by Tanta on 6/30/2007 09:55:00 AM

Lord help us. We're beginning to get some detail on just what Brookstreet's clients were buying. From the OC Register:

The securities, called Collateralized Mortgage Obligations, are backed by pools of residential mortgages. Most CMOs are safe, paying investors principal and interest drawn from thousands of mortgages.

But 30 Brookstreet CMOs reviewed by the Register were more complex than most CMOs. Their structures expose investors to losing or gaining money following tiny fluctuations in interest rates. As such, they are difficult to value. Most are "interest-only strips," which pay investors the interest stream but no principal from mortgages.

Brooks said the accounts collapsed because the clearing firm, a subsidiary of Fidelity Investments, used what are called "notional values" to price the CMOs. Those values plummeted as confidence plunged in mortgage-backed securities to subprime home loans.

"We never had a performance issue," Brooks said of the CMOs. "We had a notional pricing disparity."

These jokers were selling IO strips to retail investors?

For those of you playing along at home, here's a quick definition of the IO strip (and the yin to its yang, the PO strip) from SIFMA:

Principal-Only (PO) Securities.

Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. These Principal-Only (PO) securities may be created directly from mortgage pass-through securities, or they may be tranches in a CMO. In purchasing a PO security, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments.

The market values of POs are extremely sensitive to prepayment rates and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop. A companion tranche structured as a PO is called a “Super PO.”

Interest-Only (IO) Securities.

Separating principal payments to create PO mortgage securities necessarily involves the creation of Interest-Only (IO) securities. CMOs that have PO tranches will therefore also have IO tranches. IO securities are sold at a deep discount to their “notional” principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value. As the notional principal amortizes and prepays, the IO cash flow declines.

Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently, they are often used to “hedge” portfolios against interest rate risk. IO investors should be mindful that if prepayment rates are high, they may actually receive less cash back than they initially invested.

Issue number one: all IOs have a "notional value" by definition. This has exactly jack to do with sinister manipulation of pricing by some nefarious model. The "notional value" of an IO strip will change, just as the face value of a PO strip will change, as payments and prepayments of principal are made on the underlying mortgage loans.

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.

Brooks said clients who paid the full price for their CMOs – and other financial products – still have money in their accounts, which will accompany his former brokers to whatever new jobs they get.

What?

SEC filings said Brookstreet managed $571 million for 3,644 clients.

Although he served as Brookstreet's president, Brooks said Friday he was not responsible for overseeing the company's trades, which relied on a network of 650 independent brokers nationwide.

In March 2005, the National Association of Securities Dealers suspended Brooks' securities license for two years for inadequate supervision of trades. Last week, Brooks' license was suspended again, this time for 60 days, because of failures in record keeping.

That must be why it's all the clearing firm's fault.

(thanks again, risk capital!)