E*Trade, Missing The Obvious (ETFC, AMTD, SCH)

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E*TRADE FINANCIAL Corp. (NASDAQ:ETFC) announced it is exiting or restructuring non-core businesses that "lack a direct and strategic connection with its retail customers."   It’s also getting an earnings whack: is revising its 2007 outlook for the full year 2007 GAAP net income of between $450 million and $500 million, and earnings per share of between $1.05 and $1.15 per share.  This is down from its previous range of $1.53 to $1.67.

The Company is increasing the provision for loan losses due to charge-offs expected as a result of the disturbance in the credit markets.  Despite all the factors, the Company confirms that its balance sheet funding sources remain sound and the Company remains well capitalized based on regulatory standards. 

Given the significant deterioration in the mortgage market in August and particularly the pace of change in the performance of home equity loans in August, the Company expects charge-offs of $95 million dollars and total provision expense of $245 million in the second half of 2007. The majority of this provision is expected to be recorded in the third quarter. With this additional reserve, allowance for loan losses as a percentage of non-performing loans is expected to increase to 75 percent based on assumptions for the second half of the year, up from 45 percent on June 30, 2007. Within home equity loans, where the Company and the marketplace have seen the most significant stress, the coverage will be approximately 100 percent, up from 51 percent as of June 30, 2007.  Embedded in the Company’s modified guidance is an assumed securities impairment of up to $100 million in the second half of 2007. The Company will exit its wholesale mortgage operations and will streamline its direct mortgage lending business to focus on its retail franchise, and it sees $32 million in charges as a result in the fourth quarter.

Things were different a month ago when E*TRADE (NASDAQ:ETFC) stated that it has seen no material changes to date with respect to the availability, pricing or margin on its wholesale funding sources, including repurchase agreements.  But the truth is that one of the rumors out there was over significant mortgage losses, and the company only partly addressed that at the time.  This could even make one think they were just pulling words out of the air because of how critical the environment was at the time.  Wink, Wink!  Management maintained that it didn’t believe that the current market capitalization accurately reflects the financial strength and performance of the business.

Here was what the company released with its statement a month ago:
    * The Company’s $15.7 billion first lien mortgage portfolio is supported by high FICO scores, low Loan-to-Value ratios (LTV) and private mortgage insurance
    * All first lien mortgage loans with an 80% or higher LTV are protected by private mortgage insurance
    * $9.2 billion, or 74%, of its home equity portfolio is to borrowers with FICO scores of 700 and higher
    * $12.6 billion, or 99%, of mortgage-backed securities are rated AAA
    * 97% of its Asset-backed Securities portfolio is rated investment grade
    * Consistent and growing base of retail customer cash
    * $10 billion in excess wholesale borrowing capacity from the Federal Home Loan Bank

There may actually be a silver lining if you can act like Dr. Pangloss for a moment, although it’s hard to imagine being optimistic and fully trusting of management right now.  If Joe Moglia at TD Ameritrade (NASDAQ:AMTD), or even Charles Schwab (NYSE:SCH), is interested in pursuing a deal it probably just got a lot cheaper to do.  The other silver lining is that company press release also stated, "Given the expectations for limited balance sheet growth going forward, the capital needs of the overall business will be reduced – creating opportunities in higher return investments such as accelerated share and debt repurchase activity or other initiatives to strengthen the business."

Shares closed down 1.25% at $14.21 in normal trading, but shares are getting a 10% haircut in after-hours with shares at $12.75.  The 52-week lows of $9.92, but if this new level holds on Tuesday it will mark the lowest closing levels (again, assuming this weakness holds) since mid-2005.

Jon C. Ogg
September 17, 2007