Giving Up on Federal Help, E*Trade Turns to Self-Help

CFO Bruce Nolop discusses how the online brokerage firm recapitalized itself without aid from the Troubled Asset Relief Program.
David KatzJanuary 12, 2010

Talk about the challenges of a new job. The day Bruce Nolop joined E*Trade Financial as the online brokerage and banking firm’s CFO — September 12, 2008 — was also the day before the weekend leading up to what many people regard as the epicenter of the financial crisis: the declaration of bankruptcy by Lehman Brothers.

On that Friday, Nolop, previously finance chief at Pitney Bowes, thought that E*Trade’s brokerage business had enough upside potential to counteract the burgeoning problems in the mortgage-loan investments of the company’s banking operations. True, the company had announced in July 2008 that it had incurred a $94.6 million net loss and recorded a $319 million provision for loan losses in the second quarter. Still, Donald Layton, who would be Nolop’s new boss, could report that the “somewhat higher than expected” losses in E*Trade’s credit portfolio were “still manageable” and that the growth in the loan delinquencies experienced by the bank that quarter “continued to moderate.”

What’s more, Nolop was joining a company whose daily average revenue trades would jump from 172,000 in the second quarter of 2008 to 184,000 and 221,000 in the following two quarters. Volatile markets, after all, breed revenues in the online brokerage business.

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But less than two months later, Lehman went belly-up. E*Trade, one of the first companies to be affected by the ensuing crisis, saw its mortgage portfolio slammed by a wave of loan defaults and delinquencies. “What I thought had been crisis past was a crisis present,” says Nolop.

BNolop2“What I thought had been crisis past was a crisis present.” — E*Trade Financial CFO Bruce Nolop

To fill its widening cash and capital holes, the firm applied for help under the Capital Purchase Program of the Troubled Asset Relief Program, which was enacted in October 2008. Nolop and his colleagues waited while other financial institutions were approved for TARP money — and waited some more. As of the second quarter of 2009, in fact, the company continued to view TARP funding as a possible component of its capital planning program.

But in November, having received no response from regulators, the company’s management withdrew its application. Months before that, however, it had chosen to reverse course, according to Nolop. For one thing, while E*Trade remains a relatively large bank, with $45 billion in assets, it was already moving to deemphasize its banking business. Indeed, it had halted the issuance of new mortgages early in 2008 and is still in run-off mode. “We are a brokerage business that uses a bank as a vehicle to invest its cash,” says Nolop. “We are not in the banking business per se.”

Still, although E*Trade’s brokerage business continued to perform well, that was more than offset by big loan-loss provisions on its balance sheet. As a result, it recapitalized itself in the third quarter of this year, completing a deal with shareholders including Citadel Investment Group, the company’s biggest investor, to exchange $1.7 billion of E*Trade’s corporate debt for debentures that could be converted into stock.

The debt exchange spawned a $968 million third-quarter pretax, noncash loss and knocked $65 million out of shareholders’ equity. At the same time, the company cut its annual corporate interest payments from about $360 million to about $160 million and pushed all its debt maturities out until 2013. Besides the debt exchange, the company raised $765 million in common stock issuance, including a $147 million at-the-market offering (an offering of stock directly into the market at other than fixed prices).

Despite those moves, which Nolop enthusiastically calls an effort in “self-help,” he and CEO Layton had been trying to shake the phrase “troubled company” from descriptions of E*Trade for at least a year and a half. (Layton left at the end of 2009 in a previously announced retirement; the company’s lead independent director, Robert Druskin, became chairman and interim CEO.)

In some quarters, E*Trade is still regarded as struggling. But the finance chief believes the company has “beat the odds” with its recapitalization and change in strategy. Indeed, he views the period from May to August 2009, when the financing was completed, as one of the most satisfying in a 30-year finance career that includes 18 years in investment banking with Wasserstein Perella, Goldman Sachs, and Morgan Stanley. In a wide-ranging interview with CFO in December, Nolop talked about the shocks of the financial crisis, the frustrations of applying for TARP money, and much else. An edited version of the conversation follows.

When you started working for E*Trade, what kind of job did you think you were getting into?
My feeling was that the basic brokerage business was a tremendous franchise with outstanding upside potential, and that the company just needed to get past the crisis in the mortgage-loan portfolio to realize that potential. I thought that the worst of the crisis was behind the company and it was going to be upside from then on. What happened was that the Lehman bankruptcy and the subsequent turmoil in our mortgage portfolio hit. We had another wave of defaults and delinquencies and issues. So what I thought had been crisis past was a crisis present.

And then, one month after I started, they came out with the TARP program, and we thought, Hallelujah: here is a source of inexpensive capital that can really help us get through this. We applied immediately for the TARP, and we had very strong support from a regulator, the [Office of Thrift Supervision]. We thought that this would be a relatively straightforward process. Little did we know how long and uncertain the process would be.

What was the process like?
There was a continual need to come up with financial plans and revise them, and to update our submission to the OTS. In turn, the submission went to the Treasury with the new projections and the new capital plan. And we had to work very closely with Citadel Investments, which owned a good part of our equity but more important owned about 70% of our outstanding debt.

What was your worst moment in the process?
It would be getting a call from the OTS on a Friday night saying that we needed a new plan by Monday morning. We had to spend the weekend negotiating the terms and coming up with the new financial model by that time. And then, submitting the plan and not hearing anything for weeks. And never once having a direct dialogue with Treasury about the projections.

Ultimately, you did not get a loan from TARP.
We were never turned down, but we were never accepted. To this day we have never received an explanation. People have a number of theories, but we never had any formal communication from the government saying that we would not get TARP, or an explanation of why they didn’t give it to us.

What theories do you have about why the regulators acted the way they did?
I’d prefer not to speculate.

What factors helped you stay afloat during the crisis?
One godsend was that the crisis was actually very good for the brokerage business. That was because it produced a lot of volatility in the market, a lot of trading activity, and a lot of people questioning their advice from their traditional broker and wanting to take more direct control of their finances. We had a burst of new accounts and trading activity, and more cash than ever.

The other godsend was when the government changed the Federal Deposit Insurance Corp.’s [maximum protection of bank accounts] from $100,000 to $250,000. Ninety-four percent of our customer deposits were now fully government insured. We no longer had to worry about customers pulling out their cash, because they could feel confident that their money was good, even if we had financial difficulties.

Did you ever find yourself critically short of cash?
We never had a liquidity issue. We had more than enough cash to cover any losses.

How much cash did you have at the height of the crisis?
We would have excess cash on our balance sheet of as much as $5 billion to $7 billion. But the issue wasn’t cash, it was capital. We had to have enough capital to meet the regulatory requirements. And the secret was the earnings from the brokerage plus the gain on the sale of a Canadian subsidiary and an Indian subsidiary that produced the capital for the bank to offset the losses.

Through the Lehman [crisis] we had excess capital, but as time went on we were using capital beyond what we were generating. Our excess was being reduced, and we knew we needed more capital.

How did you respond?
At a certain point we said that we needed to raise this capital ourselves and not count on TARP. That was around May or June of 2009. It was a huge, huge decision. The term we used was “self-help.” First we said, Let’s start selling stock in the market. We did it through a “dribble-out [at-the-market] offering,” which means that you sell stock every day in the open market. We just filed the prospectus and started selling stock. And one thing about E*Trade, we [already had] such high volume in our stock that the market could handle that volume.

The second decision was, Let’s try to fix the problem once and for all. Let’s do a large transaction: sell a public-offering stock issuance and exchange equity for debt.

Were you concerned about dilution?
We knew that this would be enormously dilutive to existing shareholders. But we felt that if we did it right and put the problem behind us, the value of the stock should start going up from that point forward. It was a big decision, and we said to our board that we think this is the right way to go in order to get the value of the company [up]. In other words, the cost of dilution was offset by the reduction in the risk of bankruptcy for the company.

Describe your relationship with Citadel in the context of this decision.
Citadel was a tough negotiator, clearly looking out for its own interest. But the fact that they had such an ownership position and we could negotiate just with them rather than a widely dispersed set of holders was really the key to the transaction. It produced a lot of value for Citadel, but a lot of value was created for the other shareholders and debt holders as well. They were very much in agreement that we needed to do this transaction, and very supportive. We had to work with them in order to do the transaction in a way that met strict regulatory requirements concerning bank holding company structures. Citadel was very creative in doing that.

What was Citadel’s role in your move to a self-help structure?
Most of the transaction was done with them. They exchanged their debt for common stock. Why was that valuable? One reason was that it told investors that this is the way that the company will survive. They felt good about the company’s future, or else they would never have agreed to swap their debt ownership for equity, putting themselves further behind [the preference line] in the event of bankruptcy. They took more risk, and that was very reassuring to the stock market. And they put another $100 million of cash into the company.

As CFO, what was your role in the negotiations?
Don Layton was the key, the prime negotiator. I was the number-two person in the transaction. My role was, first, to give him my views privately. Second, I worked with our financial staff to model and analyze various structures. Third, I was one of the primary people to execute the transactions and work with the investment-banking firms, Citadel, and our internal people to accomplish the transaction.

What were your feelings during that time?
That four-month period totally changed our world. We went from “Will we survive?” to “How do we thrive?” We all got a tremendous feeling of fulfillment and accomplishment. It was a very stressful year, but those four months were some of the most satisfying in my career.