E*Trade's Meltdown

The stock price gets slashed in half after the online brokerage says it can't predict new credit losses and an analyst mentions the possibility of bankruptcy

Christos Cotsakos (left), former chairman & CEO of E*Trade Group, poses with Mitchell Caplan, the current chairman & CEO Peter Foley/Bloomberg News

by Ben Steverman

It went from bad to worse for E*Trade Financial (ETFC) on Nov. 12. First, the company said the fair value of its $3 billion asset-backed securities portfolio had deteriorated further since Sept. 30, resulting in larger-than-expected writedowns. Thanks to rating agency downgrades and more problems in the credit markets, the company said it can't stick by its previous earnings predictions.

Then, Citigroup (C) analyst Prashant Bhatia poured salt on the wounds on Nov. 12 by placing the probability of bankruptcy for E* Trade at 15%. He worried that the recent news would cause customers to pull their money out of E*Trade bank accounts. That would create a classic "run on the bank" scenario and could force E*Trade to sell its assets to give customers back their cash.

Bhatia estimates that if E*Trade were forced to liquidate its portfolio, it could sustain more than $5 billion in losses. He downgraded the stock to sell from hold.

By the close of trading Nov. 12, E*Trade shares plunged nearly 59% to $3.55 after closing the previous session at $8.59. In June, the stock traded above $25.

E*Trade struck back at Bhatia's assessment. "The management team is focused on serving our customers as we combat the market reaction to the irresponsible comments included in the recent Citigroup analyst report," E*Trade spokeswoman Pam Erickson said in an e-mailed statement. "We take exception to the sensationalism based on unfounded speculation."

Though E*Trade tried to reassure customers and investors that its deteriorating financial situation wouldn't be fatal for the firm, it had very little else to say. No one, including E*Trade execs, really knows how bad things can get.

"Actual securities-related losses will depend on future market developments, including the potential for future downgrades by rating agencies, which are extremely difficult to predict in this environment," the company said in a statement. "Accordingly, management believes it is no longer beneficial to provide earnings expectations for the remainder of the year."

E*Trade is essentially saying, "We don't know how bad things could get," says Morningstar (MORN) analyst Patrick O'Shaughnessy. "That uncertainty is letting Wall Street's imagination run."

E*Trade also tried to assure customers it's taking steps to handle the problems. "We could absorb an immediate write down in excess of $1 billion and still remain well-capitalized," wrote President Jarrett Lilien in an e-mail to E*Trade customers Nov. 12. "It is our expectation that news in the market will get worse before it gets better, and, armed with these expectations, we are taking prudent measures to effectively manage the company's balance sheet," he added.

In October, E*Trade announced almost $200 million in losses due to the tough credit conditions, prompted by worries about risky mortgage debt. "We are clearly disappointed with the overall company performance as a result of the severe volatility in the credit markets," E*Trade Chief Executive Mitchell Caplan said at the time.

The immediate concern is $450 million in assets that are considered the riskiest of E*Trade's holdings, Morningstar's O'Shaughnessy says. Of those, about $50 million was recently downgraded by credit ratings agencies, and more downgrades could be on the way.

O'Shaughnessy says huge losses above the $1 billion threshold are within "the realm of possibility," but unlikely. "It's hard for me to see where that billion dollars could come from," he says.

In response to the credit problems, E*Trade CEO Caplan announced a plan last month to restructure the company. The goal is to move away from risky credit investments and back toward traditional brokerage and banking business. But analysts say it could take a year or more to be implemented.

The irony for E*Trade is that its credit losses arrive as its core business—offering a range of financial services through a bank and online brokerage—hums along. On Nov. 12, E*Trade reported results from October showing total client assets up 4% and its strongest trading volume ever.

In the competitive online brokerage industry, E*Trade's troubles could be an opportunity for its rivals. TD Ameritrade (AMTD) was up 5.3%, to $18.89, and Charles Schwab (SCHW) shares rose 2.6%, to $22.81, on Nov. 12.

The weak balance sheet combined with the strong business results lead some to think E*Trade could be a takeover target. But a buyout might have to wait a while, until the potential credit losses become clearer. Until then, buyers may be very wary.

Steverman is a reporter for BusinessWeek's Investing channel.