If you’ll recall the demise of Enron almost 10 years ago you’ll remember the concealment of debt by moving transactions off balance sheet and onto the books of special purpose entities (SPE’s), known as the “Raptors”. SPE’s were legitimate vehicles and were used to protect the parent company from exposure to risk, but Enron abused them to their demise. And if you’ll recall it was complicated—they were the smartest people in the room and still made mistakes. Now here we are almost a decade later and Merrill Lynch forgot their history.
Merrill Lynch, which is now Bank of America, created “Pyxis” and other special purpose vehicles (SPV’s similar to SPE’s). Pyxis was set up to move risk off the books of Merrill—does this sound familiar? This SPV was a trough for vast amounts of Collateralized Debt Obligations (CDO’s) that Merrill couldn’t sell. Pyxis (owned by Merrill) bought CDO’s from Merrill using money from borrowings that were guaranteed by Merrill and leaving Merrill on the hook for any losses. Then Merrill would also sometimes use cash from the sale of new CDO’s to buy the Pyxis notes—does this remind you of a dog chasing its tail? I haven’t even mentioned the “total return swap” derivatives contract that Merrill entered into, which guaranteed the notes. It’s complicated, right?
At the center of all this is Merrill and they should have told investors of the concentration of risk long before the housing market started to fail. Pyxis continued to help Merrill’s CDO business long after the risks warranted and that translated into large profits and bonuses for Merrill employees, in 2006. This was the same year that AIG stopped underwriting the CDO market, but Merrill was doing great--they paid more than $5 billion in bonuses that year, one year later they filed for bankruptcy. Complicated or not, the motives and the resulting bankruptcy's are now better understood. I wonder if Merrill's exec's thought they were the smartest people in the room too.
