As we noted earlier, a minor casualty in Bear-Stearns-hedge-fund-meltdown-induced repricing of CMOs was a mid-sized, independent-contractor broker-dealer Brookstreet Securities, which blew a hole in its balance sheet when its clearing firm repriced the assets in many of its margin accounts and issued margin calls.
Tanta at Calculated Risk found out (via the OC Register) why things deteriorated so quickly: the firm was playing with CMOs that had invested in interest-only strips. To put it politely, they are volatile even under the best of circumstances:
The OC Register story does not tell us what the vintage was of these CMOs, but I’m sure readers of this blog can imagine that IO strips of mortgage-backed securities originated in the period from about 2002 to last quarter had pretty darned fast prepayment speeds. Us insiders call that a “refi boom.” A “refi boom” is one of those things in which buying IO strips can bite you in the ass. In any case, while there’s a lot of rocket science in the CMO business, calculating the notional balance of an IO strip isn’t all that hard: original notional balance minus prepayments of principal equals less notional balance for you to earn interest payments on. Your problem in this circumstance is not that the balance is “notional.”
That is why these things are known as sophisticated hedge vehicles and are never, ever sold to retail investors on margin. Unless, apparently, you’re Brookstreet. After all, it’s probably quite true that they “never had a performance issue.” You do not lose your shirt on an IO strip because of principal losses. You lose your shirt because enough of those underlying loans are high-quality enough (or enough refi lenders are low-standard enough) that the damned things prepay.
The latest update is that some of the buyers of this risky paper were Florida retirees, just about the last people who ought to be holders. From the Sun Sentinel:
Dozens of South Florida senior citizens have lost millions of dollars of their savings because their brokers bet wrong on risky mortgage-backed securities after promising them a stable investment.
Coral Springs lawyer Darren Blum said Tuesday that his firm is representing about 25 investors who had invested $20 million with Brookstreet Securities, a California firm that has brokers in at least a half-dozen South Florida offices. Many investors are planning legal action to recover their losses, and for damages and attorney’s fees.
‘We’ve had people in their 80s in here in tears,’ Blum said. ‘These people are devastated.’
The seniors invested in securities called collateralized mortgage obligations, or CMOs. Some independent brokers working in Brookstreet offices pitched the CMOs to wealthy seniors at dinner seminars and condominium meetings.
‘They presented these as very safe, like a bond, paying 7 to 8 percent,’ Blum said. The CMOs the brokers invested in, however, were complex and highly speculative, he said.
Brookstreet has said the money was lost in part because of too much securities trading on margin, or borrowed money. The value of the CMOs declined, Brookstreet said, as the so-called subprime mortgage market worsened.
The margin losses mean that investors not only lost their funds, but could owe money that was borrowed to trade in their accounts. Blum said he talked with one client Tuesday who has about $12 million in margin losses.
I guarantee these seniors had no idea they were buying on margin. I’m sure anyone reading this blog already knows this full well, but never, never, never let a broker trade your account. Make sure all your elderly relatives follow that rule.