E*Trade Financial Corp is getting a $2.55 billion cash infusion from investors led by Citadel Investment Group, which is also buying the mortgage-related securities portfolio that has been the primary source of the discount brokerage's recent woes.

The bail-out by Chicago-based Citadel will give the alternative fund manager about 18 percent ownership of E*Trade and a seat on the board, E*Trade said on Thursday.

E*Trade shares, which have lost about 80 percent of their value since January, surged about 23 percent in early trading before the bell, but then fell 27 cents or 5 percent to $5.01 in afternoon trade on Nasdaq.

Citadel, which often invests in troubled assets and companies, is leading an investor group that includes BlackRock Inc the largest publicly traded U.S. money manager.

E*Trade said Mitch Caplan, its chief executive since 2003, is stepping down. Donald Layton, a former vice chairman of J.P. Morgan Chase & Co who has been a strategic adviser at the brokerage, will become E*Trade's chairman. Jarrett Lilien, now chief operating officer, will become acting chief executive.

The agreement includes immediate funding of about $2.4 billion and rids the company of its troubled $3 billion asset-backed securities (ABS) portfolio.

Citadel will pay $800 million for the portfolio.

Another component of the deal is the purchase of $1.75 billion worth of 10-year notes and stock that will pay an annual interest rate of about 12.5 percent, E*Trade said.

Citadel is the clear winner in this transaction, said Bank of America analyst Michael Hecht, in a research note entitled Xmas comes early for Citadel, shareholders get lump of coal.

Hecht said that Citadel's deal gives it a $3 billion asset backed securities book for 27 cents on the dollar and $1.75 billion of secured paper at 12.5 percent, and 84 million shares of stock for nothing.

Hecht said shareholders, in contrast suffer (more than) 40 percent earnings per share dilution and 100 percent tangible equity dilution.

Still the deal shows that there is a market for the securities, with investor interest largely going cold amid the subprime mortgage meltdown earlier this year, some analysts said.

It also puts a value, albeit low, on what bargain hunters might be willing to pay. We finally have a market-determined price for all those mortgage-backed securities, and it is 27 cents on the dollar, said Robert Ellis, senior analyst with Celent, a Boston-based financial research and consulting firm.

CEO SEARCH

E*Trade said it will take a fourth-quarter pretax charge of $2.2 billion as a result of the portfolio sale. It will also increase its allowance for bad home equity loans to $400 million and will issue common stock equal to about 20 percent of its outstanding shares.

Citadel Chief Executive Ken Griffin said the investment should restore confidence in E*Trade, which he credited with a strong brand and business model, and give it a refortified balance sheet.

Caplan will retain a seat on the board and have an advisory role, E*Trade said.

The company, one of the largest U.S. online bank and brokerages, said it will launch a search for a new CEO, and Lilien, who has been with E*Trade since 1999, will be considered along with external candidates.

E*Trade is best known for its brokerage business, but in recent years has diversified into mortgages, mortgage securities and other lending areas. The change paid off until earlier this year, when the company was hit by large losses in its mortgage business.

Lilien said in an interview that the deal with Citadel allows E*Trade to get its troubled portfolio off its books and provides a much-needed cash infusion. And he said the company plans to stick with its two-pronged business model, offering brokerage and banking services to customers.

After E*Trade took large losses in its mortgage segment, analysts said the company would have to pursue strategic alternatives, such as the sale of some assets or a takeover by larger rivals like Charles Schwab Corp (SCHW.O: Quote, Profile, Research) or TD Ameritrade Holding Corp (AMTD.O: Quote, Profile, Research).

Lilien said the board had considered about 40 different transactions, including some with brokerage rivals, but he declined to name any companies. He added that the transaction with Citadel was deemed the most beneficial.

Our belief is that our business is in great shape, he said. Our strategy we feel was on target -- it was our balance sheet that had the issues.

The company said it had no update on an informal inquiry from the U.S. Securities and Exchange Commission earlier this month, part of an industry wide probe of the mortgage industry.

E*Trade earlier this month withdrew its financial outlook for 2007. Lilien said the company did not plan to issue financial forecasts at least through the end of the year.

E*Trade disclosed that retail client assets have fallen 15 percent in the month, but Lilien said it hopes to win back much of that business. As of November 27, retail client assets were $192 billion compared with $226.7 billion on October 31.

The company has historically issued financial metrics on a monthly basis, but on a conference call with investors it said it will now only make quarterly disclosures.

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