The Collapse of Brookstreet Securities

June 25, 2007 – The terse Reuters announcement this past Friday contained only 101 words.

Brookstreet Securities Corp., an Irvine, California broker-dealer, closed its doors on Friday after heavy losses in the collateralized mortgage obligation market, terminating at least 650 independent brokers, the firm’s president said.

Brookstreet President Stanley Brooks said the firm faced heavy markdowns over the last two weeks in its CMO investments held in margin accounts and was forced to close.

Brooks said the firm had a value of about $17 million at the end of May which has evaporated. He said he turned down several tentative offers to recapitalize the firm.

“I am flabbergasted,” said Brooks, 59. “My life’s work is gone.”

You probably never heard of Brookstreet. Most people haven’t, and fewer still will probably hear of its unfortunate demise. Yet the collapse of this little-known broker-dealer is significant, with profound implications for its larger Wall Street cousins. Here’s why.

An internal email sent to Brookstreet’s brokers and employees blamed its clearing firm, National Financial Services, and too many accounts on margin for the collapse, according to InvestmentNews.com. “Today, the pricing system used by National Financial has reduced values in all Collateralized Mortgage Obligation,” the e-mail said. “Many of those accounts were on margin and suffered horrendous markdowns and unrealized as well as realized losses. National Financial and the regulators expect Brookstreet to pay for realized liquidated losses and take a capital charge for unrealized (mark) to market losses.”

The key part of this statement is just the first word: “Today“. The problems in the CMO market have been front page news for months. Why is National Financial only now getting around to a realistic pricing of CMOs?

For those of you not familiar with the name, National Financial, is not some obscure and unimportant firm from Podunk. It is an important subsidiary of financial giant Fidelity Investments, and according to its website “offers Integrated Brokerage Solutions to 344 clients ranging from retail broker/dealers to institutional investment firms. Collectively, National Financial’s clients have more than 86,000 brokers. As of March 31, 2007, National Financial custodied more than $670 billion in assets representing more than 5.4 million customer accounts.” Well, they now have 343 clients because Brookstreet is no more.

The obvious question is how many other firms are going to be hit the way Brookstreet has been hit? There is also another critical question. How is it possible that National Financial had not been using realistic pricing of CMOs given the well publicized problems that have been developing, particularly in the subprime mortgage market?

The first question is unknowable at this stage. It seems highly likely though that other firms will also be surprised by the new valuations National Financial is applying to CMOs. After all, Brookstreet was hit by a bolt out of the blue, seemingly unprepared and unaware of the onslaught coming its way. If a relatively small firm like Brookstreet held CMOs in customer margin accounts, no doubt larger firms did too. Whether these larger firms were prepared or not – and possess the financial resources to meet their margin calls – remains to be seen.

We can answer the second question though. I do not think National Financial is at fault here. CMOs are highly complex securities that come in many shapes and sizes with different levels of credit risk. So the pricing of these securities is very problematic. They are worth only what someone is willing to pay for them, but these securities do not trade in a recognized market with transparent pricing and high liquidity.

Consequently, it is very difficult to determine the true (i.e., the liquid value) of these securities. Therefore, the price of many of these securities has not accurately reflected prevailing market conditions. Recently though, their pricing has become more transparent, and as the Reuters article notes, the markdowns on the CMOs in Brookstreet have occurred over the “last two weeks”. This time frame is significant.

For the past two weeks two hedge funds managed by Bear Stearns that invest in CMOs have been teetering on the brink of collapse. It seems that these two funds controlled mortgage-backed assets with a nominal value of $20 billion on $2 billion of equity. Thus they had borrowed $18 billion, giving the two funds a relatively high and therefore potentially dangerous leverage of 9-to-1. The value of the funds’ assets is unclear, but to prevent a liquidation of the fund and a fire-sale of its assets, Bear Stearns reportedly has added $3.2 billion of capital, satisfying – at least for now – the demands of the funds’ creditors for more collateral to make up for the diminishing value of the funds’ assets.

What’s clear from the reports about these Bear Stearns hedge funds is that the value of their assets has not been determined by realistic pricing. In other words, the funds’ assets were overvalued and did not reflect the ongoing meltdown in the price of securities backed by mortgage obligations.

As a result, firms like National Financial are beginning to better understand and become more aware of the risks of these complex securities, so they are now applying a more realistic pricing to CMOs. And it is this reassessment of these risky securities and their re-pricing that quickly undid Brookstreet, which leads to another important question.

Why didn’t Brookstreet just sell the CMOs and raise the cash it needed to keep itself solvent?

Here I am only speculating because neither Brookstreet nor National Financial has disclosed any details. But it appears that the implied value of the securities as determined by National Financial fell faster than either firm was able to find a buyer for them, thus leading to the margin call which Brookstreet was unable to meet.

Collapses typically have some knock-on effect as they send fear and sometimes panic through the financial scene. For example, the collapse of a little known firm called Drysdale Securities in 1982 was within weeks followed by the collapse of Penn Square Bank of Oklahoma, which in turn was one of the torpedoes that eventually sunk Continental Illinois, which at the time was the nation’s sixth largest bank. It succumbed to a run by depositors fearful that their money was at risk.

It is too early to tell today whether another large bank is at risk. But the ripple effect from the subprime mortgage collapse is spreading further.

The first consequence of the collapse was the scores of lenders who went out of business because investors stopped buying the subprime securities the lenders were issuing to raise the funds they needed to make subprime loans. Now the investors who have purchased subprime mortgage-backed bonds are taking losses.

Brookstreet is the first firm to fail, and in all likelihood, more (and perhaps many more) will follow it to the graveyard. While the two hedge funds managed by Bear Stearns appear to have been given a reprieve by their creditors, we can only speculate at this time who will be next, but one thing seems clear. So far we have only seen the tip of the iceberg.