The Securities and Exchange Commission has launched an investigation into deals Merrill Lynch & Co. undertook to allegedly cloak its vulnerability to risky mortgage debt, the Wall Street Journal reported Friday.
The Journal reported Merrill Lynch struck deals with hedge funds to take certain positions that did not transfer risk, but merely delayed when Merrill Lynch would have to disclose its exposure to that risk.
However, responding to the story Merrill said Friday it was not aware of any transactions that moved billions of dollars of risky subprime-related assets to hedge funds to reduce company exposure and delay write-downs.
“We have no reason to believe that any such inappropriate transactions occurred,” Merrill Lynch said in a statement. ”Such transactions would clearly violate Merrill Lynch policy.”
In its story, the Journal said Merrill engaged a hedge fund to lend a “Merrill-related entity” $1 billion. This normally means the hedge fund would assume the risk of the Merrill-related entity failing to repay debt. However, Merrill guaranteed it would buy the loan a year later. Thus, Merrill assumed the risk without reporting the company’s exposure on its own books.
The Journal reported Merrill has been seeking help from hedge funds in shifting as much as $5 billion in bonds backed by mortgages under a “mitigation strategy.”
Merrill said the story was “non-specific” and relied on unidentified sources.
SEC spokesman John Nester in Washington declined to comment and would neither confirm nor deny that the agency was investigating.
The bank’s stock plunged in trading Friday. The stock sank as low as $55.03, the cheapest trade since July 2005. The stock is down 40 percent for the year.
Merrill Lynch stunned Wall Street last month when it reported $7.9 billion in mortgage credit costs for the third quarter. Not only was this charge easily the biggest among Wall Street’s banks related to the mortgage crisis, it was more than three-quarters higher than the cost Merrill Lynch had estimated just three weeks earlier.
Deutsche Bank analyst Mike Mayo cut his rating on Merrill Lynch’s stock to “Buy” from “Hold,” saying he is not sure he can rely on the financial statements of a company that “may have engaged in questionable private transactions.”
During the third quarter Merrill curtailed its exposure to a risky type of investment called a collateralized-debt obligation to $15 billion from $32 billion. Because the bank only wrote off $6 billion of the exposure, Mayo said he wonders what happened to the “missing” $11 billion.
Mayo in a separate report on Thursday issued a report predicting $10 billion in additional writedowns on Wall Street for the fourth quarter, including $4 billion at Merrill. In Friday’s downgrade, he speculated Merrill’s costs may reach an additional $10 billion.
These charges have stemmed mostly from bonds and other investments backed by mortgage debt, and commitments to finance corporate takeovers. These types of investments and commitments have become less valuable amid a flight to safer investments this year.
If Mayo’s prediction comes true, the banks will collectively have recorded around $35 billion in charges in the second half of 2007.