from minyanville.com, "5 things..." column

Meanwhile, in the real world, regulators may be investigating whether Merrill Lynch (MER) violated accounting rules to delay reporting of subprime losses, the Wall Street Journal reported.

  • The heart of the Journal story rests on "unidentified people" who say Merrill engaged with some hedge funds in deals designed solely to delay disclosing losses on bonds or derivatives positions backed by subprime mortgages.
  • The U.S. Securities and Exchange Commission has opened an informal inquiry and is likely to investigate the transactions, a person familiar with the investigation said apparently told the Journal.
  • Ok, so what does all this really mean? What kind of "deals" are we talking about here?
  • The deals effectively move the securities off the balance sheet of one of Merrill's sponsored entity's and onto the balance sheet of the hedge fund involved.
  • How does that work? Well, Merrill prices the assets and the hedge involved fund agrees to "buy" the assets at that price and hold them for one year in exchange for a guaranteed minimum return.
  • Sounds shady, huh?
  • It's actually more common than one might think, and assuming the "pricing" is on the up-and-up, really not that shady at all.
  • Where the water turns murky is in the pricing.
  • In one case the Journal says Merrill sold commercial paper issued by one of its entities for $1 billion.
  • If, for example, regulators were able to determine that the transaction was unreasonably priced - say, if the assets that were transferred for $1 billion were really worth $500,000 million - then this is a serious problem.
  • In fact, then it becomes virtually identical to the off balance sheet transactions that were structured at Enron to hide losses.
  • This story is just beginning.
  • Unfortunately, if the old adage is true - news follows price - then Merrill's 11.8% move lower so far today is not encouraging for the outcome.