As online broker E*Trade Financial Corp. (ETFC) awaits word from the Treasury Department on an $800 million investment, the company's options to raise capital are shrinking.

The New York company applied for funds from the federal government's Troubled Asset Relief Program to offset mortgage woes in its banking unit. While it waits for a response from regulators, E*Trade plans to sell off more of its non-core assets and cancel some of its outstanding debt by exchanging bonds for equity, efforts it has pursued in prior quarters.

Analysts say, however, that E*Trade already sold off a majority of its non-essential businesses. Although the company has already set aside $1.1 billion to offset losses from bad loans, the amount might not be enough to cover rising delinquencies in its bank subsidiary's mortgage portfolio. These factors make TARP funding increasingly important for E*Trade.

E*Trade's bank has a Tier 1 capital ratio - a measure of financial strength - of 6.29%. That level is high enough for the bank to be considered well capitalized. But in the recession, regulators have informally considered 8% a better target ratio for banks.

In a note to clients Monday, Barclays Capital analyst Roger Freeman wrote that he expects E*Trade to "narrowly avoid breaching the well-capitalized" threshold for Tier 1. But he said E*Trade will need some other capital to shore up its bank in the absence of TARP.

In an interview Jan. 27, Chief Executive Donald Layton said that the company's capital ratios are at "fine levels." During a call with analysts that day, he said E*Trade would generate about $1 billion or more in capital at its bank through earnings and shrinking its balance sheet. E*Trade can also inject $435 million from the parent company into its bank, or make payments in kind (instead of interest payments) on notes due in 2017, which could save up to $410 million.

Shares of E*Trade in morning trading were flat at $1.16. The company's stock has plunged more than 75% over the past year, due to the bank unit's troubles and also in line with weakness in financial stocks.

 
   Capital Measures

In its fourth quarter, E*Trade set aside $512.9 million for loan losses, down from $517.8 million in the third quarter.

E*Trade also reported risk-based capital of $716 million, up from $435.1 million a year earlier.

Standard & Poor's analyst Rikin Pandya said, "we applaud E*Trade's aggressive reserving, but believe that it needs more capital to ease investor uncertainty."

That uncertainty stems from mortgage losses within E*Trade's banking unit, which has offset any growth in its brokerage business.

In E*Trade's home equity portfolio, total delinquent loans rose 20% in the fourth quarter over the third, and 44% year-over-year. The company said delinquencies spiked in November, but added that the trend was "not repeated in December and January."

Loans to residences housing one to four families are the bread and butter of E*Trade's bank. Those loans have also deteriorated in the fourth quarter. In the portfolio, which accounts for roughly one-fourth of the company's total assets, total delinquent loans increased 38% over the third quarter and more than doubled year-over-year. Total charge-offs, or loans that the company doesn't think it can collect, were 1.74% of average loans receivable, sharply up from 0.1% a year ago.

E*Trade says that its vintage loans, of which it has a higher percentage than its peers, are being paid back faster than those of its competitors. The company also says nearly 50% of its loans that were issued before 2007 are less likely to default.

Industry observers, however, project that with a weak economic environment, charge-offs and delinquencies will increase in 2009 - making further capital-raising a virtual necessity for E*Trade.

Within its home equity portfolio, E*Trade itself expects charge-offs to rise 15% to 20% over its previous $1.8 billion estimate for 2008 to 2010.

"The bottom line is, capital ratios didn't move very much from the third quarter," said Alexander Yavorsky, assistant vice president of Moody's Finance and Securities team. They are "not especially strong, but still remain above well capitalized levels."

Sandler O'Neill analyst Richard Repetto recently estimated that an $800 million TARP investment would increase E*Trade's Tier 1 ratio to 7.91%.

Others, however, say that E*Trade's capital ratios are not likely to fall much further, given the severe beating that the company has taken from turmoil in the housing market.

E*Trade "took two quarters in a row of loan loss provisions over $500 million, it's going to take something catastrophic to get them below 6%," Pandya said.

 
   With Or Without TARP?

Meanwhile, E*Trade's near-term alternatives for capital include selling more non-core assets. E*Trade raised $754 million from such transactions, including the sale of its Canadian operations, in 2008. In November, the company also converted $450 million of debt to equity at $18 a share.

Debt-for-equity swaps, however, could risk further diluting shareholder value, though E*Trade has been trading at just over $1 a share for the past three months. The company avoided such deals in the third quarter, citing the "unattractive price of both its equity and bonds."

There's also a question of what terms could be placed on E*Trade to receive government funds. While E*Trade has been shrinking its balance sheet as it stopped originating and purchasing loans at the beginning of 2007, the company said that if it receives TARP approval, it would again finance home mortgages. E*Trade plans to purchase Fannie Mae (FNM) and Freddie Mac (FRE) guaranteed mortgage-backed secruities.

Raymond James analyst Patrick O'Shaughnessy said that with the plan, he doesn't think E*Trade is "strategically or operationally aligned with the stated intention of the federal program."

The company could also be a candidate for the so-called "bad bank" plan being considered by the federal government to buy a portion of toxic assets from financial institutions. The initiative and its details have yet to be announced.

On the call last week, Layton said, "it may be another arrow in the quiver we get to look at to improve the balance sheet of the company."

-By Brett Philbin, Dow Jones Newswires; 201-938-5393; brett.philbin@dowjones.com

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