FORTUNE:
Doomsday on Wall Street  
April 4, 2008: 4:01 AM EDT
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The day $2 billion walked out the door


To stay alive, E*Trade needed cash. Lots of it. The company contacted more than 40 potential investors, including some competitors. Most of the potential deals, however, were unworkable: Many of the offers were cutthroat fire-sale options, or a potential investor wanted simply to buy the brokerage business - and not take on any of the mortgage liabilities.

Citadel, the Chicago-based hedge fund, quickly emerged as the front-runner. The fund, which had not been caught up in the credit crisis, had been eyeing E*Trade for months, ever since a July conference call when the company first reported its troubles in the mortgage markets. Since then Citadel had been scrutinizing E*Trade's balance sheet, and it understood better than most - even E*Trade management - not only how serious its problems were but also the real value of its business.

Prior to the panic, E*Trade had rebuffed Citadel. No one at the company thought its money would be needed. Now the hedge fund was the only thing standing between E*Trade and bankruptcy. "They needed to stop the bleeding of customer attrition immediately," recalls Joe Russell, the senior managing director at Citadel who helped head up the E*Trade-deal team.

The deal, which closed on Nov. 29, gave E*Trade a total of $2.5 billion in cash: $800 million in exchange for its $3 billion portfolio of asset-backed securities, where some of its biggest mortgage problems lay, and another $1.75 billion in exchange for ten-year bonds, paying out 12.5% in annual interest. As part of the agreement, Citadel would also become the company's largest shareholder, with a 20% stake.

Money in the bank

The cash infusion gave E*Trade a fighting chance, and the widely reported deal seemed to calm customers' nerves. "The customer attrition stopped almost in its tracks," says Layton, who was named chairman of E*Trade's board that day. Its CEO, Mitchell Caplan, left the company, and Lilien, the COO, was promoted to acting CEO. "Now we had to deal with the aftermath of a company that's gone through a huge change," recalls Layton.

At that point Layton still had no plans to take over as CEO. In fact, his main job as chairman was to find a permanent CEO. Making matters complicated was that Lilien, who had been with the company for nine years, was openly campaigning for the job. But as a part of the management team that had gotten E*Trade into its mortgage mess, he was going to be a tough sell for outside shareholders. For now, however, E*Trade desperately needed Lilien's experience. He would know better than almost anyone how to get E*Trade through the initial aftermath of the crisis.

Thanks to Citadel, the company had enough cash to remain open, but it still needed to rehabilitate a badly crippled business. Unfortunately for E*Trade, its competitors were eager to take advantage of its troubles.

A few weeks after the Citadel deal, Michael Curcio was at a traders' convention when something strange happened. A representative from one of the company's biggest competitors mistook him for an E*Trade customer, approached him, and tried to persuade him to pull his business from E*Trade.

"Why are you doing business with those guys?" the rep asked him. "Don't you know they are going out of business?" Other competitors launched blatant attacks. A marketing campaign run by OptionsXpress, told customers, "If you are concerned about the financial security of your brokerage firm, come join [us] .... We'll pay the transfer fee." TradeStation ran a print ad in Investor's Business Daily that said, "E*Trade Customers: Save Up to 50%."

E*Trade countered with a new marketing campaign. It offered customers special deals, like free trading days, to stay onboard. It also launched a series of ads that directly addressed the company's troubles, pledging to clean its balance sheet of exotic securities "such as CDOs, Alt-A, or second-lien ABS," one read.

Another bold move was going ahead with plans to advertise at the Super Bowl, spending close to $2 million on two TV spots portraying a baby using E*Trade, which generated buzz with its weirdness. The week after it aired, new account openings jumped 32%, as compared with the same week in 2007. "It was our way of showing the world that we are still here and very much alive," recalls Lilien. To help cover the costs, he canceled E*Trade's yearly managers' conference in Puerto Rico.

Slowly these tactics started to win customers back. For the month of December, the number of customer accounts held steady. In January the company increased net new retail accounts by 16,000. In February, E*Trade generated 43,000 new accounts.

Hearts and minds

The marketing campaign seemed to be reassuring the outside world. Internally, Lilien knew there were jangled nerves that needed soothing. So he toured E*Trade offices and met with employees. There were few complaints but lots of questions, and one in particular he heard again and again: What happens to us now? It's a tough question to answer. So much of what happens to E*Trade now depends on factors outside the company's control: How much worse will the credit crisis get? Will the mortgage market ever open up again?

In January, E*Trade unveiled a turnaround plan. On paper the plan looked simple: Shore up its core business - online trading - and shrink its banking business, which included the problematic mortgage investments. To this end the company plans to spend $85 million on marketing and advertising to help draw in new assets.

At the same time it will sell off all assets that are not relevant to its online-trading business in an effort to raise capital against future write-downs on bad loans. So far, the assets it plans to sell include a wealth-management division, an institutional arm, and a partnership in Japan. By the end of 2008, E*Trade estimates, those sales will bring in $350 million.

The company still holds billions in mortgage loans, and losses there could severely derail even the best-laid turnaround plans. For now, Wall Street is betting against E*Trade. Just about every analyst has a sell or hold rating on the stock, including Citi's Prashant Bhatia, whose recent report stated that he expects "continued meaningful deterioration" in E*Trade's mortgage portfolios. (He declined to be interviewed for this story.)

In late March the stock was trading at about $4 - close to where it was at the end of its dark day on Nov. 12. Its market capitalization is about $1.9 billion - 80% down from a year ago.

Perhaps the toughest job at E*Trade these past few months has been trying to find someone to take over as CEO. When Layton was first named chairman, he began the search. It was not easy finding qualified candidates to jump onto a foundering ship. At one point he tried to lure a Fortune 500 executive by telling him he would have more to talk about at cocktail parties as head of E*Trade. The candidate was intrigued but didn't end up taking the job. By the end of February, Layton says, he and the rest of the search committee had three viable outside candidates.

When Lilien learned that he was being passed over, he was openly disappointed. As he told Fortune, "We accomplished so much in the past 90 days. I feel like I won the fight, but didn't get the decision on the judge's scorecard." He gave notice on March 18 and plans to leave the company May 16, after the firm's annual shareholder meeting.

"One thing that I was adamant about was not leaving the company on its back," he said in an e-mail to Fortune. "At this point we have restored stability, and the franchise is clearly back on its feet. I am proud of what we have accomplished together recently - and over the past nine years - and I am sad to leave it behind. But in my gut, I know it's time for me to move on."

Pulling E*Trade out of the mortgage mess was not the way Layton planned to spend his retirement years. In fact, he came to the company in November only as an advisor to the board. But as the crisis escalated, he stepped up his responsibilities, first signing on as chairman and then last month taking the reins as CEO.

"Let's face it - usually offers like this come to you when it's a riskier situation. If you want a reference for that, I could recommend Vikram Pandit or John Thain," he says, referring to the new CEOs at Citigroup and Merrill Lynch (MER, Fortune 500), who got their jobs only after those companies had been slammed by the credit crunch.

How did Layton make the leap from searching for CEO candidates to becoming one himself? One analyst, Brian Bedell of Merrill Lynch, speculated in a recent report that no decent candidate wanted the job - leaving Layton as the only option. But Layton's long experience as a banker may be exactly what E*Trade needs to guide it through these turbulent times.

Certainly Citadel, E*Trade's biggest shareholder, believes he's the right guy for the job. He will also have help from another old-school banker, Robert Druskin, the former COO of Citi, who joined the company's board in February. On a recent March afternoon, Layton sat in a small temporary office at E*Trade's headquarters in New York City, with a half-drunk cup of soup on his desk, and talked about his surprising new role.

As to how he got offered the top job at E*Trade, Layton is circumspect, saying only, "The board asked me if I would do it." When asked why he decided to take it, he smiles and grows animated. After all, he didn't need this job - he was happily retired. But clearly there is something about saving E*Trade that appeals to him.

"I didn't get to where I am without having a competitive side," he says, slowly taking a slurp of his soup. "Or an interest in taking on a challenge."  To top of page

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