E*Trade's Brokerage Business Shouldn't Be Ignored

It makes sense that E*Trade Financial (Nasdaq: ETFC) has taken it on the chin over the past year and a half. And rightly so, its mortgage division has a large portion of problematic loans on the books even now.

The next two quarters will show us if it can engineer a soft landing from the fallout of their bad mortgage debt. But the mortgage “mark of Cain” shouldn’t be reason alone to exclude it from our short list of investment opportunities.

In the same way investors punished Altria Group (NYSE: MO) for its cigarettes and tobacco while ignoring the profitable aspects of the spun off Kraft Foods (NYSE: KFT) division, Wall Street seems to have forgotten that E*Trade has an enormously profitable brokerage business.

No doubt there are challenges there – but these are market issues, not enterprise problems.

E*Trade’s customer trading activity was down from last year, but higher than the previous month’s figures. It’s not rocket science that E*Trade only makes money when investors and traders make transactions. And with the poor market performance, it's no wonder their receipts are down.

But a few trading days with massive volume could be all it takes to bring the good times back to E*Trade's bottom line.

One of the really interesting things about this company’s situation is the amount of short interest in ETFC. Almost 74 million shares have been shorted. That’s almost 13% of the total shares outstanding. We pay close attention to large amounts of short interest because it tells us there are lots of investors speculating in one direction. If they turn out to be wrong, it drives the price up even faster.

If the market’s volume keeps picking up, and E*Trade can manage their mortgage losses, look for some big up days for E*Trade as shorts rush to cover.

Comments

[Dissenting ...:]

You have not done your due diligence.

The "mortgage division" really only originated loans for packaging to the secondary market -- all to make a bit of nice and smooth non-trading fee revenue that the analysts like to see. Their loans didn't stick around long enough for the ink to dry.

A savings bank has to have a large portion of the balance sheet in consumer loans, mortgages, credit cards, etc. They hold these assets to make spread income between what they receive in interest and what they pay their depositors. Their balance sheet was managed by an asset management company under their bank.

I'm sure that as pressure grew on management to deliver earnings, and they couldn't get it from transactions or spreads, they sold portions of their loan portfolio to make capital gains. As the secondary market soured, they sold the good loans that they could and kept the bad ones that they couldn't sell. Eventually, the only remaining assets that could be sold went to Citadel. Imagine the loan quality of the loans that even Citadel wouldn't take!

With all those brokerage sweep deposits on the balance sheet and the bank leverage, they bloomed up the balance sheet so they could continue to put out earnings that made stockholders and analysts thrilled. Most of their bank deposits are swept from the brokerage customers and pay virtually not interest.

Eventually they were stuck with assets that couldn't be sold for gains and the magic money machine grinds to a halt.

The brokerage only makes transaction and margin revenue. You can figure out pretty quickly from their metrics what their brokerage revenue is. You'll see that you can't cover the losses with the brokerage income, even with a few "massive volume" days.

Just go back over their SEC filings and company metrics to see.

Mar 12 08:47 AM

[Jim Rich:]

Geez Dissenting Opinion, do your own DD. Citadel took the toxic assets leaving ETFC the loans that for a time showed themselves to be better performing. Now we see that even better performing loans of mid 08 have continued to fall off somewhat, but the major FACT is that ETFC have set aside more loss preserves than actual loss for the past four quarters and now has 1.2 Billion of loss reserves. Actual loan writeoff peak to this point has been around 370 million last quarter and thus without setting aside any more of their money they have enough reserves for nearly three quarters. Obviously they won't stop setting aside more money, but the imperitive to set aside as much as in the past is gone. They now only need to set aside near the amount of actual loss -- a little more or a little less to maintain the reserve they have, which is a company that is well beyond over-capitalized status.

Mar 12 09:36 AM

[orca:]

Whatever happened to my gall Cindy, this was the stock she climaxed on and on and on...

Mar 12 09:52 AM

[Jim Rich:]

... before I get called on it my last line should above should say "well-capitalized", not "over-capitalized", although it might be nice if they had such a label. The three defined levels correspond to scary, low and okay which leaves nothing officially defined for better than okay; why is that?

Mar 12 09:59 AM

[Stockmajor:]

Possible modifications to the Mark to Market rule, uptick rule, geithner plan that I believe will be much better than folks think.....yep, I'm long financials. ETFC will be just fine.

Mar 12 10:42 AM

[skop:]

If anybody can explain why they don't spend a part of 1.2 Billion of loss reserves for toxic loans payout?

Mar 12 11:24 AM

[Dissenting ...:]

Ah, sorry Jim. I didn't really mean to go off on the toxic loan tangent.

If you suppose that if ETFC is AMTD with a bank (it's not but it's good to suppose things sometimes), then if we look at the numbers we can derive some interesting information.

For example, ETFC has about 2.6 mm trading accounts doing about 180k trades/day or about 1.4 trades/account/month. AMTD has about 5 mm trading accounts doing 300k trades/day or about 1.2 trades/account/month. In other words, pretty much the same activity rate, but ETFC has 40% less volume.

All things being equal (a little stretch but go with me on this), I look to the gross revenue now. I would expect to take AMTD gross revenue at 60% to get ETFC brokerage revenue. AMTD is running at $200 mm/month, so that implies ETFC at $120 mm/month. ETFC is reporting $250 mm/month (by the way, with a gross margin of 40% compared to AMTD of 90%).

So I ask why? Of course, my numbers and analysis can be totally flawed and wrong. However, more analysis might show that the whole can not be supported by the brokerage. Maybe that is something to look into.

Mar 12 11:29 AM

[jackooo:]

It is about the lack of service...
Good bye at 1 cent.

Mar 12 12:10 PM

[Jim Rich:]

Skop, FDIC requires that a certain amount of cash be held to support the possibility of bad loans. The preferred amount to be set aside is termed well-capitalized and is determined as a percentage of outstanding loans. Etrade has quite a bit more than this level set aside, but considering the current climate it is prudent on their part to do so. If the financial climate improves and it turns out that money isn't needed then they will move some of the reserves back into the company where it will be recorded as a gain; just as moving it to reserve caused a paper loss. Yes accounting rules in this regard are very questionable.

The word toxic may have a place with certain types of loans, but those are mostly off etrade's books. What etrade did have at the end of the last quarter was a growing loan default rate as dis everyone else. I'd expect this quarter to be on par with or slightly better than last quarter. At some point, those that were going to default will have already defaulted...

Dissenting Opinion; I can't run the details right now, but I would note as above that there will be a plateau and fall in loan writeoffs - eventually. The bank would otherwise be self sufficient, and paying a pretty decent interest rate I might add. Loan balances are being reduced by attrition as ETFC is not writing new loans, and there is the likelyhood that the company they funnel their loan requests to will pay some form of discovery or origination fee.

I believe a lot of people that are customers of ETFC and love the convenience of the combined brokerage and bank platform probably also own some of their shares. It is true for me, but the downside is that their current stock price prevents using those holding for margin buys, so I play an accumulation game which by nature is not as active -- but it will be once they get back to $3. It's interesting that their market cap is only $345 million when they have $1.2 Billion in cash reserves, a growing customer base, and active trading (even if those rates are not as high as some competitors at the moment).

Mar 12 12:36 PM

[jbmaria:]

orca,

I miss Cindy too.

Mar 12 06:09 PM

[mbi4ever:]

jbmaria;

are you a gay?

Mar 12 09:38 PM

[Bigmoneymine:]

I'm not a MBA/CPA type so I'm wondering what would be a good estimate of the value of the brokerage biz with respect to current price? I use E*Trade but don't follow them. Figured they would've went under or been bought out by now. Wouldn't this be a bargain right now for someone looking to add a top-notch retail brokerage business to expand their financial services? I mean the customer base alone has to be worth quite a bit?

Mar 12 11:36 PM

[drlew:]

Heads up on something that I found that might mean they got TARP money.

Obviously not a guarantee but this is a very positive sign, and should probably be mentioned in addition to all the negatives in ur article.

They recently said they would only start building up their loan portfolio again, if they got TARP money... well, they recently started offering mortgages again on their site under "Banking". They were not doing it very recently when I last looked (I use them for my banking /savings, etc., so I follow them).

This quote from marketwatch.

If they get TARP money, the company will be able to maintain its current loan balances in the portfolios, by buying mortgage from government agencies like Fannie Mae (FNM) and Freddie Mac (FRE) and other sources, Nolop said.
Without government money, they will allow the loan portfolios to run off, he added.

www.marketwatch.com/ne...

Cheers

Mar 13 01:46 AM

[BizBroker:]

You have to believe that the market will go up to produce any more quick gain on ETFC. Look at the time line on Ford's stock price increase and you'll see a strong finish on most days up to $5.00
I don't see that with ETFC.

Apr 26 02:50 PM