It's A Deal

November 3, 2007

Smooth Sailing. Right?

It was just a few weeks back that a handful of investment banks -- Lehman Brothers, Morgan Stanley and Bear Stearns among them -- went public with bold pronouncements that the worst of the credit market shellacking seems to be behind us.

They may be right; after all, who should know better than the folks who are knee-deep in it? But there's a real chance they're not right, and the end result could finish up looking worse than the original debacle. Remember, there's a reason your doctor always tells you to finish off your antibiotics when you're sick. You may think you're cured after taking half your dose, but if the infection comes back, it's often worse than the first go-round.

A couple of things got me thinking about this (besides a bad head cold). First, the Fed on Tuesday released the minutes from its Sept. 18 FOMC meeting where the central bankers decided to cut the fed funds rate by half a point. I've always viewed the release of the minutes as an overblown event, curious why the stock market would so eagerly anticipate looking at Fed sentiment through its rear-view mirror.

But in this instance, a look at the thought process behind the unexpectedly large rate cut seemed appropriate, and one sentence in particular stood out: "Given the unusual nature of the current financial shock, participants regarded the outlook for economic activity as characterized by particularly high uncertainty...."

And speaking of uncertainty, we turn to Goldman Sachs' third-quarter 10-Q, the one that says the firm's "level 3" assets -- those so illiquid that they're close to impossible to value accurately -- rose to $72 billion from $54 billion (see related story). That's 7% of the firm's total assets.

When Merrill Lynch earlier this month preannounced a whopping third-quarter loss -- on a $4.5 billion writedown related to subprime debt and CDOs -- the stock got a 2.5% bump. That's a sign investors think Merrill has wiped its slate clean and has indeed put its credit exposure to bed. To see a stock rise like that in the face of seemingly bad news -- in the belief the "worst is over" -- is not at all uncommon. It's also not always right.