E*Trade Falters, Despite Cash Infusion

The online brokerage tumbled on concerns about mortgage paper, despite Citadel's $2.5 billion.
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Updated from 12:55 p.m.

E*Trade Financial

(ETFC) - Get Report

surged more than 14% Thursday after a $2.55 billion cash infusion, only to end lower as concerns about the valuation of its mortgage-related assets remain.

Hedge fund Citadel Investments will pay $1.6 billion of capital in exchange for roughly 20% of E*Trade stock, as well as senior unsecured notes, providing much-needed liquidity for the online brokerage as its mortgage business struggles amid the ongoing credit crisis and housing slump. Upon closing, expected by Jan. 15, Citadel will provide an additional $150 million.

The investment calls for the fund to buy E*Trade's entire asset-backed securities portfolio for $800 million. As a result, E*Trade will record a $2.2 billion charge.

In addition, E*Trade said CEO Mitch Caplan plans to step down immediately. E*Trade named R. Jarrett Lilien as its acting CEO. Lilien has been E*Trade's president and chief operating officer since 2003.

The news bumped the stock as high as $6.04 Thursday morning, before it quickly flattened and eventually reversed course. Shares closed down 8.7% to $4.82.

"While the removal of certain problem

asset-backed securities from the

E*Trade Bank balance sheet is helpful, there are material risks around the company's home equity loan portfolio," writes Rich Repetto, an analyst at Sandler O'Neill & Partners.

Analysts also pointed out E*Trade's sale of its asset-backed portfolio for $800 million amounts to just 27 cents on the dollar -- a move that is considered desperate by some.

"Everyone has been running around saying we can't sell our assets no one will put a value on them. Guess what? We now have an arms length transaction, which puts a value on these types of assets," particularly the subprime mortgage-backed securities, says Robert Ellis, a senior analyst with Celent, a Boston-based financial research and consulting firm.

E*Trade, in announcing the move Thursday morning during a conference call, heralded the liquidity it provides. Lilien said the company "has a strong capital base and no future exposure to securities such as CDOs, Alt-A or second lien

asset-backed securities that have captured so many of the headlines over the past four to six months."

While he acknowledged that the writedown taken on the sale of the asset-backed portfolio was high, he defended it and the cash infusion as allowing the company to now put its balance sheet issues in the past.

"We had an issue where part of our balance sheet wasn't performing well," Lilien said in an interview. "It was causing customer concern. We have dealt with that. ... We have taken the most worrisome part of our balance sheet and completely eliminated it. We've added more capital, we've put ourselves in a position where now we are on firm footing with our balance sheet and can focus on our customer again."

The company said that while the deal solves its balance sheet problems, if a deal came along that was opportunistic, it would consider it. Market chatter about a possible sale resurfaced in recent weeks, after E*Trade disclosed its mortgage troubles.

The stock surged 25% last Friday after

CNBC

reported that the troubled online brokerage firm is talking with at least two competitors in hopes to sell itself, believed to be

TD Ameritrade

(AMTD) - Get Report

and

Charles Schwab

(SCHW) - Get Report

.

Fox-Pitt, Kelton analyst David Trone said shareholders could have benefitted more form a sale.

"In our opinion, shareholders missed an opportunity for a sale of the company that would have been $10+ share," Trone wrote. "A deal is still possible in the future but the value is reduced by the significant dilution of this deal."

The deal is not likely to become a base for banks and other financial companies to work from in selling their own assets.

"This transaction also shows there is a bid for risky assets, although we suspect the implications of this bid will not be well received by other financial institutions holding similar securities, as we believe this price represents a very depressed bid," writes Roger Freeman, an analyst at Lehman Brothers. "In other words, it is not likely this transaction will be viewed as a legitimate start of capital flows into distressed mortgage securities because we do not believe these are prices that institutions, other than those with no choice, would be willing to sell at."

Citadel is no stranger to investing in distressed companies. Last year, the fund invested in Amaranth Advisors, a hedge fund that was collapsing because of bad energy trades. Earlier this year, it bought assets of Sowood Capital, another hedge fund hit by the collapse of the credit markets.

The firm already owned approximately 2.5% to 3% of E*Trade's stock, prior to the deal.

"With its strong brand, solid business model and fortified balance sheet, we believe E*Trade is well-positioned to execute on its growth strategy for its core retail business," Citadel founder and CEO Ken Griffin said in a statement. "We believe this capital infusion will restore investor and customer confidence in the company and will allow the board to continue to grow the business from a position of strength, creating value for all shareholders."

The hedge fund will nominate one representative to E*Trade's board, which also will get a new leader at the top. In addition to Caplan's departure, Chairman George Hayter will step down to become a director. Donald Layton, a special adviser to the company, was named its new chairman.

The company spoke with nearly 40 potential partners, but Citadel already had a leg up on other firms, Layton, the brokerage firm's new chairman, told

TheStreet.com

. The hedge fund was a "significant" holder of its publicly traded bonds prior to this transaction, he noted.

"So it's clear that they were very familiar with the company and had studied it for their own investment purposes and so things started ahead from first base," Layton said. "They were somewhere between first and second."

Layton said Citadel does not have any current plans to own E*Trade bank because that would subject the hedge fund to rigorous regulation.

Brad Hintz, an analyst at Sanford Bernstein, said the sale portended bad things to come for anyone else holding unloved mortgage-related paper.

"Nervousness and general disorder in the money markets is only likely to get more severe towards year end, when demand for funding 'over the turn' is intense," he wrote. "Fear of counterparty risk and the unwillingness to take illiquid

asset-backed collateral at the 'reasonable' prices is going to put pressure on hedge funds, brokers and banks around the world over the next five weeks."