November 13, 2007

If You Want The Closest Thing To A Financial Disaster, Look To Etrade: How To Be Up 50% And Still Lose Everything

This is how I know we're entering a recession.

Etrade, ostensibly an electronic brokerage, also has a huge business as a bank-- and mortgage lender. To the tune of $42 billion. Which is at risk, a la Countrywide.

A Citigroup analyst downgraded Etrade, saying that there was a chance it could go bankrupt. It's not just the mortgages that are the problem, he explains, but nervous high net worth investors could pull their money "just in case," precipitating a further run on the bank and thus its eventual collapse. Anyone who has seen "It's a Wonderful Life" knows that the run on the bank is what implodes a bank, not something intrinsic to the bank.

And that's what has happened, is happening. No one wants to be the last one left. No one wants to be the hero and brave it out-- not to the tune of hundreds of thousands of dollars they could lose through no fault of their own.  You couldn't get through on the telephone.  People wanted out, or at least reassurance.

But let me be explicit about the cause. Etrade doesn't go out of business because the business failed; Etrade goes out of business because this guy said Etrade could go out of business. He even said it was only a 15% chance, but that's not what people heard. What they heard was, "fire!"

Let me also be clear about this: he's not wrong about Etrade. He causes himself to be right. Do you understand? Fundamentals don't matter here, only psychology.

You say: what do I care about Etrade?  I say: If Etrade collapses, your chance of a recession is 100%. Depression becomes a possibility.

Here's why.  If you default on your Countrywide mortgage, you lose your house, and Countrywide goes out of business. You lose money that you needed but that you never really had; you lose expected money. But if Etrade goes bankrupt, you could lose all your money even though you might be up 50% for the year.

First, the immediate impact of all losing that money means consumer spending falls gigantically. And that affects all the businesses one would have spent money at. Cancel Christmas.

Second, you will not be investing. Asset prices fall when demand dries up. Don't believe me? You think the selling yesterday was related to problems in Iraq? It was Etrade customers, trying to liquidate their portfolios and get out. And maybe some Ameritrade customers-- just in case, even though they had no problem. Etc.  That's why the stocks that fell were momentum names with large price tags-- people wanted cash.

Third, for the long term, you will be that much more wary about putting money in a "small" ($400billion?) brokerage. Retail investor stops investing. Want to know what that looks like? Hit up a chart from 2000.

But aren't these deposits government insured? No, and that's why this is so huge. About $15 billion of Etrade's deposits are over $100k-- the FDIC limit. So they guy who has $500k there will only get $100k back (after a long protracted struggle with the government.) That money vanishes, and it vanishes, unfortunately, from the pockets of the very people keeping the economy from evaporating. It's bad enough when the poor have cut back spending; if the rich cut back, the economy's finished.(1)

And this is how I know it won't happen.

An Etrade bankruptcy is so powerfully damaging to the our psychology of economics that it would devastate our already tenuous situation. It's also why I know we're in deflation, not inflation. When you liquidate your assets and pull them to cash-- for whatever reason-- you are pushing up the value of the dollar. You are not spending as much because you're not even sure how much you have anymore. I know prices are rising, but wages aren't. Prices could triple, if you're not spending it's irrelevant. Hoarding or not spending or not having ends up being the same force on the economy.

Deflation. On worry alone.  If Etrade actually goes bankrupt-....

So the government has no choice but to bail Etrade out. For the mental health of the economy, Etrade cannot die. Either the Fed will cut rates soon, or we'll hear a message from the Treasury. This isn't what I want or don't want, this is a bigger issue.

Jay-Z called the bottom in the dollar.  I call a bottom in Etrade, here, because I can't believe the government would let it happen.  So much, psychologically, is at stake.

Buying the stock here is a huge gamble, and I don't recommend it to anyone, but I figure if they don't save Etrade, it won't really matter how much I lose today anyway.

(long Etrade, and long the government-- for now.)