Citadel's Deal for E*Trade Debt
May Set Template For Other Firms

Ever since debt markets seized up this summer, investors have struggled with the question of how much securities backed by risky mortgages are worth.

Now, thanks to Citadel Investment Group's purchase of $3 billion in debt held by E*Trade Financial Corp., there is at least one answer. Citadel paid an average of about 27 cents on the dollar for these assets. And it received a boatload of E*Trade shares as part of the deal.

E*Trade sold the portfolio of troubled debt, which includes structured asset-backed collateralized debt obligations, or CDOs, and other mortgage securities, after seeing its stock plummet in value, and after at least one analyst suggested that the bank and online broker might have to file for bankruptcy-court protection. Few others would have been able or willing to buy such a large portfolio of this troubled debt.

While seemingly low, the Citadel price might emerge as something of a market floor, at least for some of the investments involved. It also might signal that some investors are now willing to step in and make a market for these stalled securities. Although it is unlikely that investors would use this floor as a valuation for securities held by Citigroup Inc. and Merrill Lynch & Co. -- both of which have big CDO holdings -- it may at least present a worst-case scenario for these portfolios.

The Citadel deal shows that "there is indeed money out there and certain parts of the broader credit and liquidity concerns are being addressed," says Derrick Wulf, a portfolio manager at Dwight Asset Management in Burlington, Vt. "That's a very encouraging development."

Some also see the E*Trade deal as a template for how beleaguered companies may begin selling hard-hit assets at rock-bottom prices to allay investor concerns. Although E*Trade shares didn't close higher in trading the day after the deal, if it helps E*Trade reassure skittish clients in its bank and brokerage firm, others might pursue similar moves to sell troubled assets, even at bargain-basement prices.

On its own, the Citadel investment might not be much of a guide for deciding how much other firms' debt portfolios are worth, some investors warned. That is because the kinds of debt securities included in such a portfolio aren't always standardized and so may not be directly comparable to holdings at other firms.

"Twenty-seven cents is an average price for a whole range of stuff," notes Jeffery Gundlach, who manages the TCW Total Return Bond Fund, which focuses on mortgage-backed securities and has been negative on the market. "You can't draw any conclusion from it."

Of course, some investors will try to, if for no other reason than to get an idea of what any "Armageddon scenario" would look like at some of Wall Street's biggest names. In that sense, the Citadel deal could be instructive for investors trying to create their own floor for stocks such as Citigroup and Merrill Lynch.

CDOs pool investments from mortgage bonds to credit-card loans and then sell slices based on varying degrees of risk and reward. The CDO market boomed in recent years, but the credit crunch caused trading in these complex instruments to dry up.

In many cases, that left firms that were big originators of these products with huge exposures to the now-soured investments. Oftentimes, the firms couldn't sell them as planned, or the firms have had to support off-balance-sheet vehicles that held them. Citigroup and Merrill Lynch, the leaders in this market, have both announced in recent weeks multibillion-dollar write-downs, due mainly to these products. Those hits also led to the removal of the chief executives at both firms.

Applying an E*Trade value to these two institutions' CDO holdings doesn't paint a pretty picture. At Citigroup, it would suggest a total, after-tax hit of about $26 billion, according to a note from Credit Suisse analysts Susan Roth Katzke and Ross Seiden. This figure is based on Citigroup's holding of about $55 billion in CDO assets and would include the banks' previously announced expectations of after-tax write-downs of $5 billion to $7 billion in the fourth quarter.

At Merrill Lynch, total CDO hits, based on the Citadel valuation, would come to $9 billion on an after-tax basis, the Credit Suisse report noted. Merrill has already announced $7.9 billion in write-downs on a pretax basis.

Spokeswomen for Citigroup and Merrill declined to comment on the Credit Suisse report.

The Credit Suisse analysts acknowledge in their note that extrapolating from the Citadel purchase is "simplistic and far from perfect." Citigroup's CDO portfolio, for example, includes $25 billion of notes that are considered "super senior," meaning they would be worth far more than the assets in the E*Trade portfolio.

At the same time, Citadel also is injecting $1.75 billion into E*Trade, in exchange for 10-year E*Trade notes that pay it 12.5% interest, and is receiving 84 million E*Trade shares.

That said, the Citadel deal is "also our best benchmark for a worst-case scenario," Credit Suisse noted. "The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers' balance sheets."

The composition of the E*Trade portfolio sold to Citadel may also be reason for investors to take note of the sale. In a report released in October by E*Trade that gave details on its holdings, the firm said that nearly 60% of the assets in its $3 billion portfolio were rated double-A or higher. Of these securities, $1.35 billion were residential-mortgage securities given to borrowers with good credit histories.

Those aren't the kind of assets that usually sell at 27 cents on the dollar. "We were surprised at the large discount given the quality of the assets," Goldman Sachs analyst William Tanona said in a report.

The portion of the ABX index tracking double-A-rated subprime bonds that is used by many investors as a proxy for determining the value of similar mortgage securities recently traded at 45 cents on the dollar, according to data from Markit Group. That is up about six cents, or about 15%, from a week ago. But the Citadel average of 27 cents is at a more than 30% discount to even that lower price.

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