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Merrill Hit With Fraud Charges - Forbes.com

Merrill Hit With Fraud Charges
Liz Moyer, 02.01.08, 3:40 PM ET

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Liz Moyer
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Wall Street is starting to face recriminations for its role in the credit crunch.

Massachusetts securities regulators filed fraud charges against Merrill Lynch (nyse: MER - news - people ) Friday, accusing the bank of selling "unsuitable" and now practically worthless collateralized debt obligations (CDO) to the city of Springfield, Mass.

The charges come a day after Merrill agreed to buy back the CDOs, paying Springfield the $13.9 million it had invested last spring. Merrill acknowledged Thursday that the city had not expressly approved the purchase. The investment bank said Friday the problem was not widespread, but rather a sales practice issue, and unique to the Springfield situation.

"We are puzzled by this suit," a Merrill spokesman said Friday. "We have been cooperating" in the inquiry.

Regulators are scrambling to get a handle on the subprime mortgage crisis, which has rippled through the financial system and now threatens the broader economy. At issue are billions of dollars worth of credit derivatives chock full of subprime mortgage debt that were packaged and sold by Wall Street to investors like the town of Springfield. When the subprime sector blew up, the underlying debt of those complex securities cratered and dragged down the value of the derivatives.

Many are pointing fingers not only at the banks that packaged and sold the bonds, but the ratings agencies that signed off on triple-A ratings for securities that have collapsed in value. And some are starting to question why the Securities and Exchange Commission (SEC) hasn't taken a more active role in policing the structured finance business.

Earlier this week, the Federal Bureau of Investigation disclosed it had opened criminal fraud probes into 14 companies over their mortgage securitization activities, which is everything from originating loans to buying them, packaging them and selling them to investors. The FBI didn't identify the companies.

Connecticut and New York attorneys general have also opened investigations into how Wall Street structured and sold mortgage-laden securities.

Separately, Goldman Sachs (nyse: GS - news - people ), Morgan Stanley (nyse: MS - news - people ) and Bear Stearns (nyse: BSC - news - people ) have disclosed in their recent regulatory filings that they have been questioned by multiple regulators about their activities involving subprime mortgage securities. In November, Merrill Lynch said the SEC had initiated an inquiry into its subprime mortgage portfolio. All the banks have said they are cooperating.

Wall Street banks, which enthusiastically pushed the securitization business to record levels in the last two years, got stuck holding billions of dollars worth of mortgage-related securities and derivatives that declined sharply in value in last summer's subprime meltdown. So far, the biggest banks, Merrill among the most exposed, have written down more than $100 billion worth of their holdings.

Investors in the securities are left holding near-worthless paper. Springfield, Mass., town leaders hired Merrill Lynch in Nov. 2006 to invest surplus cash. Merrill invested $13.9 million in three CDOs, the largest investment being $12.6 million put into a CDO that had been underwritten by Merrill.

Massachusetts' securities regulator says the Merrill representatives working with the city didn't discuss the risks of owning CDOs.

The value of the holdings started to plummet in the fall when the credit markets froze up and buyers of complex securities disappeared. The city of Springfield asked that the positions be sold, but were told there were no buyers. By December, the $12.6 million CDO investment had been reduced by 95%.

In agreeing to buy back the investment Thursday, Merrill said. "We are making the city whole, and we have taken appropriate steps internally to ensure this conduct is not repeated."

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