ETrade: Not for the Faint Hearted

Etrade (ETFC) is essentially two businesses. The first is a very healthy brokerage / market making business. The second is an ill-timed foray into the mortgage backed securities markets. Losses in that area have brought the company to its knees, so to speak. But, if they can make it through (I expect they will), the return for those buying now will be fantastic.

Let's look at the loan portfolio (all quotes from most recent 10Q at end of post):

Regarding Loan Loss Provisions:

Provision for loan losses increased $85.4 million to $404.5 million and $305.5 million to $858.5 million for the three and six months ended June 30, 2009, respectively, compared to the same periods in 2008. The increase in the provision for loan losses was related primarily to deterioration in the performance of our one- to four-family and home equity loan portfolios. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. Although we expect these factors will cause the provision for loan losses to continue at historically high levels in future periods, the level of provision for loan losses in the second quarter of 2009 represents the third consecutive quarter in which the provision for loan losses has declined when compared to the prior quarter. While we cannot state with certainty that this trend will continue, we believe it is a positive indicator that our loan portfolio may be stabilizing.

Here is the current loan portfolio (click to enlarge)


Here is the key chart regarding the performance (click to enlarge):

If this trend continues into Q3, Etrade fortunes improve markedly.

Loans, net decreased 10% to $21.9 billion at June 30, 2009 from $24.5 billion at December 31, 2008. This decline was due primarily to our strategy of reducing balance sheet risk by allowing our loan portfolio to pay down. We do not expect to grow our loan portfolio for the foreseeable future. In addition, we plan to allow our home equity loans to pay down, resulting in an overall decline in the balance of the loan portfolio.

Loans held-for-sale of $12.6 million as of June 30, 2009 represents loans originated through, but not yet purchased by, a third party company that we partnered with to provide access to real estate loans for our customers. The product is offered as a convenience to our customers and is not one of our primary product offerings. The third party company providing this product performs all processing and underwriting of these loans and is responsible for the credit risk associated with these loans, which minimizes our assumption of any of he typical risks commonly associated with mortgage lending. There is a short period of time after closing of the loans in which we record the originated loan as held-for-sale prior to the third party company purchasing the loan.

We have a credit default swap (“CDS”) on a portion of our first-lien residential real estate loan portfolio through a synthetic securitization structure that provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. As of June 30, 2009, the balance of the loans covered by the CDS was $2.6 billion, on which $17.8 million in losses have been recognized. The CDS provides protection for losses in excess of $4.0 million, but not to exceed approximately $30.3 million. During the three months ended June 30, 2009, we began to receive cash recoveries from the CDS for amounts reported in excess of the $4.0 million threshold. We expect to recognize the remaining benefit over the next twelve months, which is reflected in the allowance for loan losses as of June 30, 2009.

Regarding the balance sheet:

The decrease in total assets was attributable primarily to a decrease of $2.5 billion in loans, net, offset by an increase of $1.7 billion in cash. The decrease in loans, net was due to our strategy of reducing balance sheet risk by allowing our loan portfolio to pay down. For the foreseeable future, we plan to allow our home equity loans to pay down, resulting in an overall decline in the balance of the loan portfolio. For the remainder of 2009, we also plan to allow total assets to decline in order to release additional regulatory capital which we are required to hold against these assets.

The decrease in total liabilities was attributable primarily to the decrease in wholesale borrowings which was partially offset by an increase in customer payables and deposits. The decrease in wholesale borrowings was a result of paying down our FHLB advances and securities sold under agreements to repurchase in the first half of 2009. Customer payables increased due to higher trading activity during the first half of 2009 and net new brokerage customer acquisition. While our deposits increased by $287.6 million during the first half of 2009, we expect these balances, particularly the non-sweep deposit balances, to decrease over the remainder of 2009 as we focus on decreasing total assets.

Here is the Corporate debt picture (click to enlarge):

While not huge fans of debt, Etrade has done a good job extending that debt into the future, in which at such time they ought to have rid themselves of most of the RMBS portfolio freeing up reserves held for losses on it for debt repayment.

Management believes that our common stock offerings combined with the expected completion of the pending debt exchange offer, will substantially improve the regulatory capital levels at E*TRADE Bank as well as significantly enhance parent company liquidity, especially through the end of 2011. As a result, we believe we will be in a position to take advantage of favorable market conditions with regard to any additional capital planning actions, such as further debt-for-equity exchanges, additional cash capital raising activities or sales of any non-core assets.

During the fourth quarter of 2008, we applied to the U.S. Treasury for funding under the Troubled Asset Relief Program (“TARP”) Capital Purchase Program. We continue to view TARP funding as a possible component of our capital planning program. We cannot predict when or if our application will be acted upon. However, given the success of our capital raising efforts to date, we believe that our financial health is not dependent upon receiving TARP funding.

What to do? First, this is only for those with patience and strong stomachs. Loan portfolios take time to wind down and the ride in doing so is a bumpy one. Because of that, the ride will be rocky. But in Etrade's case, the company has a stable and strong brokerage business that is adding new accounts at a very healthy pace. That ought to buffer investors and its performance will begin to take more precedence as the loan portfolio is wound down.

I bought shares on Monday at $1.40 a share. I will be watching one thing. The loan portfolio. If it continues its recent improvement, the stock will appreciate. If it falters, I will pull the trigger on it. Simple...

Another side point, as Etrade lower its loan risk, priced at this level it does become dramatically more attractive to a potential suitor. While I would not invest based on this possible event alone, one does have to take it into account here in conjunction with other factors.

Full 10Q: Etrade Q2 10Q


Disclosure: Long ETFC

Comments

[whisperonth...:]

Your charts don't enlarge. And that was tried using both Firefox and IE. Something isn't working.

Aug 12 08:26 AM

[Novice Trader:]

I'm with you, Todd. I think ETFC will pull through in the end.

Do me and the rest of us novices a favor. If at any point you think ETFC is going to head South, for what ever reason, let us know... and why.

I own it @ $1.21. I think my entry point is good and that something dramatic will have to happen before this amount is tested.

Aug 12 08:37 AM

[mtcheyan:]

what do you make of the fact that ken griffin personally joined the etrade board............im an owner of etfc based on the notion of piggybacking on citadel.......while i view it as a positive still owndering why griffin would feel need to join the board personally

Aug 12 10:05 AM

[Felix1k:]

As soon as Ken Griffin became the offical owner and will soon have the total voting controll things all of sudden became better. Were they all that bad to start with and may we have write ups?? Only time will show

Aug 12 01:47 PM

[mbi4ever:]

Citadel E*Trade will be the power house in the retail market.

Aug 12 02:51 PM

[charm1:]

i own etrade an it will get its piece of the pie

Aug 12 03:18 PM

[Ralph Hunkey:]

I own this stock......I'll buy more now........instead of buying a new house.....Ill just buy some cheeseburgers from Mickydee....

Aug 12 03:19 PM

[InvestBaboo:]

Great article!

Etrade is a stock that could quadruple within the next year. It's time has come.

Aug 12 07:17 PM

[aaavoid:]

What now? Griffin is backing off and wants to sell his ETFC stake. Time to sell? The excuse is diversification, then again, thats the same old excuse.

Aug 13 10:18 PM

[Novice Trader:]

"aaavoid": Apparently, Griffin is having no problem finding buyers for his shares. Current trading range is pretty concistant with the past month.

Being that I'm not learned on this stuff like the rest of you, I could be reading this wrong. Regardless, I'm hanging in there. I just can't see ETFC going bankrupt, can you?

People got burned last year. A lot of folks like me have since taken things into their own hands. The volatility in the markets should be a catalyst for lots of trades. EFTC made about $2k off me last quarter, surely others are spending similar amounts.

I'm holding strong. See you at $6 by year end!!



On Aug 13 10:18 PM aaavoid wrote:

> What now? Griffin is backing off and wants to sell his ETFC stake.
> Time to sell? The excuse is diversification, then again, thats the
> same old excuse.

Aug 14 08:46 PM

[GotLife:]

Ooops!

seekingalpha.com/artic...


On Aug 12 07:17 PM InvestBaboo wrote:

> Great article!
>
> Etrade is a stock that could quadruple within the next year. It's
> time has come.

Aug 25 12:35 PM

[cpamtm:]

Nicely written article and I agree with your points made, thanks...

Aug 29 06:50 PM

[drbob66:]

Huge gap at $8.02 from Nov 2007. It needs to be filled sometime (could take a while, though). A (very) patient investor could be looking at a five bagger from today's levels.

Oct 30 09:53 PM