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June 01, 2008

The Pigs Ate the Sausage

That's what happened to Bear Stearns according to Andy Kessler speaking at Telecosm. Andy's a former hedge fund manager so he knows this kind of stuff and a writer so he says what he knows in an entertaining way. Bear Stearns died because the pigs ate the sausage.

His talk was titled "Who killed Bear Stearns?" Andy went back to the founding of the NYSE under the famous buttonwood tree in lower Manhattan. For most of the time since then its members have enjoyed a lucrative monopoly in trading US stocks. A license to trade there and even on other exchanges like the NASDAQ was a license to make money.

At first and for most of Exchange history, commissions were set by cartel. Plenty of profit there. Whoops – competition came to rates. That hurt but there was still plenty of margin left between the bid and ask price to make an indecent living. Whoops – people who used to have to rely on the newspaper for a daily look at prices could now see prices online in real time; spreads shrank.

Then we went from trading in fractions to trading in pennies; the spread was gone. But it was still an exclusive club with plenty of ways to make money.

Whoops – the rise of almost direct trading by day traders. How's a guy or gal to make a living?

Well, there was handling IPOs. Commissions on those somehow managed to be uncompetitive all the way through the Internet bubble. Pop – no more bubble.

Technology and transparency and competition killed the trading spread. The ingenious solution was to invent something too complex to be transparent – collateralized mortgage obligations and derivatives based on tranches of pools of mortgages were exactly that. Who knew what the damned things were worth; at the moment they were worth whatever the market would pay. So the investment banks – all of them – made a lot of money selling this stuff to the customers.

At this point Andy showed a slide of sausage being made – something, as you know, that you don't want to see. The sausage is all the mortgage-backed securities.

Everything might have been fine for the investment banks if some of them hadn't started believing their own marketing pitch that this sausage was good for you. Why should we just serve this fine sausage to our customers? they asked and began to gorge themselves on it.

Chief among the gorgers was Bear Stearns. Along came the day when the stuff that couldn't be valued began to get a little rancid and had to be marked to market and couldn't be disgorged. Bear Stearns got a fatal tummy ache. Other banks would have also succumbed to mortgage poisoning had the Fed not stepped in. JP Morgan had not been nearly as tempted to eat the sausage – they sold plenty of it, though – so they were in shape to mop up Bear Stearns.

Now, thanks to Andy Kessler, you know what happened to Bear Stearns.

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