E-Trade Suffers Subprime Wrath

It has long since passed the point where the downgrade of a company's credit rating or an announcement of reduced earnings because of problems with mortgages or with mortgage-backed securities stuns anyone. However, on Monday there were particularly dire warnings about E-Trade, the on-line brokerage firm, which is apparently heavily invested in sub-prime mortgages in its own portfolio.

E-Trade said that the value of $3 billion portfolio of asset-backed securities has eroded substantially since the end of the third quarter. Collateralized-debt obligations or CDOs as well as securities backed by second mortgages have taken the biggest hits.

An estimated $50 million in AAA-rated CDOs have been downgraded to junk status in the past few weeks, something that was not expected when E-Trade gave its most recent earnings update less than one month ago.

Citi analysts immediately lowered E-Trade's rating to sell and said that a bankruptcy filing by the firm was not unthinkable.

E-Trade also announced it is the subject of an informal Securities and Exchange Commission (SEC) inquiry about its loan and security portfolios.

E-Trade stock had been trading in the mid-$20s as recently as June. On Monday the stock was selling for $3.65 mid-day, down 4.94 or 57.5 percent from Friday's close.

E-Trade President Jarrett Lilien sent customers a letter on Monday assuring them that the company continued to be "well capitalized by regulatory standards. As a matter of fact," the letter stated, "we could absorb an immediate write down in excess of $1 billion and still remain well capitalized." The letter went on to state that, while no one knows what the ultimate impact of current market forces will be, it is E-Trade's expectation that things will get worse before they get better and that the company is taking "prudent measures to effectively manage the company's balance sheet."

Presidential reassurances aside, the financial blogs were rampant with panic from E-Trade customers worried about their money markets and 401Ks. E-Trade deposits are insured, by both the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protective Corporation (SPIC). One fear expressed on the blogs was that there would be a delay and perhaps massive paperwork involved in collecting on these insurance guarantees, but a Citi analyst stated that, while FDIC insures accounts up to $100,000 per depositor perhaps half of E-Trade accounts or approximately $15 billion in deposits are over that individual limit. (Concerns about delays and paperwork when it comes to FDIC are overblown. I worked for the Corporation for years and it is one federal agency that operates efficiently, at least when it closes a bank. Deposits are almost instantly transferred to another depository institution assuming that one can be found, and in the rare case of a payout of benefits FDIC has been known to have the checks in the mail within 48 hours even over a holiday weekend. However, the rules and exceptions to the $100,000 deposit limit are very arcane and few people are fully reimbursed above this level.)

In other sub-prime news, Countrywide Financial Corporation expressed concern that any downgrade of its credit would "severely limit" its access to corporate-debt markets and that additional cutting of its ratings would lead to higher rates at a time when the company will be renegotiating its financing arrangements.

The statement came in a 10-Q regulatory filing made on Friday Countrywide currently holds investment grade ratings from Moody's Investment Service, Standard & Poors, and Fitch, but all three have attached negative outlooks to the ratings. Moody has rated the company at Baa3 and the other two have given a BBB+ rating. Anything below Baa3 from Moodys or BBB- from the other two is considered "junk"

Countrywide has accelerated the integration of its mortgage business into its commercial bank arm and said it has received an additional $9.2 billion in funding from "highly reliable liquidity sources."

The filing also revealed that 4.9 percent of Countrywide's sub-prime mortgages were pending foreclosure at the end of September compared to 2.9 percent a year earlier.