Goldman Sachs' Credit Crunch Plan

I ran across this little article on the back page of a section of the Wall Street Journal: "Can Goldman Win on Debt?" (subscription required).

Goldman is trying to make something about the current credit crunch. Follow me through this. Aw, screw it, I'll just quote a bunch of the article. There's no easy way to rephrase this. (Fair use, right? Educational purposes, right?)

"Lloyd Blankfein's firm is mulling whether to set up one or more investment vehicles to buy the troubled debt. The approach is tricky, but it could mitigate the firm's losses -- or even turn a profit. Of course, it also boosts risk.

Here's one way it could work. Say Goldman has committed to underwrite $1.2 billion of loans backing ABC's leveraged buyout. It has effectively promised its client $1.2 billion, no matter what it sells the loans for. If it can only find buyers at 85 cents on the dollar, a 15% discount, then Goldman has lost $180 million on the deal.

Assume Goldman believes ABC is a good credit unfairly battered by the credit crunch. The firm could set up an off-balance-sheet fund, capitalizing it with 20% equity and raising the rest from outside lenders, to buy ABC's loans at the same 85 cents on the dollar.

To entice those lenders, the fund could offer a couple of percentage points more in interest than it receives from ABC on the loans. It can afford to do so because it will be paying out interest on a smaller principal amount than the fund owns in ABC loans, due to the discount at which it bought them."

If Goldman puts up the whole 20% in equity, it could earn $60 million in gains -- a third of its original loss.