I have seen several articles written about E*Trade (ETFC) recently and both the articles and comments focus almost entirely on E*Trade’s brokerage franchise. It is obvious that E*Trade has a cadre of fiercely loyal traders and investors who bristle at any suggestion that E*Trade might fail. After reading the comments following one recent article, I had the following thought:
People love this company. Every single comment glows about the company and scoffs at the idea that E*Trade might fail. What a lovefest - it almost seems contrived. I should look in to this story. This might make for a great upside trade.
Naturally, I immediately opened a small position and then I decided to do a little research. I know, that is a little backwards but I was really caught up in the fervency of E*Trade’s supporters. After doing a little digging on their investor relations website, I came to a conclusion that surprised me. E*Trade is not a broker that got in to trouble by delving in to the mortgage business. E*Trade is now a mortgage business that happens to own a brokerage. In fact, the E*Trade brokerage franchise may exist for years merely to try to earn enough money fast enough to keep up with the losses generated by the mortgage and consumer loan book.
I now believe that any discussion or analysis of E*Trade that does not look at its mortgage portfolio is simply pointless. If you do a search of E*Trade articles, however, you will notice that virtually none of the recent articles or comments discuss the mortgage portfolio at all, and instead simply focus on things such as E*Trade’s terrific trading platform. In fact, a couple of recent articles did not mention the word “mortgage” even once, yet pretended to offer solid advice on E*Trade’s future. So, since nobody else seems to be talking about “the problem” I thought I would shed some light. All of the information below comes directly from the E*Trade investor relations website.
“The Problem” Portfolio
$9.7 billion in agency CMOs
$1.2 billion in “private label” CMO
$2.6 billion in consumer loans (Primarily RV and boat)
$15.5 billion in home loans
$11.9 billion in home equity loans
$40.9 billion total
E*Trade also holds about $7 billion in margin loans and about $1 billion in corporate and municipal securities. Because I lack any loss estimates for those types of loans and figure they are fairly secure, I am going to leave them out of the discussion. As for the rest of the loan portfolio, I will take on each piece one at a time.
$11.1 billion CMO portfolio
This mortgage portfolio has two pieces, “agency” paper and “private label” paper. It is all rated AAA and AA. The “private label” securities give me concern because I simply do not know what “private label” means and I don’t trust ratings on any mortgage paper these days. Nevertheless, lacking any “who, what or where” on these securities, it is hard to say much else other than that they increase E*trade’s mortgage exposure.
$2.6 billion Consumer Loan Portfolio
Does it surprise you to know that E*Trade holds $2 billion in RV loans and $500 million in boat loans? They have a little over 1% of this total portfolio reserved for loan losses as of the end of 2007. Here is my question. How will a portfolio of RV and boat loans do in a recession? Could this portfolio be a little bigger problem in the future than just a 1% write-off? I will not pass judgment, but be sure to factor in Winnebago loans to any decision on whether to invest in E*Trade.
$15.5 billion Home Loan Portfolio Houston we have a problem. The average LTV (loan to value) on these loans is listed as 69%, which is not to bad. The problem, however, is that I believe the “V” in LTV was calculated at the time the loan was written. If anybody wants to correct me on this, please do. So, it is important to look at the quality of this portfolio. First, about 85% of these loans were written at the peak of the housing bubble with the following vintages:
20% 2005 vintage
38% 2006 vintage
26% 2007 vintage
Second, a large percentage was written for property squarely located in “bubble” areas:
12% Los Angeles
11% San Francisco
9% New York
6% Washington D.C.
5% San Jose
Finally, about half of the loans were written based on stated income. As you know, stated income loans are also known as “liar loans.”
Despite the quality issues, E*Trade has just $19 million reserved against this $15.5 billion portfolio. Moreover, the 90-day delinquency rate on these loans more than doubled in the past 6 months and now stands at over 1% of the portfolio ($160 million in loans). The low loss reserve no doubt relates to the first lien position and an assumption that the LTV is high enough to allow for a substantial recovery on bad loans. This assumption, however, goes out the window in a 30% down market, which is predicted by many pundits.
$11.9 billion Home Loan Portfolio (1-4 units) Ick, yuk, ugh! This is the UGLY stuff. These loans are mostly second liens, and the portfolio is going bad fast. The vintages are as follows:
20% 2005 vintage
49% 2006 vintage
10% 2007 vintage
The geography of the loans is similar to the first lien portfolio. A substantial amount of the loans are located in the bubble areas of California, Arizona, Florida and New York. More than 40% of these loans were stated income and over half were made with a CLTV (Combined Loan to Value) of over 80%. Remember, this valuation was done at the height of the bubble. So, with falling real estate values you can guesstimate that a substantial amount of this portfolio is collateralized by “thin air” and a handshake.
The portfolio seems to be performing accordingly. Close to 4% of loans are over 30 days delinquent and over 2% are 90 days past due. The company has already written off $91 million in losses, and it has reserved about $460 million for future losses. By its own estimate, losses will ultimately fall in the $1 to $1.5 billion range, which is 10%-15% of the entire portfolio. Again, you can decide if the losses will be higher, but keep the quality of the portfolio in mind when you make your calculation. Also, remember that E*Trade is a bank and must keep adequate reserves in order to forestall bankruptcy. If these loans go sour at a faster pace than E*Trade can replenish its reserves, it will mean big trouble. With this portfolio, E*Trade is by its own admission in a race against time.
In its best year (2006) E*Trade made about $650 million in net profits but the company has lost a substantial number of clients and deposits recently and it has greatly increased its debt burden. Also, in 2006 its mortgage business actually contributed to earnings. For the sake of argument, lets assume that the company can make an average $400 million in operating profits in 2008, 2009, and 2010. Virtually all of the profit will go just to cover losses in its home equity portfolio alone. A substantial amount will also be needed to address that puny reserve for the first lien mortgages, which Morningstar conservatively estimates will generate $145 million in eventual write-offs.
The problem is not just the absolute amount of any losses. Given time (20 years or so), the brokerage could probably pay for the entire portfolio to go bad, but time is not on E*Trade’s side. The company recently took some drastic but positive steps through asset sales and an onerous and dilutive re-capitalization deal in order to alleviate immediate concerns over its regulatory capital requirements. Nevertheless, the company has just $500 million in excess capital on the books, which puts it precariously close to being pushed into bankruptcy should its loan portfolio deteriorate faster or further than anticipated. Needless to say, E*Trade has not been great at anticipating things lately.
So, when considering an investment in E*Trade, keep in mind that what will eventually determine the fate of the company has relatively little to do with the quality of the brokerage service or trading platform, and everything to do with the housing market, the performance of liar loans in bubble areas, and the fate of RV and boat loans in a slowing economy. I know that a lot of readers won’t like me pointing out these facts, but this is unfortunately what this company has become and you should invest accordingly.
Disclosure: long ETFC