Goldman's 10% layoffs reflect debt's dangers

The Goldman Sachs Group plans to can 10% of its 32,500 person staff. Despite its glorious reputation, Goldman is not that different from other financial institutions (FIs). It earned high returns by borrowing too much and now that over-borrowing is causing a painful implosion. As I pointed out last night at The Wharton Club of Boston, the current debt-led bubble has cost $37 trillion so far -- six times more than the equity-led dot-com bubble.

The cost of debt is clear from a quick examination of Goldman's financial statements under current CEO Lloyd Blankfein. When he took over from current Treasury Secretary Hank Paulson, Goldman's ratio of assets to shareholder equity was 18.7 but by the end of 2007, the ratio peaked at 26.2 as assets more than doubled to $1.1 trillion and its return on equity (ROE) climbed to 32%.

Much of the increase in Goldman's ROE was due to debt. In particular, 65% of the increase in Goldman's ROE from 2003 to 2006 was a result of its industry-leading use of borrowed money to increase its assets. While high leverage amplifies returns when asset values climb, it causes even more offsetting pain when asset values decline. For example, the $305 billion in profits earned by the top nine investment banks over the last three years has been wiped out by $323 billion in write-downs in the last year.

With Goldman's 2007 leverage ratio of 26, a 4% decline in the value of its assets would wipe out Goldman's capital, and with losses spreading from mortgages to stocks, corporate debt, commodities, emerging markets and real estate, it should come as no surprise that Goldman is trying to raise capital and cut staff. Goldman's frantic efforts to raise capital and reduce assets are designed to ensure its survival.

But for investors the real question is where Goldman will look for growth in this treacherous market. I think there will be clues about what Goldman thinks about these opportunities when it becomes clear which parts of Goldman lose the fewest people in the now-looming layoffs.