In a previous article, we discussed that net operating interest income is the largest source of revenue for E*Trade (NASDAQ:ETFC) and we dug deeper into the mechanisms of this business. We highlighted how the company utilizes its client’s cash and deposits to generate a net interest spread and also looked at the risks involved in the business. In this article, we continue that discussion to further analyze the trends affecting this revenue stream.
How Has E*Trade’s Net Interest Income Trended In The Past?
As you can see in the table below, E*Trade’s net operating interest income has been sequentially declining for the past several years. The trend does not seem to be reversing anytime soon as its net operating interest income for Q1 2013, at $241.3 million, was also down 15% year over year.
|Net operating interest income (dollars in millions)||$241.3||$1,085.1||$1,220.0||$1,226.3|
|Enterprise net interest spread||2.30%||2.39%||2.79%||2.91%|
|Enterprise interest-earning assets (average dollars in billions)||$40.9||$44.3||$42.7||$41.1|
What is causing the net interest income to decline?
Over the past several years, the Federal Reserve has flooded the market with liquidity and created a very low interest rate environment to fuel the economic recovery. Although this is a tailwind for the economy in general, it is problematic for E*Trade because low interest rates result in prepayments in its loan portfolio. The money received as prepayments must then be reinvested at the prevailing lower rates and this causes a compression in the company’s net interest spread. Interest spread is one of the two major drivers of E*Trade’s net operating interest income. Hence, as interest spreads decline so does its net interest income.
The other major driver for the company’s net operating interest income is the amount of interest earning assets on its balance sheet. This driver has been increasing steadily over the past few years as the company continued to attract customer deposits. However, this increase has not been sufficient enough to fully offset the impact from interest spread compression. What made matters worse recently, is the fact that the increase in such assets has reversed of late as the company is focusing on deleveraging its balance sheet to improve its Tier-1 leverage ratio. The company’s interest-earning assets declined to $40.9 billion in Q1 2013, from $44.3 in 2012, as it moved sweep deposits off the balance sheet and moved new customer deposits to third-party money funds.
Why is E*Trade deleveraging?
Of late, the company has been focused on deploying bank capital to its parent company in order to pay off its high cost debt. However, banking regulators were concerned about the company’s Tier-1 leverage ratio and would allow a deployment of capital only if this ratio improves. For this purpose, E*Trade submitted a “strategic and capital plan” to its banking regulators in June 2012, and arrived at an agreement that requires the company to generate capital organically and to reduce the size of its balance sheet (deleverage) in order to improve this ratio. 
As part of this effort, the company aimed to deleverage a total of $8.5 billion from its balance sheet. Around 4.9 billion of this was achieved in 2012, while another $3 billion was accomplished in Q1 2013. The company had plans to transfer another $500 million of sweep deposits off its balance sheet in Q2 2013. Going forward, it will continue to move new customer deposits to third-party money funds in order to keep its balance sheet within limits. Obviously, this means that E*Trade’s interest-earning assets will grow at a slower pace than in the past.
What to expect in the future?
Ben Bernanke, chairman of the Federal Reserve, recently stated that a premature tightening of monetary policy could lead to slowing or ending of the economic recovery. We believe that this statement is an indication that the central bank is in no mood to start increasing interest rates anytime soon. Since interest rates are expected to remain low, we believe that the downward pressure on E*Trade’s net interest spread will continue over the next couple of years and are likely to increase gradually with an overall improvement in the economy.
Further, the company’s interest-earning assets levels are also expected to be wobbly in Q2 2013 as the some deleveraging continues in this quarter. However, the majority of deleveraging has already been achieved and the management foresees no addition proactive balance sheet reduction after Q2. Therefore, we believe that interest-earning assets will resume growing in the second half of this year, although at slow rates, as the company will continues to move new customer deposits to third-party money funds in order to keep the size of its balance sheet in check.Notes:
- E*TRADE Financial Management Discusses Q3 2012 Results, E*Trade, October 18, 2012 [↩]