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E*Trade Still Has Issues

Concerns about its home-equity loan portfolio hurt the stock after a $2.55 billion infusion.

Updated from Thursday, Nov. 29

In announcing

E*Trade Financial's

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$2.55 billion cash infusion from Citadel Investments Group Thursday, Acting CEO Jarret Lilien said the deal "takes concerns off the table."

But while the online broker has addressed one major concern that made its shares plummet a few weeks ago -- after it said it expected writedowns to its $3 billion asset-backed securities portfolio and a Citigroup analyst raised concerns that its bank was in danger of failing -- significant problems remain, particularly the quality of its $12.4 billion home-equity loan portfolio.

As part of

the deal announced Thursday, Citadel will purchase E*Trade's entire $3 billion portfolio of asset-backed securities for a nicely discounted price of $800 million. E*Trade also will receive a $1.75 billion capital infusion from Citadel, which also will add a representative on the company's board of directors.

According to the company's third-quarter 10-Q filing, the $3 billion in asset-backed securities had already been written down to $2.76 billion, meaning that E*Trade will take a charge of $1.96 billion on the sale to Citadel (not the $2.2 billion the company reported in announcing the deal). This means that E*Trade's capital will actually be reduced by $210 million when the deal is completed.

If we only consider E*Trade's desperate need to clear the asset-backed paper from its books, the Citadel deal is fantastic. The market initially was wild about the news Citadel would take a 20% stake in E*Trade early Thursday, as the company's shares jumped as high as $6.04, or more than 14%.

But by the end of the day, the stock had sunk 8.7% to $4.82. And on Friday, the stock was flat as

Moody's Investors Service

cut its rating on the company's long-term senior debt to speculative-grade Baa3 from Baa2 and BMO Capital Markets downgraded the stock to market perform from market outperform.

To see why, one needs look no further than its portfolio of home-equity loans, most of which were purchased from aggressive, nonbank mortgage lenders, many of which went out of business earlier this year.

There are many alarming signs in E*Trade's breakdown of the $12.4 billion in home-equity loans in the company's third-quarter 10-Q. For starters, 87% of the home-equity loans are in the second-lien position, which is not unusual. For these loans, E*Trade also holds the first lien for just 1%.

As far as the risk to the home-equity portfolio is concerned, factors include high loan-to-value (LTV) ratios for the combined first and second mortgages for the borrowers. While already high, these LTVs were based on appraisals made when the loans were originated. That is, the home values reflected the boom in the real estate market.

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Of the $12.4 billion total, more than half the home-equity loans are to borrowers with combined LTVs of over 80%. More alarmingly, $2.4 billion have combined LTVs greater than 90%. When you consider the continued drop in home prices, it is clear that many of these borrowers are already "upside down." If they run into trouble, they will have no option to refinance their way out of the problem.

For E*Trade, this is a terrible situation. Unless E*Trade is in the first lien position, it will likely recover nothing when high LTV loans foreclose. When you factor in the drop in home prices and expenses associated with foreclosure, there's nothing left for the second lien holder.

Another factor we keep hearing about is the "vintage" of the loans. Since the market boom peaked in 2006, loans made in that year are the ones most likely to have been based on inflated appraisals. And 46% of E*Trade's home-equity portfolio comes from the 2006 vintage.

Looking at E*Trade's Sept. 30 loan-loss reserves for the home equity portfolio, they look OK on the service.

According to the company's third-quarter 10-Q filing, loan-loss reserves allocated to the home-equity portfolio covered 1.38% of the total portfolio and 115.7% of nonperforming home-equity loans. The company achieved this level of reserve coverage by greatly increasing its quarterly provision for loan losses, which led to a net loss of $58.4 million.

While ordinarily this level of reserve coverage would be comfortable, in this market and with E*Trade's concentration in high LTV home-equity loans in the worst vintage year, reserves will likely come up very short. In Thursday's conference call, the company stated it would "take provisions for loan losses up to $400 million." This means an additional $162 million provision for loan losses in the fourth quarter.

While this may well put the reserves allocated to home-equity loans in a much better position, Lilien, who took over after former CEO Mitch Caplan stepped down Thursday as part of the Citadel deal, refused to provide any information on fourth-quarter loan quality or chargeoffs. Since we don't know where loan quality is heading, there could be more quarters of earnings wipeouts resulting from extraordinarily large provisions for loan losses. This will once again put the company in danger of slipping below "well-capitalized" per regulator guidelines.

While there have been rumors of merger discussions with rivals

TD Ameritrade

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Charles Schwab

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, new E*Trade Chairman Donald H. Layton said the company's board "concluded that the transaction with Citadel clearly provides the greatest benefits to our shareholders and other constituencies."

Lilien also said the company is continuing to consider selling part of its home equity portfolio, which would lead to very substantial writedowns.

Philip W. van Doorn joined Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.