Time to look at Financials?

Here’s my simplistic take on what’s going down at E*Trade:

E*Trade starts out as a discount online broker. They decide to create a bank once they realize they have easy access to cash deposits sitting in customer brokerage accounts. To make some money on these deposits, E*Trade Bank “reached” for yield by buying some sub-prime mortgages. (Banks make money by having a positive cost of carry on their assets. In other words, the bank pays depositors 5% on their money and lends it out at a higher rate of 6% or so, for a positive spread of 1%)

For a bank, customer deposits are liabilities. Loans – whether in the form of mortgages, investments in bonds, etc – are assets. Banks are required by regulators to keep a certain amount of net capital, or money held in reserve to pay back its liabilities (customer deposits). To illustrate, let’s say a bank accepts $100 in customer deposits. To be well capitalized, they should have about $110 of assets, which should be more than enough to pay back all the depositors when they demand their money back.

The problem at E*Trade is that they invested their $110 of assets in risky securities such as sub-prime mortgages. Now those assets might be worth only $90. So the bank actually has a negative book value – it doesn’t have enough assets to cover its liabilities.

However, as AccruedInt points out today, just because a bank has negative book value, it doesn’t mean the company is worthless. If investors are willing to bolster the capital of the bank, it can keep operating:

You are never bankrupt as long as investors are willing to keep funding you. In other words, running numbers and coming up with a negative net worth doesn’t necessarily equal insolvency. If so, the U.S. Treasury would have been bankrupt a long time ago.

So if an investor comes in with $20, the bank now has $110 in assets again and it can continue to operate. Plus, in the case of E*Trade, it also has a great online brokerage business which certainly has value. At least that’s what Citadel (hedge fund) must think. Today they announced a $2.55 billion deal to save E*Trade. From the WSJ:

Citadel’s Mr. Griffin, 39 years old, is confident the worst scenarios are already priced into the securities of a number of financial companies. That view extends to a $3 billion portfolio of E*Trade’s mortgages and other securities, which Citadel now has agreed to buy from E*Trade for $800 million. Citadel also is injecting $1.75 billion into E*Trade, in exchange for 10-year E*Trade notes that pay it 12.5% interest and shares boosting its stake to almost 20% of E*Trade’s stock outstanding.

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As I mentioned in my 3Q portfolio review, I have stayed clear of financial stocks this year. At some point, though, it will make sense to buy. While I certainly don’t think we’ve seen the worst of the credit crunch, it’s possible that most of the future bad news is already priced into stocks and bonds of these companies.

Plus, nobody wants to see these companies fail — not the Dept. of Treasury, not the Fed, and not investors.

Perhaps this is overly simplistic, but it seems to me that as long as E*Trade doesn’t fail, the stock will go higher.

What do you think? Use the comments to let me know!

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