E*Trade's New CEO Confronts Credit Woes

Some investors hope Donald Layton can sell off the troubled online broker. But first E*Trade will have to conquer its lingering problems with risky debt

E*Trade Financial (ETFC) has a new chief executive, an outsider who can't be blamed for the online broker and bank's dangerous brush with bankruptcy last year.

The appointment of former JPMorgan Chase (JPM) executive Donald Layton on Mar. 3 raises hopes that E*Trade can escape its credit troubles, perhaps by selling itself to a rival.

Still in "Desperate Straits"

The well-connected Layton could turn out to be an ideal salesman. But breaking with E*Trade's past won't be easy. E*Trade still needs to "work through" the serious trouble on its balance sheet, Layton told CNBC on Mar. 3. "Until we're through that, there is no realistic sale," he added.

E*Trade unloaded the very worst of its subprime-related exposure, along with its last CEO, Mitchell Caplan, in November. But E*Trade still holds $12 billion in home-equity loans, which makes investors and analysts nervous. E*Trade bought the home-equity loans, along with its subprime debt, in an effort to boost yields on its investments—just in time to see the value of the risky assets plunge when the credit crisis hit last July.

The company remains in "desperate straits," says Morningstar (MORN) analyst Jaime Peters. Managing the risky debt in its home-equity portfolio "is going to be his biggest challenge."

Citadel Bailout Stems Stock Slide

Layton, who spent 29 years at JPMorgan Chase and its predecessors, took over as E*Trade's chairman in November. His appointment coincided with a bailout by Citadel Investment Group. The deal with Citadel added $2.5 billion to E*Trade's balance sheet and allowed E*Trade to sell off its subprime debt at a steep discount. The terms of the deal were expensive, loading the company with $1.7 billion in debt, but executives said swift action was needed to reassure investors and customers panicking about E*Trade's exposure to subprime-related debt.

Since then, Jarrett Lilien, Caplan's former No. 2, has led E*Trade as CEO. Starting Mar. 3, Layton takes the CEO job and Lilien returns to being president and chief operating officer.

E*Trade shares moved almost 3% higher on the day of the news, to trade at 4.40. The stock has fallen more than 16% since the Citadel deal was announced in November, and it has plunged more than 80% since before the credit crisis began last summer.

Debt Holds Buyers at Bay

Deutsche Bank (DB) analyst Matthew Fischer said Layton's appointment is "good news, putting to rest uncertainty regarding the CEO post." However, the $12 billion of home-equity loans "still presents significant earnings headwinds and risk, and is likely an obstacle to potential consolidation," he wrote.

E*Trade's brokerage operation is regarded as an enticing acquisition both by rival discount brokerages and by traditional brokers and banks. Its technology is widely admired, and industry analysts say traditional brokerages are right to be worried by the rise of E*Trade and online rivals such as TD Ameritrade (AMTD) and Charles Schwab (SCHW). Many younger investors seem to prefer the online, do-it-yourself model to the traditional, higher-cost broker model.

However, the risky debt on E*Trade's bank balance sheet so far has scared away buyers interested in its brokerage operation. It's a "huge drag," says Morningstar's Peters. Because credit markets remain so troubled, Layton won't be able to sell the home-equity debt to others at a price E*Trade finds reasonable. It could take months or even years for those loans to be repaid or sold off.

Spending Big to Attract Customers

In the meantime, E*Trade is spending heavily to win back old stock-trading customers scared off by bankruptcy rumors last year. The company is advertising heavily—it even bought two Super Bowl ads—and offering favorable interest rates to depositors. It's not clear how much all this promotion is costing, but recent customer data suggest it has been initially effective. On Feb. 13, E*Trade said that it added a net 16,000 new retail customers during January.

Some analysts worry that E*Trade's heavy spending could hurt earnings and lose effectiveness if the gloomy stock market conditions scare away investors. Citadel, however, says it supports Layton's appointment and the firm's turnaround plan.

In 2008 and 2009, 90% of Layton's pay will come from stock, a sign he is hoping for a big payday by either reviving E*Trade's stock price or finding a buyer. E*Trade did not otherwise disclose the terms of Layton's pay package. "I am fully convinced that the E*Trade franchise has immense strength, perhaps best exemplified by the quick return of its customer volumes," Layton said in a statement. "I also believe that its current financial issues can be effectively managed despite the tough environment."

It may be quite a while before Layton knows whether he has made a smart investment.

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