Mortgage Meltdown Hits Main Street

While Bear Stearns scrapes together $3.2 billion to bail out proprietary hedge funds that were overexposed to some troubled subprime mortgage investments, the same bad act is playing out on Main Street.

Only this time, no one is coming to the rescue.

Brookstreet Securities, an independent broker-dealer in Irvine, California, is in hot water over investments in collateralized mortgage obligations. These C.M.O.'s are mortgage-backed securities that are usually bought and sold by institutions. They are cousins to the collateralized debt obligations, or C.D.O.'s, at issue in the Bear Stearns debacle.

The roughly 500 independent brokers affiliated with Brookstreet received an email yesterday that began: "Disaster, the firm may be forced to close."

The email was unsigned, but a Brookstreet executive confirmed its authenticity to Reuters.

It appears that a big portion of Brookstreet's investment in C.M.O.'s was made on margin -- that is, with borrowed money -- and the value of the securities has plummeted in recent weeks.

According to the email, the firm went from having a positive net capital balance of $11 million at the end of May to a negative $2.1 million balance on Friday.

The firm needs at least a $5 million infusion to be compliant with securities regulations. It is prohibited from buying any new securities at this point.

But the problems really only begin there. It turns out that Brookstreet brokers had been selling the risky C.M.O. investments to their average Joe investor clients.

Sam Edwards, a securities attorney with Shephard, Smith and Edwards, says his firm has already talked to "two dozen investors from many different states" who claimed to have seen their account balances wiped out.

Some lost in the tens of thousands of dollars, while others may have lost millions. His firm plans to file a class action suit next week.

Edwards says some investors knew they were buying C.M.O.'s and others claimed that their brokers illegally made trades in their accounts by buying them without their knowledge. Some of the investors are retirees who thought they were buying stable, income-generating investments.

Perhaps the most troubling part of the scheme is that they borrowed 90 percent of the cost of the investments, and put just 10 percent down. That is significantly higher than the 50 percent margin requirements for most securities.

"They took a terrible investment idea and made it into a horrific investment by using all margin," Edwards says. "It's about as unsuitable as it can get."

Right now, Edwards is trying to understand exactly how these retail investors, sometimes unwittingly, ended up holding the bag on the distressed debt that's usually traded only by institutional investors.

Did the brokers know what they were selling to their clients? And who gave them the sales pitch idea in the first place? A call placed to Brookstreet was unreturned by press time.

A website for Brookstreet C.E.O. Stanley Brooks gives some advice to prospective brokers: "The firm conducts extensive due diligence on all direct participation products offered through Brookstreet. ... Brookstreet can make no guarantees as to the financial success of any investment, but we can use our expertise to guide the selection and offer issuers with proven track records. ALWAYS research your products personally."

For now, Brookstreet brokers are stunned and silent, after being instructed by the firm to refrain from talking to the press. "I'm just trying to move on," one said. "We're trying to figure out what's next," said another. At least a half dozen simply didn't answer their phones at all.

Ever since the bottom fell out of the housing market many months ago, economists and Wall Street analysts have debated whether or not the subprime turmoil would spread into the mainstream investing market.

It appears some Brookstreet investors might have an answer to that question.

by Megan Barnett