DBRS Upgrades E*TRADE to BB (low), E*TRADE Bank to BB (high); Trend Remains Stable

DBRS, Inc. (DBRS) has today upgraded the ratings for ETRADE Financial Corporation (ETRADE, the Company or the Parent) and ETRADE Bank (the Bank), except the short-term instruments rating at the Parent, which was confirmed. Included in the upgrade were ETRADE’s Issuer & Senior Debt, which was raised to BB (low) from B (high), and the Bank’s Deposits & Senior Debt, which was raised to BB (high) from BB. The trend on all ratings remains Stable.

The upgrade of ETRADE’s rating by one notch to BB (low) reflects the continued strong performance of its core direct brokerage franchise, continued underlying earnings generation, reduced risk profile, improving funding and liquidity profile, and increasing capitalization. Pursuing its focused strategy, the Company is driving growth by building on its active trader franchise and expanding its customer relationships with long-term investors, while increasing the quality of its customer accounts and reducing the brokerage account attrition rate. ETRADE also benefits from its well-positioned stock plan administration business that leverages its product capabilities and is an important source of new customers.

The Bank’s rating of BB (high) is positioned two notches above the Parent’s rating, reflecting the Parent’s more limited financial flexibility and the potential for regulatory restriction on the upstreaming of dividends from its subsidiaries. The Parent has a still sizable amount of corporate debt outstanding at $1.8 billion, with just over $100 million in annual interest payments. If this debt were to be meaningfully reduced, DBRS would view the burden on the Parent as also being reduced, which could reduce the notching.

In continuing the Stable trend, DBRS considers the significant progress the Company has made in improving its financial profile, specifically through reduction of risk exposures and improving its funding profile, as balanced by the still notable legacy issues that remain. DBRS takes into account ETRADE’s continued strong momentum in its retail investor franchise, highlighted by growth across various brokerage metrics (daily average revenue trades, net new brokerage accounts/assets, margin receivable). Longer run trends demonstrate a significant reduction in credit costs, with full year 2013 provisioning for loan losses of $143 million, running at about half the 2012 level and a notable 91% below peak levels in 2008. At the same time, DBRS perceives elevated risk in the legacy loan portfolio which, despite improving credit quality, has the potential to drive losses, if rates were to rise rapidly or the economy deteriorate abruptly given the proportion of junior liens and still elevated loan-to-value ratios. Importantly, with revenue growth and much lower provisioning levels, ETRADE is consistently generating sufficient operating income before provisions and taxes that is readily able to absorb provisioning for loan losses. Successful expense control has also made an important contribution to earnings. With improving credit trends and notable reductions in the size of the overall portfolio, helped by amortization, refinancing and asset sales the drag on earnings from E*TRADE’s legacy portfolio continues to become less burdensome.

A major constraint on the rating level is the Company’s still sizable amount of expensive corporate debt outstanding. ETRADE currently has $1.8 billion of corporate debt with the highest interest rate reaching 6.75% (although down from a high of 12.5% prior to the 2012 debt refinance). Despite being less than half of peak levels, annual corporate interest expense of $114 million in 2013 remains elevated and still constrains overall profitability. Importantly, however, ETRADE was granted regulatory approval in recent quarters to upstream capital from the Bank to the Parent, given that the Bank maintains a cushion of excess capital. Provided that capitalization at the Bank remains appropriately strong, DBRS views this favorably from a ratings perspective, as it enables the Company to accumulate resources to repay its corporate debt. Inclusive of total dividend distributions of $250 million from the Bank to the Parent, corporate cash stood at $525 million at the end of 1Q14, providing for approximately 4.5 years of debt servicing capabilities, all things being equal. Increased corporate cash enhances the Parent’s ability not only to make interest payments, but also to pay down some of its corporate debt and reduce its interest costs, subject to regulatory approvals. DBRS expects that, as part of its capital planning process, the Company is discussing with its regulators the possibility of early retirement of its debt, with a first callable date in November 2014.

While DBRS sees E*TRADE as still exposed to the potential negative impact of adverse events, DBRS perceives this risk as being appropriately factored into the current rating level. Positive rating action is likely, if the Company continues to maintain momentum in its core franchise and grow earnings, while maintaining solid capitalization. Reductions in corporate debt could also positively pressure ratings, particularly at the Parent level. While less likely, the trend could revert back to Negative, if DBRS perceives any franchise weakening or significant earnings pressures, especially if driven by rising credit costs.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other applicable methodologies include the following: DBRS Criteria: Support Assessment for Banks and Banking Organisations and DBRS Criteria: Bank Capital Securities – Subordinated, Hybrid, Preferred & Contingent Capital Securities. All DBRS methodologies and criteria can be found on DBRS website under Methodologies.

The primary 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: Lisa Kwasnowski
Rating Committee Chair: William Schwartz
Initial Rating Date: 27 January 2005
Most Recent Rating Update: 16 September 2010

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