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E*Trade Financial (NASDAQ:ETFC) is scheduled to report its earnings for Q2 2013 on July 24. Over the last few quarters, the company has been trying to de-risk and deleverage its balance sheet. As part of this effort, it has been primarily (1) reducing its wholesale borrowings, (2) selling off the risky collateralized mortgage obligations (CMOs) that were accumulated before the mortgage crisis, (3) transferring sweep deposits off its balance sheet to third parties, and (4) directing customer payables and new customer cash to money funds.   Together, these initiatives have seen the company’s balance sheet size reduce from $51.3 billion at the end of Q1 2012 to almost $45 billion at the end of Q1 2013.
We believe that over the long term, E*Trade is likely to be more flexible and less risky with a smaller balance sheet. However, the smaller balance sheet is also likely to ensure that the company’s net interest revenue, which accounts for over half the value in the stock by our estimates, remains suppressed in the short-term.
Why is E*Trade deleveraging?
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 will only allow capital to be deployed 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 deleverage in order to improve this ratio. ((E*TRADE Financial Management Discusses Q3 2012 Results, E*Trade, October 18, 2012))
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. This means that E*Trade’s interest-earning assets will grow at a slower pace than in the past.
Deleveraging To Impact Net Interest Revenue Negatively
Net interest revenue is directly proportional to the average balances in interest-earning assets. However, E*Trade’s deleveraging process has taken a toll on these average balances by moving assets off its balance sheet. The process is unlikely to reverse until new customer deposits are being moved to third party money funds. In Q1 2013, the average balances in E*Trade’s interest-earning assets were around $40.9 billion, down from $44.9 billion in the year-ago quarter. At the same time, net interest revenue declined from $284.8 million in Q1 2012 to $241.3 million in Q1 2013.
Smaller Loan Portfolio Also Puts Pressure On Net Interest Income
E*Trade bet heavily on the mortgage loan market before the Great Recession and faced significant losses after the bubble popped in 2007-2008. Since then, the company has been focused on gradually reducing its exposure to the mortgage loan market. As of May 2013, it still held around $9.7 billion of mortgage loans on its balance sheet, which it intends to run-off at an average rate of around $400 million per quarter. 
While this is good over the long-term from a risk profile perspective, the decline in high-yield mortgage loans causes an immediate drop in the company’s net interest spread and net interest revenue. That is because the money received from disposing a mortgage loan is reinvested into relatively safer, lower-yield securities to improve the overall risk profile of the company. This reduces the average net interest spread that the brokerage earns on its interest-earning assets, thereby putting downward pressure on net interest revenue. E*Trade’s enterprise net interest spread declined by 19 basis points from Q1 2012 to Q1 2013, and is likely to decline further as the contraction in mortgage loan portfolio continues.
However, Trading Volumes Are Likely To Be Higher
On the transaction business side, E*Trade’s daily average revenue trades (DARTs) have shown a rebound in May after declining year-on-year for four months. The company’s DARTs for May increased by 11% over the same period last year, after posting year-on-year declines of 10%, 11% and 3% in February, March and April respectively. Since competitors such as Charles Schwab (NYSE:SCHW) have reported that their DARTs for June were up by 24% year-on-year, we expect E*Trade’s DARTs to also show a jump in the last month of Q2 2013.  Assuming that the average commission per trade has not changed significantly due to changes in product-mix or customer mix, this means that Q2 could be one of the better quarters for the company in terms of trading commissions. The trading commissions for the company are also likely to benefit from the fact that Q2 2013 had 64 trading days, compared to 63 in the year-ago quarter.Notes: