etfc

looks like shares of etfc have a favorable risk/reward over the next 12 to 18 months.

after falling victim to the subprime crisis, etfc appears to have regained its footing after receiving a cash infusion by Citadel Investment Group in november and by selling off noncore assets in an effort to free up capital. on the brokerage side, not only have outflows stabilized, but the company also added accounts in the previous quarter. that is a huge sign of confidence that investors do not believe the company will go bankrupt -- something an analyst at c predicted six months ago.

getting into the details of the company, etfc diversified itself into mortgages in 2000 after acquiring online banking franchise telebanc. the company used low-cost cash deposits to fund mortgages, but then began to extend itself into riskier loans, including asset-backed securities. the strategy paid dividends that accounted for nearly half of the company's operating profit in 2006, but then the credit markets seized up and etfc was forced to disclose higher loan losses.

negative headlines sparked huge outflows as customers pulled out billions of deposits. with a much-needed cash infusion, Citadel stepped up and bought the company's risky asset-backed portfolio for $800 million, or 27 cents on the dollar. also, etfc issued $1.75 billion in 12.5% senior notes and 85 million common shares. Citadel now owns roughly 20% of the company and has one seat on the board of directors.

this is most likely a win/win for Citadel and etfc. the 12.5% notes are spread out over 10 years, and Citadel essentially received an equity stake in the company for free as etfc was in dire need to stop client outflows. the company -- while receiving unfavorable terms on its asset- backed securities -- was able to get a quick infusion as opposed to selling off additional assets at fire-sale prices.

since the cash infusion, etfc announced plans to sell noncore assets, starting with its RAA Wealth Management division that it purchased in 8/06 for $25 million. the division could fetch as much as $80 million, which is small considering the $11.6 billion in home equity loans that etfc still has on its books. however, management continues to free up capital in an effort to reduce risk against further deterioration in the housing market.

looking at the latest quarter, which was reported 4/18/08, management provisioned an additional $234 million for loan losses. however, etfc has made significant progress, increasing its excess capital by $260 million to $695 million and expects this number to rise to $1 billion by the end of the year. this is enough to cover the $400 million to $600 million loan-loss provision that management is forecasting for 2008.

also, the company increased its assets by $300 million and added 60,000 new customers in the most recent quarter. while these numbers are small given that etfc ended the quarter with $168 billion in client assets, the increase suggests that clients are optimistic that the company will survive this credit mess.

etfc definitely has risk. further deterioration in the credit markets will result in higher loan losses that could exceed management's estimates. also, if the economy weakens we could see DARTs (daily average revenue trades) fall, which could impact cash flow moving forward. in the prior quarter, the company saw an increase in DARTs but commission rates were down 2% sequentially, mostly due to promotional trades used to attract new business and retain existing customers.

while some are saying that the housing crisis will likely get worse before stabilizing, with etfc trading at roughly $4 a share and management anticipating taking a $400 million to $600 million loan-loss provision in 2008 and $300 million to $400 million in 2009, i believe that this risk is mostly priced in to the stock. also, now that etfc's retail segment appears to have stabilized, i expect commission rates to improve over the coming quarters.

disclosure: none yet; looking at leaps with a $4 strike