The Strategy of Capital Injection

At the risk of repeating the mistake I made with the Bank of America – Countrywide deal, I have to say I like this Citadel – E*Trade deal a lot. The total cash infusion of $2.5 billion is actually larger than E*Trade's market capitalization, yet Citadel will end up with only 20% of the firm; the rest will be made up of E*Trade debt and lots of asset-backed securities. Citadel should make money on all three legs of the deal – the cash infusion is big enough that E*Trade's solvency is no longer in doubt, which in turn means that bonds paying 12.5% are going to be very valuable over their lifetime. And Citadel has proved itself an expert in buying distressed assets, so one assumes they're getting a good deal on the other bonds they're buying.

In fact, if you read Valerie Bauerlein's piece on the BofA deal, even that one doesn't necessarily look quite as idiotic as some might think given the continued implosion of Countrywide's share price.

If Countrywide's stock goes all the way to zero, then BofA is in a prime position to convert its debt to equity and acquire the company on the cheap – it even has an official right of first refusal on the firm.

Bank of America also has the right to meet any competitor's bid. Some analysts say Mr. Lewis is prepared to sacrifice some of his initial investment if it meant he got a better deal on buying Countrywide assets, such as its product suite and loan-processing technology.
"He did it to plant a flag and keep others away," said bank analyst Nancy Bush of NAB Research in Aiken, S.C. She compares the Countrywide strategy to the bank's snapping up credit-card giant MBNA Corp. in 2005, largely to keep it out of the hands of competitors such as cross-town rival Wachovia Corp.

Indeed, BofA has more than pole position in terms of buying Countrywide. Its deal also acts as a bit of a poison pill for anybody else who might be interested:

Bank of America points out that if Countrywide were to seek bankruptcy-law protection, the bank would be in line to be repaid behind bondholders but ahead of common shareholders. If any other party purchased Countrywide, the new owner would still be on the hook for the full $2 billion obligation.

All the same dynamics are likely to be in place with the Citadel investment. Ken Griffin is not the kind of person who shies away from taking over underperforming companies, and if E*Trade continues to struggle, he'll be very well placed to simply absorb the whole thing.