The US Securities and Exchange Commission (SEC) has stepped up its inquiry into Merrill Lynch's accounting of its sub-prime mortgage investment portfolio at the same time as federal prosecutors have opened a criminal investigation into the Wall Street firm.

The SEC had been scrutinising Merrill Lynch informally since October to establish whether the brokerage knew more than it revealed to shareholders about the value of its sub-prime investments before announcing its third-quarter results. The regulator is thought to have established that Merrill Lynch may have a case to answer, and so it has initiated a formal investigation. This gives it the power to subpoena documents from companies not registered by the SEC and to compel their employees to testify under oath.

The SEC can already force brokers and dealers, such as Merrill Lynch, to comply with its investigation because they are registered. It will now be able to secure key evidence from those unregistered parties with whom Merrill Lynch did business. The regulator is a step closer to filing a civil case against the firm and, possibly, some of its executives. This could result in penalties such as a fine of several hundred million dollars for Merrill Lynch and the banning of executives from the industry.

In a further sign that the legal screws were being tightened on Merrill Lynch, it emerged yesterday that federal prosecutors had opened a preliminary investigation into the group's sub-prime valuations. The Manhattan branch of the US Attorney's office, which has the power to bring criminal cases, has notified the SEC that it wants to see the evidence that the regulator gathers in its investigation of the firm.

The US Attorney's office, which is part of the Justice Department, the SEC and Merrill Lynch all declined to comment on the investigations, although a spokesman for the Wall Street firm noted that it always co-operated on regulatory matters.

The SEC and the Justice Department investigations both centre on disclosures that Merrill Lynch made to its investors in October. The bank gave warning on October 5 that it faced a writedown of about $5billion (£2.6billion) in the third quarter relating to collateralised debt obligations — pools of bonds and other securities — and loans to back leveraged buyouts. On October 24 Merrill Lynch announced that, in fact, it had taken an $8.4billion writedown for the period, giving the firm what, at the time, was the largest quarterly loss, of $2.2 billion, in its 93-year history. However, that loss was dwarfed in

the fourth quarter, as Merrill Lynch recorded more than $16billion of writedowns related to the credit crunch, leaving the group with an overall loss of $9.8billion for the period.

The investigations into Merrill Lynch are only a portion of multiple cases being built against the firm and its competitors. The city of Cleveland, Ohio, is suing 21 Wall Street firms, claiming that they encouraged mortgage lenders to keep making loans to people who could not afford them by buying even the most suspect of them and packaging them into bonds.

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