Merrill Lynch & Co. (NYSE:MER) may face heavy fines and prosecution from regulatory authorities after reports surfaced that the firm may have been hiding its losses from investors through a series of transactions resembling the network of lies at Enron. Sources say that Merrill may have hidden its exposure to risky mortgage-backed securities by selling commercial papers through related entities that it agreed to repurchase in a year at a premium.

One of the deals being discussed was a $1 billion commerical paper sale by a Merrill-related entity containing mortgages. The hedge fund who purchased the papers had the right to sell back the paper to Merrill after one year for a guaranteed minimum return. Since the liabilities were never transferred, this transaction should have been reported to shareholders who could then account for them on Merrill's books. But instead, they were hidden for a year.

The issues never came to light until now after Merrill was forced to take a $7.9 billion write-down fueled by mortgage-related issues. Some are projecting that next quarter the firm will be forced to write-down $4 billion more in the fourth quarter after a combined $8.4 billion loss this quarter. Merrill still appears to be making its rounds with hedge funds, however, in an effort to reduce their exposure. But presumably, they will be a little more careful now as regulators begin to take a look into their activities.

In the end, Merrill is in a world of hurt that could get worse if regulators find that the firm took illegal actions to hide its risky mortgage exposure from shareholders and investors. The firm is not likely to close as a result of these allegations, but shares could see even more downside pressure. Combined, these factors make MER a stock worth watching!

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