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 towards greater disclosure.”
The Pyxis episode begins in 2006, when the overheated and overleveraged housing market was beginning its painful decline.
During the bubble years, many Wall Street banks built a lucrative business packaging home mortgages into bonds and other investments. But few players were bigger than Merrill Lynch, which became a leader in creating C.D.O.’s
Initially, Merrill often relied on credit insurance from the American International Group to make certain parts of its C.D.O.’s attractive to investors. But when A.I.G. stopped writing those policies in early 2006 because of concerns over the housing market, Merrill ended up holding on to more of those pieces itself.
So that summer, 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 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. 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.
“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.
Former Merrill employees said it would have been virtually impossible for Merrill to continue to carry out so many C.D.O. deals in 2006 without the likes of Pyxis. Those lucrative deals helped fatten profits in the short term — and hence the annual bonuses paid to its employees. In 2006, even as the seeds of its undoing were being planted, Merrill Lynch paid out more than $5 billion in bonuses.
It was not until the autumn of 2007 that Pyxis and its brethren set off alarm bells outside Merrill. C.D.O. specialists at Moody’s pieced together the role of Pyxis and warned Moody’s analysts who rated Merrill’s debt. Merrill soon preannounced a quarterly loss, and Moody’s downgraded the firm’s credit rating. 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.