How one of the top 25 Independent firms went under in an epic failure of management; an unfortunate example of what can go wrong when business seems to be going right.
Aug 1, 2007 12:00 PM, By John Churchill
Stanley Brooks was living the dream. With a $16,000 investment in 1990, Brooks built Brookstreet Securities of Irvine, Calif., into a $150 million revenue firm — placing it among the top 25 independent broker/dealers. By 2007, the firm had amassed $8 billion in client assets and 680 registered reps. Along the way, Brooks picked up some black marks — nine regulatory “disclosures” on his U4, eight of which were related to supervisory failures. But Brookstreet continued to prosper anyway: “We never had a bad year,” Brooks recalls.
Nonetheless, Brookstreet couldn’t dodge the bullet this time. In what will most surely go down as a colossal failure to supervise (among other potential regulatory violations) and a series of actions motivated by greed, Brookstreet Securities is dead. Its assets were blown on multiple margin calls, its reps were suddenly forced to jump to other firms and perhaps dozens of retail clients were decimated by a risky, complicated investing strategy. As few as five to 10 reps may have been involved, according to one lawyer who is himself representing 30 to 40 disgruntled Brookstreet clients.
Indeed, Brookstreet will probably be remembered as a b/d that was too aggressive, too greedy, too stupid and perhaps even grossly negligent in the way it ran some of its clients’ money. The thing is, when a complicated trade works, and a handful of brokers and their clients are quite literally printing money, some brokers just go for it. The mastermind behind the trades at Brookstreet, a man with a checkered past (see sidebar pg. 34), was living so large that even otherwise clean and prudent reps decided to play the odds, says one observer with knowledge of the case.
In the month since the firm collapsed, regulators have been crawling over Brookstreet headquarters, collecting books, records and trying to find out which rules (if any) Brookstreet reps broke. Along with some individual brokers, Brooks, his reputation and any remaining assets he may have will soon be under attack from the dozen or so law firms trolling for injured Brookstreet clients, several of whom have been described as modest, risk-averse retirees and pre-retirees. The question becomes, how many other broker/dealers are sitting on significantly devalued (or even worthless) securities? Can an individual rep even know what risk other reps may be taking that may potentially damage his firm? One thing is certain, it’s not too often that a broker/dealer goes belly up on bad trades.
DEATH BY CMO
Brookstreet’s sudden change of fortune started on June 14 when an unknown number of institutional and individual customer accounts got hit with margin calls from Brookstreet’s clearing firm, National Financial Services, a unit of Fidelity Investments. The calls were related to investments in collateralized mortgage obligations, many of them in high-risk varieties called “inverse floaters” and “interest only strips,” which had suddenly been priced down, an inherent risk carried by the instruments. The re-pricings resulted in significant devaluations for many of the investors, some of whom had borrowed as much as 90 percent of their total investment from NFS.
Cliff Popper, Brookstreet firm’s top producer, the man who built the CMO program and managed those heavily leveraged portfolios, resigned earlier in June when, according to Brooks, he asked Popper to help him liquidate some customers’ CMO positions. By June 22, Brooks had spent his firm’s entire net capital of $12 million to meet a margin balance. In fact, after reducing margin exposure by 80 percent, “That still left a $70 million margin balance against $85 million of value,” Brooks said in a letter to brokers. Of course, that $85 million was being revalued downward even as he was writing the note, he indicated in the letter. He also warned: “I have told many of you that you are always in danger of not being paid on your last check when working for any broker/dealer… I will try to get enough money from our account at NFS to complete our upcoming payrolls.” Brooks, whose company motto was “press on and never give up,” was forced to close the firm. In the end, he says he still owed NFS $2.5 million; regulators, lawyers and investors are now left to clean up the mess.
What happened? “It’s pretty typical for a regional b/d trafficking in this stuff that’s over its head to lose its shirt,” says a trader at one of Wall Street’s large mortgage trading shops. He’s referring to 1994, the last time the CMO market collapsed, when firms like Piper Jaffray and Alex. Brown lost millions in CMOs and CMO derivative investments. “People see Triple A-rated and think, ‘Oh, how bad can it be?’” he says. (Because CMOs are agency backed, their various tranches, which have completely different risk profiles, retain their triple A rating.) But investing in this area is tricky and complicated. “It’s all about the timing of cash flows, which are dependent on mortgage prepayments, and there’s a very complex system of inputs to determine what those are,” he says. In other words, most reps don’t understand how the investment works — let alone the risk involved — and therefore neither will their clients. The sale of these products to Brookstreet’s retail clients was wrong, he says. “Is an inverse floater CMO a retail product? If I were a compliance guy, no way,” he says.
Collateralized mortgage obligations, first introduced in 1983, are not considered inherently risky investments, but CMO derivatives are. There were between 45 and 75 brokers selling “regular” CMOs to some portion of Brookstreet’s 88,000 customers, according to Stan Brooks. That represents roughly 10 percent of the reps at Brookstreet, most of whom “were insurance and mutual fund guys,” in the words of one rep. But all 680 of them suddenly lost their jobs on June 22. Beyond plain vanilla CMOs, an unknown number of those 75 brokers — some say as many as 10, including some of the firm’s top producers — were also selling “inverse floaters” and “interest only strips,” especially volatile classes of CMOs, which were made even more risky because they were sold on up to 90 percent margin. And yet, the securities were being sold to retail clients as Triple-A-rated instruments offering guaranteed returns with no risk to principal, says New York attorney Stuart Meissner who is representing several Brookstreet clients.
According to Brooks, the CMO business, which was little more than three years old, accounted for 10 percent of monthly firm-wide revenues, which were averaging $14 million to $16 million per month. It was good business — and not just for the firm, he says. Clients in the program were seeing returns in the seven to eight percent range, with up to 14 to 16 percent for some, primarily those who’d stuck it out and reinvested in the program, Brooks says.
What’s A CMO?
A CMO is a security made up of pools of home mortgages backed by U.S. government-sponsored agencies like Freddie Mac and Ginnie Mae. Each pool generates two streams of income: one from the aggregate of the interest payments, the other from the aggregate of the principal payments made on the mortgages. These income streams are divided into “tranches,” which are the securities sold to investors.
In a “Compliance Alert” issued around the time Brookstreet was collapsing, FINRA warned members about improper CMO sales to retail customers. Citing “several examinations of broker/dealers,” the regulator said it found that the b/ds “had sold some of the most complex and riskiest classes of securities to their retail customers.” The alert also mentioned that investors had received misleading sales literature (or no disclosure at all) and unsuitable sales recommendations, and warned that adequate supervision of sales materials and sales practices was lacking.
One of the risks associated with CMO derivatives like inverse floaters and interest-only strips — both of which were sold to Brookstreet clients — is that their value fluctuates wildly with small moves in interest rates. They’re also illiquid. For these reasons, most independent b/ds don’t touch these securities.
But Brookstreet found out there’s another major risk with these types of investments: Pricing can be guesswork. Brooks blames the re-pricing of the bonds, an occurrence he says was monthly before June 14, when it became daily, for the collapse of his firm. “I still don’t know why the pricing model changed,” says Brooks who admits to not totally understanding the IDC pricing service NFS uses to price the CMOs. “Did the investment stop paying interest? Principal? No, it didn’t. There may be a lot of smart guys out there that may tell me I’m wrong about this one day, but to my understanding it’s the re-pricing that caused this,” he says.
But like any investment, of course, “pricing” risk, to use Brooks’ term, is always there, especially with derivatives amped with leverage. “With stuff like inverse floaters, guys only get them marked once a month and often by a pricing service, not by a real b/d,” says the same trader that called the CMO derivatives non-retail investments. “So it’s an extrapolated price. In a volatile market, the pricing service’s value may be very different from what you would realize if you needed to get out of a position right away,” he says.
NFS’ decision to re-price may have stemmed from general concern regarding mortgage-related investments. It was that same week in June that Bear Stearns suffered multi-billion dollar losses in two of its hedge funds: the aptly named “High Grade Structured Credit Strategies Enhanced Leverage Fund,” and the “High Grade Structured Credit Strategies Fund.” Both funds’ losses were magnified by 90 percent margin leverage. Brooks says the market pressure created by the Bear Stearns news made Brookstreet’s losing positions in an illiquid market that much harder to offload. Asked why the firm re-priced the securities, NFS spokesman Adam Banker would not say anything further than “we are not responsible” for what happened at Brookstreet, and that client margin lending obligations are clearly laid out in their contracts.
WHO WILL GET SPANKED?
Whether the brokers who sold retail clients risky CMOs violated suitability requirements or misrepresented the investments, or whether inappropriate amounts of leverage were used will come out as regulators and plaintiffs’ lawyers begin to present their cases. Sam Edwards, a Houston attorney with Shephard Smith & Edwards, says his firm is representing 30 to 40 former Brookstreet clients that allege all kinds of wrongdoing on the part of between five and 10 Brookstreet brokers. That list of brokers includes Popper, the mastermind of the strategy (see sidebar) and Barry Kornfeld, a principal in a group of Brookstreet reps in Coral Gables, Fla., called The CMO Bond Group. Neither Popper nor Kornfeld returned calls for comment.
Meissner, who has fielded many calls from former Brookstreet clients, says his clients’ complaints relate to “three or four brokers.” He says most of his clients are reporting losses between $200,000 and $400,000. “None of these people were rich,” he says. Meissner says all of his clients have told him virtually the same thing: their broker sold them the CMO investments as triple-A rated bonds with no risk to principal, and a guaranteed 10 percent return. “That’s the story, no matter where the client is from,” says Meissner, who says fluctuations in price were explained to clients as temporary.
One client, who lost his entire initial investment of $200,000 — all of his liquid assets, according to Meissner — was invested in a portfolio of 14 CMO bond positions, half of which were “inverse floaters” or “interest only strips,” and on 80 percent margin. “This client says he told his broker he wanted an investment that was safe and secure,” says Meissner, who adds that the Brookstreet rep assured him it was. One of the seven inverse floaters his client owned showed a current face value of $3,117,610.92, as of April 30. But, the estimated current market value was only $108,991.68, according to the client’s statement.
Brokers at wirehouse firms contacted repeatedly told Registered Rep. that they stayed away from such investments with clients because the “risk wasn’t worth it.” A top Smith Barney broker that used his Bloomberg station to look up the CUSIP number of the bond mentioned above had this to say upon reading its description: “That’s a bond with a lot of hair on it. You’re in an area here that 98 percent of your readers don’t dabble in, thank God.” He quoted Warren Buffett for emphasis: “Derivatives are what you get when you combine MBAs and ignorance,” and “You never know who’s swimming naked until the tide goes out.”
THE “GENIUS” BEHIND BROOKSTREET’S CMO BIZ
The man who built Brookstreet’s CMO business, managed the portfolios and basked in the glory of being Brookstreet’s top producer was Cliff Popper, a Boca Raton-based broker with a rather active U4. It shows 13 firms in the 15 years prior to joining Brookstreet in 2004. According to an old boss of Popper’s who spoke on the condition of anonymity, the 37-year old Popper had done very well for himself and clients by investing in CMOs and CMO derivatives like inverse floaters and interest-only strips. Besides driving a BMW Z8 and owning a skybox at Miami’s Dolphin Stadium, according to one source, Popper was also rumored to be producing $1 million a month in revenue while at Brookstreet. He was “clever,” says his old boss. Because interest rates were declining or stable for so many years, investors in CMO derivatives juiced with leverage made a lot of money, he says.
But Popper didn’t know when to walk away, says his former boss. It was Popper’s penchant for leverage that eventually made him unwelcome at his firm, as well as other firms Popper later joined, he says. When Popper was working for him, he says he asked him to reign in his leveraged positions in CMO derivatives and, when Popper resisted, he was asked to leave.
Despite working in the buttoned-up world of financial services, Popper’s private life appears to have been anything but. In fact, he is something of a ladies man — or was, on his MySpace page, anyway. The page, which he made private soon after it got the attention of regulators, attorneys and Registered Rep., included a “friends” page chock-full of bikini and thong-wearing women posing (mostly from behind), lying down, bent over or embracing other women. Scrolling down the page several half-naked cartoons danced around the page to a song laced with sexually-explicit lyrics. An SEC official who was asked if he’d seen the page laughed sheepishly, said yes, then said that the SEC is not interested in anything that doesn’t provide facts about Popper’s involvement in Brookstreet’s demise. But he did call the site an aspect of his “character.” Enough said