E*Trade Tries to Reboot

Its customers are no longer panicking, but the online bank and brokerage still faces a shaky stock market and potential loan losses

by Ben Steverman

E*Trade Financial (ETFC) appears to have dodged the bullet of bankruptcy—for now.

Three months ago, the online bank and brokerage was facing a classic run on the bank scenario as customers, panicked by E*Trade's exposure to toxic subprime debt, pulled billions out of their accounts. But new evidence suggests the danger has passed: According to data released Feb. 13, E*Trade was able to increase its net new retail accounts by 16,000 in January. Clients' cash balances also increased, though their total holdings fell along with the stock market. Acting Chief Executive Jarrett Lilien says E*Trade has turned a corner.

Customers were calmed by a quickly arranged bailout deal with a private equity firm and a wave of feel-good advertising, including two Super Bowl ads. Featuring the slogan "1,000 New Accounts a Day," E*Trade's ad campaign includes a spot featuring a talking, stock-trading baby that appeared during the Super Bowl. The subtext of the campaign is "We're still here, we're as strong as ever, and we're not going anywhere," Lilien said in an interview with BusinessWeek.

Analyst Blamed for Inciting Panic

E*Trade is in many ways a poster child for the effects of the subprime financial crisis. While it ran a successful online discount brokerage, E*Trade's banking operation invested in complex, risky credit securities. Why? Morningstar (MORN) analyst Jaime Peters echoed other critics when she wrote that "E*Trade's management greed—stretching for additional interest yield—has led to the current crisis."

When the crisis hit credit markets in July and investors fled en masse from risk, E*Trade was left with a pile of toxic debt. But the true crisis came after a Citigroup (C) analyst, Prashant Bhatia, warned the subprime exposure could cause a "run on the bank" leading to E*Trade's bankruptcy.

Lilien admits E*Trade made investing mistakes, but he insists Bhatia's comments were irresponsible and incited the panic. (Bhatia was not available for comment.) E*Trade didn't have a "capital crisis" or a "subprime crisis," Lilien says. "We had a crisis of confidence with our customers." Net-savvy customers saw the news of Bhatia's warning and quickly yanked $16.5 billion out of E*Trade accounts, about 8% of total assets and 17% of cash balances. Much of the cash would have been insured even if E*Trade had gone bankrupt, but customers weren't willing to take the chance.

E*Trade's difficulties attracted the attention of rival online brokerages, including TD Ameritrade (AMTD) and Charles Schwab (SCHW), eager to win over defecting customers. After taking out a full-page ad in The Wall Street Journal, Ameritrade executives on Jan. 17 said about $2.3 billion flowed from E*Trade to Ameritrade, a fourth of the firm's new assets in the quarter.

An Expensive Bailout

After considering several options, E*Trade agreed to a bailout plan with Chicago's Citadel Investment Group. Citadel injected $2.5 billion into E*Trade's balance sheet and bought its subprime debt at a steep discount, paying $800 million for investments with a face value of $3 billion. E*Trade CEO Mitchell Caplan also left the firm, leaving Lilien as acting CEO until a permanent leader is named.

The deal was criticized as too expensive for E*Trade, but Lilien says it needed to be done, and quickly: "There was a run on the bank. We needed to do a deal to stem that crisis." The bailout immediately slowed customer withdrawals, Lilien says, and renewed advertising and marketing efforts seemed to stop the bleeding altogether. E*Trade said Feb. 13 that the number of new brokerage accounts added in the week after the Super Bowl was up 32% compared with the same week a year earlier. In January, a turbulent month in the markets, trading volume rose 19% for E*Trade.

Most analysts say the latest data are encouraging. "It appears…the pickup in advertising has calmed clients," wrote UBS (UBS) analyst Mike Carrier . But Citigroup's Bhatia remains a skeptic, writing that, based on his calculations, "clients continue to pull money out of E*Trade at a rapid pace."

E*Trade says it will spend $85 million on new marketing and products in 2008, efforts aimed at adding new customers and winning back money lost in November's crisis.