Citadel Takes 20% Stake in E*Trade; Shares Retreat (update)

Shares of troubled online broker E*Trade Financial (ETFC) were down 7.2% to $4.90 Thursday morning, having surged as much as 27%, after the firm said it will get a $2.55 billion cash infusion from a consortium led by Citadel Investment Group LLC. CEO Mitchell Caplan will step down, to be replaced by COO Jarrett Lilien until a replacement is found. E*Trade floundered after Caplan's ill-fated effort to boost yields by converting the brokerage into a bank backfired when borrowers fell behind on loan payments and the U.S. housing market began to slide. E*Trade shares are down 77% over the past half-year after the company warned four times about the falling value of its mortgage-based portfolio. So far, it has announced $197 million in pretax writedowns on its securities, and has put aside $238 million in loan-loss provisions.

In a plan overseen by federal bank regulators, Citadel will make a two-part investment in E*Trade. First, it will buy E*Trade's entire $3 billion portfolio of asset-backed securities, including collateralized debt obligations (CDOs) and second lien securities, for about $800 million. E*Trade will take a $2.2 billion charge on the sale. Second, it will buy $1.75 billion in 10-year notes yielding about 12.5%. Citadel will end up owning almost 20% of E*Trade, including its current 3% stake, and receive a seat on the company's board.

The Wall Street Journal says the deal could signal a vote of confidence for mortgage markets plagued by fear and doubt. Citadel CEO Ken Griffin has said the time to buy distressed securities is when the media is completely negative about them. The move shows Griffin sees current market deflation is due not to a complete loss of intrinsic values for the securities, but to a lack of buyers. It will allow E*Trade to get the most-troubled of its holdings off its books, although it will still carry billions of dollars in mortgage securities. About 30 bidders, eight of which were taken seriously, approached E*Trade, the Journal says. In the end, E*Trade went with the capital infusion as opposed to a sale to a rival like TD Ameritrade (AMTD) or Schwab (SCHW) because they were only interested in its brokerage unit.

"E*TRADE's core business is strong," said Lilien. "This transaction with Citadel is not only a major vote of confidence from one of the world's leading financial institutions but also allows us to directly address customer concerns and get back to our real business, which is providing industry leading products and services to our customers," (chat with Lilien).

Bank of America analyst Michael Hecht called the deal an "early Xmas" for Citadel, saying E*Trade shareholders got "a lump of coal." He notes Citadel received $3B in securities that yield 12.5% for $0.27 on the dollar. Egan-Jones analyst Sean Egan notes that a mere "10% haircut on the [remaining] $47 billion portfolio... could wipe out" the company.

Sources: Press release, Wall Street Journal

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Comments

[Lisa:]

E*Trade never tried to "convert the brokerage into a bank". It offers exactly the product that customers want: an integrated view of their bank and brokerage accounts, with the ability to move money easily between them and to maximize yield by parking cash in whichever account offers the highest interest rate.

Caplan's mess-up was the purchase of CDOs, and E*Trade's massive misjudgement of the mortgage market. But the integration of bank and brokerage, both from a customer perspective and the company's perspective, is a no-brainer. As a result, E*Trade has by far the best online financial platform, and Citadel will profit massively from this investment.

It's amazing that in the hysteria about E*Trade's financial melt-down so much confusion has been spread from a product perspective. Next thing, we'll be hearing how banks that offer deposit accounts and CDs shouldn't be making mortgage loans because mortgages have been a disaster. But of course banks should make loans as well as take deposits -- just not on ridiculous terms to customers lacking the ability to pay back the loans.

2007 Nov 29 09:11 AM

[bobh:]

Things may be looking up for E*Trade Financial Corp as Citadel Investment Group agreed to make a $2.55 billion investment into the discount brokerage. The NewsVisual article www.newsvisual.com/new... suggests that Donald Layton will bring to the table the experience necessary to help reverse the company's downturn.

2007 Nov 29 11:12 AM

[kurt walter:]

E-Trade is a trading stock now. It moves enough to trade a few times per week. Trade the heck out of it. Don't buy and hold.

2007 Nov 29 06:34 PM