E*Trade: Back from the Abyss

A $2.5 billion cash infusion from Citadel helps relieve the firm's toxic debt problem. But the bailout comes at a high price

E*Trade Financial (ETFC) will unload $3 billion in risky debt and bid goodbye to its CEO in a deal designed to regain the trust of investors and customers after weeks of uncertainty for the online broker and bank.

Though E*Trade reportedly talked with rivals about being acquired, Chicago-based Citadel Investment Group dared to tread where others wouldn't go, buying up E*Trade's most troubled assets for 27 cents on the dollar. Citadel will inject $2.5 billion in cash onto E*Trade's balance sheet, including the purchase of $3 billion in toxic, asset-backed securities for just $800 million,

That cash effectively quiets critics who worried about E*Trade's financial stability. One Citigroup (C) analyst spooked investors in mid-November by warning there was a 15% chance of bankruptcy, particularly if worried customers rushed to pull out their money.

But avoiding that possibility -- considered remote by other analysts -- comes with a price. By taking on an extra $1.7 billion in debt to Citadel, E*Trade will be on the hook for debt payments to the hedge fund at a high coupon rate of 12.5%. Citadel will also get 19.9% of E*Trade's stock, diluting other shareholders' stakes.

E*Trade's chief executive, Mitch Caplan, will lose his job. Though he brought E*Trade out of the disastrous dot-com bust and built its once-profitable online banking business, Caplan was criticized for causing the latest crisis by investing in risky assets.

"He's been very innovative and creative," Robert J. Ellis, a senior analyst at financial research firm Celent, said of Caplan. "But someone has to be responsible for this last misstep, and he's the CEO."

E*Trade, by investing in risky and complex debt instruments, seemed to go astray from its strong suit as an online broker and bank. "They took on more risk," says Standard & Poor's equity analyst Jason Willey. And that raised "a lot of questions about management and where their focus is."

The firm's chief operating officer, Jarrett Lilien, will take over as acting CEO. Also, E*Trade's chairman of the board will be replaced by a former JP Morgan (JPM) executive, Donald Layton.

The recent credit crisis made it impossible to sell and hard to value E*Trade's asset-backed holdings. The falling value of those investments threatened to leave E*Trade without enough capital at its banking business, though some analysts said the chance was remote.

The Citadel deal "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," Lilien said in a statement.

E*Trade's balance sheet crisis arrived as its business was doing quite well, signing up new customers and seeing record trading volume last month. Since the alarming news headlines, however, it's not clear yet how many customers have pulled money out of E*Trade accounts.

Though analysts said the Citadel deal settled most near-term worries for E*Trade, the firm is not completely out of the woods. It unloaded the debt instruments being pummeled by the recent financial crisis, but it still could lose money on other forms of debt.

For example, Willey and others worry E*Trade could take more losses on $12.4 billion in home equity loans. That's especially true if the housing prices continue to decline. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

Those worries were reflected in a muted reaction on Wall Street to the Citadel deal. E*Trade's stock had already moved up a bit in recent days from its lows on speculation of a buyout by Charles Schwab (SCHW), Bank of America (BAC), TD Ameritrade (AMTD) or another rival. In the early afternoon on Nov. 29, shares were trading less than 2% higher, at about $5.40. That still below its $10 price at the beginning of November, before the latest crisis, and well below its $25 high in June.

Investors may still be worried about not just home equity exposure but also the long-term impact of the Citadel deal — an extra $1.7 billion in debt, a charge of over $2 billion on toxic debt and an extra 86 million shares of stock.

Despite that high price, investors are hoping E*Trade moved in time to saved something irreplaceable: its reputation.

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