Over-Reaction

14 November 2007



E-Trade Stock Loses 59% of its Value in One Day

E-Trade Financial Corp. is one of many online brokerages that cropped up with the advent of the internet. Since there is little reason to have a brick and mortar temple to speculative capitalism (apart from the directors’ egos), they have an inherent advantage of lower overheads. The result is dirt cheap trades that are still profitable for the firm. This model worked well until E-Trade began playing in the mortgage backed assets market. In one day, E-Trades shares dropped 59% in what can only be described as an over-reaction by a panicked market.

Monday afternoon, E-Trade’s stock was going for $3.55, down $5.04 since Friday’s close. Moreover, that $3.55 represents an 84% decline from the beginning of the year. The drop Monday stemmed from comments made by Prashant Bhatia at Citigroup Inc., an analyst in the field. He chose to call his study “Bankruptcy Risk Cannot Be Ruled Out.” Enough said.

Since many of the accounts at E-Trade are bigger than the $100,000 insured deposit, Mr. Bhatia believes that investors will pull their money and ask questions later. A run on deposits would seriously impair the company’s ability to generate the fees needed to continue operating. In theory, one can readily see his point. But just how big are the possible losses?

E-Trade has a mortgage-backed securities portfolio worth around $3 billion, including $450 million in collateralized debt obligations and second-lien securities. E-Trade's president and chief operating officer, Jarrett Lilien, sent out a letter to shareholders noting that his company could write-off $1 billion and “still remain well capitalized.” Moreover, there is no way that the board of directors would let the company go under; they own too many shares themselves. They might sell it at a bargain price, but E-Trade probably won’t be allowed to go broke.

This is another case of market panic rather than the rational markets one learns about in high school or college economics classes. Yes, E-Trade made some bad investments (or bets if one wants to be accurate). It will cost them a billion or two. That won’t bankrupt the company, and it doesn’t justify an 84% stock-price decline in eleven months. Mr. Bhatia may well be right in his analysis, but one man can’t move a rational market, he can only move a panicked one.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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