Earnings Call Transcript - COF Q4 2023

Jeff Norris, Senior Vice President of Finance

Thanks very much, Amy, and welcome everyone to Capital One's fourth quarter 2023 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One's website at capitalone.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our fourth-quarter results. With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer, and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew are going to walk you through the presentation. To access a copy of the presentation and the press release, please go to Capital One's website, click on Investors, then click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events, or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factors section of our annual and quarterly reports accessible at Capital One's website and filed with the SEC. Now, I will turn the call over to Mr. Young. Andrew?

Andrew Young, CFO

Thanks, Jeff, and good afternoon everybody. I'll start on Slide 3 of today's presentation. In the fourth quarter, Capital One earned $706 million or $1.67 per diluted common share. For the full year, Capital One earned $4.9 billion or $11.95 per share. Included in the results for the fourth quarter was a $289 million accrual for our current estimate of the FDIC special assessment. Net of this adjusting item, fourth-quarter earnings per share were $2.24 and full-year earnings per share were $12.52. On a linked-quarter basis, growth in our Domestic Card business drove period-end loans up 2% and average loans up 1%. Period-end deposits increased 1% in the quarter, and average deposits were flat. Our percentage of FDIC-insured deposits grew to 82% of total deposits in the fourth quarter. Revenue in the linked quarter increased 1% driven by both higher net interest and non-interest income. Non-interest expense was up 18% in the quarter. Operating expense increased 15%, with roughly half of that increase driven by the FDIC special assessment. The full-year operating efficiency ratio, net of adjustments, improved 99 basis points to 43.54%. Provision expense was $2.9 billion, comprised of $2.5 billion of net charge-offs and an allowance build of $326 million. Turning to Slide 4, I will cover the allowance balance in greater detail. The $326 million increase in allowance brings our total company allowance balance up to approximately $15.3 billion as of December 31. The total company coverage ratio is now 4.77%, up 2 basis points from the prior quarter, largely driven by a higher mix of card assets. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. Outside of interest rates, most of our economic assumptions are largely unchanged from the third quarter and we continue to assume several key economic variables have modestly worsened from today's levels. In our Domestic Card business, the coverage ratio decreased by 16 basis points to 7.63%. The allowance balance increased by $336 million. The predominant driver of the increased allowance was the loan growth in the quarter. In our Consumer Banking segment, the allowance was essentially flat at roughly $2 billion. Coverage increased by 4 basis points to 2.71%, driven by a decline in auto loans in the quarter. In our Commercial Banking business, the coverage ratio declined by 3 basis points to 1.71%. The allowance decreased by $37 million, primarily driven by the charge-offs of office real estate loans in the quarter. We have included additional details on the office portfolio on Slide 17 of tonight's presentation. Turning to Page 6, I'll now discuss liquidity. Total liquidity reserves in the quarter increased by $2.3 billion to about $121 billion. The increase was driven by a higher market value of our investment securities portfolio, partially offset by modestly lower cash balances. Our cash position ended the quarter at approximately $43.3 billion, down $1.6 billion from the prior quarter. You can see our preliminary average liquidity coverage ratio during the fourth quarter was 167%, up from 155% in the third quarter. The increase in the LCR was driven by holding more of our cash balances at the parent company versus our banking subsidiary. Turning to Page 7, I'll cover our net interest margin. Our fourth quarter net interest margin was 6.73%, 4 basis points higher than last quarter and 11 basis points lower than the year-ago quarter. The quarter-over-quarter increase in NIM was largely driven by a continued mix-shift toward card loans and higher asset yields, partially offset by higher rate paid on deposits. Turning to Slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 12.9%, approximately 10 basis points lower than the prior quarter. Asset growth, common and preferred dividends, and the share repurchases more than offset net income in the quarter. And with that, I will turn the call over to Rich. Rich?

Richard Fairbank, Chairman and CEO

Thanks, Andrew. Good evening, everyone. Slide 10 shows fourth quarter results in our credit card business. Credit card segment results are largely a function of our domestic card results and trends, which are shown on Slide 11. Top line growth trends in the domestic card business remained strong, even with growth moderating somewhat in the fourth quarter. Purchase volume for the fourth quarter was up 4% from the fourth quarter of last year. Ending loan balances increased $16 billion or about 12% year-over-year. Average loans increased 14%. And fourth-quarter revenue was also up 14% year-over-year, driven by the growth in purchase volume and loans. The charge-off rate for the quarter was up 213 basis points year-over-year to 5.35%. The 30-plus delinquency rate at quarter-end increased 118 basis points from the prior year to 4.61%. On a sequential-quarter basis, the charge-off rate was up 95 basis points and the 30-plus delinquency rate was up 30 basis points. For the month of December, the charge-off rate was 5.78%, including a one-time impact of 15 basis points, described in a footnote in the monthly credit 8-K. Adjusted for this impact, the monthly charge-off rate for December would have been 5.63%. Pulling up on Domestic Card credit, we believe that normalization has run its course and credit results have stabilized. The 30-plus delinquency rate has been stable on a seasonally adjusted basis for a number of months now. Since August, our monthly delinquency rate has been moving in line with normal seasonality and at stable ratios relative to the same month in 2018 and 2019. And at this point, we have a pretty good window into January as delinquency entries in December indicate continuing delinquency rate stability in January. We've always said that delinquencies are the leading indicator of where charge-offs are going. Charge-off rate tends to follow delinquency rate by about three to six months. Based on the stability we've seen in our delinquencies since August and extrapolating from our current delinquency inventories and flow rates, we believe the charge-off rate is stabilizing now and settling out to about 15% above 2019 levels. I give this window because investors have been asking for quite some time when will charge-offs level off. So this is the point where we see that happening, meaning charge-offs should move more or less with seasonality in the coming months. This window comes from modeling the flows in our delinquency buckets which have stabilized, and our recoveries which have also stabilized and started to rebuild. This isn't designed to be longer-run guidance but rather to indicate that charge-offs are finally moving more or less with seasonality over the near term. In the longer run, there could be additional forces such as potential pressure from economic worsening and potential benefits from the depletion of deferred charge-offs from the pandemic and recoveries picking up over time from increased inventory. Non-interest expense was up 11% compared to the fourth quarter of 2022, with increases in both operating expense and marketing expense. Total company marketing expense of about $1.25 billion for the quarter was up 12% year-over-year. Our choices in our card business are the biggest driver of total company marketing. We continue to see attractive growth opportunities in our Domestic Card business. Our opportunities are enhanced by our technology transformation. Our marketing continues to deliver strong new account growth across the Domestic Card business. And in the fourth quarter, marketing also included higher media spend and increased marketing for franchise enhancements, like our travel portal, airport lounges, and Capital One Shopping. We continue to lean into marketing to drive resilient growth and enhance our domestic card franchise. As always, we're keeping a close eye on competitor actions and potential marketplace risks. Slide 12 shows fourth-quarter results for our Consumer Banking business. In the fourth-quarter auto originations declined 7% year-over-year. Driven by the decline in auto originations, consumer banking ending loans decreased about $4.5 billion or 6% year-over-year. On a linked-quarter basis ending loans were down 2%. We posted another strong quarter of year-over-year growth in federally insured consumer deposits. Fourth-quarter ending deposits in the consumer bank were up about $26 billion or 9% year-over-year. Compared to the sequential quarter, ending deposits were up about 2%, average deposits were up 11% year-over-year, and up 1% from the sequential quarter. Powered by our modern technology and leading digital capabilities, our digital-first national direct banking strategy continues to deliver strong consumer deposit growth and gradually increase the percentage of total company deposits that are FDIC-insured. Consumer Banking revenue for the quarter was down about 17% year-over-year, largely driven by lower auto loan balances and higher deposit costs. Non-interest expense was down about 3% compared to the fourth quarter of 2022. Lower operating expenses were partially offset by an increase in marketing to support our national digital bank. The auto charge-off rate for the quarter was 2.19%, up 53 basis points year-over-year. The 30-plus delinquency rate was 6.34%, up 72 basis points year-over-year. Compared to the linked quarter, the charge-off rate was up 42 basis points, while the 30-plus delinquency rate was up 70 basis points. Both of these linked-quarter increases were in line with typical seasonal expectations. Monthly auto credit began to stabilize even earlier than domestic card credit results. On a monthly basis, the auto delinquency rate and charge-off rate had been tracking normal seasonal patterns since the first half of 2023 and continued to do so through December. Slide 13 shows fourth-quarter results for our Commercial Banking business. Compared to the linked-quarter, ending loan balances decreased about 1%. Average loans were also down about 1%. The modest declines are largely the result of choices we made earlier in the year to tighten credit. Ending deposits were down about 9% from the linked quarter. Average deposits were down about 7%. The declines are largely driven by our continuing choices to manage down selected less attractive commercial deposit balances. Reducing these less attractive deposits also drove the 14 basis point linked-quarter improvement in our average rate paid on commercial deposits. Fourth-quarter revenue was down 5% from the linked quarter. Non-interest expense was also down about 5%. The Commercial Banking annualized charge-off rate for the fourth quarter increased 28 basis points from the third quarter to 0.53%. The Commercial Banking criticized performing loan rate was 8.81%, up 73 basis points compared to the linked quarter. The criticized non-performing loan rate was down 6 basis points to 0.84%. Commercial Banking credit trends were largely driven by continuing pressure in our commercial office portfolio. Slide 17 of the fourth-quarter 2023 results presentation shows additional information about the remaining commercial office portfolio, which is less than 1% of our total loans. In closing, we continued to deliver solid results in the fourth quarter. We posted another strong quarter of top line growth in domestic card revenue, purchase volume, and loans. Domestic card and auto delinquency trends were in line with normal seasonal patterns, a continuing indicator of stabilizing consumer credit results. We grew consumer deposits and total deposits. And we added liquidity and maintained capital to further strengthen our already strong and resilient balance sheet. Our annual operating efficiency ratio, net of adjustments for the full year 2023, was 43.54%. In 2023, we saw incremental opportunities and made choices to grow revenue and tightly manage costs to achieve a 99 basis point improvement in our annual operating efficiency ratio. The actual improvement was better than the modest improvement we had been expecting. Over the last decade, we've driven significant operating efficiency improvement even as we've invested to transform our technology. And we continue to drive for efficiency improvement over time. For the full year 2024, we expect annual operating efficiency ratio, net of adjustments, will be flat to modestly down compared to 2023. Our expectation includes the partial year impact of the proposed CFPB late fee rule, assuming that rule takes effect in October 2024. Pulling way up, our modern technology capabilities are generating an expanding set of opportunities across our businesses. We continue to drive improvements in underwriting, modeling, and marketing, as we increasingly leverage machine learning at scale. And our tech engine drives growth, efficiency improvement, and enduring value creation over the long term. We remain well-positioned to deliver compelling long-term shareholder value and to thrive in a broad range of possible economic scenarios. And now we'll be happy to answer your questions. Jeff?

Jeff Norris, Senior Vice President of Finance

Thank you, Rich. We’ll now start the Q&A session. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. So if you have any questions after the Q&A session, the Investor Relations team will be available after the call. Amy, please start the Q&A.

Operator, Operator

Our first question comes from Sanjay Sakhrani with KBW. Your line is open.

Sanjay Sakhrani, Analyst

Thank you. And, Rich, thank you for the color on the charge-offs. I know you cited the pluses and minuses from here, from stabilizing charge-offs. But I'm curious if you feel like the consumer positioning leans towards improvement here as inflation declines, real income growth has resumed. And should interest rates come down? This coupled with the recoveries could benefit the charge-off rate, correct? And I'm just thinking sort of how to think about the reserve rate going forward.

Richard Fairbank, Chairman and CEO

Thank you, Sanjay. First, regarding my commentary on credit and our delinquency metrics, I wanted to highlight that our charge-offs are currently around 15% higher than levels seen in 2019. It's important to mention that in any given year, first-half losses tend to be higher than those in the second half, making the first half the peak period for losses. While we're not providing long-term guidance, we can discuss potential dynamics going forward. At this moment, our economy is quite strong, with unemployment at impressive levels. This suggests that unemployment may pose more risks than benefits. On the other hand, inflation appears to have more potential to increase than decrease, but I don't have any insights beyond what others might offer. I also want to emphasize the two positive trends that are likely to emerge over time. We've previously addressed the delayed charge-off impact stemming from the pandemic. The pandemic created an extraordinary situation for consumers, characterized by stimulus and forbearance measures, leading us to believe that while some charge-offs were permanently avoided, many were merely postponed. This phenomenon of delayed charge-offs is challenging to quantify but it has certainly influenced the current normalization process and will inevitably unfold over time. Additionally, regarding recoveries, although the recovery rate per dollar of charge-off remains strong, the total number of charge-off dollars has been unusually low due to the pandemic. Now that this situation is stabilizing, inventory levels are increasing as credit markets normalize, which should positively affect our outcomes. Furthermore, if we consider our origination strategies and underwriting practices, these align with a longer-term view that anticipates lower loss rates than our current levels. Therefore, we've intentionally focused our credit discussion on where we expect to settle. While there are various factors that could influence outcomes in different directions, I believe there are certainly several positive trends to note.

Sanjay Sakhrani, Analyst

Okay, just a follow-up. Maybe, Andrew, could you just talk about the reserve rate on a go-forward basis and how we should think about it? Should it stabilize? Can it come down? And maybe just also on the NIM with rates coming down, how we should think about the movement over the course of the year? Thanks.

Andrew Young, CFO

Sure. Sanjay, let me compartmentalize those two things, NIM will be a whole separate answer, but with respect to allowance. Well, let me first start with just a tactical housekeeping item, which is a reminder that in Q4 we have seasonal balances that quickly pay off in the first quarter and therefore have negligible coverage. So the coverage ratio in Q4 is modestly lower as a result of that dynamic and it reverses itself in Q1, but again a real modest effect there. Longer-term though, projected losses are really going to be the biggest driver of coverage. And as we've said before, delinquencies are the best leading indicator of that and Rich just provided a fulsome description of all of the forces at play there. So from a reserve perspective, every quarter we're just going to be looking at the next 12 months of projected losses with the first six more consequential in the calculation, but also far more predictable, given the visibility that we have through delinquencies. And then the remainder of that window really informed by economic assumptions, and then the reversion to the long-term average. And so over the last few quarters, things have played out consistent with or slightly better than what we've expected and you've seen the coverage ratio in card roughly stay flat. So, I think it's important to note that even in a period where projected losses in future quarters are lower than today and might otherwise indicate a release, we could very well see a coverage ratio that remains flat or only modestly declines as we incorporate some of that uncertainty into the allowance, but eventually in a scenario like that, after a period of coverage stability like we've seen, you would see coverage coming down in the release of non-growth related reserves. NIM, sure. There is a lot of factors at play with NIM and maybe I'll do the same housekeeping with NIM. Just to remind everyone that in the first quarter with one fewer day, we're going to see roughly a 7 basis points headwind there. But let me then also enumerate here the puts and takes to NIM. On the tailwind side, growth in card balances as percentage of the balance sheet and even within those balances possibly a higher revolver rate. Certainly a tailwind, and that's something we've seen over the last couple of quarters. And then also a lower cash balance, we've talked about this before, but cash balances today in total of $43 billion. I think the number is with about $37 billion at the Fed is quite a bit higher than pre-pandemic. I don't think we'll get back to where we were pre-pandemic but I would expect over time that, that will come down from today's level. So that would also be a tailwind to NIM. On the headwind side, even though the Fed has stopped moving up in July, we continue to see some deposit product rotation, and it creates a bit of upward pressure to the deposit betas. And then even if the Fed starts decreasing rates, we're going to see the assets reprice more quickly than the deposits. And the competitive environment in the backdrop of QT will potentially have an impact on betas on a downward cycle. So that would create a bit of marketing pressure. And then a couple of other things that I would just highlight as potential headwinds, the uncertainty around potential regulatory changes that could impact interest income as well as just the path of credit. You've seen suppression go up over the last few quarters, as losses go up, so that also creates some pressure to NIM. So, I know that that was a list of puts and takes, but I partially go into that level of detail to say, it's kind of hard to say where NIM is going to go in the near term, especially because the path of interest rates remains fairly wide at this point, but kind of gives you a sense of all of the forces at play. But over the much longer term, I would say there's nothing really structurally different about our balance sheet from where it was pre-pandemic that leads me to believe that NIM will be materially different than where it was based on at least what we know today.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Our next question comes from the line of Ryan Nash with Goldman Sachs. Your line is open.

Ryan Nash, Analyst

Hey, good evening, everyone.

Andrew Young, CFO

Hey, Ryan.

Richard Fairbank, Chairman and CEO

Hey, Ryan.

Ryan Nash, Analyst

Rich, when I look you put about $4 billion of marketing expense for the second straight year and you continuing to drive strong growth, we're hearing about some others with a little bit of a more cautious tone on growth. So maybe just talk about, are you leaning in and do you expect marketing to increase, and really where you're seeing the best opportunities in the market and how are you thinking about growth looking ahead? Thanks. And I have a follow-up.

Richard Fairbank, Chairman and CEO

Thank you, Ryan. We are very optimistic about the opportunities in the marketplace, and we are fully committed to pursuing them. There was significant marketing in the fourth quarter, and we continue to see potential across the board, particularly in the card business. There are a few key factors influencing our marketing strategy that we want to highlight. Firstly, we are truly excited about the growth prospects throughout our business. Over the past few years, we've made subtle adjustments, but recently we haven't needed to trim much. We are in a stable position concerning the business we're pursuing, the results we're achieving, and the opportunities available to us. Our technology transformation has been advantageous, enabling us to utilize more data and machine-learning models to pinpoint attractive investment opportunities and customize solutions for customers. Overall, the opportunities remain robust. Secondly, our marketing investment is focused on capturing high-end market share. We've targeted affluent spenders for nearly 15 years, which requires sustained high investment levels. You can see this reflected in flagship products, exceptional customer experiences, and top-notch elite servicing, including our online travel portal and advanced fraud defense strategies to ensure the reliability of our cards. Additionally, we are introducing exclusive services and experiences, like airport lounges and access to select properties, which sets us apart from the general marketplace. The third area of marketing investment centers on our efforts to build our National Bank. Given our smaller branch footprint, we rely more on technology investments, digital experiences, our café network, and marketing initiatives to grow this bank organically. We are pleased with the progress we've made, which has taken years of effort, and we are committed to continuing this direction. These insights provide a glimpse into our perspective on the compelling opportunities we see, and we will keep capitalizing on them as they arise.

Ryan Nash, Analyst

Got it. And, Rich, if you put late fees aside for the first part of my question, you talked about stable to modest improvement which ex-late fees would imply continued improvement on the operating efficiency. Do you think we're back ex-late fees on a sustained journey of improving efficiency, like you were talking about before the pandemic? And then second, just how are you thinking about the timing of offsetting late fees? Thank you.

Richard Fairbank, Chairman and CEO

Thank you. Our focus on efficiency has been consistent over the years. Many companies achieve efficiency by continuously cutting costs, and while we do put significant effort into managing costs, our approach is fundamentally about developing a technology-driven business model that enhances customer experiences, driving both revenue growth and efficiency simultaneously. Much of our success in this area is linked to our technology investments, and we remain committed to this direction. We also see expanding opportunities to enhance efficiency as a result of these technology investments. Overall, although specific yearly results may vary, we believe our ongoing investments are crucial to creating greater operating efficiency, which adds value for our investors. Regarding the CFPB question, the CFPB's late fee proposal currently suggests a reduction of about 75% in late fees. While the proposal is not yet finalized, we anticipate its publication soon. Once the final rule is released, we expect industry litigation that may postpone or hinder its implementation, potentially delaying it until the latter half of this year or longer. If the proposed rule takes effect, it will significantly impact our profit and loss in the short term compared to our original projections. However, we are actively working on several mitigating strategies that we believe will gradually alleviate this impact over the next couple of years after the rule is implemented. These strategies involve adjustments to our policies, products, and investment decisions, some of which will occur before the rule change takes effect, while others are already in progress and many will follow after the rule is implemented.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from the line of Arren Cyganovich with Citi. Your line is open.

Arren Cyganovich, Analyst

Thanks. I was hoping you talk a little bit about the auto business. You continue to kind of pull back a little bit from that side, thinking about how you're feeling about potentially increasing some originations. Still a healthy amount of originations at $27 billion this year, but just wondering when you might make a pivot there.

Richard Fairbank, Chairman and CEO

Thank you, Arren. We have been careful in the auto sector for the past couple of years and have observed several challenges during this time. Let's summarize those challenges: margin pressure due to the interest-rate cycle, the stabilization of credit, vehicle values returning to normal from their peak levels, and affordability issues caused by the high interest rates combined with elevated car prices. We do not base our approach on growth targets; instead, we maintain discipline in our originations, establishing pricing and terms that we are comfortable with and then responding to market conditions. In 2022, we increased prices and tightened our credit standards in the lower end of the market while taking steps to enhance the resilience of our lending. Consequently, our current rate of originations is lower than it was two years ago. However, we are pleased with the performance of our auto originations. The credit performance has been impressive, which is evident. Although vehicle values continue to stabilize, the risk associated with our most recent originations in 2023 is lower than what we experienced in our pre-pandemic originations, likely due to our proactive measures. Additionally, the risk remains stable on a vintage-over-vintage basis. Margins on new originations have also improved, especially in recent months as interest rates have declined from their peaks. Overall, we are optimistic about the performance of our auto originations. We will continue to adjust our strategies in response to growth opportunities or emerging risks, as we always do. Regarding the headwinds we face, it seems that some of those challenges are easing, and the outcomes we are observing from our own lending are quite impressive and encouraging. This gives us a more positive outlook while still exercising caution.

Arren Cyganovich, Analyst

Thank you.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from the line of Rick Shane with J.P. Morgan. Your line is open.

Rick Shane, Analyst

Thanks for taking my questions this afternoon. Hey, Rich, you've given some framework for charge-offs into '24. One of the observations we would make is that delinquencies even through December on a year-over-year basis due are trending, are up on a year-over-year basis, even though that increase has slowed substantially. That suggests and very consistent with your description that charge-offs will continue to rise through the first half of the year. What I'm curious about is, given that delinquencies are still up 100 basis points or 115 basis points year-over-year in December, when we look into the second half of the year, I understand, seasonally, that they will be down. But would you expect the charge-offs in the second half of the year will still be up versus '23?

Richard Fairbank, Chairman and CEO

I believe the best approach is to concentrate on the most stable benchmarks. Our emphasis is on stability, so we are examining the benchmarks we can rely on, leading us back to 2019 and 2018. Our delinquencies are currently above pre-pandemic levels but have been consistent with normal seasonal patterns for some time. Since August, our delinquencies have been approximately 17% higher than the same month in 2019, and since May, about 13% above the corresponding months in 2018. Looking ahead to January 2024, based on delinquency entries in December, it seems we will continue to experience stability. Thus, we are confident that our delinquencies have stabilized. Delinquencies serve as our best leading indicator of credit performance. Charge-offs have been trending toward stability in the second half of 2023 as well. However, charge-offs tend to exhibit greater month-to-month volatility compared to delinquencies due to the nature of the data involved. Since every delinquency data point encompasses five months of delinquency inventories, while charge-offs focus on the smaller number that falls off at the end of the last bucket, there is less reliability in using 2019 as a charge-off benchmark due to some irregularities that quarter. Therefore, we believe 2018 is a more appropriate benchmark for comparing our recent charge-offs. In the fourth quarter, our net charge-offs were approximately 15% above 2018 levels. Since 2018 transitioned into 2019, this provides a suitable benchmark as we move into 2024. Looking forward, based on our current delinquency inventories and recent flow rates, we estimate our net charge-offs are stabilizing at around 15% above 2019 levels, albeit with some normal month-to-month fluctuations. The groundwork for this stabilization has been laid over an extended period, influenced by decisions made in 2020 and 2021. After the pandemic, we identified two key trends: an influx of credit offers from FinTechs, particularly in the subprime market, posing risks for credit quality and adverse selection in our originations, and the expectation that temporary boosts in consumer credit scores could revert over time. We responded by tightening our underwriting and have continued to make subtle adjustments since then. This has resulted in remarkable stability in our origination vintages, with post-pandemic originations showing similar performance across segments and aligning closely with pre-pandemic vintages, contributing to the stabilization of our portfolio credit trends. While we have all been monitoring the ultimate effects of this stabilization on our portfolio, another aspect aiding stability is our recovery rate. The unusually low recovery rates have been the main factor driving our overall charge-off rate above pre-pandemic levels, largely due to the minimal charge-offs in the past three years, which resulted in limited material for future recovery. At Capital One, this effect is even greater than for many competitors because our recovery rates are significantly higher than the industry average, and we manage our recoveries over time rather than all at once through debt sales. Recently, we have seen our recovery rates stabilize and begin to improve, indicating a positive trend as our recoveries inventory starts to rebuild, though it is still coming from a low base. This gives us confidence that our overall loss trends have stabilized. Regarding your question about our position compared to 2023, we have anchored our benchmarking to the stable years of 2018 and 2019. With delinquencies and charge-offs stabilizing relative to those years, we believe it is best to describe our current situation as a multiple of those benchmarks. We are approaching 2024 with a solid sense of stability and have used these two stable years to benchmark our progress.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from the line of Moshe Orenbuch with TD Cowen. Your line is open.

Moshe Orenbuch, Analyst

Thanks, Rich. Following up on that, it seems that a significant amount of marketing funds in the card sector have already been utilized, particularly in the transactor business. Given this, and the stability you've mentioned, I assume that most of the losses and delinquencies are originating from the lower end of the card market. Does this indicate that there may be opportunities for growth in 2024? How should we approach this? I have a follow-up as well.

Richard Fairbank, Chairman and CEO

Sorry, Moshe, are you suggesting that the lower-end is a potential area for expansion?

Moshe Orenbuch, Analyst

Yes.

Richard Fairbank, Chairman and CEO

We feel positive about all of our segments across the credit spectrum in cards and the overall health of consumers. As we've discussed for many years, we have a strong track record of maintaining resilience and profitability at the lower end of the market. Reflecting on this, subprime credit cards represent a complex business that requires significant investment in information-based underwriting. We have dedicated decades to developing and refining tailored product structures and enhancing our analytical, operational, underwriting, and marketing capabilities to effectively attract and serve this market, all while focusing on resilience. Notably, our strategy has remained consistent over the years, including through the Great Recession. In the context of the lower end of the market we serve, whether looking at income or FICO scores, we have observed solid curing occurring in that segment. It actually began to improve slightly earlier than other segments, and the leveling-off we are discussing applies broadly. Additionally, regarding your point about Fintechs, we were previously concerned about their overwhelming presence in that market; however, they have significantly scaled back. Given the success of our vintages and the overall stabilization of Capital One's portfolio along with market dynamics, we are optimistic about the opportunities in that area and will be focusing more on it.

Moshe Orenbuch, Analyst

Great. As a follow-up, you've discussed before not only the financial impact of late fees but also their deterrent effect. How do you view that regarding the resilience of that segment as we look ahead after any changes to late fees? Additionally, you mentioned that you could maintain or improve the efficiency ratio even with the late fee. It seems like achieving that would require cutting a couple hundred million dollars in expenses. If you could elaborate on how that might be accomplished, that would be helpful too. Thanks.

Andrew Young, CFO

Capital One has long focused on creating and delivering simple products. This approach is integral to our mission and strategy, and it has helped us build a brand centered around uncomplicated offerings. For instance, on the banking side, we have eliminated minimum balance requirements, membership fees, and even overdraft fees. We have significantly reduced fees, but if we were to keep one, it would be the late fee, as it plays a crucial role in deterring consumer behavior. We often compare it to a speeding ticket; if the penalty were just a small amount, it might not effectively promote safe driving. We are proactive in alerting customers about late payments, aiming to enhance their payment performance rather than maximize late fees. We share your concerns about the potential impact of the CFPB rule on credit performance; it will be a collective experience. Late fees are important for our financials, and we are taking various actions across policies, products, pricing structures, and investments to mitigate the economic impact. Some of these actions are already in progress, while others will unfold over time. By the time the rule is implemented, some effects will have already surfaced in our operations, although many will not yet be realized. Regarding the fourth quarter, the changes will have a mild effect on our annual efficiency ratio, but they will still influence it. Overall, we are making considerable progress on the efficiency ratio, which is reflected in our guidance for a flat to modestly decreasing ratio that includes the impact of the fourth quarter.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from John Pancari with Evercore ISI. Your line is open.

John Pancari, Analyst

Hi, thank you for taking my call. In the interest of time, I’ll ask both of my questions now. First, regarding marketing, I understand you plan to continue focusing on this area this year. What does that mean for your expectations regarding full-year marketing expenses? Could we see spending exceed the $4 billion mark from this year, or do you anticipate it remaining stable or slightly decreasing? My second question is about the commercial real estate office sector. I know you experienced some uneven losses this quarter and are still facing some pressure with criticized and non-accrual loans. Could you provide more detail on what you charged off and your outlook in that area? Thank you.

Richard Fairbank, Chairman and CEO

Thank you for your questions, John. We usually do not provide full-year marketing guidance because it largely depends on the opportunities we encounter. In response to Ryan Nash's question, I'm happy to share that we remain optimistic about the real-time response and performance of our vintages, as well as the structural investments we are making in the business, especially concerning targeting heavy spenders. While we don't have full-year guidance, we continue to see appealing opportunities ahead.

Andrew Young, CFO

On the office side, it is extremely challenging to make generalizations as it is highly specific to each property. We have previously mentioned our holdings in gateway cities and the mix of A, B, and C properties. However, the breakdown is less significant than the performance of the individual properties. In the last quarter, we experienced over $80 million in losses related to office loans. We continue to refrain from originating new office loans. Our balances have decreased to around $2.3 billion, which is a reduction of about $150 million for the quarter, representing less than 1% of our total loans. We accounted for these losses in our reserves during the quarter and slightly increased reserves for the remainder of the portfolio to maintain coverage at approximately 13%.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from Don Fandetti with Wells Fargo. Your line is open.

Don Fandetti, Analyst

Rich, you've made a lot of progress on heavy spenders. As you sort of look out, where are we I guess on that expense cycle? Are we sort of still looking at many years of acceleration or do you hit some type of level where there is some scale kicking in? Just trying to get a sense on where we are on that investment cycle.

Richard Fairbank, Chairman and CEO

I think the pursuit of heavy spenders in the marketplace will be a long-term endeavor. Similarly, it is for the few players specifically targeting that market segment. The crucial aspect is that we are gaining more scale as we progress. Over the years, you've observed growth in purchase volume, but what's not as visible is the growth rate of purchase volume by spending level. Any segmentation we've analyzed shows that the growth rate consistently increases as we move toward heavy spenders. This indicates that we're gaining significant momentum in that area. I wouldn't say we can just make a quick investment and then be finished. Achieving scale requires attracting more customers in a competitive landscape where all players, even the largest ones, continue to invest. We are very pleased with the progress we're making, which is why we keep investing.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from Bill Carcache with Wolfe Research. Your line is open.

Bill Carcache, Analyst

Thank you. Good evening, Rich and Andrew. I appreciate all of the very clear commentary on what you're seeing in credit. There is a view that if we'd had a mild recession and experienced the purging of weaker credits, that would have provided a clear runway for growth coming out of that. But instead, the environment we're in is arguably a little bit muddier and some would say still late cycle. Could you speak to that dynamic, Rich, and whether that weighs on how you're thinking about growth from here in any way? And as a follow-up, I'll just ask it now for you, Andrew. Can you update us on how you're thinking about capital return from here?

Andrew Young, CFO

Sure. I'll begin. Bill, at this stage, there is still a lot of uncertainty surrounding capital, particularly with the end-game proposal. We know there has been significant advocacy on this matter, and there remains uncertainty about where the rule will ultimately be, including the impacts of AOCI, phase-in, operational risk, and other influencing factors. We have as much information as you do and are waiting to see the final details of the rule. Additionally, as we approach CCAR, we do not yet have this year's scenarios. Historically, the scenarios and the starting balance sheet have a significant effect on outcomes. Our SCB has varied over the past four years, ranging from 10.1% down to 7%, and currently, we are at 9.3%. We are looking for more clarity on what CCAR will entail. Furthermore, we are seeing a variety of outcomes in our growth projections. Finally, regarding the economy, there is a growing consensus about a soft landing, but the range of potential outcomes remains broad. Given these factors, we have opted to operate around 13% for the last few quarters. We understand that when we find ourselves in a position of excess capital, returning it can create value. Under the SCB framework, we have the flexibility to manage repurchases dynamically and will exercise that flexibility when it seems wise to do so.

Richard Fairbank, Chairman and CEO

Bill, I appreciate the question regarding our continued commitment despite some perspectives on the economic environment being late cycle. First and foremost, we are indeed continuing to lean into the market while remaining cautious of potential changes. The health of the consumer is strong, with the US consumer being a key source of strength in the economy. The labor market has shown impressive resilience over the past year, exceeding many economists' expectations in light of rising interest rates. Consumer debt servicing remains relatively low historically, despite the increase in interest rates. Home prices are rebounding and generally nearing all-time highs. Overall, consumers across various income levels still possess excess savings from the pandemic, although these savings are diminishing. Inflation has eased, leading to real wage growth after nearly two years of decline. With student loan repayments resuming in October and a new income-driven repayment plan in place, payments for lower-income borrowers will be significantly reduced during the 12-month on-ramp period. In summary, consumers are in relatively good shape compared to historical benchmarks. Looking at our own portfolio, we observe higher average payments compared to 2019, with a notable difference in metrics across segments. In the auto industry, we've noticed pricing practices that raise concerns; however, we have not had to pull back as significantly in the card business. The competitive landscape remains stable and rational, despite being competitive. Importantly, our results continue to outperform previous vintages. The adjustments we've made over the past few years have provided stability in our results, differentiating us from the comparatively weaker marketplace performance. Our portfolio charge-offs are stabilizing at about 15% above the level seen in 2019, interestingly with gross charge-offs approaching the levels of 2018 and 2019. The difference lies in the lower recovery rates we are experiencing due to a diminished inventory of charge-off debt. We're seeing strong traction in our business, particularly through enhanced brand performance and unique customer experiences stemming from customized underwriting and untapped marketing channels. Therefore, despite the usual apprehensions associated with the credit business, I feel optimistic about our current position. A couple of years back, I expressed concern about the pandemic leading to unsustainable credit practices, but we seem to have achieved a more stable situation. I would describe this scenario as a soft landing for our credit business, placing us in a favorable position compared to past experiences in this exciting journey.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our final question comes from the line of Dominick Gabriele with Oppenheimer. Your line is open.

Dominick Gabriele, Analyst

Hey, great. Thanks so much for all the color on the call today. I just have two questions. Rich, what are you seeing you think that's making the net charge-off stabilize 15% above 2019 levels? Is there something in the consumer payment behavior that's changed? Is there something you think that shifted the consumer, in general, where the credit card industry may be seeing a higher through-the-cycle net charge-off rate going forward or for Capital One in particular? And I just have a follow-up. Thanks so much.

Richard Fairbank, Chairman and CEO

I believe what we're observing is a credit situation reminiscent of the pre-pandemic period. From Capital One's perspective, we have seen gross charge-offs settling at a level that is somewhat stabilized, particularly after we made some significant adjustments to our models to account for the strong credit performance among consumers, which was largely influenced by stimulus and forbearance. We noticed a potential inflation of credit scores and intervened to prevent being misled by those numbers. As a result, we have managed to stabilize, positioning ourselves at 15% above the benchmark of 2019 levels. The current gross charge-off figures are quite close to what we experienced pre-pandemic. Our recoveries are currently lower due to having fewer charge-offs to collect on, which is an encouraging sign for the future. Additionally, we’ve discussed the delayed charge-off effect, where many charge-offs that could have occurred during the pandemic did not happen at that time but may manifest later. This is a temporary situation that contributes to an elevated level of charge-offs relative to what we consider equilibrium. From Capital One's standpoint, our guidance reflects this stabilization, which is currently at 15% above 2019 levels. The underlying credit dynamics appear consistent with what we saw in the past. While we remain cautious about the economy, there are positive factors at play that could further strengthen our credit metrics, making them increasingly similar to pre-pandemic conditions. Overall, I don't see a significant shift; rather, we are witnessing emerging trends, and we are optimistic about our stabilization and outlook.

Jeff Norris, Senior Vice President of Finance

Well, thank you very much everyone for joining us on the conference call tonight, and thank you for your continuing interest in Capital One. The Investor Relations team is available this evening to answer further questions if you have them. Have a great evening.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.