The unsustainability of debt-for-equity conversion

By Felix Salmon
July 14, 2009

According to its earnings release today, Goldman Sachs posted a loss of $500 million on its “real estate principal investments”. On the conference call, CFO David Viniar said that was based on a loan book of about $6.4 billion, which is now being marked “in the low 50s”.

Needless to say, a diversified loan book should never be marked in the low 50s — that’s equity-like returns, and in exactly the wrong direction. But more to the point, it’s hard to imagine that the value of commercial real estate itself (as opposed to real-estate loans) has fallen by much more than 50%, on average, from the last time it was mortgaged. What I take from this mark, then, is that Goldman is basically marking its loans to the value of the underlying real estate; it’s assuming that all of them will default, and is counting only on recovery value rather than mortgage payments.

The upside of this is that what we’re seeing is exactly the kind of debt-to-equity converstion that Nassim Taleb was pushing in his FT column today. Goldman used to own lots of commercial real-estate debt; now, to all intents and purposes, all that debt has been converted to equity. The problem of course is that Goldman doesn’t particularly want to own lots of commercial real-estate. It’s going to end up selling those assets, and when it does, the buyers will have financing — debt will come back. Indeed, there’s a good chance that Goldman itself will finance the sales. That’s the problem with debt-to-equity conversions: they tend to be temporary things, and get followed in due course by the raising of new debt to replace the old.


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Goldman is valuing their loans at a low number because they know the government will make them whole, even if they don’t even default on them. I know it sounds ridiculous, but that’s what they did with AIG’s collateral.

Maybe companies like Goldman can’t perform the debt to equity swap, and maybe the conversion can’t be performed within the US economy, but there are lots of dollars sitting outside the US that can be used to finance the conversion. The US has been running trade deficits for decades, and a trade deficit is just a measure of how much more we consume than we produce. That imbalance has to be paid for either by borrowing money or selling assets. We have been doing both, but over the past decade or so, it’s been debt that has financed our consumption. The countries that hold all that debt also have lots of dollar reserves which they can use to buy assets or inject capital into firms to allow them to reduce their debt.

Or, we can just print a few trillion dollars, give it away to firms like Goldman, and let them buy all of the distressed debt out there, and then sell it for a profit. We’ll have inflation, but by that time Goldman will have moved all of their cash into other currencies.

Posted by KenG | Report as abusive

why are you assuming that 100% of their book is senior mortgages? I would guess more than 50% is mezz or higher in the stack.

For some commercial real estate properties and securities, it’s not mortgages or underlying values that have been the big issue of late, it’s the fear that the property of structure won’t get refinanced, even if the current debt doesn’t mature for three years or more

Posted by Murray | Report as abusive

Of course you are right. You convert debt into equity, the equity is sold to someone who borrowed the money to buy it. The difference is, that this time the total nominal amount borrowed is less than last time. Of course that doesn’t prevent GS or the borrower from ending up in much the same situation as this time around, since asset prices could continue to go down and economic misery may last a while. But assuming that real estate prices will continue to go down forever is just as dumb an assumption as believing they will never go down. Yes there are risks involved. There are always risks, good companies manage them, others pretend they don’t exist.
I say: take out the knife, slash the debts by converting them to equity. You may lose a lot, but also, you free up capital which you can put to work in a challenging environment. And that should be a capitalist’s dream.

Posted by Marc | Report as abusive

I don’t hear anyone saying ‘that’s too bad’ here. These companies only have themselves to blame. They have caused the meltdown through their own greed. They saw what was coming but did nothing to stop it, and it is the people who will suffer.

Doesn’t seem right that Goldman can distribute that money before meeting its AIG obligations and maybe hiring back some of the 6000 people they laid off. There is a related post at

Posted by carly | Report as abusive

Goldman Sachs will be eternally grateful to Obama for staying out of its way. Goldman has an uncommon grasp of the joystick.

This could be its letter of appreciation, —-  /07/goldman-sachs-thank-you-mr-presiden t.html