charges and share repurchases, our guidance also assumes that some notable business trends seen in the second quarter will continue through the year; we expect declining loan balances year-over year with expanding revenue margin in our U.S. Card business; and we expect to see elevated loss levels throughout the year in the prime Auto Finance business. The 2007 guidance continues to assume no change in the following market conditions: continued pressure in secondary mortgage market pricing; continued U.S consumer credit normalization in the wake of the late 2005 spike in bankruptcies and new legislation, a more stable U.K. consumer credit environment, a solid U.S. labor market and yield curve which remains at currently flat levels.

The share count used to translate our expected GAAP NIAT to earnings per share assumes the completion of the previously announced $3 billion share repurchase program. As described in “Notes to the Condensed Reported Financial Statements - Note 10 – Accelerated Share Repurchase Program,” on March 12, 2007, we entered into a $1.5 billion Accelerated Share Repurchase agreement with Credit Suisse. The effective date of the ASR agreement is April 2, 2007. We also executed $250 million in additional open market repurchases in the quarter, and now expect to complete our $3 billion total share repurchase program by the end of 2007.

Our earnings are a function of our revenues (net interest income and non-interest income), consumer usage, payment and attrition patterns, the credit quality and growth rate of our earning assets (which affect fees, charge-offs and provision expense), the growth rate of our branches and deposits, and our marketing and operating expenses. Specific factors likely to affect our 2007 earnings are the portion of our loan portfolio held in higher credit quality assets; the level of off-balance sheet securitizations; changes in consumer payment behavior; the amount and quality of deposits we generate; the competitive, legal, regulatory and reputational environment; the level of investments; growth in our businesses; and the health of the economy and its labor markets. Other factors that may affect our revenues are described in Item 1A “Risk Factors”.

 

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We expect to achieve these results based on the continued success of our business strategies and our current assessment of the competitive, regulatory and funding market environments that we face (each of which is discussed elsewhere in this document), as well as the expectation that the geographies in which we compete will not experience significant credit quality erosion, as might be the case in an economic downturn or recession. In addition, we expect to realize cost efficiencies across business lines to ensure operating efficiency.

Beginning in the first quarter of 2007, we changed our primary reportable business segments to reflect our strategy of National Lending and Local Banking platforms. In addition to schedules detailing results in those segments, we provide a similar level of detail for our sub-segments within National Lending – U.S. Card, Global Financial Services, Auto Finance, and Mortgage Banking.

Local Banking Segment Outlook

Deposits in the Local Banking segment were flat compared to the first quarter of 2007, at $74.5 billion. Growth in commercial deposits in the quarter was offset by modest declines in public funds, consumer, and direct bank deposits. As expected in the current environment, our deposit mix continues to shift towards higher-cost deposits. Deposit net interest margin was stable in the quarter, as a result of modest pricing adjustments.

Loan balances grew modestly from the first quarter of 2007, to $41.9 billion. Commercial and small business loans grew slightly, which offset the planned reduction in residential mortgages. Commercial real estate and multifamily loan portfolios were flat from the first quarter.

Our integration efforts remain on track, with the Hibernia integration completed, and the North Fork integration proceeding and on track. We expect North Fork Bank integration efforts to accelerate in the second half of 2007, with the final phase of the deposit platform conversion scheduled for the first quarter of 2008.

National Lending Segment Outlook

Loans in the National Lending Segment grew by $1.9 billion or 2% to $102.3 billion in the second quarter of 2007. The growth in loans was primarily from our U.S. Card and Global Financial Services sub-segments. We also transferred $700.8 million in residential mortgage loans from held-for-sale to held-for-investment.

U.S. Card Sub-Segment Outlook

The U.S. Card sub-segment consisted of $50.0 billion of managed U.S. consumer credit card loans as of June 30, 2007. Annual and quarterly growth in the quarter resulted from growth in targeted segments. Our year-over-year loan growth rate declined due to our decision to pull back further from already low levels of marketing teaser products in the prime space, as well as the co-branded credit card partnership sale in the first quarter of 2007.

We continue to see intensive competitive pressure in the prime space, with little abatement in market intensity. We have continued to limit marketing in the prime revolver segment, where we believe that the prevailing industry headline pricing practices are heavily dependent on secondary pricing moves (often to rates well above the “go to” rate) to achieve profitability and are inconsistent with generating long-term customer loyalty. Instead, we have chosen to focus on marketing to prime transactors, and we expect these strategies will drive growth and revenue margins through the rest of 2007, even as prime balances decline. Competitive pressure in the subprime business continued to intensify in the quarter, but we remain confident in our efforts to generate modest growth in loans and revenues by marketing to customers at the upper end of subprime with competitively priced revolver products.

We expect many of the second quarter trends to continue through the second half of 2007. While we expect to see modest loan growth in the second half, we also expect to end the year with lower loan balances than at year-end 2006. We also expect steady growth in revenues to continue, as many of the drivers of revenue growth in the second quarter continue through the second half of the year. While charge-off dollars continue to track with our expectations of credit normalization, the expected decline in loan balances will push the charge-off rate higher as a result of the lower denominator. As a result, we expect charge-offs to continue to rise over the second half, stabilizing around 5% at the end of 2007.

Global Financial Services Sub-Segment Outlook

The Global Financial Services sub-segment consisted of $27.5 billion of managed loans as of June 30, 2007. Annual growth in the quarter resulted from growth in managed loans and originations throughout many of the lending businesses in the sub-segment, including small business loans, installment loans, and our direct-to-consumer home loans business. Loan balances in our U.K. business declined over the year, as we slowed growth as a result of the challenges facing the industry.

 

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We expect continued growth from most of our North American businesses over the course of 2007, as a result of the wide range of full credit spectrum product offers, our ability to leverage the Capital One brand, and continued improvement in operating scale. We also expect more stable results from our U.K. credit card business, as we believe credit in the UK has stabilized, driven by a leveling off in the number of insolvencies and third-party debt management charge-offs. We remain cautious, however, as there are still industry-wide challenges in both the U.K. and the U.S. mortgage market, which we continue to watch closely.

Auto Finance Sub-Segment Outlook

Our Auto Finance sub-segment consisted of $24.1 billion of managed U.S. auto loans as of June 30, 2007, marketed across the full credit spectrum via direct to consumer and dealer marketing channels.

Auto Finance profits for the second quarter were $38.0 million, down $57.0 million, or 60%, from the second quarter of 2006. The decline in net income resulted primarily from provision expense, which increased by $107.6 million from the second quarter of last year, when our Auto business charge-off rate reached its record low of 1.54%. While we continue to see the effects of the ongoing normalization of charge-offs that we have seen in our U.S. lending businesses, our Auto business has also been impacted by continued elevated losses in its recent Dealer Prime originations. This increase in losses relates primarily to the transition from a judgmental underwriting approach to our first-generation automated underwriting model for prime loans in the dealer channel. In the first half of 2007, we pulled back Dealer Prime originations by $2 billion because of these elevated levels of charge-offs and delinquencies. We are now booking prime business under our next generation risk model, which we believe has addressed these issues. However, charge-offs for the loans booked under the old model will remain elevated for several quarters.

While we are currently facing challenges regarding both credit normalization and in our continuing efforts to expand in the prime business, we remain optimistic about the future growth and profitability of our Auto business.

Mortgage Banking Sub-Segment Outlook

Our mortgage banking business posted a modest profit of $2.6 million in the second quarter of 2007, even as secondary market challenges continue to pressure earnings across the mortgage industry. Our performance reflected modest increases in revenues as a result of a moderate expansion in our net gain-on-sale margin, and a $22.1 million pre-tax increase in our service fee income, which was primarily attributable to an increase in the valuation of our mortgage servicing rights, which currently stands at $316.0 million.

Origination volumes declined significantly in the quarter due the company’s tightening of the underwriting standards, which it uses to originate its mortgage loans. The challenging interest rate environment, as well as continued uncertain secondary mortgage market demand, added to the pressure on origination volumes.

The year to date results of our mortgage banking business reflect the secondary market volume and pricing risks of our originate-and-sell model. We expect that the continuing uncertainty and challenges facing the secondary markets will continue to put significant pressure on our business throughout 2007. In addition, although our strategy is to predominantly originate and sell, we do hold some mortgage assets on our balance sheet, including assets that have been previously sold but returned to us based on representation and warranty obligations. The current market environment also places pressure on the performance and value of these assets. The pressures on mortgage assets and secondary market conditions can together create a variety of potential adverse impacts for us, including: deterioration of credit performance in the assets we hold on our balance sheet and in the form of our representation and warranty reserves; an inability to sell assets that we have already originated or to sell them at economically reasonable prices; an increase in the number of previously sold loans returned to us; and/or an inability to reduce the fixed costs associated with our business at the same pace as we reduce origination volumes, if we choose to do so. Our year to date results reflect the fact that we have already experienced some of these pressures and, to the extent these pressures continue or increase, we could experience additional negative impacts on financial performance, including increased losses on sales, increased provision expenses and/or impairments to the value of assets held on our balance sheet. We will continue in our mortgage banking business to take steps necessary to minimize our exposure to longer-term risks, and protect our corporate profitability in these adverse market conditions.

XI. Supervision and Regulation

We have consolidated several of our banking subsidiaries into our existing national bank, CONA, and moved the headquarters of CONA from New Orleans, Louisiana to McLean, Virginia. On July 1, 2007, the Savings Bank merged with and into CONA. On August 1, 2007, North Fork Bank merged with and into CONA, and North Fork Bank’s mortgage lending subsidiary, GreenPoint, became an operating subsidiary of CONA. We are exploring other reorganization and consolidation options to streamline our operations.

 

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For additional information on our Supervision and Regulation activities, see our Annual Report on Form 10-K for the year ended December 31, 2006, Part I, Item 1 “Supervision and Regulation”. For a summary of our regulatory issues and activities.

XII. Enterprise Risk Management

Risk is an inherent part of our business and activities. We have an Enterprise Risk Management (ERM) program designed to ensure appropriate and comprehensive oversight and management of risk. The ERM program has three components. First, the Board of Directors and senior management committees oversee risk and risk management practices. Second, the centralized department headed by the Chief Risk Officer establishes risk management methodologies, processes and standards. Third, the individual business areas throughout the Company are responsible for managing risk in their businesses and performing ongoing identification, assessment and response to risks. Our ERM framework includes eight categories of risk: credit, liquidity, market, operational, legal, strategic, reputation, and compliance.

For additional information on our ERM program, see our Annual Report on Form 10-K for the year ended December 31, 2006, Part I, Item 1, “Enterprise Risk Management”.

XIII. Tabular Summary

TABLE A—STATEMENTS OF AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES

Table A provides average balance sheet data and an analysis of net interest income, net interest spread (the difference between the yield on earning assets and the cost of interest-bearing liabilities) and net interest margin for the three and six months ended June 30, 2007 and 2006.

 

     Three Months Ended June 30  
     2007     2006  

(Dollars in Thousands)

  

Average

Balance

   

Income/

Expense

  

Yield/

Rate

   

Average

Balance

   

Income/

Expense

   Yield/
Rate
 

Assets:

              

Earning assets

              

Consumer loans (1)

              

Domestic

   $ 56,817,138     $ 1,468,194    10.34 %   $ 44,670,021     $ 1,297,675    11.62 %

International

     3,194,666       99,287    12.43 %     3,718,870       105,066    11.30 %
                                          

Total consumer loans

     60,011,804       1,567,481    10.45 %     48,388,891       1,402,741    11.60 %

Commercial loans

     31,608,151       699,417    8.85 %     10,444,485       214,196    8.20 %
                                          

Total Loans Held for Investment

     91,619,955       2,266,898    9.90 %     58,833,376       1,616,937    10.99 %
                                          

Mortgage Loans Held for Sale (2)

     3,898,065       71,149    7.30 %     240,245       4,714    7.85 %

Securities available for sale (3)

     19,349,938       237,978    4.92 %     14,256,956       167,352    4.70 %

Other

              

Domestic (3)

     7,215,648       123,691    6.86 %     4,489,017       84,234    7.51 %

International

     1,125,610       13,345    4.74 %     1,446,352       23,920    6.62 %
                                          

Total (3)

     8,341,258       137,036    6.57 %     5,935,369       108,154    7.29 %
                                          

Total earning assets

     123,209,216     $ 2,713,061    8.81 %     79,265,946     $ 1,897,157    9.57 %

Cash and due from banks

     2,100,933            1,416,944       

Allowance for loan losses

     (2,107,172 )          (1,678,091 )     

Premises and equipment, net

     2,285,200            1,419,151       

Other (2)

     22,270,066            9,219,679       
                          

Total assets

   $ 147,758,243          $ 89,643,629       
                          
Liabilities and Equity:               

Interest-bearing liabilities

              

Deposits

              

Domestic

   $ 72,861,146     $ <