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Before we begin, something to get you in the mood.

I’ve taken on a large speculative position on ETFC recently, one that has exponentially grown in size over the course of the week. I believe this to be one of the last remaining opportunities left from the Oct-Mar meltdown to make a wild profit on ‘risky paper’. (Hat tip to Jason Schwarz for providing the original impetus for this trade.)

Having read some excellent commentary on personal investment picks on SA (especially from Tom Armistead, Alan Brochstein, and Marc Gerstein), I’ve decided to also outline and organize my decision-making:

Quantitative:

ETFC is in a peculiar situation right now. In addition to a typical focus on fundamentals, its capital structure is also worth noting, due to its dilutive effects.

10/15/09

ETFC 6/30/2009

ETFC 12/31/2004

AMTD 6/30/2009

(sourced from WSJ and 10Ks)

Cash

5.2bn

0.9bn

1.1bn

Book

3.0bn

2.2bn

3.4bn

Tangible Book

0.7bn

1.6bn

(negative)

Loan Portfolio^

34.0bn

24.1bn

n/a

Brokerage Income

202mil

338mil

Total Revenue

797mil

616mil

Net Income

<123mil>

280mil

Loan Provision

404mil

n/a

Shares (WSJ as of today)

1.1bn

0.4bn

0.6bn

Market Cap

1.9bn

5.5bn

12.2bn

(w/ dilution*)

4.9bn

^ - includes MBSs, but not loan allowances

* - dilution is assuming 2.8 bn shares ($1.7bn in debentures convertible around $1)

Loan Portfolio as of 12/31/08:

  • MBS – 10.1bn
  • 1-4 family (1st lien mortgages) – 13.0bn
  • 2nds – 10.0bn
  • Other – 2.3bn
  • Fixed: 8.0bn
  • ARMs (including 2nds): 17.3bn

From these numbers, we can see how much of an impact the banking division has on ETFC’s bottom line. Its brokerage arm is about 60% the size of AMTD, and overall, excluding the loan provision, they both have similar margins. Outside of large loss provisions, the banking division contributes a sizable amount to the bottom line, meaning that if it is ever given anything close to a clean bill of health, one could expect similar overall valuations to AMTD. That would result in a near tripling of ETFC, given today’s prices.

Personally, given its large cash balances, I’d say that ETFC has already been given the go-ahead. Although this will mark the first financial institution I’ve seriously looked at (my prior speculation on C completely discounted Citi Holdings as an externality), I would say that it looks quite healthy compared to the "too big to fail" institutions out there. I do not see derivative exposures that are several times the size of the US GDP, for example.

Qualitative:

There are several complications surrounding ETFC, all related in one way or another to its loan portfolio:

  1. Loan operations
  2. Citadel’s involvement
  3. The Fed

1) Loan operations - ETFC is winding down its loan portfolio, at a rate of about $1bn per quarter. It has a standing allowance of $1.2bn, or over 5% of its portfolio. As of its 2008 annual report, it had nearly $1bn in non-performing loans (90 days overdue), or about 4% of its portfolio. These numbers are about in-line for the financial sector as a whole (not that such a fact should be encouraging). It is also inexplicably expanding on its MBS portfolio. Apparently this is all government guaranteed agency debt, so perhaps it is not that bad of a deal.

According to its website, it offers fixed mortgages, 5 - 7 year ARMs and interest-only loans. I could not find any information about 2nd mortgage offerings, and will assume they account for the majority of its portfolio shrinkage.

From CEO Bob Layton, during the last quarterly conference call:

We’ve gone from that liability position where we had to pay high rates on deposits, to a position where we’re actually ultra-liquid at the bank and we are literally looking to have reduction in deposits to accommodate our shrinking asset side balance sheet as the loan portfolios and total runoff.

2) Citadel’s involvement - Instead of a government bailout, for all intents and purposes Citadel has fulfilled this role. Anyone familiar with ETFC is probably keenly aware of the $2.6bn transaction in Nov 2007. This transaction has two parts in my opinion, a) a bullish bet on distressed mortgage-related debt, and b) high frequency trading (HFT).

We’ll focus on the HFT. Matthew Goldstein has written a superb article highlighting what one can argue is the ‘real’ reason Citadel got involved. As you can see, it has proven to be spectacularly profitable for Citadel, even with only 40% of ETFC traffic routed to the hedge fund over the past two years. If we can pin a majority of the growth in HFT profits to the ETFC deal, we’re looking at a significant return on its $2.6bn investment. Not to mention that the convertible debentures already have an additional 58% return baked into it. According to the WSJ, Citadel still holds over $800mil of these debentures, along with its approximate 9.9% position in the stock. This would place its ownership percentage somewhere upward of 30-35%, assuming a fully diluted 2.8bn shares.

This New York Times article highlights the OTS stonewalling Citadel’s attempt to route nearly all of ETFC’s traffic to its desks. Apparently the concession granted was to allow Citadel to hold more than 25% of ETFC without the typical regulatory oversight over ‘holding companies’.

This points to a commitment on the part of Citadel. It’s certainly possible for hedge funds to take long positions in companies that may give favorable returns, such as John Paulson’s stake in ROH (now DOW), and Soros’s past commitment in QCOM. I see Citadel’s current stance as similar in nature.

One last thing to note is that Citadel has its own problems. I would imagine that Ken Griffin would rather not have to deal with an angry mob at his backside. Like all mobs, they're appeased with large wads of cash, the raising of which may be a cause for Citadel’s selling of ETFC. This is great for all other investors who have deep enough pocketbooks to speculate on ETFC at these depressed prices.

3) The Fed - Sometimes I wonder if we actually are subject to a centrally planned economy. I’ve been making speculative bets along with being outright bearish due to what I perceive as a dearth of actual investment opportunities in the marketplace. I’ve since altered my stance. What has erased my suspicions of a justified re-mauling of the market, IMHO, is the Fed. Marc Faber, among other things, is now famous for uttering the quote “Don’t underestimate the power of printing money,” and it seems that at least for asset prices, this has proven to be prescient. As long as the Fed keeps the punch bowl out, it looks like everyone is going to get drunk with greed.

Since countless analysts have posted more eloquent summaries of the situation, I will merely say that I believe it to be in the Fed’s best interest to keep QE on for as long as feasible, i.e. until inflation risks becoming an uncontrollable danger. This may end up buoying risky assets enough so that they’re no longer risky, mainly by inflating debt to a fraction of its current value. Both of these results will give ETFC a double-shot in the arm, as the former restores its balance sheet, and the latter assumes a general consumer recovery, one in which ETFC would naturally participate.

Conclusion:

  1. ETFC is priced at pre-bankruptcy prices without a bankruptcy in sight.
  2. Citadel has shown clear signs of holding onto its position.
  3. The Fed has been explicit in supporting an ‘easy money’ policy, perfect for banks to recover their balance sheets.
  4. Add 1-3 together, and I believe that ETFC, despite seeming like a risky stock, is actually a pretty solid deep-value play.

One more time...Whoa.

Disclosure: I’ve written cash-secured LEAP puts @ 5 exp Jan 2011, and used the 65% premium to purchase LEAP calls @ 2.50 exp Jan 2011 – these options currently trade at a 7-1 ratio. Partial exit strategy would be to wait until the options reach close to a 1-1 ratio (probably when ETFC hits around 3.5 - 4), and close the put position by selling calls. If ETFC hits 5, this strategy will yield at least 350% on secured cash.

Source: E*Trade: A Solid, Deep Value Stock