The Banking Bargain Bin
Liz Moyer,

Talk about a blue-light special.

E*Trade Financial's (nasdaq: ETFC - news - people ) sale of mortgage assets to a Citadel-led investor group Thursday netted the beleaguered online brokerage a much-needed $2.5 billion in capital. It also punctuated a growing trend: for distressed asset hunters, the credit crunch is a bargain-hunter's paradise.

Citadel gets the E*Trade assets practically for free. It's paying $800 million cash for $3 billion worth of asset-backed securities--the brokerage's entire portfolio--a mark-down of 73 cents on the dollar. E*Trade is issuing the equivalent of 19.9% of its shares' outstanding and unsecured debt to Citadel for $1.7 billion at a rate of 12.5%.

No wonder analysts following E*Trade hate the deal. "Citadel is the clear winner in this transaction," says Bank of America's Michael Hecht. It's getting 84 million shares "for nothing."

As the effects of the summer mortgage meltdown work their way through the system, bank after bank has come forward to disclose major write-downs of their mortgage securities holdings--a total of more than $70 billion so far, with this figure poised to rise. It's pressured capital levels at many companies, the perfect scenario for value-oriented buyers like Chicago-based hedge fund Citadel, among others.

Earlier this week, Citigroup (nyse: C - news - people ) got a $7.5 billion infusion from the Abu Dhabi Investment Authority and said the funds will shore up sagging capital levels. Freddie Mac (nyse: FRE - news - people ), one of the big government-sponsored mortgage entities, is raising capital by cutting its dividend and selling preferred shares. Fannie Mae (nyse: FNM - news - people ) is also selling stock. In August, Bank of America threw troubled mortgage lender Countrywide Financial (nyse: CFC - news - people ) a $2 billion lifeline.

The E*Trade deal also raises the question of whether other holders of similar mortgage securities will have to price their securities to match Citadel's mark. Banks have been slashing the value of their credit derivative holdings to acknowledge that the market for them has all but evaporated, but there is some room for discretion in the prices they set, and some banks have not revalued them at all, parking assets in the so-called "Level 3" accounting category, which denotes that there is no observable price with which to mark them.

Now Citadel has provided a floor, at least. "We finally have a market-determined price for all those mortgage-backed securities, and it is 27 cents on the dollar," said Robert Ellis, a consultant at Celent. "It also puts a pricing floor for all the other holders of these types of securities."

That latter point is the key point: It establishes a floor. Some analysts believe credit derivatives have been marked too low and their value is set to rise. No doubt Citadel and BlackRock (nyse: BLK - news - people ), another member of the E*Trade investment group, see that as the case.

The market prices for these assets, implied by the now widely watched ABX index, is "well below what their true economic value should prove to be," says Brad Hintz, an analyst at Sanford Bernstein. The AAA tier, the highest-rated paper, trades at 72.9 cents on the dollar, up from 66 last week, which was a record low. The next rung, AA, trades at 37, up from 34, and A paper trades at 28, up from 23.

There have been rumors of major deals between financial firms, another way to stop the bleeding. E*Trade, for example, has been the subject of on-again-off-again speculation about its ongoing independence, which Thursday's deal only temporarily halts, even though the company seems to think otherwise.

E*Trade didn't have much of a choice with Citadel. It faced a flight of customers and deposits after an analyst from Citigroup said earlier this month the company may need to seek bankruptcy protection from mounting losses on mortgage securities holdings. The company faces excess capacity in the online brokerage world and fierce competition driving commissions to zero. Shares of E*Trade fell 46% in November, and are down 70% since August. Thursday, they had gained 4% by midday.

Donald Layton, a former senior executive at JPMorgan Chase (nyse: JPM - news - people ) who is stepping in as E*Trade's chairman, said in a statement that the board of directors held discussions with strategic and financial partners. "In the end, the board unanimously concluded the transaction with Citadel clearly provides the greatest benefits to our shareholders and other constituencies. The company now has the financial strength to aggressively compete in the marketplace."

Citadel is making a habit of this kind of play. Last year, they joined JPMorgan Chase in purchasing the energy portfolio of failing hedge fund Amaranth Advisors, later buying up JPMorgan's share of that deal. Earlier this year, Citadel raised its stake in home builder Beazer Homes to 5.7% after rumors circulated about that company's impending demise.

Citadel positioned itself to pull off the E*Trade deal by selling debt last year and earlier this year--raising its own source of capital makes it less subject to the whims of banks, which are less inclined to extend credit for risky ventures. "With permanent capital, Citadel can afford to buy out of favor assets--like MBS and CDOs--and hold them for term," Sanford Bernstein's Hintz said. "This will be a very profitable deal for the fund."