Wall Street did an about-face on E*Trade Financial (ETFC) a day after an analyst's use of the scary "B" word — bankruptcy — terrified investors. The stock bounced back 41% on Nov. 14 after falling almost 59% the previous day.
Investors likely had two reasons for buying: They may be looking for bargains, deciding the risk of a Chapter 11 filing by the company is remote. Or they may be hoping for a wealthy buyer or investor to rescue E*Trade from its crisis.
The stock has taken a beating ever since the firm admitted late Nov. 9 that it can't stick by previous profit forecasts. It said it expects more credit downgrades and an unknown amount of losses from risky debt in future quarters.
The online bank and brokerage's balance sheet has been tainted by exposure to subprime loans and other mortgage-backed debt. Trading at $5 per share, the stock is still down 41% from before the recent announcement. The stock was trading above $25 as recently as June.
The company's announcement prompted Citigroup (C) analyst Prashant Bhatia to warn that E*Trade faces the threat of bankruptcy — a probability he placed at 15%. A classic "run on the bank," when worried customers all rush to pull their money out at the same time, could force E*Trade to sell off its portfolio and sustain big losses, Bhatia said.
The company hit back, saying through a spokeswoman that Bhatia's comments were irresponsible. "E*Trade is well capitalized by regulatory standard and is capable of adapting to shifting market trends," the spokeswoman said.
But big worries remain about E*Trade. Standard & Poor's Ratings Services downgraded E*Trade's credit rating on Nov. 13. "We are concerned that future liquidity could be strained and funding at the bank could weaken," S&P said in a statement. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)
The biggest concern? That customers could bleed away from E*Trade as its financial crisis continues. Depositors may be worried about their accounts in the event of bankruptcy at E*Trade. The company's bank holds $36 billion in customer deposits. Though $29 billion of that amount is insured by the Federal Deposit Insurance Corporation, about $7 billion of would be uninsured as it is held in accounts that exceed the FDIC coverage limit of $100,000, analysts estimate.
A loss of customers would tarnish the only recent good news for E*Trade: While its balance sheet is a mess, its business — as an online bank and broker — is doing well. October activity figures released Nov. 12 confirmed this, with total client assets up 4% and record trading volume.
The more worries, however overblown, about E*Trade's survival, the worse for its core business, says Morningstar (MORN) analyst Patrick O'Shaughnessy. "E*Trade would like nothing more than it's name to be absent from the news headlines," he says.
Analysts say E*Trade needs to find a way to stop the bleeding.
Matt Snowling, an analyst at Friedman, Billings, Ramsey (FBR), proposes one way for the company to do this: Sell its entire portfolio of troubled assets to eliminate — once and for all time — its exposure to risky debt. "Although we see significant upside to the intrinsic value of the standalone broker, the value cannot be realized until E*Trade sheds its troubled assets," Snowling wrote.
The problem with this plan is it is very expensive. Selling its $12.4 billion portfolio could result in a $1.9 billion loss. That would bring E*Trade below required capital levels, so it would need another investor to inject about $800 million in capital into the company, Snowling estimates.
That could be an attractive investment, however, because of the value of E*Trade's core brokerage business.
E*Trade could also be a buyout candidate, though any acquirer wouldn't necessarily know what kind of toxic debt is hiding on its balance sheet. A buyout would be a "gamble," O'Shaughnessy says. Acquirers "wouldn't be sure what they're getting until a year or two down the road."
Bill Doyle, vice president of Forrester Research, says E*Trade would be "terrifically attractive" absent its balance sheet issues. Its online brokerage rivals would love to snap up E*Trade's affluent clients. Competition was fierce to buy TD Waterhouse; Ameritrade (AMTD) eventually bought the online broker for $2.9 billion in 2006. Also, Doyle says, E*Trade's technology and employees would be appealing to a large financial institution "playing catch up in the online space."
Investors will be watching closely to make sure E*Trade's customers aren't fleeing. Though some of E*Trade's rivals claimed on Nov. 14 they were winning away some of its customers, it's hard to know the extent of the damage. Its November activity figures won't arrive for another month.
But without a rescue plan, E*Trade is stuck in a difficult spot, waiting helplessly as more credit losses and downgrades eat away at its balance sheet. Both investors and customers may not stand for that kind of prolonged uncertainty.