Loss Implications of E*Trade’s Mark to Market

Many commentators on the bailout of E*Trade by hedge fund Citadel focused on either the terms of the deal (costly to E*Trade) or the fact that Citadel, like some other risk-minded investors, are starting to pick and choose among distressed mortgage assets, a sign they believe that the bottom is nigh.

But a Reuters story, “E*Trade firesale seen hurting Wall St portfolios” (hat tip Michael Shedlock), points to fallout that has gone comparatively unnoticed: the mark-to-market implications of the E*Trade trade:

E*Trade Financial Corp’s firesale of mortgage-backed securities has conjured up a new worst-case scenario for Wall Street’s portfolio of subprime assets by knocking their value even lower.

Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.

“The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers’ balance sheets,” Credit Suisse analyst Susan Roth Katzke said.

The portfolios are hard to value because demand has dried up for them and the brokerages sometimes use their own models to put a value on the assets. Any rare actual transaction could have an effect on other brokerages’ valuations.

The article then discusses a research note by Katzke in which she made a quick and dirty analysis of what the impact would be if the major Wall Street firm had to mark down their subprime portfolios to the levels implied by the E*Trade investment. She used 26% of face value. She also made allowance for the writedown previously made. Her conclusions:

Merrill would take an additional $9 billion of writedowns

Citigroup would take an additional $26 billion in writedown

Note that while Katzke’s estimates may be rough, they are also conservative. These are after tax writedowns. She used 26 cents on the dollar, near the very top of the 11 to 27 cent range. And these values were realized on a portfolio with 70% prime mortgages, while Katzke only marked down Merrill and Citi subprime holdings.

Indeed, Citigroup’s own analyst argued that the prices realized by E*Trade were even lower:

Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel’s received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.

Par for the course, we have some very lame reporting from the Wall Street Journal on the E*Trade deal. Merely consider the title: “A CDO Floor of 27 Cents on the Dollar?” That is already absurd. Some CDOs are in default, others were downgraded from AAA to junk. Those that were downgraded that far had tranches below the AAA layer.

To make any kind of blanket statement about a market as heterogenous as CDOs, particularly when they have tremendous embedded leverage, is amazingly ignorant. But after the hype about how this trade might signal a floor (how exactly? Markets are volatile. Does someone buying a large block of stock put a floor under its price?), there were some sensible comments:

On its own, the Citadel investment might not be much of a guide for deciding how much other firms’ debt portfolios are worth, some investors warned. That is because the kinds of debt securities included in such a portfolio aren’t always standardized and so may not be directly comparable to holdings at other firms.

“Twenty-seven cents is an average price for a whole range of stuff,” notes Jeffery Gundlach, who manages the TCW Total Return Bond Fund, which focuses on mortgage-backed securities and has been negative on the market. “You can’t draw any conclusion from it.”