Citadel's E*Trade moves expose limits as rescuer

NEW YORK (Reuters) - Citadel Investment Group pumped new capital into E*Trade Financial Corp (ETFC.O) and is refinancing loads of costly debt, yet the moves only buy a little breathing space for the struggling online broker and expose the hedge fund giant's limits as a rescuer.

E*Trade, among the best known brands in finance but hobbled by mortgage losses for two years, on Monday announced Citadel, its largest stockholder, would swap up to between $800 million and $1.2 billion of high-yield debt for convertible bonds paying zero interest.

The Chicago-based firm, led by legendary trader Kenneth Griffin, last week also bought 90.1 million shares for $100 million, giving it a more than 17 percent stake.

Still, analysts say that Griffin may simply be making the best of a bad situation. For a modest $100 million, he buys time for E*Trade -- which expanded into mortgages through its 2000 merger with online bank Telebanc -- to line up a merger partner and could, if all goes well, break even.

"If the company survives, they can sell the broker and salvage whatever is left," Fox-Pitt Kelton analysts David Trone said. "They made a bet and then things got worse. Now they're trying to climb back out."

While its online brokerage business remains vibrant, E*Trade struggles under a mountain of sour and quickly souring loans and other assets. And while the latest balance sheet moves appeases regulators, analysts warn E*Trade needs a lot more capital to get through the downturn.

"They bought some flexibility over the next two to three quarters, betting that things will stabilize," JMP Research analyst Michael Hecht said. "It's about buying time."

Citadel and E*Trade spokeswomen declined to comment.

LIMITS

Yet as a hedge fund manager, Citadel has nearly maxed out its capacity to recapitalize E*Trade.

According to a prospectus last week, Citadel's combined stock and debt holdings, if fully converted, would give it about 50 percent ownership in the brokerage. Yet any stake exceeding 24.9 percent would trigger tough bank regulatory oversight from the Federal Reserve -- something a hedge fund firm would want to avoid.

"It limits their flexibility and their willingness," said Hecht.

Those limits help explain why rather than swapping debt for equity, which would bolster E*Trade's bank unit and give it a dominant stake, the Chicago firm is giving up debt yielding a whopping 12.5 percent, and 8 percent for zero interest bonds with a convertible feature that may never be exercised.

Hecht, long critical of E*Trade's expansion into mortgages and its aggressive borrowing in years past, said E*Trade is still under-capitalized despite these moves, especially if you presume loan losses remain troubling.

"They're playing 'chicken' with time. They can squeak along or raise capital, selling enough non-core assets to absorb losses," Hecht said.

BREAK-UP

Analysts argue the next step is a break-up of E*Trade, namely selling its brokerage operations to rival TD Ameritrade (AMTD.O). The brokerage unit could generate between $3 billion and $5 billion of proceeds, which could be used to repay debts and leave about $1.70 a share remaining.

"We continue to firmly believe that E*Trade will be either bankrupt or sold by the middle of 2010, with the latter now looking more likely," said Trone, who on Monday raised his E*Trade rating to "in line" performance.

In hindsight, Citadel's Griffin probably wishes he did not invest $1.75 billion for distressed assets and a 20 percent stake in E*Trade in November 2007. Citadel was among the many investors at the time which tried to snap up banks and brokerages at the bottom, only to find they were far too early.

The purchase of $800 million of toxic asset-backed securities and collateralized debt obligations from E*Traded was by most accounts a highly profitable trade. But E*Trade's stock, which had fallen 78 percent from its high when Citadel announced its 2007 deal, has plunged 76 percent since.

When Griffin joined Citadel's board of directors two weeks ago, he cited the firm's great potential value. "E*Trade is among the most recognized and innovative brands in America," he said in a June 9 statement.

That said, the company posted its seventh straight quarterly loss in April and analysts forecast E*Trade losses this year, next year and in 2010. E*Trade, meanwhile, only has enough capital for several more quarters of losses.

"The point is, they are not repaying their debts through earnings," Trone said.

(Reporting by Joseph A. Giannone; Editing by Richard Chang)