A risky balance sheet has forced E*Trade to try to dispel bankruptcy rumors despite the profitable brokerage business for which it's best known. While the bankruptcy risk is not zero and we think this stock is only suitable for risk-tolerant investors, we believe E*Trade is likely to survive this mess.

E*Trade took advantage of its list of affluent customers from its brokerage business and began offering banking products. The logic behind the strategy was sound: E*Trade could offer consumer deposit and loan products to its customers, benefiting from a steady and predictable stream of income that came with banking products.

The problem is that E*Trade did not just stick to basic banking for current customers. E*Trade used its bank to take significant risks. It originated $3.7 billion of mortgages and home-equity loans for customers but purchased $25.6 billion of riskier wholesale loans. It also combined the purchase of safe government-agency-backed securities with riskier asset-backed securities such as collateralized debt obligations. When the subprime mortgage market blew up in late summer, E*Trade was forced to disclose higher loan losses and a deteriorating securities book. The weakness in E*Trade's strategy has become apparent. Customers and depositors read the awful headlines, panicked, and pulled out billions of dollars of deposits from the firm.

In an effort to stop the bleeding, the company announced a massively dilutive capital infusion led by Citadel Investment Group and sold its troubled asset-backed securities portfolio for $0.27 on the dollar. Citadel now owns roughly 18% of E*Trade and has a seat on its board. The strict debt covenants on the capital infusion effectively prevent E*Trade from seeking another white knight, should the need arise.

E*Trade's first priority is to avoid bankruptcy. The bank needs to maintain well-capitalized status in order to avoid violating covenants and regulatory problems. As of Dec. 31, E*Trade had excess capital of $418 million and expects excess capital to equal roughly $1 billion by the end of 2008. However, we believe higher loan losses could eat through the capital cushion over the next two years. If loan losses mount and the cushion starts to erode, E*Trade's well-publicized problems could panic customers and create a second massive withdrawal of deposits and brokerage assets, which could rapidly push the company to the brink of bankruptcy.