Merrill Lynch (NYSE: MER) may have used deals with hedge funds to delay reporting its exposure to risky mortgage-backed securities to investors, according to a report in the Wall Street Journal (subscription required)today. If this is sounding more and more like the Enron story to you, that's because it is.
Enron found ways to hide its derivatives (and that's what these mortgage-backed securities are) by setting up shell companies so the debt could be held off its books. Details about Merrill's moves are becoming clearer as part of an SEC investigation now in the works regarding how Merrill Lynch valued its mortgage securities and how it reported those holdings to investors.
Initial reports indicate Merrill Lynch sold commercial paper to hedge funds with promises of buying it back a year later and guaranteeing the hedge funds a minimum return. If this is true, the primary difference between Merrill's tactics and Enron's would be that Enron set up its own shell companies while Merrill used hedge funds. Merrill Lynch refused to comment on any specific transactions mentioned in the Journal's story.
The Journal quotes Janet Tavakoli, a consultant on derivatives, as reporting, "Merrill has been making the rounds asking hedge funds to engage in one-year off-balance-sheet credit facilities. One fund claimed that Merrill was offering a floor return (set buy-back price) so this risk would return to Merrill."
By engaging in this type of deal-making with hedge funds, Merrill was able to keep much of its exposure to these risky securities off the books, while at the same time publicly minimizing its exposure to investors and employees. In fact, in what seems very reminiscent of Enron's moves to assure employees just before its fall, former CEO Stan O'Neal sent a memo to Merrill employees last July to assure them that the firm's risk level was under control.
Merrill investors had no idea how bad its situation was until it finally came clean about its losses and took a $7.9 billion write-down on these risky securities, one of Wall Street's largest write-downs ever, plus another $463 million write-down of deal-related lending commitments for a total of $8.4 billion. One has to wonder with these hedge fund deals if more write-downs will be needed as some of these securities come back onto Merrill's books? Is the only reason this became public because Merrill realized it couldn't find any buyers for its next round of commercial paper sales?
Another key question that needs to be asked is how many other companies are using similar hedge fund deals to minimize the risks they must show on their books? Earlier in the week the Journal reported that Bear Stearns (NYSE: BSC) sold $1 billion of risky mortgage loans to a hedge fund under a one-year agreement called a "mandatory auction call." Another way to guarantee the hedge fund a minimum return.
Also, investors need to ask how is the Super SIV any different? Isn't that just another way to delay reporting losses to investors?
Lita Epstein has written more than 20 books, including Trading for Dummies and Reading Financial Reports for Dummies.
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Reader Comments (Page 1 of 1)
11-02-2007 @ 12:45PM
william lindblad said...
Lita:
Pot calling the kettle black. The SEC should investigate itself. Ther policy of allowing "guesstimate" reporting allows too much leeway for manipulation. Given present conditions who in their right mind is going to tell a tale of woe when there is an option to, at least temporarily, keep it out of sight? I blame the SEC as their policy basically says that it is OK to steal a little candy, but don't take the whole jar. The old adage of given and inch, take a mile applies. True, they have to give a "revised" accurate figure, but at a later point. This stinks as it can manipulate stock and cause a great deal of consternation for investors. I think that there is a lot more to come as the public houses report accurate year end.
I have no way to dig into the private area, but certainly expect red ink. We have a lot of large mortgage brokers/banks that fit this bill.
The U.K. institutions operate under a different system and "fess up" day I believe to be Dec. 7.
Currently, housing and the financials are the headlines, but fuel and water will soon be the frontline. Tidbit. Everybody is pushing ethanol. It take 2 gal of water to make 1 gal of E85. It appears that a fresh water shortage is on the horizon. I can't wait to get Cramer's take on this one.
11-08-2007 @ 9:25AM
jill monroe said...
i have a mortgage with first franklin financial, who was bought by merrill lynch in july 2006. i am self-employed and did not over-report my income.
i could have refi'ed in july of 2006, for a hefty prepayment penalty, but didn't.
now the market has gone to heck in a handbag, 1st franklin will not re-adjust my mortgage; even though i have paid my mortgage perfectly for 2 years.
they tell me, "we are not the same company. we don't do stated-income loans. oh, and by the way, you don't make enough to pay your mortgage." (even thought my income has not changed in 2 years.)
they are foreclosing. i will not go bankrupt for this home.
1st franklin wants my home for profit or loss, i don't know.
so don't do business with merrill lynch or 1st franklin. they're thieves. they stole my home.
merrill knew what they were buying when they bought 1st franklin... a company they don't or won't do business with.
way to go, guys. just screw the small business owner who just happened to get stuck with a mortgage from your company.
i should have signed with countrywide. at least they're giving relief to those who, like me, paid on time, every time.
i hope they rot in hell.
11-08-2007 @ 9:26AM
Lita Epstein said...
You should reach out for help from a source outside your lender. I give you some ideas for how to do that in http://pg.bloggingstocks.com/2007/11/06/feds-finally-giving-clues-to-its-solutions-for-mortgage-mess/. The first call you should make is to the Center for Foreclosure solutions at 1-888-495-HOPE (4673).
Lita