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On November 29, 2007 Citadel invested $2.5 billion of cash into E*Trade (NASDAQ:ETFC). Citadel had been “scrutinizing E*Trade’s balance sheet” since July 2007, when E*Trade first reported its mortgage market problems in a conference call. “So Citadel understood better than most—even E*Trade management—not only how serious its problems were but also the real value of E*Trade’s business” (source).

With this transaction, Citadel also became E*Trade’s largest shareholder with 20% of E*Trade’s stock. At this time Citadel owns 89.53 million shares; and holds $1.75 billion of 10-year bonds at 12.5% interest. As E*Trade’s biggest shareholder and debtor, Citadel influenced the appointment of Donald Layton as CEO on March 3, 2008. Layton had worked for 29 years at JP Morgan Chase, but was at that time living leisurely as a retired banker and serving on E*Trades board of directors. Pulling E*Trade out of this mortgage mess was not the way Layton planned to spend his retirement years. Why did Layton come out of retirement and accept the position of CEO? When asked, Layton stated, “The board ask me if I would do it... I didn’t get to where I am without having a competitive side” (source).

Mr. Layton’s commitment to E*Trade Stock and to Shareholders is demonstrated by the fact that all of his 2008 and 2009 incentive compensation is in the form of equity... “nearly 90 percent of his total compensation will be composed of restricted stock and stock options, with no cash bonus” (source).

In just three months, Layton’s team has demonstrated commitment to E*Trade’s shareholders value through frugal cost cutting, non-core asset liquidation to increase cash, and creative and aggressive advertising to strengthen their brokerage activity. Layton’s competitive nature has moved E*Trade rapidly forward in its “turn around” plan as proven by the recently announced 10% cost cut, liquidation of India stake for $145 million and other monetization of non-core assets, and brokerage metrics for April that showed the best DART in the brokerage industry.

But the Mortgage Portfolio continues to hamper E*Trade’s Brokerage Image and analyst ratings. Maybe the trigger is about to be pulled to remove this problem from E*Trade.

This week, on May 27, 2008, it was announced that Senior JP Morgan executive Bill King would be joining Citadel (source). Since Layton came from JP Morgan, this move of talent into the Citadel/E*Trade circle makes sense. Mr. King was co-head of global securitized products at JP Morgan. At Citadel, King will be “head of securitized products—a newly created position—with responsibilities for mortgage securities, asset-backed securities, collateralized debt obligations and related products.”

Citadel now has “a newly created position” and a specific department for handling complicated mortgage instruments; so Citadel and E*Trade will most likely “prudently manage the risk” of E*Trade’s Mortgage Portfolio by transferring it to Citadel’s Specialized Department. This is best for effectively managing the mortgage instruments, and is best for the future success of E*Trade to function as a global brokerage service. With 20% ownership, E*Trade’s success will mean millions of dollars of increased value for Citadel’s 89.53 million shares. Increased stock value will also mean that Mr. Layton will get appropriately compensated for his unprecedented efforts to help E*Trade turn around. Since both Mr. Layton and Citadel will gain tremendous and well-deserved benefits from this arrangement, Citadel may very well quickly pull the trigger on this one.

But wait a minute … what about the other 22% of E*Trade’s Shareholders? The “111.4 million short side” shareholders that own 22 percent of E*Trade’s outstanding shares? With all of Layton’s “turn around,” and Citadel support, why does such a large “short position” exist? Here are three prevalent theories:

Theory #1: The market is going to drop, and all stocks will drop as the market goes down. Rebuttal: Even if the market adjusts downward, a stock price that has been “beaten down” will recover quickly. Price drop will be small, volume will be low, and low price will not be sustainable.

Theory #2: Short interest of 80 to 111 million shares has existed since December 2007 (source). Hedge funds have identified mortgage stocks as great “short position” stocks and have heavily shorted E*Trade because “everyone is doing it” after all it is a “mortgage stock.” Rebuttal: This is an example of Wall Street firms “not dotting the i’s and crossing the t’s when it comes to risk management” as was discussed by Kenneth Griffin (Citadel Investment Group founder) in the recent New York Times article entitled “A Wish List for Fixing Wall Street.” Firms that are blindly shorting without doing homework on business fundamentals will suffer the most from large short positions when a “short squeeze” occurs (source).

Theory #3: Mr. Layton will dilute shareholders by issuing a large number of shares for cash since a large block of shares were authorized (600 million) in the Annual Shareholder Meeting on May 16, 2008. Rebuttal: This type of dilutive stock issuance is highly unlikely for the following reasons: a) cash has been obtained by liquidating non-core assets, and b) impact on stock price would negatively affect Mr. Layton’s compensation, but more importantly would affect Citadel’s Equity Value.

The bottom line is that E*Trade and Citadel are operated by experienced and competitive executives. Donald Layton and Kenneth Griffin are men who have proven success records and great respect in the financial sector. In due time, they will make E*Trade a respected success.

Disclosure: Long ETFC

Source: Citadel Infuses E*Trade with Strong, Experienced Management