Merrill Lynch hid its toxic subprime exposure inside off-balance sheet “Special Purpose Vehicles” (like one named Pyxis) until autumn of 2007 when CDO specialists at Moody’s figured it out and set off alarm bells that forced Merrill to revise its self-reported subprime exposure from $15.2 billion to $46 billion, according to an August 9, 2010 New York Times article by Louise Story, “Merrill’s Risk Disclosure Dodges Are Unearthed.” And ? get this ? Merrill’s senior executives supposedly did not know what was going on!
During the bubble years, Merrill became a big player in the creation of collaterized debt obligations (CDOs), notes backed by pools of mortgages that were tranched or sliced into layers of different preferences and risk. At first Merrill bought credit insurance from American International Group (AIG) to enhance the appeal of the riskiest tranches to investors. When AIG stopped writing this insurance in 2006, according to the article, Merrill effectively self-insured by holding on to more of those riskier tranches, and depositing them in Special Purpose Vehicles like Pyxis.
According to the article, Pyxis and similar vehicles issued short-term notes to investors and used the proceeds to buy these leftover risky CDO tranches.
Unbeknownst to its shareholders (and apparently its senior management), Merrill entered into derivative contracts called swaps that left it on the hook for losses in such vehicles.
When Merrill was forced to revise its reported subprime exposure in the fall of 2007, it explained that it had not reported subprime exposure to the extent that it was hedged, but the hedges failed. Under the securities laws, Merrill is only required to disclose material facts and risks. If Merrill had a reasonable basis for believing its risk was hedged, it was not requited to disclose that risk. As the article states, however, Citigroup used similar arrangements that the Securities and Exchange Commission says should have been disclosed.
These undisclosed high-risk CDO deals increased Merrill’s profits in the short term and led to hefty bonuses for some of its employees. In 2006, Merrill paid $5 billion in bonuses. This is the type of situation that led Wall Street traders in the know to email each other: IBGYBG ? I’ll be gone, you’ll be gone ? when the stuff hits the fan.
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