Federal approval of

E*Trade Financial's

(ETFC) - Get Report

application for government bailout money would benefit its largest investor, ailing hedge fund

Citadel Investment Group

.

Citadel, like any deep-pocketed investor in the credit crunch, has been hit hard by the market's steep downturn. The Chicago alternative asset firm has suffered losses of 47% in its main funds this year, according to

The Wall Street Journal

, citing investors. Since its decision a year ago to make a $2.5 billion debt and equity commitment to E*Trade -- while not a make or break investment for a firm with some $12 billion in assets -- Citadel has seen the stock fall nearly 80% from its closing price the day before it made its investment.

E*Trade announced last month that its banking subsidiary had applied for an $800 million investment through the Troubled Assets Relief Program, or TARP. E*Trade has not yet received even preliminary approval for the aid, but has said publicly that it is "optimistic" that it will receive an approval "in the near future."

As E*Trade's largest shareholder, Citadel likely would see the value of its investment stabilize, if not rise, as the capital injection soothes investor fears that the broker will not survive the crisis. As a major E*Trade creditor, Citadel also would see improved chances the brokerage will continue to pay a lucrative 12.5% interest on its $1.2 billion in debt, which is mostly springing lien notes.

A TARP investment would give E*Trade "better capital and liquidity and leverage ratios," says John Jay, a senior analyst at Aite, an independent research and advisory firm. Citadel's connection to E*Trade's bank gives the firm "a small window to liquidity," Jay says.

"Citadel, even though they got dinged by this crisis, they're not dummies," he says. "From a cash flow perspective,

the money will find its way back to Citadel."

Citadel, which declined to comment for this story, took a stake in E*Trade last November, after the company was forced to take writedowns on its asset-backed securities portfolio, primarily due to its collateralized debt obligations, or CDOs, and second-lien securities.

E*Trade received approximately $1.8 billion of capital from Citadel in exchange for senior unsecured notes and common stock. The deal amounted to Citadel receiving a total of 84.7 million shares -- just under a 20% stake in E*Trade. Citadel also acquired E*Trade's underwater $3 billion asset-backed securities portfolio for just $800 million.

At Sept. 30, Citadel owned roughly 89 million shares, or 16.6%, of E*Trade directly and another 9.5 million, or 1.78%, through one of its subsidiaries, as well as options on the firm.

Roger Freeman, an analyst at Barclays Capital, says that even without a TARP injection, E*Trade has "sufficient capital." He predicted that E*Trade could absorb a little more than $1 billion in additional losses to its roughly $10.3 billion home equity portfolio -- originally $12 billion -- without assistance from a TARP injection.

"The market is trading the stock as if its future depends on the TARP," he says.

Freeman says he believes E*Trade will be approved for the government investment, but sees some cause for concern that it hasn't yet received word.

"It hasn't been confidence-inspiring that they announced that they applied for it and they haven't got it yet," he says.

One potential hang-up humming in the market rumor mill is that the government is leery of appearing to bail out Citadel. Several financial firms that received private equity investments since the credit crunch began either did not receive TARP funding or are still waiting to hear if they were approved.

National City

( NCC) agreed to a sale to

PNC Financial Services

(PNC) - Get Report

after it was told it was unlikely to receive TARP funding. The Cleveland-based bank received a $7 billion capital injection this past spring from

Corsair Capital

when it could not find a buyer.

General Motors'

(GM) - Get Report

consumer finance arm, GMAC, which is majority owned by

Cerberus Capital Management

is also waiting to hear if it has been approved for TARP funds after simultaneously applying to become a bank holding company. On the other hand, Treasury is still reviewing TARP applications through the end of the year and other financial companies not backed by private equity -- mostly small banks and companies for whom banking is not a primary business -- are awaiting word.

Moreover, Capitol Hill lawmakers have been critical that the $211 billion invested in banks and financial institutions by the government thus far has not been used to jump start the stalled credit markets. E*Trade has all but curtailed most lending, perhaps making it more difficult to justify an investment through TARP.

At the end of the third quarter, E*Trade's total loans fell 15% to $25.5 billion compared to the end of last year, according to its latest quarterly filing with the

Securities and Exchange Commission

. E*Trade originated a total of $158 million of residential mortgages this year -- none of which were in the third quarter.

In the future it will partner with a third-party to offer customers real estate loans, it said in the filing.

Freeman says he doesn't think the government would deny E*Trade an investment based on what it might do with the money, since that has not been a criteria for other TARP recipients. He also dismisses the idea that the government was not attempting to surreptitiously aid Citadel.

"This would not be a back-door way

for Citadel to take capital," he says.

But company officials have indicated they may use the money, if the government approves the application, in ways that could benefit Citadel.

E*Trade Chairman and CEO Don Layton said on the company's third-quarter earnings call that it will use a portion of the expected TARP money to further reserve for loan losses and other "customer confidence issues" at the bank level. But at some point another portion of the capital could be used to pay down debt, he added.

"

The timing of that would probably not be immediate," Layton said, in answer to an analyst's question on the October conference call. "We would be looking to see that the provisions really did come down over several quarters to be sure that that cash, which provides a cushion for us, would not be needed for credit and therefore could be used for other purposes, including debt repayment."

He said that E*Trade's largest need for cash at the parent level is the interest expense on the debt sold to Citadel.

An E*Trade spokeswoman said in an email that the company is well-capitalized with a "substantial capital cushion," including $516 million of excess capital and $665 million in corporate cash as of the end of the third quarter.

"The TARP Capital Purchase Program would improve the balance sheet strength of E*Trade and as such the program is in the best interests of our investors, customers and employees," she added.

She declined to comment further on the Citadel investment or when the company may receive approval for the TARP.