E*Trade's A Total Wreck: Really A Mortgage Company That Happens to Own A Brokerage

Discussion in 'Stocks' started by ByLoSellHi, Feb 18, 2008.

  1. Read This Before Buying E*Trade
    posted on: February 18, 2008 | about stocks: ETFC


    Richard Shinnick

    I have seen several articles written about E*Trade (ETFC) recently and both the articles and comments focus almost entirely on E*Trade’s brokerage franchise. It is obvious that E*Trade has a cadre of fiercely loyal traders and investors who bristle at any suggestion that E*Trade might fail. After reading the comments following one recent article, I had the following thought:

    “Self, people love this company. Every single comment glows about the company and scoffs at the idea that E*Trade might fail. What a lovefest, it almost seems contrived. Self, you should look in to this story. This might make for a great upside trade.”

    Naturally, I immediately opened a small position and then I decided to do a little research. I know, that is a little backwards but I was really caught up in the fervency of E*Trade’s supporters. After doing a little digging on their investor relations website, I came to a conclusion that surprised me. E*Trade is not a broker that got in to trouble by delving in to the mortgage business. E*Trade is now a mortgage business that happens to own a brokerage. In fact, the E*Trade brokerage franchise may exist for years merely to try to earn enough money fast enough to keep up with the losses generated by the mortgage and consumer loan book.

    I now believe that any discussion or analysis of E*Trade that does not look at it’s mortgage portfolio is simply pointless. If you do a search of E*Trade articles, however, you will notice that virtually none of the recent articles or comments discuss the mortgage portfolio at all, and instead simply focus on things such as E*Trade’s terrific trading platform. In fact, a couple of recent articles did not mention the word “mortgage” even once, yet pretended to offer solid advice on E*Trade’s future. So, since nobody else seems to be talking about “the problem” I thought I would shed some light. All of the information below comes directly from the E*Trade investor relations website.

    “The Problem” Portfolio
    $9.7 billion in agency CMOs
    $1.2 billion in “private label” CMO
    $2.6 billion in consumer loans (Primarily RV and boat)
    $15.5 billion in home loans
    $11.9 billion in home equity loans
    $40.9 billion total

    E*Trade also holds about $7 billion in margin loans and about $1 billion in corporate and municipal securities. Because I lack any loss estimates for those types of loans and figure they are fairly secure, I am going to leave them out of the discussion. As for the rest of the loan portfolio, I will take on each piece one at a time.

    $11.1 billion CMO portfolio
    This mortgage portfolio has two pieces, “agency” paper and “private label” paper. It is all rated AAA and AA. The “private label” securities give me concern because I simply do not know what “private label” means and I don’t trust ratings on any mortgage paper these days. Nevertheless, lacking any “who, what or where” on these securities, it is hard to say much else other than that they increase E*trade’s mortgage exposure.

    $2.6 billion Consumer Loan Portfolio
    Does it surprise you to know that E*Trade holds $2 billion in RV loans and $500 million in boat loans? They have a little over 1% of this total portfolio reserved for loan losses as of the end of 2007. Here is my question. How will a portfolio of RV and boat loans do in a recession? Could this portfolio be a little bigger problem in the future than just a 1% write-off? I will not pass judgment, but be sure to factor in Winnebago loans to any decision on whether to invest in E*Trade.

    $15.5 billion Home Loan PortfolioHouston we have a problem. The average LTV (loan to value) on these loans is listed as 69%, which is not to bad. The problem, however, is that I believe the “V” in LTV was calculated at the time the loan was written. If anybody wants to correct me on this, please do. So, it is important to look at the quality of this portfolio. First, about 85% of these loans were written at the peak of the housing bubble with the following vintages:

    20% 2005 vintage
    38% 2006 vintage
    26% 2007 vintage

    Second, a large percentage was written for property squarely located in “bubble” areas:

    12% Los Angeles
    11% San Francisco
    9% New York
    6% Washington D.C.
    5% San Jose
    2% Riverside
    2% Phoenix
    2% Miami

    Finally, about half of the loans were written based on stated income. As you know, stated income loans are also known as “liar loans.”

    Despite the quality issues, E*Trade has just $19 million reserved against this $15.5 billion portfolio. Moreover, the 90-day delinquency rate on these loans more than doubled in the past 6 months and now stands at over 1% of the portfolio ($160 million in loans). The low loss reserve no doubt relates to the first lien position and an assumption that the LTV is high enough to allow for a substantial recovery on bad loans. This assumption, however, goes out the window in a 30% down market, which is predicted by many pundits.

    $11.9 billion Home Loan Portfolio (1-4 units) Ick, yuk, ugh! This is the UGLY stuff. These loans are mostly second liens, and the portfolio is going bad fast. The vintages are as follows:

    20% 2005 vintage
    49% 2006 vintage
    10% 2007 vintage

    The geography of the loans is similar to the first lien portfolio. A substantial amount of the loans are located in the bubble areas of California, Arizona, Florida and New York. More than 40% of these loans were stated income and over half were made with a CLTV (Combined Loan to Value) of over 80%. Remember, this valuation was done at the height of the bubble. So, with falling real estate values you can guesstimate that a substantial amount of this portfolio is collateralized by “thin air” and a handshake.

    The portfolio seems to be performing accordingly. Close to 4% of loans are over 30 days delinquent and over 2% are 90 days past due. The company has already written off $91 million in losses, and it has reserved about $460 million for future losses. By its own estimate, losses will ultimately fall in the $1 to $1.5 billion range, which is 10%-15% of the entire portfolio. Again, you can decide if the losses will be higher, but keep the quality of the portfolio in mind when you make your calculation. Also, remember that E*Trade is a bank and must keep adequate reserves in order to forestall bankruptcy. If these loans go sour at a faster pace than E*Trade can replenish its reserves, it will mean big trouble. With this portfolio, E*Trade is by its own admission in a race against time.

    In its best year (2006) E*Trade made about $650 million in net profits but the company has lost a substantial number of clients and deposits recently and it has greatly increased its debt burden. Also, in 2006 its mortgage business actually contributed to earnings. For the sake of argument, lets assume that the company can make an average $400 million in operating profits in 2008, 2009, and 2010. Virtually all of the profit will go just to cover losses in its home equity portfolio alone. A substantial amount will also be needed to address that puny reserve for the first lien mortgages, which Morningstar conservatively estimates will generate $145 million in eventual write-offs.

    The problem is not just the absolute amount of any losses. Given time (20 years or so), the brokerage could probably pay for the entire portfolio to go bad, but time is not on E*Trade’s side. The company recently took some drastic but positive steps through asset sales and an onerous and dilutive re-capitalization deal in order to alleviate immediate concerns over its regulatory capital requirements. Nevertheless, the company has just $500 million in excess capital on the books, which puts it precariously close to being pushed into bankruptcy should its loan portfolio deteriorate faster or further than anticipated. Needless to say, E*Trade has not been great at anticipating things lately.

    So, when considering an investment in E*Trade, keep in mind that what will eventually determine the fate of the company has relatively little to do with the quality of the brokerage service or trading platform, and everything to do with the housing market, the performance of liar loans in bubble areas, and the fate of RV and boat loans in a slowing economy. I know that a lot of readers won’t like me pointing out these facts, but this is unfortunately what this company has become and you should invest accordingly.
  2. Scary stuff. I cannot believe they are in so deep in mortgages in such a short period of time.
  3. I get the impression citadel is bottoming picking way to early.
  4. piezoe


    E*Trade's big swinging dicks have made one bad decision after another, and the mortgage paper is only half the story. I have no confidence in the company to survive intact because i have no confidence in their management. They may be taken over or merged, but they are not, in my opinion, a very attractive target. At present their Goodwill value is minimal and god only knows whether there is really any positive book value to be had.
  5. this doesnt explain the insider trading though?
  6. piezoe


    Well those insiders are the ones responsible for the present position of the company. So perhaps they are continuing to use the impeccable logic that got them into their present predicament, or possibly they are planning a scam, i.e., "news release", so they can dump and exit.
  7. Citadel laid off some of the risk to BlackRock...

    The big positive for them is most of the order flow is going to them. If Etrade goes down on the mortgage portfolio they would be first in line to peel off the brokerage arm as well.

  8. AK100


    ByLo - Nice info and research thanks a lot.
  9. The following admissions from Rich in follow comments relating to his irresponsible article.

    Some Shinnick snippets:

    "At the present time E*Trade indicates that it is well capitalized and it has plans to improve the situation. It is making progress, no doubt. Does E*Trade truly have a handle on their mortgage losses? I don't know and neither do you because it is hard to predict how far things will deteriorate or improve."

    "And, yes, I will be a better author in the future based on this discussion-it is a tremendous learning experience."

    "In fact, Prescient11 has great points and has really balanced out the discussion."


    By the way, the Ambac thing was a joke meant to point out that with all such insurance these days there is counterparty risk. Bad joke, irresponsible, sorry."

    "In any case, thanks for all your counterpoints and thoughtfulness. My intention was to point out risks and your intention is to show that those risks are "dealt with." It makes for a great discussion."
  10. Daal


    25 years of a bull market and good corporate enviroment spolied people, now everytime things go down its just a dip that should be bought, nevermind financial companies with huge leverage on risky securities with little equity to support that, a decline is just an opportunity and an acquisition can happen at any time, even the smart money is buying the dips, it might take a big bankruptcy to wake investors up and see that we're in for a tough time
    #10     Feb 19, 2008