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Monday, November 12, 2007 2:04 PM

E*Trade Heads For Bankruptcy?

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Shares of E*Trade Financial Corp. lost more than half their value Monday, plunging as the company faces more subprime-related write-downs and as analysts at Citigroup suggest a possible bankruptcy for the online broker.

Fitch Ratings downgraded the firm's collateralized CDO asset manager rating to CAM4 from CAM2- in light of concerns about E-Trade's ability to manage exposure to some debt securities.

The rating agency said E Trade's performance on CDOs, short for collateralized debt obligations, remains below the average of its peers.

Companies with CAM4 ratings, Fitch explained Monday, "will generally necessitate heightened ... surveillance owing to the presence of situations or conditions in need of improvement or as a result of significant recent changes in operating practices, ownership, management, operational infrastructure, and/or business strategy that give rise to concerns regarding the match between the organization's current competencies and wherewithal and the planned execution of CDO investment objectives."
My comment: There are actually two questions here. 1) What the heck was E*Trade doing in mortgage related CDOs in the first place? 2) Why did it take so long for Fitch to react to the situation?
"Bankruptcy risk cannot be ruled out," Citi analysts wrote in a note Sunday. They also lowered E-Trade's rating to sell.
My comment: It will take a miracle for E*Trade to survive.
Also late Friday, E-Trade revealed that it's the target of an informal Securities and Exchange Commission inquiry regarding its loan and security portfolios.

Will customers pull their assets?

"The continued negative news flow about charges resulting from its mortgage and CDO exposure, an SEC inquiry and continued deterioration in its financial condition all increase the likelihood of significant client attrition," the Citi analysts said.
My Comment: Any customers that do not pull their accounts with a SEC investigation and Citigroup talking openly about bankruptcy are not thinking clearly.
"We estimate that trying to liquidate E-Trade's loan and ABS portfolio would result in over $5 billion of losses, more than wiping out tangible equity," Citi analysts said. They estimated the write-downs and provisions would total about $500 million.
My Comment: That is essentially all you need to know right there. E-Trade's balance sheet shows $4.32 Billion in shareholder equity. So a $5 billion loss would indeed wipe that out.
E-Trade had roughly $450 million in total exposure to asset-backed CDOs and second-lien securities as of Sept. 30. That included about $50 million of AAA-rated asset-backed CDOs that have been downgraded to junk status.
Daily chart of E-Trade (ETFC)

click on chart for a crisper image

E-Trade Claims to be "Well Capitalized"

Reuters is reporting E*Trade says can absorb writedown up to $1 billion.
E*Trade President and Chief Operating Officer Jarrett Lilien said in a message to customers posted on the company's Web site, "We could absorb an immediate write-down in excess of $1 billion and still remain well capitalized."
My comment: That's nice. But with Citigroup estimating $5 billion in losses, where does that leave you other than bankrupt?
Lilien also acknowledged that because "news in the market" will get worse before it gets better, E*Trade is taking "prudent measures" to manage its balance sheet.
My comment: Lilien has no business talking about "prudent measures". Had prudent measures been taken up front, E*Trade would not be in this mess. Simply put E*Trade had no reason other than greed to be investing cash in asset backed paper.
Citi's Bhatia said the brokerage has altered its earnings forecasts five times in the past eight months, "reflecting poor risk management."
My comment: So why the downgrade today by Citigroup and Fitch and not months ago?

Bhatia warned that E*Trade risks losing customers to rivals Charles Schwab Corp (SCHW) and TD Ameritrade Holding Corp (AMTD), which have not been burned by the subprime crisis.

Bhatia also said E*Trade could realize losses of over $5 billion if it tries to liquidate its loan and asset-backed securities portfolio as a result of losing its funding sources.

He cut his price target to $7.50 from $13, while Banc of America analyst Michael Hecht reduced his target by $1.50 to $10.50, citing diminished earnings visibility. Hecht maintained his "neutral" rating on the stock.

My comment: You have to love this. Citigroup is openly discussing bankruptcy and putting a sell rating on the stock that is now trading under $4. But the price target is $7.50. Meanwhile Banc of America cuts the target to $10.50 while remaining "neutral" on the stock. What planet are these guys on? Bizarro World?
E*Trade said last week the U.S. Securities and Exchange Commission was investigating whether its Capital Markets division executed orders ahead of customer orders during the period 1999 to 2005.

Why anyone would want to remain at E*trade is a mystery to me.

Mike Shedlock / Mish
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