The late Mark Pittman told me this a year and a half ago about the fraud at the heart of the financial crisis:

PITTMAN: The reporters who didn’t question the tight, tight spreads [the narrow difference in interest rates offered by Treasury bills and other, less secure instruments] that were going on in corporate [bonds], it was wrong. Where is this demand coming from? How can you guys sell this issue in thirty minutes? Who the hell’s buying this stuff like that? We’re going to come to the answer that it was going off balance sheet, at least temporarily, and then it might be sold to other customers.

THE AUDIT: So they were buying it themselves and…

MP: They were buying it themselves. Yeah. And not every deal. But you know what—it happened enough.

The New York Times today gets in on this with an important piece by Louise Story on how Merrill Lynch, the biggest of the big toxic-waste factories, churned out CDOs by feeding them to itself.

It’s not very well edited. There’s way too much throat clearing up top before we get to the meat of the story, which begins in the seventeenth paragraph. And, alas, the Times shortarms what it’s got and missed a key part of the story, as we’ll see below. This is a critically important story, but it doesn’t make the front page. It could have and should have.

Basically, Merrill Lynch misled its investors and everyone else about what it was doing in the subprime market. In 2006, things really got out of hand in the mortgage market. So much so, that AIG, which had enabled the market by issuing insurance on the CDOs, quit issuing those credit default swaps early in the year.

But somehow the gravy train kept going. And that’s where you can bet the real scandals are. Magnetar was apparently the biggie here, as reported by The Wall Street Journal, Yves Smith, as well as ProPublica (and if you really want to understand this complex tale, listen to Alex Blumberg’s fantastic This American Life collaboration with Jesse Eisinger and Jake Bernstein right now). Just as the mortgage market was deflating in 2006, that hedge fund bought up the riskiest slices no one else would touch—so the CDOs would still get churned out and it could bet against them. It made billions.

Merrill couldn’t offload all the CDOs it was creating. But its rapacious greed meant that it figured out a way—any way—to keep cranking them out. When Merrill couldn’t offload the risk to dumber money, it created off balance sheet vehicles to house the toxic assets and used accounting tricks to count them as sales.

It created vehicles called Pyxis, Steers, and Parcs to buy the stuff itself without “really” buying it.

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.

So Merrill was creating toxic assets, trying to sell them to dumb money, and then putting them off balance sheet as a last resort. That last resort ended up becoming a primary resort, apparently, as we saw when the CDOs nearly sank the bank two years later.

Why did it do this? Because the folks making the CDOs got tens of millions of dollars in fees for creating them. That increased these folks’ bonus pools bigtime. They made their money and crippled the bank (not to mention the financial system and the economy).

Speaking of Magnetar, it was involved here, but the Times flat misses that connection. Yves Smith and Tom Adams heavily criticize that and other elements of the piece. Much of that criticism is way over the top, but the Magnetar aspect is indeed a serious miss:

A simple Google search of “Pyxis” and “CDO” turns up not only the Magnetar connection, provides links to deal lists (ours, recapping and adding to our discussion in ECONNED and ProPublica’s), which show that there was not one Pyxis deal, as the story suggests, but two, a Pyxis 2006-1, issued in October, 2006 with Calyon as the underwriter (that deal is not the subject of this article), and the deal in which Merrill provided assets, Pyxis 2007-1, issued in March 2007, with Lehman as the underwriter. She also fails to mention Putnam, the CDO manager for the Pyxis deals, anywhere in the story or indicate that Magnetar’s CDO deals were being put together by an analyst they hired from Putnam.

(UPDATE: Felix Salmon points out that the Magnetar connection isn’t there. There were similarly named CDOs that had nothing to do with Merrill’s off-balance-sheet doings.)

I imagine there’s more thread to be pulled on this one. It’s good, if not exactly confidence-inducing, to hear that the SEC is investigating this stuff. I won’t hold my breath. But where’s the Financial Crisis Inquiry Commission on this?


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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.