This investigation, reported by the Wall Street Journal, comes after Merrill Lynch revealed a stunning $8 billion in mortgage-related losses, leading to the ouster this week of CEO Stanley O'Neal.
The Journal reported Merrill Lynch struck deals with hedge funds to take certain positions that did not transfer risk, but merely delayed when Merrill Lynch would have to disclose its exposure to that risk.
For example, the Journal said, Merrill engaged a hedge fund to lend a "Merrill-related entity" $1 billion. This normally means the hedge fund would assume the risk of the Merrill-related entity failing to repay debt. However, Merrill guaranteed it would buy the loan a year later. Thus, Merrill assumed the risk without reporting the company's exposure on its own books.
The Journal reported Merrill has been seeking help from hedge funds in shifting as much as $5 billion in bonds backed by mortgages under a "mitigation strategy."
"Yes, they're trying to hide it from investors - I mean, that's the incentive," Sean Egan of Egan-Jones Rating Company told CBS News correspondent Anthony Mason. "Is it illegal? Time will tell."
"But if the facts are as bad as the Journal has suggested, this could be the same kind of fraud that we saw Enron practicing 5 years ago, when they also parked assets, ironically with Merrill Lynch," said professor John Coffee of Columbia Law School.
SEC spokesman John Nester in Washington declined to comment and would neither confirm nor deny that the agency was investigating.
In a statement today, Merrill Lynch said it has "no reason to believe that any such inappropriate action occurred," adding it "would clearly violate Merrill Lynch policy."
The bank's stock plunged more than 11 percent to $55.14 in midday trading Friday. The stock sank as low as $55.03, the cheapest trade since July 2005. The stock is down 40 percent for the year.
Merrill Lynch stunned Wall Street last month when it reported $7.9 billion in mortgage credit costs for the third quarter. Not only was this charge easily the biggest among Wall Street's banks related to the mortgage crisis, it was more than three-quarters higher than the cost Merrill Lynch had estimated just three weeks earlier.
Deutsche Bank analyst Mike Mayo cut his rating on Merrill Lynch's stock to "Buy" from "Hold," saying he is not sure he can rely on the financial statements of a company that "may have engaged in questionable private transactions."
During the third quarter Merrill curtailed its exposure to a risky type of investment called a collateralized-debt obligation to $15 billion from $32 billion. Because the bank only wrote off $6 billion of the exposure, Mayo said he wonders what happened to the "missing" $11 billion.
But the company's problems could get even worse. Merrill & Citigroup could each suffer another $4 billion in mortgage-related losses this year, according to one analyst's forecast. That would bring their total losses to $12 billion and $10 billion each.
And the damage to the financial industry?
"It's in excess of $400 billion dollars," Egan said.
That would make it bigger than the savings & loan crisis of the 1980s.
Meanwhile, Citigroup reportedly has called an emergency board meeting for the weekend. Speculation is that Charles Prince, CEO of the nation's largest financial company, could be the next to be fired.