Citadel's risky play in E*Trade

NEW YORK (Fortune) -- On the back of bold and savvy trades, Citadel Investment Group has quickly earned a reputation as one of Wall Street's smartest investment firms. Now, though, investors are betting that the company's most recent headline-grabbing investment - a $2.55 billion rescue package for E*Trade Financial - will be a huge flop.

Facing overwhelming losses on distressed mortgage-related securities, online brokerage E*Trade on Nov. 29 agreed to a transaction that involved Citadel purchasing debt and equity in the company. But E*Trade (Charts) stock has fallen by 29% since the deal was announced, which is a rude awakening for Citadel, because it indicates that investors disagree with Citadel's apparent view that E*Trade can recover.

However, investing in distressed companies and securities rarely result in an early payoff, which means any signs that E*Trade's business can stabilize could send the stock soaring, and further enhance Citadel's reputation for making money from rescue investments that not many others had the nerve to touch.

In 2006, Citadel stepped in to take over big natural gas trades from distressed hedge fund Amaranth Advisers, and in the summer it assumed the credit portfolio of troubled hedge fund Sowood Capital. Now, Citadel executives think they can make the E*Trade rescue work in their favor. They strongly believe the worries about E*Trade are overblown and that the brokerage can soon regain its footing.

"We saw a great business model with a troubled balance sheet," said Joe Russell, senior managing director at Citadel. "This transaction puts the company in a position of strength to refocus and expand its core franchise and maximize shareholder value."

Citadel's CEO Kenneth Griffin has ambitions to bring Citadel public in an IPO and grow it to the point where it stands shoulder to shoulder with established Wall Street firms. Depending on its outcome, the E*Trade investment could make or break Citadel's ambitions.

In assessing what might happen to E*Trade stock and whether Citadel will emerge looking smarter than before, two questions have to be asked. First: Has Citadel structured the deal to protect itself if E*Trade goes into bankruptcy? That's a key question to ask, because if Citadel has taken steps to gain an advantage under a bankruptcy, its investment objectives are in no way aligned with investors holding E*Trade stock, who'd be wiped out in a bankruptcy.

The second key question: What are the chances that Citadel can make money from the deal under any scenario, given that E*Trade still has large exposure to loans that could go bad at a high rate? Citadel's investment in E*Trade has three main parts to it. The investment firm is buying $1.75 billion of 10-year notes yielding 12.5%, and has purchased E*Trade's $3 billion of asset-backed securities for $800 million. The deal will leave Citadel with a stake just below 20% in E*Trade, up from 3% before the deal.

E*Trade didn't disclose important details about the deal until a filing with the Securities and Exchange Commission on Tuesday afternoon, leaving investors guessing about Citadel's motives in the deal. In particular, market participants wanted to see if Citadel had structured the deal to give itself any sort of advantage in a bankruptcy. If so, that would be a sign not to be so bullish about the stock.

The filing gives mixed messages on this subject. One detail to look for is any indication that Citadel $1.75 billion of debt stands ahead of - or has "seniority" over - other debt in a bankruptcy. From the filing, it appears that Citadel's debt has been given seniority over two other debt issues, which are scheduled to mature in 2013 and 2015 -- before Citadel's notes, which mature in 2017.

But the filing indicates that Citadel doesn't get seniority on its debt until notes maturing in 2011 mature in that year or are paid off by the company earlier than 2011. What if E*Trade were to go bankrupt before 2011 -- would the deal allow Citadel's debt to gain seniority over the 2013 and 2105 debt?

No, says a person familiar with the deal. Citadel's debt is on equal standing with the 2011, 2013 and 2015 debt until 2011 or until those 2011 notes are paid back before 2011, this person says. Since E*Trade's fate is likely to be known well before 2011, it doesn't appear that Citadel has made strong provisions to protect itself against a bankruptcy in the near term. That's a strong sign that Citadel believes E*Trade can make it.

But, if so, why get a provision that gives seniority over the 2013 and 2015 debt at all? Citadel got that provision to prevent E*Trade adding new debt that would be senior to Citadel's debt, according to the person familiar with the deal.

What's more, investors can more or less forget about the risk of bankruptcy if it becomes clear that there won't be overwhelming losses from loans that remain at E*Trade, particularly losses on the $12 billion of home equity loans. Citadel's cash infusion has allowed E*Trade to build up the capital cushion against bad loan losses, but analysts wonder if that will be sufficient.

Clearly, Citadel would have looked closely at the characteristics of the home equity loans and made loss projections before investing in E*Trade. But the deal would have been cleaner if Citadel had also taken the home equity loans off the bank's books, along with the other troubled assets. At the same time, the loss a one-off sale would have caused may have been too big for E*Trade to bear, which would have required an even bigger cash infusion from Citadel. The investment firm may have balked at putting in more than $2.55 billion.

Citadel's E*Trade investment was characteristically bold; it remains to be seen if it will be characteristically savvy.