The New York Times has a fascinating article detailing how Merrill Lynch was able to hide $31 billion in toxic CDO assets off balance sheet beginning in early 2006. During the housing bubble of 2002-2007 Merrill made big money packaging mortgages and selling CDO's to investors. If the firm was unable to sell certain tranches of a CDO they would normally go to AIG to buy some credit protection, but in early 2006 AIG stopped selling credit protection on risky assets backed by mortgages. This left Merrill with a serious problem and left them exposed to billions in possible losses. To solve the problem, Merrill created a special purpose vehicle called Pyxis, which issued short term debt backed by the cash flow from the CDO's. But as the New York Times points out there was a catch:
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In forming Pyxis and the other programs, Merrill guaranteed the notes they issued by agreeing to take back any securities put in the programs that turned out to be of poor quality. In other words, these vehicles were essentially buying pieces of C.D.O.’s from Merrill using the proceeds of notes guaranteed by Merrill and leaving Merrill on the hook for any losses.
To further complicate the matter, Merrill traders sometimes used the cash inside new C.D.O.’s to buy the Pyxis notes, meaning that the C.D.O.’s were investing in Pyxis, even as Pyxis was investing in C.D.O.’s.
"It was circular, yes, but it was all ultimately tied to Merrill,” said a former Merrill employee, who asked to remain anonymous so as not to jeopardize ongoing business with Merrill. To provide the guarantee that made all of this work, Merrill entered into a derivatives contract known as a total return swap, obliging it to cover any losses at Pyxis.With the use of entities such as Pyxis, Merrill was able to claim that these assets were adequately hedged and keep them off the balance sheet, even though Merrill would ultimately be responsible for any losses. This is how Merrill was able to claim in mid 2007 that their total sub-prime exposure was only 15 billion when in reality it was $46 billion. Is this financial innovation or financial fraud? Apparently the SEC had no problem with these practices at the time. Of course now they claim that financial firms should have been quicker to disclose these off balance sheet transactions. The real problem is that nothing has changed and banks are still using these questionable practices to keep bad assets off their books. This along with the fact that banks can openly lie about the value of these assets, thanks to the FASB, makes it impossible to understand the true state of a company's balance sheet. Reading 10k's and 10Q's are a waste of time as banks purposely obscure off balance sheet transactions to understate their total exposure.
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