It's not much of a surprise that E*Trade (NASDAQ:ETFC) is the latest addition to the list of Wall Street firms choking on mortgage-backed dog food. What is incredible is that, unlike last week's sickened financials -- Citigroup (NYSE:C), Merrill Lynch (NYSE:MER), Morgan Stanley (NYSE:MS), and Wachovia (NYSE:WB) -- E*Trade is down nearly 60% on the news, and at least one analyst is giving odds on an impending bankruptcy.

Worse than the talking heads predicted
This is one reason why all those pundits out there -- otherwise smart guys like Ben Stein -- were so utterly wrong when they claimed that subprime problems wouldn't spread, would be no big deal. It's true that subprime lending is only a tiny portion of the economy, but it's also painfully apparent that subprime loans -- and let's toss in rotting Alt-A as well -- once minced, mixed, and spread around in collateralized debt obligations (CDOs), have the ability to contaminate a much larger asset pool. (E*Trade's worst-performing CDOs are second liens, which should come as no surprise, because as bubble-buyers begin to default, the first payments to go out the window are usually those for second loans.)

Securities backed by these rotting mortgages go so bad, so fast, because no one knows exactly how bad things are getting, or where the risk is hiding. Read E*Trade's press release on its CDO downgrades, writedowns, and crummy upcoming earnings. It notes that it has $50 million in "AAA" rated assets that have been rerated as "below investment grade." In other words, what were allegedly prime cuts have turned out to be low-grade Wall Street dog food.

An avalanche starts with a snowball
And it gets even worse, as E*Trade is showing us today. Many banks depend on trust in order to survive. If your depositors don't believe their money is safe, they'll yank it out. We don't see bank runs often on these shores. Countrywide Financial (NYSE:CFC) had a small one a couple months back. In the U.K., Northern Rock depositors desperate to get their money out helped put that lender on life support. Unfortunately, the same thing could happen to E*Trade.

As my colleague Rick Munarriz already pointed out, bank depositors are FDIC insured to $100,000, and brokerage customers have a half million-dollar cushion via SPIC. But with 50% of E*Trade's depositors reportedly carrying more than the FDIC limit, you can bet plenty of them will be moving money out. Ditto brokerage customers above the limit. But even those who carry balances at less than those marks (I'm one of them) may jump ship. It's very tough to be level-headed when it feels like your nest egg is at risk.

Foolish final thought
The shame of it is, E*Trade has a great trading platform for both cash and retirement accounts, along with very convenient savings and checking products. It's also one of the first to offer us regular Joes global trading capabilities. I really believe it's one of the best choices out there for consumers -- and I've tried nearly all the major discount brokerages. Unfortunately, being good wasn't good enough, and, in its quest for growth, E*Trade put far too much of its asset base into residential real estate loans or related derivatives -- at the top of a since-crumbled market. (Last Friday's 10-Q shows that, at current estimates of fair value, 72% of E*Trade's $16.6 billion in available-for-sale securities are mortgage-backed.)

Bad move. Terrible move. As E*Trade is finding out today, it only takes a little bit of badness to pollute an entire pool. Investors who think banks are cheap across the board would do well to remember how risks like these can reverberate.

For more on Wall Street's dog-food diet:

At the time of publication, Seth Jayson, a top-ten CAPS player, had several accounts at E*Trade, but no positions in any other company mentioned here. See his latest CAPS blog commentary here. View his stock holdings and Fool profile here. Fool rules are here.