The unsustainability of debt-for-equity conversion

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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