Updated from 12:36 p.m. EDTE*Trade Financial's ( ETFC) stock lost more than a third of its value Wednesday, after the online brokerage suffered downgrades a day after it posted a steep loss and said it needed to raise capital. Moody's Investor Services on Wednesday placed E*Trade's debt ratings on review for possible downgrades, while at least two equity analysts told investors to sell the stock, mainly on concerns about the company's capital situation and the potential share dilution investors could suffer in addressing it. E*Trade said after the market closed on Tuesday that it lost $233 million, or 41 cents a share, in the first quarter, a penny wider than estimates according to an analysts' poll by Thomson Reuters. In the year-earlier period, E*Trade posted a net loss of $91 million, or 20 cents a share. The company set aside $454 million in loan-loss provisions during the period, $59 million less than the prior quarter, primarily for rising problem loans in its residential mortgage portfolio as opposed to its home equity portfolio -- the main source of trouble for E*Trade as the credit crisis intensified -- which showed early signs of improvement. E*Trade said that after discussions with its primary banking regulator, the Office of Thrift Supervision, the company was alerted that it needed to add to its capital levels at the bank and holding company "quickly." E*Trade's Tier 1 capital level was 5.63% at the end of the first quarter, slightly below what is considered "well capitalized." Its total risk-based capital level was at 11.85% at the end of the quarter. With banks such as JPMorgan Chase ( JPM), PNC Financial Services ( PNC) and BB&T ( BBT) touting Tier-1 capital levels above 10%, E*Trade's Tier-1 is staggeringly low, despite the three large banks each having received funding from the Troubled Asset Relief Program. E*Trade still has not received approval for its TARP application, which it applied for in November.
The company says it continues to pursue TARP funds. "
To replenish the bank's capital cushion we will need to pursue financing alternatives including equity issuances through public or private transactions, as well as asset sales or special transactions," according to chairman and CEO Don Layton during conference call to discuss first-quarter earnings. The company is also looking to reduce its large debt and leverage at the parent company and is "working closely" with Citadel Investment Group, its largest bond and equity holder "as a potential partner," Layton said. Matt Snowling, an analyst at Friedman Billings Ramsey, said the risk to shareholders would be "significant" as the company "needs capital not just to stabilize the bank but to de-lever the holding company as well," he writes in a note. "Therefore we recommend investors exit E*Trade now." Snowling estimates that a capital injection of $400 million to $450 million "could put the bank on reasonably solid footing." The bigger problem is that regulators are asking the company to de-leverage the holding company, Snowling writes. "We estimate that this could require the company to pay down approximately $1.7 billion of its debt, putting necessary capital in the $2.1 billion range," he adds. Fox-Pitt Kelton Cochran Caronia Waller analyst David Trone lowered his rating to underperform. "Although we are encouraged by signs of stabilization in the home equity mortgage portfolio, the increasing severity in first mortgages, worries at the OTS, and the likelihood of a dilutive equity capital raise and debt-for-equity swaps should conspire to drive down the stock," Trone writes in a note.
Moody's said that the primary reason for its concerns "is the continuing poor performance of E*Trade Bank's legacy mortgage portfolio, which is severely constraining the company's operating and financial flexibility." Moody's is also reviewing the company's ratings of its bank subsidiary and bank financial strength rating. The senior credit rating of E*Trade's holding company is already B2, which is defined as speculative grade lacking characteristics of a "desirable investment," according to Moody's. A downgrade would mean that E*Trade's debt could be considered Caa or lower, meaning "poor standing." Moody's could also downgrade it to its lowest rating at C, which means it has "extremely poor prospects of attaining any real investment standing." Moody's said it will examine E*Trade's "various capital-raising strategies, and their likelihood of success in improving the financial flexibility and health of the company." "To the extent that E*Trade is forced to rely on debt-for-equity swaps as a major component of its de-levering strategy, Moody's may consider this a distressed exchange," it added. "In this case, this would likely lead to multi-notch downgrade as Moody's considers a distressed exchange to be an event of default." Substantial loan loss provisions at the bank subsidiary "have continued to require periodic capital infusions from E*Trade in order to maintain a cushion above regulatory capital requirements," leaving the holding company "burdened" with large interest costs, Moody's said. E*Trade said in its conference call on Tuesday evening that it is looking to reduce its annual interest costs by $200 million to $150 million a year, among other things.
E*Trade spokeswoman Pam Erickson did not respond to questions about the company's capital position or analyst downgrades, other than to point to Layton's statement that the loan portfolio is "further advanced in the credit cycle than the broader industry based on the portfolio's composition and seasoning." So-called "special mention delinquencies" -- or those loans for which payments are 30 to 89 days late -- in its home equity portfolio declined during the first quarter. The company said that "preliminary data" for April showed the trend continuing. E*Trade expects "reduced" charge-off levels in its home equity portfolio during the second half of this year. Sandler O'Neill & Partners analyst Rich Repetto says that "seasonal factors," such as borrowers using tax refunds or bonuses to get current on their loans could be affecting the improved delinquency data. Erickson said E*Trade doesn't "see seasonal factors as a plausible reason for the downturn." She said the downturn began in December, appears set to continue through at least April and was not unexpected. She also said E*Trade was "aggressive" in freezing home equity lines beginning in the second quarter of last year, limiting losses. Shares fell 83 cents to close $1.63, on a day when financial stocks rallied.