Merrill's Downfall Provides a Disclosure Lesson Says NY Times Dealbook

According to an August 9, 2010 article in the NY Times Dealbook, Merrill's downfall provides a disclosure lesson, a lesson that readers of this blog have seen discussed in numerous other posts.

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It was named after a faint constellation in the southern sky: Pyxis, the Mariner’s Compass. But it helped to steer the mighty Merrill Lynch toward disaster, The New York Times’s Louise Story reports. 

Barely visible to any but a few inside Merrill, Pyxis was created at the height of the mortgage mania as a sink for subprime securities. Intended for one purpose and operated off the books, this entity and others like it helped Merrill obscure the outsize risks it was taking. 

The Pyxis story is about who knew what and when on Wall Street — and who did not. 

Publicly, banks vastly underestimated their exposure to the dangerous mortgage investments they were creating. Privately, trading executives often knew far more about the perils than they let on. 

Only after the housing bubble began to deflate did Merrill and other banks begin to clearly divulge the many billions of dollars of troubled securities that were linked to them, often through opaque vehicles like Pyxis.

In the third quarter of 2007, for instance, Merrill reported that its potential exposure to certain subprime investments was $15.2 billion. Three months later, it said that exposure was actually $46 billion. At the time, Merrill said it had initially excluded the difference because it thought it had protected itself with various hedges. 

But many of those hedges later failed, and Merrill, the brokerage giant that brought Wall Street to Main Street, soon collapsed into the arms of Bank of America. 

.... But even now, two years on, regulators are still trying to piece together how so much went so wrong on Wall Street. 

The Securities and Exchange Commission is investigating whether banks adequately disclosed their financial risks during the boom and subsequent bust.... 

The recent overhaul of financial regulation did little to address this shadow banking system. Nor does it address whether banking executives should be required to disclose more about the risks their banks take. 

Most Wall Street firms disclosed little about their mortgage holdings before the crisis, in part because many executives thought the investments were safe. But in some cases, executives failed to grasp the potential dangers partly because the risks were obscured, even to them, via off-balance sheet programs. 

Executives’ decisions about what to disclose may have been clouded by hopes that the market would recover, analysts said. 

“There was probably some misplaced optimism that it would work out,” said John McDonald, a banking analyst with Sanford C. Bernstein & Company. “But in a time of high uncertainty, maybe the disclosure burden should be pushed toward greater disclosure.” 

Under the FDR Framework, governments are responsible for insuring that financial market participants have access to useful, relevant information in an appropriate, timely manner.  This disclosure should not be subject to management hoping they have no exposure.

For financial institutions, the appropriate disclosure is current asset-level disclosure on an observable event basis.

Why?  In the absence of current asset-level disclosure, market participants do not have the data needed to analyze the risk and solvency of the financial institution.

The Pyxis story begins in 2006, when the overheated and overleveraged housing market was beginning its long, painful decline. 

... Merrill Lynch created a group of three traders to reduce its exposure to the fast-sinking mortgage market. According to three former employees with direct knowledge of this group, the traders first tried sell the vestigial C.D.O. investments. If that did not work, they tried to find a foreign bank to finance their own purchase of the C.D.O.’s. If that failed, they turned to Pyxis or similar programs, called Steers and Parcs, as well as to custom trades. 

These programs generally issued short-term i.o.u.’s to investors and then used that money to buy various assets, including the leftover C.D.O. pieces. 

But there was a catch. 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 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. Citigroup used similar arrangements that the S.E.C. now says should have been disclosed to shareholders in the summer of 2007. 

One difficulty for the S.E.C. and other investigators is determining exactly when banks should have disclosed more about their mortgage holdings. Banks are required to disclose only what they expect their exposure to be. If they believe they are fully hedged, they can even report that they have no exposure at all. Being wrong is no crime. 

Moreover, banks can lump all sorts of trades together in their financial statements and are not required to disclose the full face value of many derivatives, including the type of guarantees that Merrill used. 

Banks should always have to disclose their current asset-level positions, including hedges, on an observable event basis.

“Should they have told us all of their subprime mortgage exposure?” said Jeffery Harte, an analyst with Sandler O’Neill. “Nobody knew that was going to be such a huge problem. The next step is they would be giving us their entire trading book.”  

Still, Mr. Harte and other analysts said they were surprised in 2007 by Merrill’s escalating exposure and its initial decision not to disclose the full extent of its mortgage holdings. 

Greater disclosure about Merrill’s mortgage holdings and programs like Pyxis might have raised red flags to senior executives and shareholders, who could have demanded that Merrill stop producing the risky securities that later brought the firm down. 

Other market participants like credit and equity market analysts, investors, regulators and rating services could also have demanded that Merrill stop producing or investing in the risky securities and prevented Merrill from blowing up at all.

... By late 2007, Merrill had added pages of detailed disclosures to its earnings releases. 

It was too late. The risks inside Merrill, virtually invisible a year earlier, had already mortally wounded one of Wall Street’s proudest names.