E*Trade Financial (ETFC) appears to have dodged the bullet of bankruptcy—for now.
Three months ago, the online bank and brokerage was facing a classic run on the bank scenario as customers, panicked by E*Trade's exposure to toxic subprime debt, pulled billions out of their accounts. But new evidence suggests the danger has passed: According to data released Feb. 13, E*Trade was able to increase its net new retail accounts by 16,000 in January. Clients' cash balances also increased, though their total holdings fell along with the stock market. Acting Chief Executive Jarrett Lilien says E*Trade has turned a corner.
Customers were calmed by a quickly arranged bailout deal with a private equity firm and a wave of feel-good advertising, including two Super Bowl ads. Featuring the slogan "1,000 New Accounts a Day," E*Trade's ad campaign includes a spot featuring a talking, stock-trading baby that appeared during the Super Bowl. The subtext of the campaign is "We're still here, we're as strong as ever, and we're not going anywhere," Lilien said in an interview with BusinessWeek.
Analyst Blamed for Inciting Panic
E*Trade is in many ways a poster child for the effects of the subprime financial crisis. While it ran a successful online discount brokerage, E*Trade's banking operation invested in complex, risky credit securities. Why? Morningstar (MORN) analyst Jaime Peters echoed other critics when she wrote that "E*Trade's management greed—stretching for additional interest yield—has led to the current crisis."
When the crisis hit credit markets in July and investors fled en masse from risk, E*Trade was left with a pile of toxic debt. But the true crisis came after a Citigroup (C) analyst, Prashant Bhatia, warned the subprime exposure could cause a "run on the bank" leading to E*Trade's bankruptcy.
Lilien admits E*Trade made investing mistakes, but he insists Bhatia's comments were irresponsible and incited the panic. (Bhatia was not available for comment.) E*Trade didn't have a "capital crisis" or a "subprime crisis," Lilien says. "We had a crisis of confidence with our customers." Net-savvy customers saw the news of Bhatia's warning and quickly yanked $16.5 billion out of E*Trade accounts, about 8% of total assets and 17% of cash balances. Much of the cash would have been insured even if E*Trade had gone bankrupt, but customers weren't willing to take the chance.
E*Trade's difficulties attracted the attention of rival online brokerages, including TD Ameritrade (AMTD) and Charles Schwab (SCHW), eager to win over defecting customers. After taking out a full-page ad in The Wall Street Journal, Ameritrade executives on Jan. 17 said about $2.3 billion flowed from E*Trade to Ameritrade, a fourth of the firm's new assets in the quarter.
An Expensive Bailout
After considering several options, E*Trade agreed to a bailout plan with Chicago's Citadel Investment Group. Citadel injected $2.5 billion into E*Trade's balance sheet and bought its subprime debt at a steep discount, paying $800 million for investments with a face value of $3 billion. E*Trade CEO Mitchell Caplan also left the firm, leaving Lilien as acting CEO until a permanent leader is named.
The deal was criticized as too expensive for E*Trade, but Lilien says it needed to be done, and quickly: "There was a run on the bank. We needed to do a deal to stem that crisis." The bailout immediately slowed customer withdrawals, Lilien says, and renewed advertising and marketing efforts seemed to stop the bleeding altogether. E*Trade said Feb. 13 that the number of new brokerage accounts added in the week after the Super Bowl was up 32% compared with the same week a year earlier. In January, a turbulent month in the markets, trading volume rose 19% for E*Trade.
Most analysts say the latest data are encouraging. "It appears…the pickup in advertising has calmed clients," wrote UBS (UBS) analyst Mike Carrier . But Citigroup's Bhatia remains a skeptic, writing that, based on his calculations, "clients continue to pull money out of E*Trade at a rapid pace."
E*Trade says it will spend $85 million on new marketing and products in 2008, efforts aimed at adding new customers and winning back money lost in November's crisis.
Heavy Loan Losses and Debt Likely
The Citadel transaction solved the worst of E*Trade's balance-sheet problems and restored some confidence, but significant problems remain: A $12 billion portfolio of home-equity loans could face large losses, particularly if housing prices continue to fall. The Citadel deal also saddled E*Trade with a heavy debt load. E*Trade shares still trade at one-fifth of their June, 2007, price.
E*Trade expects to lose $1 billion to $1.5 billion over the next three years on its $12 billion in home-equity loans. It might like to unload that debt the same way it sold its subprime debt, but it can't, because, Lilien says, the debt can't be sold in dysfunctional credit markets, even at reasonable prices. The home-equity exposure "will continue to weigh down the stock until the company can demonstrate that it is able to earn its way through future losses," wrote analyst Matt Snowling of Friedman, Billings, Ramsey (FBR).
E*Trade hopes to earn a profit in 2008, something many analysts think won't happen until 2009.
The Outlook for Online Trading
E*Trade does have at least one big advantage: The online discount brokerage sector appears to be getting stronger. Younger investors are more comfortable on the Internet, and they are increasingly willing to leave traditional brokerage houses for a low-fee, do-it-yourself model, says Adam Honoré, an analyst at the Aite Group.
On Feb. 14, Charles Schwab said its total client assets rose 10%,to $1.4 trillion, in January from the year before, despite the tough stock market. Trading volumes jumped 33%. Ameritrade saw profits jump 67% last quarter from the year before.
Without its balance-sheet troubles, E*Trade would be in a very different position. Until the crisis, E*Trade's brokerage business was winning new customers, and it is still widely admired for its top-notch technology. In the meantime, despite tough conditions for financial firms, Schwab's and Ameritrade's stock prices have climbed about 13% in the last six months, while E*Trade's has tumbled 67%.
Lilien says E*Trade can capitalize on the positive trends for its sector, which he says is winning customers from traditional brokers. Discount brokers are "fierce competitors, but we're also brothers-in-arms," Lilien says. "The true targets are the big, bad offline brokers and banks that overcharge and underserve."
E*Trade executives say they can make it even in tough conditions, and Lilien expects an economic slowdown (but not a deep recession) and a further fall in housing prices of 15% to 20%. But an extended bear market for stocks could hurt even thriving discount brokers. And tough conditions in the housing and credit markets could get worse, leaving E*Trade with more balance-sheet losses than expected.
What's Next for E*Trade
Many suggest E*Trade could be a great buyout target, either for a healthier discount rival such as Ameritrade or a more traditional rival like Bank of America (BAC). Its recognizable brand and well-regarded technology make E*Trade a tempting target.
Honoré says E*Trade may be attractive "once things shake out. But you really want to make sure that you understand your risk," he says. After a few quarters of solid earnings and limited losses on its balance sheet, E*Trade's stock could bounce back rapidly. But there will be trouble if loan losses mount or if profits suffer as it spends big to win new customers.
Ultimately management's turnaround skill—and the direction of the stock market—will determine E*Trade's fate. Until then, the vultures will be watching.