DBRS: E*TRADE Ratings Unchanged After 3Q12 Earnings; Senior at B (high)

DBRS, Inc. (DBRS) has today commented that its ratings of ETRADE Financial Corporation (ETRADE or the Company) remain unchanged following the release of the Company’s 3Q12 results. DBRS rates ETRADE’s Issuer & Senior Debt at B (high) and ETRADE Bank’s (the Bank) Deposits & Senior Debt at BB. All ratings have a Stable trend. The Company reported a net loss of $29 million in 3Q12, following net income of $40 million 2Q12 and net income of $71 million in 3Q11. The quarter was highlighted by an elevated loan loss provision that was in large part due to a third party servicer not providing timely information related to borrower bankruptcies. As a result, the Company’s loan loss provisions more than doubled sequentially to $141 million.

While the quarterly loss is disappointing, DBRS notes that there was evidence of continued positive underlying trends for the Company in 3Q12 results. E*TRADE reported sustained momentum in its flagship brokerage business, positive quarter-over-quarter (QoQ) operating leverage and further improvement in asset quality metrics. There was also a notable reduction in wholesale borrowings in the quarter and the Company is targeting $3 billion of additional deleveraging in the fourth quarter.

In general, the Company’s results were reflective of the typically seasonally weak third quarter. E*TRADE’s net revenues of $490 million for 3Q12 compared favorably to $452 million in 2Q12, but were down from $507 million in 3Q11. Net interest income of $261 million in 3Q12 was down 15% YoY and 7% lower than 2Q12, due to further narrowing of the net interest spread. Positively, 3Q12 net revenues were supported by non-interest income at $229 million, the highest level for nine quarters. Non-interest income was boosted by $79 million in net gains on securities, which were up $54 million from 2Q12. DBRS notes that the 3Q12 gain on sale of securities was directly related to the Company’s deleveraging in the quarter. Specifically, the extra gains offset $51 million of charges related to the prepayment of $520 million of fixed rate wholesale borrowings. The sale of the securities also brought down asset levels in line with the reduced liabilities, thereby improving leverage.

Importantly from a ratings perspective, DBRS sees the Company as having success in its core brokerage franchise. The Trading and Investment segment, which is largely the online brokerage franchise, generated net income of $127 million in 3Q12, down only slightly from 2Q12 net income of $129 million. Positively for future results, this segment added 18,000 in net new brokerage accounts (up from 13,000 in 3Q11) and $1.9 billion in net new customer assets in 3Q12 (down from $2.6 billion in 3Q11), as well as reporting ETRADE’s second best quarter in terms of account retention with an annualized churn rate of just 8.5%. Nevertheless, daily average revenue trades (DARTs) of 128,701 were down 7% QoQ and 22% year-over-year (YoY). DBRS sees lower DARTs in the quarter as reflective of the challenging environment and not the result of any weakening of the ETRADE franchise. The decline in DARTs at E*TRADE was consistent with industry trends.

The Company’s other segment, Balance Sheet Management (BSM), which houses ETRADE’s legacy loan portfolio, reported a net loss of $12 million for 3Q12. BSM’s loss was driven by the aforementioned $141 million loan loss provision. Importantly, however, ETRADE’s asset quality metrics continue to signal improvement. For the entire loan portfolio, special mention delinquencies (30-89 days past due) were down 6% and total at-risk delinquencies (30-179 days past due) were down 7% sequentially. Both were down 29% YoY. Total delinquent loans (excluding TDRs) as a percentage of gross loans declined to 7.6% at 30 September 2012 from 9.6% a year earlier. The legacy loan portfolio decreased by $616 million during 3Q12 to $11.1 billion and has shrunk 66% from its peak.

Management continues to emphasize cost control to help alleviate revenue pressure on its earnings. Total 3Q12 operating expenses of $289 million were impacted by $13 million in severance pay, driving a 3% QoQ increase. However, with quarterly revenues rising 8% sequentially, the Company recorded positive operating leverage for 3Q12. Looking ahead, E*TRADE has identified $70 million in expense reductions and expects to meet its new target of $100 million in reductions from run-rate expenses by the end of 2013.

Reducing the size of the balance sheet remains a priority for management. During the quarter, $1.3 billion of deleveraging initiatives were completed and, as noted, another $3 billion are targeted for 4Q12. This target is expected to be reached through a combination of reduced wholesale borrowings, the transfer of $1.2 billion of sweep deposits to a third party, and the anticipated movement of some customer payables (segregated cash) into third party money market funds. Ultimately, the Company is targeting a Bank Tier 1 leverage ratio of 9.5% which should facilitate regulatory approval for excess Bank capital to be distributed to the parent to help pay off high cost debt at the parent level. At quarter end, the Bank’s Tier 1 leverage ratio was 7.9%, unchanged from 2Q12.

On a consolidated basis, ETRADE reported a Tier 1 common ratio of 10.9% at 3Q12, up from 10.2% in 2Q12 and 9.3% in 3Q11. At the Bank-level, the Company reported a Tier 1 common ratio of 18.0% at 3Q12, up from 16.7% at 2Q12 and 16.0% at 3Q11. The solid capital ratios reflect ETRADE’s comfortable capital cushion that provides it with it ample loss absorption capacity, in DBRS’s view.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids. All can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Roger Lister
Approver: Alan G. Reid
Initial Rating Date: 27 January 2005
Most Recent Rating Update: 2 February 2012

For additional information on this rating, please refer to the linking document under Related Research.