E*Trade (ETFC), the big discount broker, was in such bad shape that the market thought a firm like TD Ameritrade (AMTD) would walk in and get the firm for next to nothing. It would have to pay something to cover the mortgage-backed portfolios on the books, but that would probably cost less than E*Trade’s $2.5 billion market cap. E*Trade was in enough trouble so that its bargaining position was weak

And, for TD Ameritrade or Schwab (SCHW), it would have been a great deal. One of them would have picked up E*Trade’s huge retail brokerage business for about 20% of what it would have cost to buy the company just a few months ago.

But, as Robert Burns wrote "the best laid plans of mice and men do often go awry". Citadel Investment Group stepped in and rescued E*Trade. According to The Wall Street Journal the brokerage "which is ensnared in the mortgage crisis, is getting a $2.55 billion cash infusion from Citadel Investment Group, people familiar with the transaction say,"

The structure of the investment is clever. In the first part of the deal Citadel will buy E*Trade’s entire $3 billion portfolio of asset-backed securities for about $800 million. If these securities rise in value over time, the buy-out firm could make a fortune. As a private investor, it is under no pressure to sell them immediately or show them on a public company balance sheet.

The balance of the investment will go in as 10-year debt with a 12.5% yield. And, Citadel gets 20% of the company and a board seat.

Other discount brokers were looking at E*Trade and probably thought they could get a deal beyond belief. And, it was too good to be true. Someone smarter beat them to it.

Douglas A. McIntyre

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