E*TRADE Financial's Dirty Little Secret

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Here's how I encourage you to think about E*Trade Financial : It's like an out-of-control truck that's barreling toward a cliff. Everybody sees the truck. And everybody sees the cliff. But despite the driver's frantic efforts to stop the truck from plummeting into the abyss, he's only succeeded at marginally slowing its approach.

When most people hear the name "E*Trade," the first thing that comes to mind is its discount brokerage operation -- which, I might add, provides excellent customer service and one of the best retail trading platforms in the industry. And if this were all there was to the company, then it would be in fine shape today.

Yet, as you may have guessed, this isn't all there is to E*Trade. More specifically, in the lead-up to the financial crisis, it invested its customers' funds into billions of dollars of mortgages and home equity loans -- the latter of which remain a very real threat to the company's existence today.

E*TRADE's Achilles' heel
At the end of the third quarter, E*Trade held $3.6 billion in home equity loans, 80% of which don't begin amortizing until 2015 at the earliest. While this is down from $4.2 billion at the end of last year, it's still uncomfortably large when you consider that the company has less than $3 billion in tangible shareholders' equity.

In addition, despite the fact that it's already set aside $319 million to cover future losses from the portfolio (and continues to do so every quarter), there's little reason to believe this will be enough to cover the eventual hole.

In the first case, as I've already alluded to, the majority of these loans are still in the interest-only phase. In 2015, 26% of them begin to amortize (meaning the principal starts becoming due). An added 41% come online in 2016. And 13% more enter the mix in 2017. The problem for E*Trade is that the borrower's monthly payments are almost certain to increase once the amortization schedule kicks in.

Making things worse, the credit quality associated with these loans is questionable at best. A full 60% of them were originated at the height of the housing bubble in 2006 and 2007. Roughly half were accompanied by low or no documentation of income or net worth. And even updated estimates reveal that almost 40% of the borrowers have FICO scores below 700.

To top things off, absent another massive wave of home price appreciation, there will be little collateral to cover losses once the default rate starts ticking up over the next few years. Virtually all of the home equity loans are second liens, meaning the first lien takes precedent. And once you take the multiple encumbrances into consideration, the average loan-to-value ratio on E*Trade's home equity portfolio clocks in at 101.7%. (For the record, an LTV in excess of 100% means there's negative equity in the property.)

Now, to be fair, E*Trade does have one major thing in its favor: time. This provides an opportunity for the unemployment rate to decrease, giving more borrowers the ability to shoulder higher payments. It also provides more time for home prices to appreciate, though this trend has already started to decelerate. And finally, it allows E*Trade to continue stockpiling reserves in preparation of the inevitable onslaught.

Will these factors be enough to ward off failure? That remains to be seen, but one thing's certain: E*Trade's new leaders -- both its CEO and chairman are new additions to the company -- have their hands full.

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The article E*TRADE Financial's Dirty Little Secret originally appeared on Fool.com.

John Maxfield and The Motley Fool have no position in any stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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