UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
Commission File Number: 001-14965
The Goldman Sachs Group, Inc.(Exact name of registrant as specified in its charter)
(212) 902-1000(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
APPLICABLE ONLY TO CORPORATE ISSUERS
As of June 23, 2006 there were 431,695,902 shares of the registrant’s common stock outstanding.
THE GOLDMAN SACHS GROUP, INC.
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PART I: FINANCIAL INFORMATION
The accompanying notes are an integral part of these condensed consolidated financial statements.
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
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The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, together with its consolidated subsidiaries (collectively, the firm), is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
The firm’s activities are divided into three segments:
Basis of Presentation
These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles that require management to make certain estimates and assumptions. The most important of these estimates and assumptions relate to fair value measurements, the accounting for goodwill and identifiable intangible assets, the determination of compensation and benefits expenses for interim periods, and the provision for potential losses that may arise from litigation and regulatory proceedings and tax audits. Although these and other estimates and assumptions are based on the best available information, actual results could be materially different from these estimates.
These condensed consolidated financial statements include the accounts of Group Inc. and all other entities in which the firm has a controlling financial interest. All material intercompany transactions and balances have been eliminated.
The firm determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity, a variable interest entity (VIE) or a qualifying special-purpose entity (QSPE) under generally accepted accounting principles.
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These condensed consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements incorporated by reference in the firm’s Annual Report on Form 10-K for the fiscal year ended November 25, 2005. The condensed consolidated financial information as of November 25, 2005 has been derived from audited consolidated financial statements not included herein.
These unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. These adjustments are of a normal, recurring nature. Interim period operating results may not be indicative of the operating results for a full year.
Unless specifically stated otherwise, all references to May 2006 and May 2005 refer to the firm’s fiscal periods ended, or the dates, as the context requires, May 26, 2006 and May 27, 2005, respectively. All references to November 2005, unless specifically stated otherwise, refer to the firm’s fiscal year ended, or the date, as the context requires, November 25, 2005. All references to 2006, unless specifically stated otherwise, refer to the firm’s fiscal year ending, or the date, as the context requires, November 24, 2006. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.
Revenue Recognition
Investment Banking. Underwriting revenues and fees from mergers and acquisitions and other financial advisory assignments are recognized in the condensed consolidated statements of earnings when the services related to the underlying transaction are completed under the terms of the engagement. Expenses associated with such transactions are deferred until the related revenue is recognized or the engagement is otherwise concluded. Underwriting revenues are presented net of related expenses. Expenses associated with financial advisory transactions are recorded as non-compensation expenses, net of client reimbursements.
Financial Instruments. “Total financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” are reflected in the condensed consolidated statements of financial condition on a trade-date basis and consist of financial instruments carried at fair value or amounts that approximate fair value, with related unrealized gains or losses generally recognized in the condensed consolidated statements of earnings. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
In determining fair value, the firm separates its financial instruments into three categories — cash (i.e., nonderivative) trading instruments, derivative contracts and principal investments.
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In general, transfers of financial assets are accounted for as sales under SFAS No. 140 when the firm has relinquished control over the transferred assets. For transfers accounted for as sales,
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any related gains or losses are recognized in net revenues. Transfers that are not accounted for as sales are accounted for as collateralized financing arrangements and secured borrowings, with the related interest expense recognized in net revenues over the lives of the transactions.
Collateralized Financing Arrangements. Collateralized financing arrangements consist of resale and repurchase agreements and securities borrowed and loaned. Interest income or expense on resale and repurchase agreements and securities borrowed and loaned is recognized in net revenues over the life of the transaction.
Power Generation. Power generation revenues associated with the firm’s consolidated power generation facilities are included in “Trading and principal investments” in the condensed consolidated statements of earnings when power is delivered. “Cost of power generation” in the condensed consolidated statements of earnings includes all of the direct costs of these facilities (e.g., fuel, operations and maintenance), as well as the depreciation and amortization associated with the facilities and related contractual assets.
The following table sets forth the power generation revenues and costs directly associated with the firm’s consolidated power generation facilities:
Commissions. Commission revenues from executing and clearing client transactions on stock, options and futures markets worldwide are recognized in “Trading and principal investments” in the condensed consolidated statements of earnings on a trade-date basis.
Insurance Contracts. Revenues from variable annuity and variable life insurance contracts generally consist of fees assessed on contract holder account balances for mortality charges, policy
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administration and surrender charges. These fees are recognized in the condensed consolidated statements of earnings in the period that services are provided. Premiums earned for providing property and catastrophe reinsurance are recognized in revenues over the coverage period, net of premiums ceded for the cost of reinsurance. Insurance revenues are included in “Trading and principal investments” in the condensed consolidated statements of earnings.
Merchant Banking Overrides. The firm is entitled to receive merchant banking overrides (i.e., an increased share of a fund’s income and gains) when the return on the funds’ investments exceeds certain threshold returns. Overrides are based on investment performance over the life of each merchant banking fund, and future investment underperformance may require amounts of override previously distributed to the firm to be returned to the funds. Accordingly, overrides are recognized in the condensed consolidated statements of earnings only when all material contingencies have been resolved. Overrides are included in “Trading and principal investments” in the condensed consolidated statements of earnings.
Asset Management. Management fees are recognized over the period that the related service is provided based upon average net asset values. In certain circumstances, the firm is also entitled to receive asset management incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are generally based on investment performance over a 12-month period and are subject to adjustment prior to the end of the measurement period. Accordingly, incentive fees are recognized in the condensed consolidated statements of earnings when the measurement period ends. Asset management fees and incentive fees are included in “Asset management and securities services” in the condensed consolidated statements of earnings.
Share-Based Compensation
In the first quarter of 2006, the firm adopted SFAS No. 123-R, “Share-Based Payment,” which is a revision to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123-R focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for share-based payments. Under SFAS No. 123-R, share-based awards that do not require future service (i.e., vested awards) are expensed immediately. Share-based employee awards that require future service are amortized over the relevant service period. The firm adopted SFAS No. 123-R under the modified prospective adoption method. Under that method of adoption, the provisions of SFAS No. 123-R are generally applied only to share-based awards granted subsequent to adoption. The accounting treatment of share-based awards granted to retirement-eligible employees prior to the firm’s adoption of SFAS No. 123-R has not changed and financial statements for periods prior to adoption are not restated for the effects of adopting SFAS No. 123-R.
Two key differences between SFAS No. 123-R and SFAS No. 123 are:
First, SFAS No. 123-R requires expected forfeitures to be included in determining share-based employee compensation expense. Prior to the adoption of SFAS No. 123-R, forfeiture benefits were recorded as a reduction to compensation expense when an employee left the firm and forfeited the award. In the first quarter of 2006, the firm recorded a benefit for expected forfeitures on all outstanding share-based awards. The transition impact of adopting SFAS No. 123-R as of the first day of the firm’s 2006 fiscal year, including the effect of accruing for expected forfeitures on outstanding share-based awards, was not material to the firm’s results of operations for that quarter.
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Second, SFAS No. 123-R requires the immediate expensing of share-based awards granted to retirement-eligible employees, including awards subject to non-compete agreements. Share-based awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R must continue to be amortized over the stated service period of the award (and accelerated if the employee actually retires). Consequently, the firm’s compensation and benefits expenses in fiscal 2006 (and, to a lesser extent, in fiscal 2007 and fiscal 2008) will include both the amortization (and acceleration) of awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R as well as the full grant-date fair value of new awards granted to such employees under SFAS No. 123-R. The estimated annual non-cash expense in fiscal 2006 associated with the continued amortization of share-based awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R is approximately $650 million, of which $138 million and $375 million were recognized in the three and six months ended May 2006, respectively.
The firm began to account for share-based awards in accordance with the fair value method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” in 2003. Share-based employee awards granted for the year ended November 29, 2002 and prior years were accounted for under the intrinsic-value-based method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” as permitted by SFAS No. 123. Therefore, no compensation expense was recognized for unmodified stock options issued for years prior to fiscal 2003 that had no intrinsic value on the date of grant.
If the firm were to recognize compensation expense over the relevant service period, generally three years, under the fair value method per SFAS No. 123 with respect to stock options granted for the year ended November 29, 2002 and prior years, net earnings would have decreased for the three and six months ended May 2005, resulting in pro forma net earnings and earnings per common share (EPS) as set forth below:
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The firm pays cash dividend equivalents on outstanding restricted stock units. Dividend equivalents paid on restricted stock units accounted for under SFAS No. 123 and SFAS No. 123-R are charged to retained earnings when paid. Dividend equivalents paid on restricted stock units that are later forfeited by employees are reclassified to compensation expense from retained earnings. Dividend equivalents paid on restricted stock units granted prior to 2003 were accounted for under APB Opinion No. 25 and charged to compensation expense.
Prior to the adoption of SFAS No. 123-R, the firm presented all tax benefits resulting from share-based compensation as cash flows from operating activities in the condensed consolidated statements of cash flows. SFAS No. 123-R requires cash flows resulting from tax deductions in excess of the grant-date fair value of share-based awards to be included in cash flows from financing activities.
Goodwill
Goodwill is the cost of acquired companies in excess of the fair value of identifiable net assets at acquisition date. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is tested at least annually for impairment. An impairment loss is triggered if the estimated fair value of an operating segment is less than its estimated net book value. Such loss is calculated as the difference between the estimated fair value of goodwill and its carrying value.
Identifiable Intangible Assets
Identifiable intangible assets, which consist primarily of customer lists, above-market power contracts, specialist rights and the value of business acquired (VOBA) in the firm’s insurance subsidiaries, are amortized over their estimated useful lives. Identifiable intangible assets are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.
Property, Leasehold Improvements and Equipment
Property, leasehold improvements and equipment, net of accumulated depreciation and amortization, are included in “Other assets” in the condensed consolidated statements of financial condition.
Property and equipment placed in service prior to December 1, 2001 are depreciated under the accelerated cost recovery method. Property and equipment placed in service on or after December 1, 2001 are depreciated on a straight-line basis over the useful life of the asset. Leasehold improvements for which the useful life of the improvement is shorter than the term of the lease are amortized under the accelerated cost recovery method if placed in service prior to December 1, 2001. All other leasehold improvements are amortized on a straight-line basis over the useful life of the improvement or the term of the lease, whichever is shorter. Certain costs of software developed or obtained for internal use are capitalized and amortized on a straight-line basis over the useful life of the software.
Property, leasehold improvements and equipment are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not
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be fully recoverable in accordance with SFAS No. 144. An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the expected undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.
The firm’s operating leases include space held in excess of current requirements. Rent expense relating to space held for growth is included in “Occupancy” in the condensed consolidated statements of earnings. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the firm records a liability, based on the remaining lease rentals reduced by any potential or existing sublease rentals, for leases where the firm has ceased using the space and management has concluded that the firm will not derive any future economic benefits. Costs to terminate a lease before the end of its term are recognized and measured at fair value upon termination.
Foreign Currency Translation
Assets and liabilities denominated in non-U.S. currencies are translated at rates of exchange prevailing on the date of the condensed consolidated statement of financial condition, and revenues and expenses are translated at average rates of exchange for the fiscal period. Gains or losses on translation of the financial statements of a non-U.S. operation, when the functional currency is other than the U.S. dollar, are included, net of hedges and taxes, on the condensed consolidated statements of comprehensive income. The firm seeks to reduce its net investment exposure to fluctuations in foreign exchange rates through the use of foreign currency forward contracts and foreign currency-denominated debt. For foreign currency forward contracts, hedge effectiveness is assessed based on changes in forward exchange rates; accordingly, forward points are reflected as a component of the currency translation adjustment in the condensed consolidated statements of comprehensive income. For foreign currency-denominated debt, hedge effectiveness is assessed based on changes in spot rates. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are included in the condensed consolidated statements of earnings.
Income Taxes
Deferred tax assets and liabilities are recognized for temporary differences between the financial reporting and tax bases of the firm’s assets and liabilities. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. The firm’s tax assets and liabilities are presented as a component of “Other assets” and “Other liabilities and accrued expenses,” respectively, in the condensed consolidated statements of financial condition. Tax provisions are computed in accordance with SFAS No. 109, “Accounting for Income Taxes.” Contingent liabilities related to income taxes are recorded when the criteria for loss recognition under SFAS No. 5, “Accounting for Contingencies,” as amended, have been met.
Earnings Per Common Share
Basic EPS is calculated by dividing net earnings applicable to common shareholders by the weighted average number of common shares outstanding. Common shares outstanding includes common stock and restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted EPS includes the determinants of basic EPS and, in addition, reflects the dilutive effect of the common stock deliverable pursuant to stock options and to restricted stock units for which future service is required as a condition to the delivery of the underlying common stock.
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Cash and Cash Equivalents
The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business.
Recent Accounting Developments
In June 2005, the EITF reached consensus on Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights,” which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. The firm, as the general partner of numerous merchant banking and asset management partnerships, is required to adopt the provisions of EITF 04-5 (i) immediately for partnerships formed or modified after June 29, 2005 and (ii) in the first quarter of fiscal 2007 for partnerships formed on or before June 29, 2005 that have not been modified. The firm generally expects to provide limited partners in these funds with rights to remove the firm as the general partner or to terminate the partnerships and, therefore, does not expect that EITF 04-5 will have a material effect on the firm’s financial condition, results of operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 permits an entity to measure at fair value any financial instrument that contains an embedded derivative that otherwise would require bifurcation. As permitted, the firm early adopted SFAS No. 155 in the first quarter of fiscal 2006. Adoption did not have a material effect on the firm’s financial condition, results of operations or cash flows.
Effective for the first quarter of 2006, the firm adopted SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” which permits entities to elect to measure servicing assets and servicing liabilities at fair value and report changes in fair value in earnings. The firm acquires residential mortgage servicing rights in connection with its mortgage securitization activities and has elected under SFAS No. 156 to account for these servicing rights at fair value. Adoption did not have a material effect on the firm’s financial condition, results of operations or cash flows.
In April 2006, the FASB issued FASB Staff Position (FSP) FIN No. 46-R-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46-R.” This FSP addresses how a reporting enterprise should determine the variability to be considered in applying FIN No. 46-R by requiring an analysis of the purpose for which an entity was created and the variability that the entity was designed to create. This FSP must be applied prospectively to all entities with which a reporting enterprise first becomes involved and to all entities previously required to be analyzed under FIN No. 46-R when a reconsideration event has occurred. In accordance with the transition provisions, the firm will adopt this FSP prospectively in the fourth quarter of fiscal 2006 and does not expect it to have a material effect on the firm’s financial condition, results of operations or cash flows.
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Fair Value of Financial Instruments
The following table sets forth the firm’s financial instruments owned, at fair value, including those pledged as collateral, and financial instruments sold, but not yet purchased, at fair value:
Derivative Activities
Derivative contracts are instruments, such as futures, forwards, swaps or option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. Derivative instruments may be privately negotiated contracts, which are often referred to as OTC derivatives, or they may be listed and traded on an exchange. Derivatives may involve future commitments to purchase or sell financial instruments or commodities, or to exchange currency or
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interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, securities, commodities, currencies or indices.
Certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments, are not considered derivatives even though their values or contractually required cash flows are derived from the price of some other security or index. However, certain commodity-related contracts are included in the firm’s derivatives disclosure, as these contracts may be settled in cash or are readily convertible into cash.
Substantially all of the firm’s derivative transactions are entered into for trading purposes, to facilitate client transactions, to take proprietary positions or as a means of risk management. Risk exposures are managed through diversification, by controlling position sizes and by establishing hedges in related securities or derivatives. For example, the firm may hedge a portfolio of common stock by taking an offsetting position in a related equity-index futures contract. Gains and losses on derivatives used for trading purposes are generally included in “Trading and principal investments” in the condensed consolidated statements of earnings.
In addition to derivative transactions entered into for trading purposes, the firm enters into derivatives accounted for as hedges to manage certain interest rate and currency exposures, including derivatives used to hedge the firm’s net investment in non-U.S. operations. The firm applies fair value hedge accounting to derivative contracts that hedge changes in the relevant benchmark interest rate (e.g. London Interbank Offered Rate (LIBOR)), effectively converting a substantial portion of the firm’s long-term and certain short-term borrowings into floating rate obligations. In addition, the firm applies cash flow hedge accounting to derivative transactions that hedge currency exposure on certain forecasted transactions in its consolidated power generation facilities. See Note 2 for information regarding the firm’s policy on derivative transactions used to hedge its net investment in non-U.S. operations.
The firm applies long-haul hedge accounting to substantially all of its hedge accounting relationships and performs an ongoing assessment of the effectiveness of these transactions in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. For fair value hedges, gains or losses on derivative transactions as well as the hedged item are recognized in net revenues in the condensed consolidated statements of earnings. For cash flow hedges, the effective portion of gains or losses on derivative transactions is reported as a component of “Other comprehensive income.” Gains or losses related to hedge ineffectiveness for all hedges are included in net revenues. These gains or losses and the component of gains or losses on derivative transactions excluded from the assessment of hedge effectiveness (e.g. the effect of time value on fair value hedges of the firm’s borrowings) were not material to the firm’s results of operations for the three and six months ended May 2006.
Fair values of the firm’s derivative contracts are reflected net of cash paid or received pursuant to credit support agreements and are reported on a net-by-counterparty basis in the firm’s condensed consolidated statements of financial condition when management believes a legal right of
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setoff exists under an enforceable netting agreement. The fair value of derivative financial instruments, computed in accordance with the firm’s netting policy, is set forth below:
Securitization Activities
The firm securitizes commercial and residential mortgages, home equity and auto loans, government and corporate bonds and other types of financial assets. The firm acts as underwriter of the beneficial interests that are sold to investors. The firm derecognizes financial assets transferred in securitizations provided it has relinquished control over such assets. Transferred assets are accounted for at fair value prior to securitization. Net revenues related to these underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.
The firm may retain interests in securitized financial assets. Retained interests are accounted for at fair value and included in “Total financial instruments owned, at fair value” in the condensed consolidated statements of financial condition.
During the six months ended May 2006 and May 2005, the firm securitized $49.65 billion and $37.94 billion, respectively, of financial assets, including $36.57 billion and $30.11 billion, respectively, of residential mortgage loans and securities. Cash flows received on retained interests were approximately $422 million and $394 million for the six months ended May 2006 and May 2005, respectively.
As of May 2006 and November 2005, the firm held $5.31 billion and $6.07 billion of retained interests, respectively, including $4.94 billion and $5.62 billion, respectively, held in QSPEs. The fair value of retained interests valued using quoted market prices in active markets was $2.04 billion and $1.34 billion as of May 2006 and November 2005, respectively.
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The following table sets forth the weighted average key economic assumptions used in measuring retained interests for which fair value is based on alternative pricing sources with reasonable, little or no price transparency and the sensitivity of those fair values to immediate adverse changes of 10% and 20% in those assumptions:
The preceding table does not give effect to the offsetting benefit of other financial instruments that are held to hedge risks inherent in these retained interests. Changes in fair value based on an adverse variation in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value is not usually linear. In addition, the impact of a change in a particular assumption is calculated independently of changes in any other assumption. In practice, simultaneous changes in assumptions might magnify or counteract the sensitivities disclosed above.
In addition to the retained interests described above, the firm also held interests in residential mortgage QSPEs purchased in connection with secondary market-making activities. These purchased interests approximated $8 billion and $5 billion as of May 2006 and November 2005, respectively.
In connection with the issuance of asset-repackaged notes to investors, the firm had derivative receivables from QSPEs, to which the firm has transferred assets, with a fair value of $101 million and $108 million as of May 2006 and November 2005, respectively. These receivables are collateralized by a first-priority interest in the assets held by each QSPE.
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Variable Interest Entities (VIEs)
The firm, in the ordinary course of its business, retains interests in VIEs in connection with its securitization activities. The firm also purchases and sells variable interests in VIEs, which primarily issue mortgage-backed and other asset-backed securities and collateralized debt obligations (CDOs), in connection with its market-making activities and makes investments in and loans to VIEs that hold performing and nonperforming debt, equity, real estate, power-related and other assets. In addition, the firm utilizes VIEs to provide investors with credit-linked and asset-repackaged notes designed to meet their objectives.
VIEs generally purchase assets by issuing debt and equity instruments. In certain instances, the firm provides guarantees to VIEs or holders of variable interests in VIEs. In such cases, the maximum exposure to loss included in the tables set forth below is the notional amount of such guarantees. Such amounts do not represent anticipated losses in connection with these guarantees.
The firm’s variable interests in VIEs include senior and subordinated debt; limited and general partnership interests; preferred and common stock; interest rate, foreign currency, equity, commodity and credit derivatives; guarantees; and residual interests in mortgage-backed and asset-backed securitization vehicles and CDOs. The firm’s exposure to the obligations of VIEs is generally limited to its interests in these entities.
The following table sets forth the firm’s total assets and maximum exposure to loss associated with its significant variable interests in consolidated VIEs where the firm does not hold a majority voting interest:
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The following tables set forth total assets in nonconsolidated VIEs in which the firm holds significant variable interests and the firm’s maximum exposure to loss associated with these interests:
Secured Borrowing and Lending Activities
The firm obtains secured short-term financing principally through the use of repurchase agreements, securities lending agreements and other financings. In these transactions, the firm receives cash or securities in exchange for other securities, including U.S. government, federal agency and sovereign obligations, corporate debt and other debt obligations, equities and convertibles, letters of credit and other assets.
The firm obtains securities as collateral principally through the use of resale agreements, securities borrowing agreements, derivative transactions, customer margin loans and other secured
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borrowing activities to finance inventory positions, to meet customer needs and to satisfy settlement requirements. In many cases, the firm is permitted to sell or repledge securities held as collateral. These securities may be used to secure repurchase agreements, to enter into securities lending or derivative transactions, or to cover short positions. As of May 2006 and November 2005, the fair value of securities received as collateral by the firm that it was permitted to sell or repledge was $690.05 billion and $629.94 billion, respectively, of which the firm sold or repledged $594.63 billion and $550.33 billion, respectively.
The firm also pledges securities it owns. Counterparties may or may not have the right to sell or repledge the securities. Securities owned and pledged to counterparties that have the right to sell or repledge are reported as “Financial instruments owned and pledged as collateral, at fair value” in the condensed consolidated statements of financial condition and were $41.99 billion and $38.98 billion as of May 2006 and November 2005, respectively. Securities owned and pledged in connection with repurchase and securities lending agreements to counterparties that did not have the right to sell or repledge are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition and were $90.57 billion and $93.90 billion as of May 2006 and November 2005, respectively.
In addition to repurchase and securities lending agreements, the firm also pledges securities and other assets it owns to counterparties that do not have the right to sell or repledge, in order to collateralize secured short-term and long-term borrowings. In connection with these transactions, the firm pledged assets of $33.36 billion and $27.84 billion as collateral as of May 2006 and November 2005, respectively. See Note 4 and Note 5 for further information regarding the firm’s secured short-term and long-term borrowings.
The firm obtains short-term borrowings primarily through the use of promissory notes, commercial paper, secured debt and bank loans. As of May 2006 and November 2005, secured short-term borrowings were $9.98 billion and $7.97 billion, respectively. Unsecured short-term borrowings were $52.34 billion and $47.25 billion as of May 2006 and November 2005, respectively. Short-term borrowings also include the portion of long-term borrowings maturing within one year of the financial statement date and certain long-term borrowings that are redeemable within one year of the financial statement date at the option of the holder. The carrying value of these short-term obligations approximates fair value due to their short-term nature.
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Short-term borrowings are set forth below:
The firm obtains secured and unsecured long-term borrowings, which consist principally of senior borrowings with maturities extending to 2036. As of May 2006 and November 2005, secured long-term borrowings were $17.84 billion and $15.67 billion, respectively. Unsecured long-term borrowings were $107.75 billion and $84.34 billion as of May 2006 and November 2005, respectively.
Long-term borrowings are set forth below:
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Long-term borrowings include nonrecourse debt issued by the following subsidiaries, as set forth in the table below. Nonrecourse debt is debt that only the issuing subsidiary or, if applicable, a subsidiary guaranteeing the debt is obligated to repay.
Long-term borrowings by fiscal maturity date are set forth below:
The firm enters into derivative contracts, such as interest rate futures contracts, interest rate swap agreements, currency swap agreements, equity-linked and indexed contracts, to effectively convert a substantial portion of its long-term borrowings into U.S. dollar-based floating rate obligations. Accordingly, the aggregate carrying value of these long-term borrowings and related hedges approximates fair value.
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The effective weighted average interest rates for long-term borrowings, after hedging activities, are set forth below:
Subordinated Borrowings
Long term borrowings include $2.84 billion of junior subordinated debentures as of May 2006 and November 2005 and $1.50 billion of subordinated notes as of May 2006.
Junior Subordinated Debentures. The firm issued $2.84 billion of junior subordinated debentures in its first fiscal quarter of 2004 to Goldman Sachs Capital Trust I (the Trust), a Delaware statutory trust created for the exclusive purposes of (i) issuing $2.75 billion of guaranteed preferred beneficial interests and $85 million of common beneficial interests in the Trust, (ii) investing the proceeds from the sale to purchase junior subordinated debentures issued by the firm and (iii) engaging in only those other activities necessary or incidental to these purposes. The preferred beneficial interests were purchased by third parties, and, as of May 2006 and November 2005, the firm held all the common beneficial interests. The Trust is a wholly owned finance subsidiary of the firm for regulatory and legal purposes but is not consolidated for accounting purposes.
The firm pays interest semiannually on these debentures at an annual rate of 6.345% and the debentures mature on February 15, 2034. The coupon rate and the payment dates applicable to the beneficial interests are the same as the interest rate and payment dates applicable to the debentures. The firm has the right, from time to time, to defer payment of interest on the debentures, and, therefore, cause payment on the Trust’s preferred beneficial interests to be deferred, in each case up to ten consecutive semiannual periods. During any such extension period, the firm will not be permitted to, among other things, pay dividends on or make certain repurchases of its common stock. The Trust is not permitted to pay any distributions on the common beneficial interests held by the firm unless all dividends payable on the preferred beneficial interests have been paid in full. These notes are junior in right of payment to all of the firm’s senior indebtedness and all of the firm’s subordinated notes (described below). See Note 6 for information regarding the firm’s guarantee of the preferred beneficial interests issued by the Trust.
Subordinated Notes. The firm issued $1.50 billion of subordinated notes in its second fiscal quarter of 2006. The firm pays interest semiannually on these notes at an annual rate of 6.45% and the notes mature on May 1, 2036. These notes are junior in right of payment to all of the firm’s senior indebtedness.
Commitments
Forward Secured Financings. The firm had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing
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and lending arrangements, of $58.19 billion and $49.93 billion as of May 2006 and November 2005, respectively.
Commitments to Extend Credit. In connection with its lending activities, the firm had outstanding commitments of $72.17 billion and $61.12 billion as of May 2006 and November 2005, respectively. The firm’s commitments to extend credit are agreements to lend to counterparties that have fixed termination dates and are contingent on the satisfaction of all conditions to borrowing set forth in the contract. Since these commitments may expire unused, the total commitment amount does not necessarily reflect the actual future cash flow requirements. The firm accounts for these commitments at fair value.
The following table summarizes the firm’s commitments to extend credit at May 2006 and November 2005:
Commitments to Extend Credit(in millions)
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Letters of Credit. The firm provides letters of credit issued by various banks to counterparties in lieu of securities or cash to satisfy various collateral and margin deposit requirements. Letters of credit outstanding were $8.94 billion and $9.23 billion as of May 2006 and November 2005, respectively.
Merchant Banking Commitments. The firm acts as an investor in merchant banking transactions, which includes making long-term investments in equity and debt instruments in privately negotiated transactions, corporate acquisitions and real estate transactions. In connection with these activities, the firm had commitments to invest up to $4.34 billion and $3.54 billion in corporate and real estate investment funds as of May 2006 and November 2005, respectively.
Construction-Related Commitments. As of May 2006 and November 2005, the firm had construction-related commitments of $1.40 billion and $579 million, respectively, including commitments of $1.05 billion and $481 million, respectively, related to the development of wind energy projects. Construction-related commitments also include outstanding commitments of $290 million and $47 million as of May 2006 and November 2005, respectively, related to the firm’s new world headquarters in New York City, expected to cost between $2.3 billion and $2.5 billion.
Underwriting Commitments. As of May 2006, the firm had commitments to purchase $311 million of securities in connection with its underwriting activities.
Other. The firm had other purchase commitments of $732 million and $644 million as of May 2006 and November 2005, respectively.
Leases. The firm has contractual obligations under long-term noncancelable lease agreements, principally for office space, expiring on various dates through 2069. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other charges. Future minimum rental payments, net of minimum sublease rentals, are set forth below:
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Contingencies
The firm is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its businesses. Management believes, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on the firm’s financial condition, but may be material to the firm’s operating results for any particular period, depending, in part, upon the operating results for such period. Given the inherent difficulty of predicting the outcome of the firm’s litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, the firm cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred.
The firm is contingently liable to provide guaranteed mortality benefits in connection with its insurance business. The net amount at risk, representing guaranteed mortality benefits in force under annuity contracts in excess of contract holder account balances, was $1.40 billion as of May 2006. The average attained age of contract holders was 70 years as of May 2006.
Guarantees
The firm enters into various derivative contracts that meet the definition of a guarantee under FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” Such derivative contracts include credit default swaps, written equity and commodity put options, written currency contracts and interest rate caps, floors and swaptions. FIN No. 45 does not require disclosures about derivative contracts if such contracts may be cash settled and the firm has no basis to conclude it is probable that the counterparties held, at inception, the underlying instruments related to the derivative contracts. The firm has concluded that these conditions have been met for certain large, internationally active commercial and investment bank end users and certain other users. Accordingly, the firm has not included such contracts in the tables below.
The firm, in its capacity as an agency lender, indemnifies most of its securities lending customers against losses incurred in the event that borrowers do not return securities and the collateral held is insufficient to cover the market value of the securities borrowed. In connection with certain asset sales and securitization transactions, the firm guarantees the collection of contractual cash flows. In connection with its merchant banking activities, the firm may issue loan guarantees to secure financing. In addition, the firm provides letters of credit and other guarantees, on a limited basis, to enable clients to enhance their credit standing and complete transactions.
In connection with the firm’s establishment of the Trust, Group Inc. effectively provided for the full and unconditional guarantee of the beneficial interests in the Trust held by third parties. Timely payment by Group Inc. of interest on the junior subordinated debentures and other amounts due and performance of its other obligations under the transaction documents will be sufficient to cover payments due by the Trust on its beneficial interests. As a result, management believes that it is unlikely the firm will have to make payments related to the Trust other than those required under the junior subordinated debentures and in connection with certain expenses incurred by the Trust.
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The following tables set forth certain information about the firm’s derivative contracts that meet the definition of a guarantee and certain other guarantees as of May 2006 and November 2005:
In the normal course of its business, the firm indemnifies and guarantees certain service providers, such as clearing and custody agents, trustees and administrators, against specified potential losses in connection with their acting as an agent of, or providing services to, the firm or its affiliates. The firm also indemnifies some clients against potential losses incurred in the event specified third-party service providers, including sub-custodians and third-party brokers, improperly execute transactions. In addition, the firm is a member of payment, clearing and settlement networks as well as securities exchanges around the world that may require the firm to meet the obligations of
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such networks and exchanges in the event of member defaults. In connection with its prime brokerage and clearing businesses, the firm agrees to clear and settle on behalf of its clients the transactions entered into by them with other brokerage firms. The firm’s obligations in respect of such transactions are secured by the assets in the client’s account as well as any proceeds received from the transactions cleared and settled by the firm on behalf of the client. In connection with joint venture investments, the firm may issue loan guarantees under which it may be liable in the event of fraud, misappropriation, environmental liabilities and certain other matters involving the borrower. The firm is unable to develop an estimate of the maximum payout under these guarantees and indemnifications. However, management believes that it is unlikely the firm will have to make any material payments under these arrangements, and no liabilities related to these guarantees and indemnifications have been recognized in the condensed consolidated statements of financial condition as of May 2006 and November 2005.
The firm provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. The firm may also provide indemnifications protecting against changes in or adverse application of certain U.S. tax laws in connection with ordinary-course transactions such as securities issuances, borrowings or derivatives. In addition, the firm may provide indemnifications to some counterparties to protect them in the event additional taxes are owed or payments are withheld, due either to a change in or an adverse application of certain non-U.S. tax laws. These indemnifications generally are standard contractual terms and are entered into in the normal course of business. Generally, there are no stated or notional amounts included in these indemnifications, and the contingencies triggering the obligation to indemnify are not expected to occur. The firm is unable to develop an estimate of the maximum payout under these guarantees and indemnifications. However, management believes that it is unlikely the firm will have to make any material payments under these arrangements, and no liabilities related to these arrangements have been recognized in the condensed consolidated statements of financial condition as of May 2006 and November 2005.
On June 12, 2006, the Board of Directors of Group Inc. (the Board) declared a dividend of $0.35 per common share with respect to the firm’s second fiscal quarter of 2006 to be paid on August 24, 2006 to common shareholders of record on July 25, 2006.
During the three and six months ended May 2006, the firm repurchased 6.5 million shares and 25.6 million shares of its common stock at a total cost of $1.02 billion and $3.59 billion, respectively. The average price paid per share for repurchased shares was $156.59 and $140.28 for the three and six months ended May 2006, respectively. In addition, to satisfy minimum statutory employee tax withholding requirements related to the delivery of shares underlying restricted stock units, the firm cancelled 3.0 million restricted stock units with a total value of $374 million in the first half of 2006.
On May 24, 2006, the firm issued 34,000 shares of perpetual Floating Rate Non-Cumulative Preferred Stock, Series D.
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As of May 2006, the firm had 104,000 shares of perpetual non-cumulative preferred stock outstanding in four series as set forth in the following table:
Each share of preferred stock has a par value of $0.01, has a liquidation preference of $25,000, is represented by 1,000 depositary shares and is redeemable at the firm’s option at a redemption price equal to $25,000 plus declared and unpaid dividends. Dividends on each series of preferred stock, if declared, are payable quarterly in arrears. The firm’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event that the firm fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period. All preferred stock also has a preference over the firm’s common stock upon liquidation.
On June 12, 2006, the Board declared a dividend per preferred share of $377.58, $387.50, $377.58 and $318.36 for Series A, Series B, Series C and Series D preferred stock, respectively, to be paid on August 10, 2006 to preferred shareholders of record on July 26, 2006.
The following table sets forth the firm’s accumulated other comprehensive income by type:
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The computations of basic and diluted earnings per common share are set forth below:
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The following table sets forth the carrying value of the firm’s goodwill by operating segment, which is included in “Other assets” in the condensed consolidated statements of financial condition:
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The following table sets forth the gross carrying amount, accumulated amortization and net carrying amount of identifiable intangible assets:
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Substantially all of the firm’s identifiable intangible assets are considered to have finite lives and are amortized over their estimated useful lives. The weighted average remaining life of the firm’s identifiable intangibles is approximately 13 years.
Amortization expense associated with identifiable intangible assets was $69 million and $56 million for the three months ended May 2006 and May 2005, respectively, and $113 million and $93 million for the six months ended May 2006 and May 2005, respectively, including amortization associated with the firm’s consolidated power generation facilities reported within “Cost of power generation” in the condensed consolidated statements of earnings.
The estimated future amortization for existing identifiable intangible assets through 2011 is set forth below:
Other Assets
Other assets are generally less liquid, nonfinancial assets. The following table sets forth the firm’s other assets by type:
Other Liabilities
Other liabilities and accrued expenses primarily includes insurance-related liabilities, compensation and benefits, minority interest in consolidated entities, litigation liabilities, tax-related
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payables, deferred revenue and other payables. The following table sets forth the firm’s other liabilities and accrued expenses by type:
The firm sponsors various pension plans and certain other postretirement benefit plans, primarily healthcare and life insurance. The firm also provides certain benefits to former or inactive employees prior to retirement.
Defined Benefit Pension Plans and Postretirement Plans
The firm maintains a defined benefit pension plan for substantially all U.S. employees hired prior to November 1, 2003. As of November 2004, this plan has been closed to new participants and no further benefits will be accrued to existing participants. Employees of certain non-U.S. subsidiaries participate in various local defined benefit pension plans. These plans generally provide benefits based on years of credited service and a percentage of the employee’s eligible compensation. In addition, the firm has unfunded postretirement benefit plans that provide medical and life insurance for eligible retirees and their dependents covered under the U.S. benefits program.
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The components of pension expense/(income) and postretirement expense are set forth below:
The firm expects to contribute a minimum of $14 million to its pension plans and $6 million to its postretirement plans in fiscal 2006.
Stock Incentive Plan
The firm sponsors a stock incentive plan, The Goldman Sachs Amended and Restated Stock Incentive Plan (the Amended SIP), which provides for grants of incentive stock options, nonqualified stock options, stock appreciation rights, dividend equivalent rights, restricted stock, restricted stock units and other share-based awards. In the second quarter of fiscal 2003, the Amended SIP was approved by the firm’s shareholders, effective for grants after April 1, 2003, and no further awards were or will be made under the original plan after that date, although awards granted under the original plan prior to that date remain outstanding.
The total number of shares of common stock that may be issued under the Amended SIP through fiscal 2008 may not exceed 250 million shares and, in each fiscal year thereafter, may not exceed 5% of the issued and outstanding shares of common stock, determined as of the last day of the immediately preceding fiscal year, increased by the number of shares available for awards in previous fiscal years but not covered by awards granted in such years. As of May 2006 and November 2005, 195.7 million and 196.6 million shares, respectively, were available for grant under the Amended SIP.
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Restricted Stock Units
The firm issued restricted stock units to employees under the Amended SIP, primarily in connection with year-end compensation and acquisitions. Of the total restricted stock units outstanding as of May 2006 and November 2005, (i) 28.8 million units and 30.1 million units, respectively, required future service as a condition to the delivery of the underlying shares of common stock and (ii) 18.7 million units and 25.0 million units, respectively, did not require future service. In all cases, delivery of the underlying shares of common stock is conditioned on the grantees satisfying certain other requirements outlined in the award agreements. When delivering the underlying shares to employees, the firm generally issues new shares of common stock, as opposed to reissuing treasury shares.
The activity related to these restricted stock units is set forth below:
Stock Options
As of November 2004, all stock options granted to employees in May 1999 in connection with the firm’s initial public offering became fully vested and exercisable. Stock options granted to employees subsequent to the firm’s initial public offering generally vest as outlined in the applicable stock option agreement and first become exercisable on the third anniversary of the grant date. Year-end stock options for 2005 become exercisable in January 2009 and expire on November 27, 2015. Shares received on exercise prior to January 2010 will not be transferable until January 2010. All employee stock option agreements provide that vesting is accelerated in certain circumstances, such as upon retirement, death and extended absence. In general, all stock options expire on the tenth anniversary of the grant date, although they may be subject to earlier termination or cancellation in certain circumstances in accordance with the terms of the Amended SIP and the applicable stock option agreement. The dilutive effect of the firm’s outstanding stock options is included in “Average common shares outstanding — Diluted” on the condensed consolidated statements of earnings.
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The activity related to these stock options is set forth below:
The total intrinsic value of options exercised during the six months ended May 2006 and May 2005 was $945 million and $454 million, respectively.
The following table sets forth share-based compensation and the related tax benefit:
As of May 2006, there was $1.87 billion of total unrecognized compensation cost related to nonvested share-based compensation arrangements. This cost is expected to be recognized over a weighted average period of 2.11 years.
The firm’s stock repurchase program is intended to maintain our total shareholders’ equity at appropriate levels and to substantially offset increases in share count over time resulting from employee share-based compensation. The repurchase program has been effected primarily through regular open-market purchases and is influenced by, among other factors, the level of our common shareholders’ equity, our overall capital position, share-based awards and exercises of employee stock options, the prevailing market price of our common stock and general market conditions.
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The firm has formed numerous nonconsolidated investment funds with third-party investors. The firm generally acts as the investment manager for these funds and, as such, is entitled to receive management fees and, in certain cases, advisory fees, incentive fees or overrides from these funds. These fees amounted to $1.94 billion and $951 million for the six months ended May 2006 and May 2005, respectively. As of May 2006 and November 2005, the fees receivable from these funds were $347 million and $388 million, respectively. Additionally, the firm may invest alongside the third-party investors in certain funds. The aggregate carrying value of the firm’s interests in these funds was $3.42 billion and $2.17 billion as of May 2006 and November 2005, respectively. In the normal course of business, the firm may also engage in other activities with these funds, including among others, securities lending, trade execution, trading and custody. See Note 6 for the firm’s commitments related to these funds.
The firm is regulated by the U.S. Securities and Exchange Commission (SEC) as a Consolidated Supervised Entity (CSE). As such, it is subject to group-wide supervision and examination by the SEC and to minimum capital requirements on a consolidated basis. As of May 2006 and November 2005, the firm was in compliance with the CSE capital requirements.
The firm’s principal U.S. regulated subsidiaries include Goldman, Sachs & Co. (GS&Co.) and Goldman Sachs Execution & Clearing, L.P. (GSEC). GS&Co. and GSEC are registered U.S. broker-dealers and futures commission merchants subject to Rule 15c3-1 of the SEC and Rule 1.17 of the Commodity Futures Trading Commission, which specify uniform minimum net capital requirements, as defined, for their registrants. GS&Co. and GSEC have elected to compute their minimum capital requirements in accordance with the “Alternative Net Capital Requirement” as permitted by Rule 15c3-1. As of May 2006 and November 2005, GS&Co. and GSEC had net capital in excess of their minimum capital requirements. In addition to its alternative minimum net capital requirements, GS&Co. is also required to hold tentative net capital in excess of $1 billion and net capital in excess of $500 million in accordance with the market and credit risk standards of Appendix E of Rule 15c3-1. GS&Co. is also required to notify the SEC in the event that its tentative net capital is less than $5 billion. As of May 2006 and November 2005, GS&Co. had tentative net capital and net capital in excess of both the minimum and the notification requirements.
The firm’s principal non-U.S. regulated subsidiaries include Goldman Sachs International (GSI) and Goldman Sachs (Japan) Ltd. (GSJL). GSI, a regulated U.K. broker-dealer, is subject to the capital requirements of the U.K.’s Financial Services Authority, and GSJL, a regulated broker-dealer based in Tokyo, is subject to the capital requirements of Japan’s Financial Services Agency. As of May 2006 and November 2005, GSI and GSJL were in compliance with their local capital adequacy requirements. Certain other non-U.S. subsidiaries of the firm are also subject to capital adequacy requirements promulgated by authorities of the countries in which they operate. As of May 2006 and November 2005, these subsidiaries were in compliance with their local capital adequacy requirements.
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In reporting to management, the firm’s operating results are categorized into the following three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services.
In reporting segments, certain of the firm’s business lines have been aggregated where they have similar economic characteristics and are similar in each of the following areas: (i) the nature of the services they provide, (ii) their methods of distribution, (iii) the types of clients they serve and (iv) the regulatory environments in which they operate.
The cost drivers of the firm taken as a whole — compensation, headcount and levels of business activity — are broadly similar in each of the firm’s business segments. Compensation expenses within the firm’s segments reflect, among other factors, the overall performance of the firm as well as the performance of individual business units. Consequently, pre-tax margins in one segment of the firm’s business may be significantly affected by the performance of the firm’s other business segments. The timing and magnitude of changes in the firm’s bonus accruals can have a significant effect on segment results in a given period.
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Segment Operating Results
Management believes that the following information provides a reasonable representation of each segment’s contribution to consolidated pre-tax earnings and total assets:
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Report of Independent Registered Public Accounting Firm
To the Directors and Shareholders of The Goldman Sachs Group, Inc.:
We have reviewed the accompanying condensed consolidated statement of financial condition of The Goldman Sachs Group, Inc. and its subsidiaries (the Company) as of May 26, 2006, the related condensed consolidated statements of earnings for the three and six months ended May 26, 2006 and May 27, 2005, the condensed consolidated statement of changes in shareholders’ equity for the six months ended May 26, 2006, the condensed consolidated statements of cash flows for the six months ended May 26, 2006 and May 27, 2005, and the condensed consolidated statements of comprehensive income for the three and six months ended May 26, 2006 and May 27, 2005. These condensed consolidated interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition as of November 25, 2005 and the related consolidated statements of earnings, changes in shareholders’ equity, cash flows and comprehensive income for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of November 25, 2005 and the effectiveness of the Company’s internal control over financial reporting as of November 25, 2005; and in our report dated February 3, 2006, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of November 25, 2005, and the condensed consolidated statement of changes in shareholders’ equity for the year ended November 25, 2005, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived.
/s/ PricewaterhouseCoopers LLP
New York, New YorkJune 29, 2006
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INDEX
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Introduction
Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
Our activities are divided into three segments:
This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended November 25, 2005. References herein to the Annual Report on Form 10-K are to our Annual Report on Form 10-K for the fiscal year ended November 25, 2005.
Unless specifically stated otherwise, all references to May 2006 and May 2005 refer to our fiscal periods ended, or the dates, as the context requires, May 26, 2006 and May 27, 2005, respectively. All references to November 2005, unless specifically stated otherwise, refer to our fiscal year ended, or the date, as the context requires, November 25, 2005. All references to 2006, unless specifically stated otherwise, refer to our fiscal year ending, or the date, as the context requires, November 24, 2006.
When we use the terms “Goldman Sachs,” “we,” “us” and “our,” we mean The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, and its consolidated subsidiaries.
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Executive Overview
Our diluted earnings per common share were $4.78, annualized return on average tangible common shareholders’ equity (1) was 39.0% and annualized return on average common shareholders’ equity was 32.5% for the second quarter of 2006. Excluding incremental non-cash expenses of $138 million related to the accounting for certain share-based awards under SFAS No.123-R (2), diluted earnings per common share were $4.97 (2), annualized return on average tangible common shareholders’ equity (1) was 40.8%(2) and annualized return on average common shareholders’ equity was 33.9% (2) for the second quarter of 2006. Diluted earnings per common share for the second quarter of 2005 were $1.71.
Our results for the second quarter of 2006 reflected strong growth in each of our three segments as compared with the second quarter of 2005. The increase in Trading and Principal Investments reflected significantly higher net revenues in Fixed Income, Currency and Commodities (FICC) and Equities, as customer-driven activity remained strong and the market environment was generally favorable, although the equity markets became more challenging in May. Net revenues in Principal Investments also increased as gains and overrides from corporate and real estate principal investments were significantly higher than the same period last year, and more than offset a decline in results related to our investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG). The increase in Investment Banking net revenues reflected strong growth across all regions. Net revenues were significantly higher in Underwriting and Financial Advisory, reflecting strong corporate activity levels. Our investment banking backlog increased during the quarter. (3) The strong net revenue growth in our Asset Management and Securities Services businesses reflected significantly higher management and other fees as well as continued growth in our prime brokerage business.
Our diluted earnings per common share were $9.86 for the six months ended May 2006 compared with $4.65 for the first half of 2005. Annualized return on average tangible common shareholders’ equity (1) was 41.4% and annualized return on average common shareholders’ equity was 34.3%. Excluding incremental non-cash expenses of $375 million related to the accounting for certain share-based awards under SFAS No. 123-R (2), diluted earnings per common share were $10.38 (2), annualized return on average tangible common shareholders’ equity (1) was 43.7% (2) and annualized return on average common shareholders’ equity was 36.2% (2) for the six months ended May 2006. Our results for the first half of 2006 reflected strong net revenue growth in each of our three segments as compared with the same period last year.
During the first half of 2006, each of our segments achieved record results. In Investment Banking, industry-wide volumes across mergers and acquisitions and equity underwriting were significantly ahead of the same prior year period, and debt underwriting volumes remained at very high levels. In our FICC and Equities businesses, we continued to see favorable trading and investing opportunities for our clients and ourselves, and consequently, we increased our market risk, particularly in equities, to capitalize on these opportunities. In our Asset Management business, continued revenue growth was driven by record assets under management and strong investment performance, and in our Securities Services business, our customer balances grew significantly. We continued to focus on managing our capital base, with the goal of optimizing our returns while, at the same time, growing our businesses. We repurchased 19.1 million shares and 6.5 million shares of our common stock during our first quarter and second quarter, respectively, at a total cost of $3.59 billion. In addition, we increased our quarterly dividend to $0.35 per common share from $0.25 per common share during our first quarter. With respect to the regulatory environment, financial services firms continued to be under intense scrutiny, with the volume and amount of claims against financial institutions and other related costs remaining significant. Given the range of litigation and investigations presently under way, our litigation expenses can be expected to remain high.
Though our operating results were very strong in the first half of 2006, our business, by its nature, does not produce predictable earnings. Our results in any given period can be materially affected by conditions in global financial markets and economic conditions generally. For a further discussion of the factors that may affect our future operating results, see “Risk Factors” in Part I, Item 1A of our Annual Report on Form10-K.
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Business Environment
Global economic conditions remained favorable during our second fiscal quarter of 2006, as real gross domestic product continued to grow at a solid pace and business confidence generally remained at high levels. However, concerns over inflationary pressures, particularly in the U.S., became apparent near the end of our fiscal quarter. These concerns were reflected, in part, in the global equity markets, which declined in May, after generally rising for the first two months of our fiscal quarter. In the fixed income markets, although remaining relatively flat, yield curves in both the U.S. and Europe steepened, with the 10-year U.S. Treasury note yield increasing to 11 basis points above the 2-year yield, while corporate credit spreads remained narrow. In Investment Banking, corporate activity levels in mergers and acquisitions remained strong and equity underwriting activity increased significantly during the quarter.
In the United States, although economic growth remained solid, the pace appeared to moderate in our second fiscal quarter, as consumer spending began to slow, reflecting the impact of high energy prices. In addition, business and consumer confidence remained high, but appeared to decline towards the end of our fiscal quarter. Unemployment reached its lowest levels since 2001 and measures of core inflation began to increase. The U.S. Federal Reserve raised its federal funds rate target during the quarter by 50 basis points to 5.00% and has increased the rate in each of its last 16 meetings. Expectations for further rate increases rose towards the quarter end. Long-term bond yields increased, with the 10-year U.S. Treasury note yield ending the quarter up 48 basis points at 5.05%. Although U.S. equity markets were higher for much of the quarter, they declined in May. The Dow Jones Industrial Average ended our fiscal quarter up 2%, while the NASDAQ and the S&P 500 Index ended our fiscal quarter down 3% and 1%, respectively.
In Europe, economic growth continued to improve during our second fiscal quarter, reflecting growth in exports and business investment. In addition, inflation remained relatively contained and business confidence continued to improve during our second fiscal quarter. However, employment growth and private consumption remained subdued. The European Central Bank increased its main refinancing operations rate by 25 basis points during the quarter to 2.50%. In the U.K., although financial conditions became significantly less accommodative, the economy showed continued modest growth and the Bank of England left rates unchanged. European equity markets were higher for much of the quarter, but ended the quarter lower, while long-term yields ended the quarter higher.
In Japan, real gross domestic product growth appeared to remain solid during our second fiscal quarter, reflecting continued growth in domestic demand and exports. Improvements in the labor market helped raise consumer confidence, which reached its highest levels since 1990. This improvement was reflected in an increase in personal consumption. Although inflation began to increase modestly during the fiscal quarter, the Bank of Japan maintained its uncollateralized overnight call rate at zero percent. Despite a sharp rise early in the quarter, the Nikkei 225 ended our fiscal quarter down 1%. In China, economic growth remained solid, although the pace of growth appeared to decrease slightly from the first quarter. Exports and domestic demand remained strong. The People’s Bank of China increased the one-year lending rate by 27 basis points to 5.85%. Elsewhere in Asia, growth in exports and domestic demand remained steady. Equity markets ended our fiscal quarter higher in China and Taiwan, essentially unchanged in Hong Kong and lower in South Korea.
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Critical Accounting Policies
Fair Value
The use of fair value to measure our financial instruments, with related unrealized gains or losses generally recognized immediately in our results of operations, is fundamental to our financial statements and is our most critical accounting policy. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
In determining fair value, we separate our financial instruments into three categories — cash (i.e., nonderivative) trading instruments, derivative contracts and principal investments, as set forth in the following table:
Financial Instruments by Category(in millions)
Cash Trading Instruments. The following table sets forth the valuation of our cash trading instruments by level of price transparency:
Cash Trading Instruments by Price Transparency(in millions)
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Fair values of our cash trading instruments are generally obtained from quoted market prices in active markets, broker or dealer price quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued in this manner include U.S. government and agency securities, other sovereign government obligations, liquid mortgage products, investment-grade and high-yield corporate bonds, listed equities, money market securities, state, municipal and provincial obligations, and physical commodities.
Certain cash trading instruments trade infrequently and have little or no price transparency. Such instruments may include certain corporate bank loans, mortgage whole loans and distressed debt. We value these instruments initially at cost and generally do not adjust valuations unless there is substantive evidence supporting a change in the value of the underlying instrument or valuation assumptions (such as similar market transactions, changes in financial ratios or changes in the credit ratings of the underlying companies). Where there is evidence supporting a change in the value, we use valuation methodologies such as the present value of known or estimated cash flows.
Cash trading instruments we own (long positions) are marked to bid prices, and instruments we have sold but not yet purchased (short positions) are marked to offer prices. If liquidating a position is expected to affect its prevailing market price, our valuation is adjusted generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine this adjustment.
Derivative Contracts. Derivative contracts consist of exchange-traded and over-the-counter (OTC) derivatives. The following table sets forth the fair value of our exchange-traded and OTC derivative assets and liabilities:
Derivative Assets and Liabilities(in millions)
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Fair values of our exchange-traded derivatives are generally determined from quoted market prices. OTC derivatives are valued using valuation models. We use a variety of valuation models including the present value of known or estimated cash flows and option-pricing models. The valuation models that we use to derive the fair values of our OTC derivatives require inputs including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. The selection of a model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. We generally use similar models to value similar instruments. Where possible, we verify the values produced by our pricing models to market transactions. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model selection does not involve significant judgment because market prices are readily available. For OTC derivatives that trade in less liquid markets, model selection requires more judgment because such instruments tend to be more complex and pricing information is less available in these markets. Price transparency is inherently more limited for more complex structures because they often combine one or more product types, requiring additional inputs such as correlations and volatilities. As markets continue to develop and more pricing information becomes available, we continue to review and refine the models that we use.
At the inception of an OTC derivative contract (day one), we value the contract at the model value if we can verify all of the significant model inputs to observable market data and verify the model to market transactions. When appropriate, valuations are adjusted to reflect various factors such as liquidity, bid/offer spreads and credit considerations. These adjustments are generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine these adjustments.
Where we cannot verify all of the significant model inputs to observable market data and verify the model to market transactions, we value the contract at the transaction price at inception and, consequently, record no day one gain or loss in accordance with Emerging Issues Task Force (EITF) Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” Following day one, we adjust the inputs to our valuation models only to the extent that changes in these inputs can be verified by similar market transactions, third-party pricing services and/or broker quotes, or can be derived from other substantive evidence such as empirical market data. In circumstances where we cannot verify the model to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value.
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The following tables set forth the fair values of our OTC derivative assets and liabilities by product and by remaining contractual maturity:
OTC Derivatives(in millions)
We enter into certain OTC option transactions that provide us or our counterparties with the right to extend the maturity of the underlying contract. The fair value of these option contracts is not material to the aggregate fair value of our OTC derivative portfolio. In the tables above, for option contracts that require settlement by delivery of an underlying derivative instrument, the remaining contractual maturity is generally classified based upon the maturity date of the underlying derivative instrument. In those instances where the underlying instrument does not have a maturity date or either counterparty has the right to settle in cash, the remaining contractual maturity is generally based upon the option expiration date.
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Principal Investments. The following table sets forth the carrying value of our corporate and real estate principal investments in private companies (excluding our investment in the ordinary shares of Industrial and Commercial Bank of China Limited (ICBC)), in public companies (excluding our investment in the convertible preferred stock of SMFG) and our investments in SMFG and ICBC:
Principal Investments(in millions)
Our private principal investments, by their nature, have little or no price transparency. Such investments (including our investment in ICBC) are initially carried at cost as an approximation of fair value. Adjustments to carrying value are made if there are third-party transactions evidencing a change in value. Downward adjustments are also made, in the absence of third-party transactions, if we determine that the expected realizable value of the investment is less than the carrying value. In reaching that determination, we consider many factors including, but not limited to, the operating cash flows and financial performance of the companies or properties relative to budgets or projections, trends within sectors and/or regions, underlying business models, expected exit timing and strategy, and any specific rights or terms associated with the investment, such as conversion features and liquidation preferences.
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Our public principal investments, which tend to be large, concentrated holdings that result from initial public offerings or other corporate transactions, are valued using quoted market prices discounted based on predetermined written policies for nontransferability and illiquidity.
Our investment in the convertible preferred stock of SMFG is carried at fair value, which is derived from a model that incorporates SMFG’s common stock price and credit spreads, the impact of nontransferability and illiquidity, and the downside protection on the conversion strike price. The fair value of our investment is particularly sensitive to movements in the SMFG common stock price. As a result of transfer restrictions and the downside protection on the conversion strike price, the relationship between changes in the fair value of our investment and changes in SMFG’s common stock price is nonlinear. During the second quarter, the fair value of our investment (excluding the economic hedge on the unrestricted shares of common stock) decreased 6% (expressed in Japanese yen), primarily reflecting a decrease in the SMFG common stock price, partially offset by the impact of passage of time in respect of the transfer restrictions on the underlying common stock.
Our investment in the convertible preferred stock of SMFG is generally nontransferable, but is freely convertible into SMFG common stock. Restrictions on our ability to hedge or sell two-thirds of the common stock underlying our investment in SMFG lapsed in equal installments on February 7, 2005 and March 9, 2006. As of the date of this filing, we have fully hedged the first one-third installment of the unrestricted shares and have hedged approximately one-half of the second one-third installment of the unrestricted shares. Restrictions on our ability to hedge or sell the remaining one-third installment lapse on February 7, 2007. As of March 1, 2006, the conversion price of our SMFG preferred stock into shares of SMFG common stock was ¥320,700. This price is subject to downward adjustment if the price of SMFG common stock at the time of conversion is less than the conversion price (subject to a floor of ¥105,700).
Controls Over Valuation of Financial Instruments. A control infrastructure, independent of the trading and investing functions, is fundamental to ensuring that our financial instruments are appropriately valued and that fair value measurements are reliable. This is particularly important in valuing instruments with lower levels of price transparency.
We employ an oversight structure that includes appropriate segregation of duties. Senior management, independent of the trading functions, is responsible for the oversight of control and valuation policies and for reporting the results of these policies to our Audit Committee. We seek to maintain the necessary resources to ensure that control functions are performed to the highest standards. We employ procedures for the approval of new transaction types and markets, price verification, review of daily profit and loss, and review of valuation models by personnel with appropriate technical knowledge of relevant products and markets. These procedures are performed by personnel independent of the revenue-producing units. For trading and principal investments with little or no price transparency, we employ, where possible, procedures that include comparisons with similar observable positions, analysis of actual to projected cash flows, comparisons with subsequent sales and discussions with senior business leaders. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management” in Part II, Item 7 of the Annual Report on Form 10-K for a further discussion on how we manage the risks inherent in our trading and principal investing businesses.
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Goodwill and Identifiable Intangible Assets
As a result of our acquisitions, principally SLK LLC (SLK) in fiscal 2000, The Ayco Company, L.P. (Ayco) in fiscal 2003, Cogentrix Energy, Inc. (Cogentrix) in fiscal 2004, National Energy & Gas Transmission, Inc. (NEGT) in fiscal 2005 and the acquisition of the variable annuity and variable life insurance business of The Hanover Insurance Group, Inc. (formerly Allmerica Financial Corporation) in fiscal 2006, we have acquired goodwill and identifiable intangible assets. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date.
Goodwill. We test the goodwill in each of our operating segments for impairment at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” by comparing the estimated fair value of each operating segment with its estimated net book value. We derive the fair value of each of our operating segments primarily based on price-earnings multiples. We derive the net book value of our operating segments by estimating the amount of shareholders’ equity required to support the assets of each operating segment. Our last annual impairment test was performed during our fiscal 2005 fourth quarter and no impairment was identified.
The following table sets forth the carrying value of our goodwill by operating segment:
Goodwill by Operating Segment(in millions)
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Identifiable Intangible Assets. We amortize our identifiable intangible assets over their estimated useful lives in accordance with SFAS No. 142, and test for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.
The following table sets forth the carrying value and range of remaining useful lives of our identifiable intangible assets by major asset class:
Identifiable Intangible Assets by Asset Class($ in millions)
A prolonged period of weakness in global equity markets and the trading of securities in multiple markets and on multiple exchanges could adversely impact our businesses and impair the value of our goodwill and/or identifiable intangible assets. In addition, certain events could indicate a potential impairment of our identifiable intangible assets, including (i) changes in market structure that could adversely affect our specialist businesses, (ii) an adverse action or assessment by a regulator, (iii) a default event under a power contract or physical damage or other adverse events impacting the underlying power generation facilities, or (iv) adverse actual experience on the contracts in our variable annuity and variable life insurance business.
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Use of Estimates
The use of generally accepted accounting principles requires management to make certain estimates. In addition to the estimates we make in connection with fair value measurements and the accounting for goodwill and identifiable intangible assets, the use of estimates is also important in determining compensation and benefits expenses for interim periods and in determining provisions for potential losses that may arise from litigation and regulatory proceedings and tax audits.
A substantial portion of our compensation and benefits represents discretionary bonuses, which are determined at year end. We believe the most appropriate way to allocate estimated annual discretionary bonuses among interim periods is in proportion to the net revenues earned in such periods. In addition to the level of net revenues, our overall compensation expense in any given year is also influenced by, among other factors, prevailing labor markets, business mix and the structure of our share-based compensation programs. We generally target compensation and benefits at 50% (plus or minus a few percentage points) of consolidated net revenues. During the first half of 2006, our ratio of compensation and benefits to net revenues was 50.8%. Excluding the $375 million impact of the continued amortization of prior year share-based awards under SFAS No. 123-R, our ratio of compensation and benefits to net revenues was 49.0%. (1)
We estimate and provide for potential losses that may arise out of litigation and regulatory proceedings and tax audits to the extent that such losses are probable and can be estimated, in accordance with SFAS No. 5, “Accounting for Contingencies.” Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability in respect of litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses after considering, among other factors, the progress of each case or proceeding, our experience and the experience of others in similar cases or proceedings, and the opinions and views of legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. See “Legal Proceedings” in Part I, Item 3 of the Annual Report on Form 10-K, and in Part II, Item 1 of our Quarterly Report on Form 10-Q for the quarter ended February 24, 2006 and in Part II, Item 1 of this Quarterly Report on Form 10-Q for information on our judicial, regulatory and arbitration proceedings.
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Results of Operations
The composition of our net revenues has varied over time as financial markets and the scope of our operations have changed. The composition of net revenues can also vary over the shorter term due to fluctuations in U.S. and global economic and market conditions. For a further discussion of the impact of economic and market conditions on our results of operations, see “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.
Financial Overview
The following table sets forth an overview of our financial results:
Financial Overview($ in millions, except per share amounts)
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Net Revenues
Three Months Ended May 2006 versus May 2005. Our net revenues were $10.10 billion for the second quarter of 2006, an increase of 110% compared with the second quarter of 2005, reflecting strong growth in each of our three segments. The increase in Trading and Principal Investments reflected significantly higher net revenues in FICC and Equities, as customer-driven activity remained strong and the market environment was generally favorable, although the equity markets became more challenging in May. Net revenues in Principal Investments also increased as gains and overrides from corporate and real estate principal investments were significantly higher than the same period last year, and more than offset a decline in results related to our investment in the convertible preferred stock of SMFG. The increase in Investment Banking net revenues reflected strong growth across all regions. Net revenues were significantly higher in Underwriting and Financial Advisory, reflecting strong corporate activity levels. The strong net revenue growth in our Asset Management and Securities Services businesses reflected significantly higher management and other fees as well as continued growth in our prime brokerage business.
Six Months Ended May 2006 versus May 2005. Our net revenues were $20.43 billion for the first half of 2006, an increase of 82% compared with the same period last year, reflecting strong net revenue growth in each of our three segments. The increase in Trading and Principal Investments reflected significantly higher net revenues in FICC, with strong performance across all major businesses, as customer-driven activity was strong and market conditions were favorable. In addition, net revenues in Equities increased significantly, reflecting strength across all businesses, as customer-driven activity was solid and global equity prices were generally higher. Net revenues in Principal Investments also increased as gains and overrides from corporate and real estate principal investments and the gain related to our investment in the convertible preferred stock of SMFG were higher than the same prior year period. The increase in Investment Banking net revenues reflected strong growth across all regions. Net revenues were significantly higher in Financial Advisory, equity underwriting and debt underwriting, reflecting strong corporate activity levels. The strong net revenue growth in our Asset Management and Securities Services businesses reflected incentive fees of $843 million (compared with $163 million for the same prior year period) and a 25% increase in management and other fees, as well as significantly higher global customer balances in Securities Services.
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Operating Expenses
Our operating expenses are primarily influenced by compensation, headcount and levels of business activity. A substantial portion of our compensation expense represents discretionary bonuses, with our overall compensation and benefits expenses generally targeted at 50% (plus or minus a few percentage points) of consolidated net revenues. In addition to the level of net revenues, our compensation expense in any given year is influenced by, among other factors, prevailing labor markets, business mix and the structure of our share-based compensation programs. During the first half of 2006, our ratio of compensation and benefits to net revenues was 50.8%. Excluding the $375 million impact of the continued amortization of prior year share-based awards under SFAS No. 123-R for the first half of 2006, our ratio of compensation and benefits to net revenues was 49.0%. See “— Use of Estimates” above for more information on our ratio of compensation and benefits to net revenues.
The following table sets forth our operating expenses and number of employees:
Operating Expenses and Employees($ in millions)
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The following table sets forth non-compensation expenses of consolidated entities held for investment purposes and our remaining non-compensation expenses by line item:
Non-Compensation Expenses(in millions)
Three Months Ended May 2006 versus May 2005. Operating expenses of $6.57 billion increased 85% compared with the second quarter of 2005. Compensation and benefits expenses of $5.09 billion increased 112% compared with the second quarter of 2005, primarily reflecting higher net revenues. The ratio of compensation and benefits to net revenues for the second quarter of 2006 was 50.4% compared with 50.0% for the second quarter of 2005. Excluding the $138 million impact of the continued amortization of prior year share-based awards under SFAS No. 123-R, the ratio of compensation and benefits to net revenues was 49.0% for the second quarter of 2006 compared with 50.0% for the second quarter of 2005. Employment levels increased 2% during the second quarter of 2006. See “— Use of Estimates” above for more information on our ratio of compensation and benefits to net revenues.
In the first quarter of 2006, we adopted SFAS No. 123-R, which requires that share-based awards granted to retirement-eligible employees, including those subject to non-compete agreements, be expensed in the year of grant. In addition to expensing current year awards, prior year awards must continue to be amortized over the relevant service period. Therefore, our compensation and benefits expenses in fiscal 2006 (and, to a lesser extent, in fiscal 2007 and fiscal 2008) will include both amortization of prior year awards and new awards granted to retirement-eligible employees for services rendered in fiscal 2006. The majority of the expense related to the continued amortization of prior year awards will be recognized in fiscal 2006. The estimated annual expense for fiscal 2006 is approximately $650 million of which $138 million was recognized in the second quarter of 2006.
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Non-compensation expenses were $1.49 billion, 28% higher than the second quarter of 2005. Excluding consolidated entities held for investment purposes, non-compensation expenses were 23% higher than the second quarter of 2005. One-half of this increase was attributable to higher brokerage, clearing and exchange fees, primarily in Equities. Other expenses were higher primarily due to costs related to our insurance business, which was acquired in the first quarter of 2006, and net provisions for litigation and regulatory proceedings of $19 million.
Six Months Ended May 2006 versus May 2005. Operating expenses of $13.22 billion for the first half of 2006 increased 69% compared with the first half of 2005. Compensation and benefits expenses of $10.39 billion increased 85% compared with the first half of 2005, primarily reflecting higher net revenues. The ratio of compensation and benefits to net revenues for the first half of 2006 was 50.8% compared with 50.0% for the same period last year. Excluding the $375 million impact of the continued amortization of prior year share-based awards under SFAS No. 123-R, the ratio of compensation and benefits to net revenues was 49.0% for the first half of 2006 compared with 50.0% for the first half of 2005. Employment levels increased 2% during the first half of 2006.
Non-compensation expenses were $2.83 billion, 28% higher than the first half of 2005. Excluding consolidated entities held for investment purposes, non-compensation expenses were 21% higher than the first half of 2005. Approximately one-half of this increase was attributable to higher brokerage, clearing and exchange fees, primarily in Equities. Other expenses were higher primarily due to costs related to our insurance business, which was acquired in the first quarter of 2006, and increased charitable contributions. Other expenses included net provisions for litigation and regulatory proceedings of $48 million for the first half of 2006 compared with $23 million for the same period last year.
Provision for Taxes
The provision for taxes for the three and six months ended May 2006 was $1.21 billion and $2.42 billion, respectively. The effective income tax rate for the first half of 2006 was 33.6%, up from 32.8% for the first quarter of 2006 and 32.0% for fiscal year 2005. The increase in the effective tax rate for the first half of 2006 compared with the first quarter of 2006 was primarily due to the effect of lower estimated tax credits. The increase in the effective tax rate for the first half of 2006 compared with fiscal year 2005 was primarily due to the impact of audit settlements in fiscal year 2005 and lower estimated tax credits in 2006.
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The following table sets forth the net revenues, operating expenses and pre-tax earnings of our segments:
Segment Operating Results(in millions)
Net revenues in our segments include allocations of interest income and interest expense to specific securities, commodities and other positions in relation to the cash generated by, or funding requirements of, such underlying positions.
The cost drivers of Goldman Sachs taken as a whole — compensation, headcount and levels of business activity — are broadly similar in each of our business segments. Compensation expenses within our segments reflect, among other factors, the overall performance of Goldman Sachs as well as the performance of individual business units. Consequently, pre-tax margins in one segment of our business may be significantly affected by the performance of our other business segments. The timing and magnitude of changes in our bonus accruals can have a significant effect on segment results in a given period. A discussion of segment operating results follows.
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Investment Banking
Our Investment Banking segment is divided into two components:
The following table sets forth the operating results of our Investment Banking segment:
Investment Banking Operating Results(in millions)
The following table sets forth our financial advisory and underwriting transaction volumes:
Goldman Sachs Global Investment Banking Volumes (1)(in billions)
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Three Months Ended May 2006 versus May 2005. Net revenues in Investment Banking of $1.53 billion for the second quarter of 2006 increased 87% compared with the second quarter of 2005, reflecting growth across all regions. Net revenues in Financial Advisory of $608 million increased 58% compared with the second quarter of 2005, primarily reflecting strong growth in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business of $918 million increased 114% compared with the second quarter of 2005. Net revenues were significantly higher in equity underwriting, primarily reflecting an increase in industry-wide equity and equity-related offerings, and in debt underwriting, primarily due to an increase in leveraged finance activity. Our investment banking backlog increased during the second quarter of 2006. (1)
Operating expenses of $1.09 billion for the second quarter of 2006 increased 52% compared with the second quarter of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Pre-tax earnings were $432 million compared with $97 million in the second quarter of 2005.
Six Months Ended May 2006 versus May 2005. Net revenues in Investment Banking of $3.00 billion for the first half of 2006 increased 75% compared with the first half of 2005, reflecting growth across all regions. Net revenues in Financial Advisory of $1.34 billion increased 68% compared with the same period last year, primarily reflecting an increase in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business of $1.65 billion increased 82% compared with the first half of 2005. Net revenues were significantly higher in equity underwriting, primarily reflecting an increase in industry-wide equity and equity-related offerings, and in debt underwriting, primarily due to an increase in leveraged finance and investment-grade activity.
Operating expenses of $2.28 billion for the first half of 2006 increased 52% compared with the first half of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Pre-tax earnings were $714 million for the first half of 2006 compared with $203 million in the same period last year.
Trading and Principal Investments
Our Trading and Principal Investments segment is divided into three components:
Substantially all of our inventory is marked-to-market daily and, therefore, its value and our net revenues are subject to fluctuations based on market movements. In addition, net revenues derived from our principal investments in privately held concerns and in real estate may fluctuate significantly depending on the revaluation or sale of these investments in any given period. We also regularly enter into large transactions as part of our trading businesses. The number and size of such transactions may affect our results of operations in a given period.
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Net revenues from Principal Investments do not include management fees generated from our merchant banking funds. These management fees are included in the net revenues of the Asset Management and Securities Services segment.
The following table sets forth the operating results of our Trading and Principal Investments segment:
Trading and Principal Investments Operating Results(in millions)
Three Months Ended May 2006 versus May 2005. Net revenues in Trading and Principal Investments of $6.96 billion for the second quarter of 2006 increased 147% compared with the second quarter of 2005. Net revenues in FICC of $4.32 billion increased 184% compared with the second quarter of 2005, reflecting significantly higher net revenues in commodities, credit products and interest rate products. The increase in commodities reflected a $700 million gain related to the sale of East Coast Power, L.L.C., one of our power generation facilities, as well as strong results across the business. In addition, net revenues were higher in currencies and mortgages. During the quarter, FICC operated in a favorable environment generally characterized by strong customer-driven activity, favorable market opportunities, tight credit spreads and volatile markets. Net revenues in Equities of $2.35 billion increased 113% compared with the second quarter of 2005, reflecting significantly higher net revenues across all regions in shares and derivatives. In addition, net revenues in our principal strategies business improved compared with the second quarter of 2005. During the quarter, the business operated in an environment characterized by strong customer-driven activity and generally favorable market opportunities, although conditions became more challenging in May. Principal Investments recorded net revenues of $293 million, reflecting $354 million in gains and overrides from corporate and real estate principal investments, partially offset by a $61 million loss related to our investment in the convertible preferred stock of SMFG.
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Operating expenses of $4.37 billion for the second quarter of 2006 increased 112% compared with the second quarter of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Excluding consolidated entities held for investment purposes, the increase in non-compensation expenses was primarily attributable to higher brokerage, clearing and exchange fees, principally in Equities. In addition, other expenses were higher primarily due to costs related to our insurance business. Pre-tax earnings were $2.59 billion compared with $748 million in the second quarter of 2005.
Six Months Ended May 2006 versus May 2005. Net revenues in Trading and Principal Investments of $13.85 billion for the first half of 2006 increased 92% compared with the first half of 2005. Net revenues in FICC of $8.06 billion increased 101% compared with the same period last year, reflecting significantly higher net revenues in commodities, credit products, currencies and interest rate products. In addition, results in mortgages were strong, as net revenues for the first half of 2006 were higher compared with the same period last year. During the first half of 2006, FICC operated in an environment characterized by strong customer-driven activity, favorable market opportunities and tight credit spreads. Net revenues in Equities of $4.80 billion increased 81% compared with the same period last year, primarily due to significantly higher net revenues in derivatives and shares. In addition, net revenues in our principal strategies business increased in the first half of 2006, reflecting a particularly strong performance in the first quarter. During the first half of the year, Equities operated in an environment characterized by strong customer-driven activity, favorable market opportunities and generally higher equity prices, although conditions became more challenging in May. Principal Investments recorded net revenues of $988 million, reflecting $644 million in gains and overrides from corporate and real estate principal investments and a $344 million gain related to our investment in the convertible preferred stock of SMFG.
Operating expenses of $8.70 billion for the first half of 2006 increased 81% compared with the first half of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Excluding consolidated entities held for investment purposes, the increase in non-compensation expenses was primarily attributable to higher brokerage, clearing and exchange fees, principally in Equities. In addition, other expenses were higher primarily due to costs related to our insurance business and increased charitable contributions. Pre-tax earnings of $5.14 billion for the first half of 2006 increased 114% compared with the same period last year.
Asset Management and Securities Services
Our Asset Management and Securities Services segment is divided into two components:
Assets under management typically generate fees as a percentage of asset value. In certain circumstances, we are also entitled to receive asset management incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are recognized when the performance period ends and they are no longer subject to adjustment. We have numerous incentive fee arrangements, many of which have annual performance periods that end on December 31. For that reason, incentive fees are seasonally weighted each year to our first fiscal quarter.
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The following table sets forth the operating results of our Asset Management and Securities Services segment:
Asset Management and Securities Services Operating Results(in millions)
Assets under management include our mutual funds, alternative investment funds and separately managed accounts for institutional and individual investors. Substantially all assets under management are valued as of calendar month end.
The following table sets forth our assets under management by asset class:
Assets Under Management by Asset Class (1)(in billions)
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The following table sets forth a summary of the changes in our assets under management:
Changes in Assets Under Management(in billions)
Three Months Ended May 2006 versus May 2005. Net revenues in Asset Management and Securities Services of $1.61 billion for the second quarter of 2006 increased 37% compared with the second quarter of 2005. Asset Management net revenues of $954 million increased 38% compared with the second quarter of 2005. The increase was driven by significantly higher management and other fees, primarily due to growth in assets under management, as well as higher incentive fees. During the quarter, assets under management increased 4% to $593 billion, reflecting net asset inflows of $15 billion, spread across all asset classes, as well as market appreciation of $7 billion, primarily in alternative investment and fixed income assets. Securities Services net revenues of $656 million increased 34% compared with the second quarter of 2005, as our prime brokerage business continued to generate strong results, reflecting significantly higher global customer balances in securities lending and margin lending as well as higher seasonal activity levels in Europe.
Operating expenses of $1.09 billion for the second quarter of 2006 increased 38% compared with the second quarter of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Market development costs increased due to higher levels of business activity. Pre-tax earnings were $522 million compared with $391 million in the second quarter of 2005.
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Six Months Ended May 2006 versus May 2005. Net revenues in Asset Management and Securities Services of $3.59 billion for the first half of 2006 increased 56% compared with the first half of 2005. Asset Management net revenues of $2.44 billion increased 70% compared with the same period last year, reflecting significantly higher incentive fees and a 25% increase in management and other fees. Incentive fees were $843 million for the first half of 2006 compared with $163 million for the first half of 2005. During the first half of 2006, assets under management increased 11% to $593 billion, reflecting net asset inflows of $40 billion across all asset classes, as well as market appreciation of $21 billion in equity, fixed income and alternative investment assets. Securities Services net revenues of $1.15 billion increased 32% compared with the same period last year, as our prime brokerage business generated strong results, primarily reflecting significantly higher global customer balances in securities lending and margin lending as well as higher seasonal activity levels in Europe during the second quarter of 2006.
Operating expenses of $2.19 billion for the first half of 2006 increased 46% compared with the first half of 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Market development costs increased due to higher levels of business activity. In addition, occupancy expenses increased, reflecting higher rent and higher operating expenses. Pre-tax earnings were $1.40 billion for the first half of 2006 compared with $807 million in the same period last year.
Capital and Funding
Capital
The amount of capital we hold is principally determined by regulatory capital requirements, rating agency guidelines, subsidiary capital requirements and our overall risk profile, which is largely driven by the size and composition of our trading and investing positions. Goldman Sachs’ total capital (total shareholders’ equity and long-term borrowings) increased 23% to $157.39 billion as of May 2006 compared with $128.01 billion as of November 2005. See “— Liquidity Risk — Cash Flows” below for a discussion of how we deployed capital raised as part of our financing activities.
The increase in total capital resulted primarily from an increase in long-term borrowings to $125.59 billion as of May 2006 from $100.01 billion as of November 2005. The weighted average maturity of our long-term borrowings as of May 2006 was approximately seven years. We swap a substantial portion of our long-term borrowings into U.S. dollar obligations with short-term floating interest rates in order to minimize our exposure to interest rates and foreign exchange movements. See Note 5 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our long-term borrowings.
Over the past several years, our ratio of long-term borrowings to total shareholders’ equity has been increasing. The growth in our long-term borrowings has been driven primarily by (i) our ability to replace a portion of our short-term borrowings with long-term borrowings and pre-fund near-term refinancing requirements, in light of the favorable debt financing environment, and (ii) the need to increase total capital in response to growth in our trading and investing businesses.
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Total shareholders’ equity increased by 14% to $31.80 billion (common equity of $29.20 billion and preferred stock of $2.60 billion) as of May 2006 from $28.00 billion as of November 2005. On May 24, 2006, Goldman Sachs issued 34,000 shares of perpetual Floating Rate Non-Cumulative Preferred Stock, Series D. As of May 2006, Goldman Sachs had 104,000 shares of perpetual non-cumulative preferred stock outstanding in four series as set forth in the following table:
Preferred Stock by Series
Each share of preferred stock has a par value of $0.01, has a liquidation preference of $25,000, is represented by 1,000 depositary shares and is redeemable at our option at a redemption price equal to $25,000 plus declared and unpaid dividends. Dividends on each series of preferred stock, if declared, are payable quarterly in arrears. Our ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, our common stock is subject to certain restrictions in the event we fail to pay or set aside full dividends on our preferred stock for the latest completed dividend period. All preferred stock also has a preference over our common stock upon liquidation.
Our stock repurchase program is intended to maintain our total shareholders’ equity at appropriate levels and to substantially offset increases in share count over time resulting from employee share-based compensation. The repurchase program has been effected primarily through regular open-market purchases and is influenced by, among other factors, the level of our common shareholders’ equity, our overall capital position, share-based awards and exercises of employee stock options, the prevailing market price of our common stock and general market conditions.
During the three and six months ended May 2006, we repurchased 6.5 million shares and 25.6 million shares of our common stock at a total cost of $1.02 billion and $3.59 billion, respectively. The average price paid per share for repurchased shares was $156.59 and $140.28 for the three and six months ended May 2006, respectively. In addition, to satisfy minimum statutory employee tax withholding requirements related to the delivery of shares underlying restricted stock units, we cancelled 3.0 million restricted stock units with a total value of $374 million in the first half of 2006. As of May 2006, we were authorized to repurchase up to 17.2 million additional shares of stock pursuant to our repurchase program. For additional information on our repurchase program, see “Unregistered Sales of Equity Securities and Use of Proceeds” included in Part II, Item 2 of this Quarterly Report on Form 10-Q.
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The following table sets forth information on our assets, shareholders’ equity, leverage ratios and book value per common share:
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The following table sets forth the reconciliation of total shareholders’ equity to tangible equity capital:
Consolidated Supervised Entity
Goldman Sachs is regulated by the U.S. Securities and Exchange Commission (SEC) as a Consolidated Supervised Entity (CSE). As such, it is subject to group-wide supervision and examination by the SEC and to minimum capital requirements on a consolidated basis. As of May 2006 and November 2005, Goldman Sachs was in compliance with the CSE capital requirements. See Note 14 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our regulated subsidiaries.
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Short-Term Borrowings
Goldman Sachs obtains short-term borrowings primarily through the use of promissory notes, commercial paper, secured debt and bank loans. Short-term borrowings also include the portion of long-term borrowings maturing within one year of our financial statement date and certain long-term borrowings that are redeemable within one year of our financial statement date at the option of the holder.
The following table sets forth our short-term borrowings by product:
Short-Term Borrowings(in millions)
Our liquidity depends to an important degree on our ability to refinance these borrowings on a continuous basis. Investors who hold our outstanding promissory notes (short-term unsecured debt that is nontransferable and in which Goldman Sachs does not make a market) and commercial paper have no obligation to purchase new instruments when the outstanding instruments mature.
The following table sets forth our secured and unsecured short-term borrowings:
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A large portion of our secured short-term borrowings are similar in nature to our other collateralized financing sources such as securities sold under agreements to repurchase. These secured short-term borrowings provide Goldman Sachs with a more stable source of liquidity than unsecured short-term borrowings, as they are less sensitive to changes in our credit ratings due to underlying collateral. Our unsecured short-term borrowings include extendible debt if the earliest maturity occurs within one year of our financial statement date. Extendible debt is debt that allows the holder the right to extend the maturity date at predetermined periods during the contractual life of the instrument. These borrowings can be, and in the past generally have been, extended. See “— Liquidity Risk” below for a discussion of the principal liquidity policies we have in place to manage the liquidity risk associated with our short-term borrowings. For a discussion of factors that could impair our ability to access the capital markets, see “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K. See Note 4 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our short-term borrowings.
Credit Ratings
We rely upon the short-term and long-term debt capital markets to fund a significant portion of our day-to-day operations. The cost and availability of debt financing is influenced by our credit ratings. Credit ratings are important when we are competing in certain markets and when we seek to engage in longer term transactions, including OTC derivatives. We believe our credit ratings are primarily based on the credit rating agencies’ assessment of our liquidity, market, credit and operational risk management practices, the level and variability of our earnings, our capital base, our franchise, reputation and management, our corporate governance and the external operating environment. See “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K for a discussion of the risks associated with a reduction in our credit ratings.
The following table sets forth our unsecured credit ratings as of May 2006:
As of May 2006, collateral or termination payments pursuant to bilateral agreements with certain counterparties of approximately $498 million would have been required in the event of a one-notch reduction in our long-term credit ratings. In evaluating our liquidity requirements, we consider additional collateral or termination payments that would be required in the event of further reductions in our long-term credit ratings, as well as collateral that has not been called by counterparties, but is available to them. For a further discussion of our excess liquidity policies, see “— Liquidity Risk — Excess Liquidity — Maintenance of a Pool of Highly Liquid Securities” below.
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Contractual Obligations and Commitments
Goldman Sachs has contractual obligations to make future payments under long-term debt and long-term noncancelable lease agreements and has commitments under a variety of commercial arrangements.
The following table sets forth our contractual obligations by fiscal maturity date as of May 2006:
Contractual Obligations(in millions)
As of May 2006, our long-term borrowings were $125.59 billion and consisted principally of senior borrowings with maturities extending to 2036. These long-term borrowings consisted of $17.84 billion in secured long-term borrowings and $107.75 billion in unsecured long-term borrowings. As of May 2006, long-term borrowings included nonrecourse debt of $15.49 billion, consisting of $5.23 billion issued by William Street Funding Corporation (a wholly owned subsidiary of Group Inc. formed to raise funding to support loan commitments to investment-grade clients made by another wholly owned William Street entity), and $10.26 billion issued by other consolidated entities, of which $1.06 billion was related to our power generation facilities. Nonrecourse debt is debt that only the issuing subsidiary or, if applicable, a subsidiary guaranteeing the debt is obligated to repay. See Note 5 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our long-term borrowings.
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The following table sets forth our quarterly long-term borrowings maturity profile through the second fiscal quarter of 2012:
Long-Term Borrowings Maturity Profile($ in millions)
As of May 2006, our future minimum rental payments, net of minimum sublease rentals, under noncancelable leases were $4.11 billion. These lease commitments, principally for office space, expire on various dates through 2069. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other charges. See Note 6 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our leases.
Our occupancy expenses include costs associated with office space held in excess of our current requirements. This excess space, the cost of which is charged to earnings as incurred, is being held for potential growth or to replace currently occupied space that we may exit in the future. We regularly evaluate our current and future space capacity in relation to current and projected staffing levels. We may incur exit costs in fiscal 2006 and thereafter to the extent we (i) reduce our space capacity or (ii) commit to, or occupy, new properties in the locations in which we operate and, consequently, dispose of existing space that had been held for potential growth. These exit costs may be material to our results of operations in a given period.
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As of May 2006, we had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $58.19 billion.
The following table sets forth our commitments as of May 2006:
Commitments(in millions)
Our commitments to extend credit are agreements to lend to counterparties that have fixed termination dates and are contingent on the satisfaction of all conditions to borrowing set forth in the contract. In connection with our lending activities, we had outstanding commitments of $72.17 billion as of May 2006 compared with $61.12 billion as of November 2005. Since these commitments may expire unused, the total commitment amount does not necessarily reflect the actual future cash flow requirements. Our commercial lending commitments outside the William Street credit extension program are generally extended in connection with contingent acquisition financing and other types of corporate lending. We may reduce our credit risk on these commitments by syndicating all or substantial portions of commitments to other investors. In addition, commitments that are extended for contingent acquisition financing are often short-term in nature, as borrowers often replace them with other funding sources.
With respect to the William Street credit extension program, substantially all of the commitments extended are to investment-grade corporate borrowers. With respect to these commitments, we have credit loss protection provided to us by SMFG, which is generally limited to 95% of the first loss we realize on approved loan commitments, subject to a maximum of $1.00 billion. In addition, subject to the satisfaction of certain conditions, upon our request, SMFG will provide protection for 70% of the second loss on such commitments, subject to a maximum of $1.13 billion. We also use other financial instruments to hedge certain William Street commitments not covered by SMFG.
Our commitments to extend credit also include financing for the warehousing of financial assets to be securitized, primarily in connection with collateralized debt obligations (CDOs) and mortgage securitizations, which are expected to be repaid from the proceeds of the related securitizations for which we may or may not act as underwriter. These arrangements are secured by the warehoused
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assets, primarily consisting of mortgage-backed and other asset-backed securities, residential and commercial mortgages and corporate debt instruments.
As of May 2006 and November 2005, we had construction-related commitments of $1.40 billion and $579 million, respectively, including commitments of $1.05 billion and $481 million, respectively, related to the development of wind energy projects. Construction-related commitments also include outstanding commitments of $290 million and $47 million as of May 2006 and November 2005, respectively, related to our new world headquarters in New York City, expected to cost between $2.3 billion and $2.5 billion.
See Note 6 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further information regarding our commitments, contingencies and guarantees.
Liquidity Risk
Liquidity is of critical importance to companies in the financial services sector. Most failures of financial institutions have occurred in large part due to insufficient liquidity resulting from adverse circumstances. Accordingly, Goldman Sachs has in place a comprehensive set of liquidity and funding policies that are intended to maintain significant flexibility to address both firm-specific and broader industry or market liquidity events. Our principal objective is to be able to fund Goldman Sachs and to enable our core businesses to continue to generate revenue even under adverse circumstances.
Management has implemented a number of policies according to the following liquidity risk management framework:
Excess Liquidity
Maintenance of a Pool of Highly Liquid Securities. Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity. This “Global Core Excess” liquidity is intended to allow us to meet immediate obligations without needing to sell other assets or depend on additional funding from credit-sensitive markets. We believe that this pool of excess liquidity provides us with a resilient source of funds and gives us significant flexibility in managing through a difficult funding environment. Our Global Core Excess reflects the following principles:
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The following table sets forth the average loan value (the estimated amount of cash that would be advanced by counterparties against these securities) of our Global Core Excess:
The U.S. dollar-denominated excess is comprised of only unencumbered U.S. government and agency securities and highly liquid mortgage securities, all of which are Federal Reserve repo-eligible, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and euro, British pound and Japanese yen overnight cash deposits. We strictly limit our Global Core Excess to this narrowly defined list of securities and cash that we believe are highly liquid, even in a difficult funding environment.
The majority of our Global Core Excess is structured such that it is available to meet the liquidity requirements of our parent company, Group Inc., and all of its subsidiaries. The remainder is held in our principal non-U.S. operating entities, primarily to better match the currency and timing requirements for those entities’ potential liquidity obligations.
The size of our Global Core Excess is determined by an internal liquidity model together with a qualitative assessment of the condition of the financial markets and of Goldman Sachs. Our liquidity model identifies and estimates cash and collateral outflows over a short-term horizon in a liquidity crisis, including, but not limited to:
Other Unencumbered Assets. In addition to our Global Core Excess described above, we have a significant amount of other unencumbered securities as a result of our business activities. These assets, which are located in the United States, Europe and Asia, include other government bonds, high-grade money market securities, corporate bonds and marginable equities. We do not include these securities in our Global Core Excess.
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We maintain Global Core Excess and other unencumbered assets in an amount that, if pledged or sold, would provide the funds necessary to replace at least 110% of our unsecured obligations that are scheduled to mature (or where holders have the option to redeem) within the next 12 months. This implies that we could fund our positions on a secured basis for one year in the event we were unable to issue new unsecured debt or liquidate assets. We assume conservative loan values that are based on stress-scenario borrowing capacity and we regularly review these assumptions asset-by-asset. The estimated aggregate loan value of our Global Core Excess and our other unencumbered assets averaged $124.56 billion, $121.12 billion and $125.36 billion in the second quarter of 2006, first quarter of 2006 and in the fiscal year 2005, respectively.
Asset-Liability Management
Asset Quality and Balance Sheet Composition. We seek to maintain a highly liquid balance sheet and substantially all of our inventory is marked-to-market daily. We utilize aged inventory limits for certain financial instruments as a disincentive to our businesses to hold inventory over longer periods of time. We believe that these limits provide a complementary mechanism for ensuring appropriate balance sheet liquidity in addition to our standard position limits. In addition, we periodically reduce the size of certain parts of our balance sheet to comply with period end limits set by management. Because of these periodic reductions and certain other factors including seasonal activity, market conventions and periodic market opportunities in certain of our businesses that result in larger positions during the middle of our reporting periods, our balance sheet fluctuates between financial statement dates and is lower at fiscal period end than would be observed on an average basis. Over the last six quarters, our total assets and adjusted assets at quarter end have been, on average, 5% and 7% lower, respectively, than amounts that would have been observed based on a weekly average over that period. These differences, however, have not resulted in material changes to our credit risk, market risk or liquidity position because they are generally in highly liquid assets that are typically financed on a secured basis.
Certain financial instruments may be more difficult to fund on a secured basis during times of market stress and, accordingly, we generally hold higher levels of capital for these assets than more liquid types of financial instruments. The table below sets forth our aggregate holdings in these categories of financial instruments:
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A large portion of these assets are funded on a secured basis through secured funding markets or nonrecourse financing. We focus on demonstrating a consistent ability to fund these assets on a secured basis for extended periods of time to reduce refinancing risk and to help ensure that these assets have an established amount of loan value in order that they can be funded in periods of market stress.
See Note 3 to the condensed consolidated financial statements included in this Quarterly Report on the Form 10-Q for further information regarding the financial instruments we hold.
Appropriate Financing of Asset Base. We seek to manage the maturity profile of our funding base such that we should be able to liquidate our assets prior to our liabilities coming due, even in times of prolonged or severe liquidity stress. We generally do not rely on immediate sales of assets (other than our Global Core Excess) to maintain liquidity in a distressed environment. However, we recognize that orderly asset sales may be prudent and necessary in a persistent liquidity crisis.
In order to avoid reliance on asset sales, our goal is to ensure that we have sufficient total capital (long-term borrowings plus total shareholders’ equity) to fund our balance sheet for at least one year. We seek to maintain total capital in excess of the aggregate of the following long-term financing requirements:
Our total capital of $157.39 billion and $128.01 billion as of May 2006 and November 2005, respectively, exceeded the aggregate of these requirements.
Conservative Liability Structure. We structure our liabilities conservatively to reduce refinancing risk as well as the risk that we may redeem or repurchase certain of our borrowings prior to their contractual maturity. For example, we may repurchase Goldman Sachs’ commercial paper through the ordinary course of business as a market maker. As such, we emphasize the use of promissory notes (in which Goldman Sachs does not make a market) over commercial paper in order to improve the stability of our short-term unsecured financing base. We have also created internal guidelines regarding the principal amount of debt maturing on any one day or during any single week or year and have average maturity targets for our unsecured debt programs.
We seek to maintain broad and diversified funding sources globally for both secured and unsecured funding. We have imposed various internal guidelines, including the amount of our commercial paper that can be owned and letters of credit that can be issued by any single investor or group of investors. We benefit from distributing our debt issuances through our own sales force to a large, diverse global creditor base and we believe that our relationships with our creditors are critical to our liquidity.
We access funding in a variety of markets in the United States, Europe and Asia. We issue debt through syndicated U.S. registered offerings, U.S. registered and 144A medium-term note programs, offshore medium-term note offerings and other bond offerings, U.S. and non-U.S. commercial paper and promissory note issuances, and other methods. We make extensive use of
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the repurchase agreement and securities lending markets and arrange for letters of credit to be issued on our behalf.
Additionally, unsecured debt issued by Group Inc. does not contain provisions that would, based solely upon an adverse change in our credit ratings, financial ratios, earnings, cash flows or our stock price, trigger a requirement for an early payment, collateral support, change in terms, acceleration of maturity or the creation of an additional financial obligation.
Intercompany Funding
Subsidiary Funding Policies. Substantially all of our unsecured funding is raised by our parent company, Group Inc. The parent company then lends the necessary funds to its subsidiaries, some of which are regulated, to meet their asset financing and capital requirements. In addition, the parent company provides its regulated subsidiaries with the necessary capital to meet their regulatory requirements. The benefits of this approach to subsidiary funding include enhanced control and greater flexibility to meet the funding requirements of our subsidiaries.
Our intercompany funding policies are predicated on an assumption that, unless legally provided for, funds or securities are not freely available from a subsidiary to its parent company or other subsidiaries. In particular, many of our subsidiaries are subject to laws that authorize regulatory bodies to block or limit the flow of funds from those subsidiaries to Group Inc. Regulatory action of that kind could impede access to funds that Group Inc. needs to make payments on obligations, including debt obligations. As such, we assume that capital or other financing provided to our regulated subsidiaries is not available to our parent company or other subsidiaries. In addition, we assume that the Global Core Excess held in our principal non-U.S. operating entities will not be available to our parent company or other subsidiaries and therefore is available only to meet the potential liquidity requirements of those entities.
We also manage our intercompany exposure by requiring senior and subordinated intercompany loans to have maturities equal to or shorter than the maturities of the aggregate borrowings of the parent company. This policy ensures that the subsidiaries’ obligations to the parent company will generally mature in advance of the parent company’s third-party borrowings. In addition, many of our subsidiaries and affiliates pledge collateral at loan value to the parent company to cover their intercompany borrowings (other than subordinated debt) in order to mitigate parent company liquidity risk.
Equity investments in subsidiaries are generally funded with parent company equity capital. As of May 2006, Group Inc.’s equity investment in subsidiaries was $28.74 billion compared with its total shareholders’ equity of $31.80 billion.
Group Inc. has provided substantial amounts of equity and subordinated indebtedness, directly or indirectly, to its regulated subsidiaries; for example, as of May 2006, Group Inc. had $17.25 billion of such equity and subordinated indebtedness invested in Goldman, Sachs & Co., its principal U.S. registered broker-dealer; $21.14 billion invested in Goldman Sachs International, a regulated U.K. broker-dealer; $2.51 billion invested in Goldman Sachs Execution & Clearing, L.P., a U.S. registered broker-dealer; and $2.71 billion invested in Goldman Sachs (Japan) Ltd., a regulated broker-dealer based in Tokyo. Group Inc. also had $46.86 billion of unsubordinated loans to these entities as of May 2006, as well as significant amounts of capital invested in and loans to its other regulated subsidiaries.
Subsidiary Foreign Exchange Policies. Our capital invested in non-U.S. subsidiaries is generally exposed to foreign exchange risk, substantially all of which is hedged. In addition, we generally hedge the non-trading exposure to foreign exchange risk that arises from transactions denominated in currencies other than the transacting entity’s functional currency.
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Crisis Planning
In order to be prepared for a liquidity event, or a period of market stress, we base our liquidity risk management framework and our resulting funding and liquidity policies on conservative stress-scenario planning.
In addition, we maintain a liquidity crisis plan that specifies an approach for analyzing and responding to a liquidity-threatening event. The plan provides the framework to estimate the likely impact of a liquidity event on Goldman Sachs based on some of the risks identified above and outlines which and to what extent liquidity maintenance activities should be implemented based on the severity of the event. It also lists the crisis management team and internal and external parties to be contacted to ensure effective distribution of information.
Cash Flows
As a global financial institution, our cash flows are complex and interrelated and bear little relation to our net earnings and net assets and, consequently, we believe that traditional cash flow analysis is less meaningful in evaluating our liquidity position than the excess liquidity and asset-liability management policies described above. Cash flow analysis may, however, be helpful in highlighting certain macro trends and strategic initiatives in our business.
Six Months Ended May 2006. Our cash and cash equivalents decreased by $2.54 billion to $7.72 billion as of May 2006. We raised $32.16 billion in net cash from financing activities, primarily in long-term debt, in light of the favorable debt financing environment, partially offset by common stock repurchases. We used net cash of $34.70 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients.
Six Months Ended May 2005. Our cash and cash equivalents increased by $3.68 billion to $8.04 billion as of May 2005. We raised $12.19 billion in net cash from financing activities, primarily in long-term debt, in light of the favorable debt financing environment, as well as from the issuance of preferred stock, partially offset by common stock repurchases. We used net cash of $8.51 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients.
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In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123-R, “Share-Based Payment,” which is a revision to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123-R focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for share-based payments. Under SFAS No. 123-R, the cost of employee services received in exchange for an award of equity instruments is generally measured based on the grant-date fair value of the award. Effective for the first quarter of 2006, we adopted SFAS No. 123-R, under the modified prospective adoption method. Under that method of adoption, the provisions of SFAS No. 123-R are generally applied only to share-based awards granted subsequent to adoption. The accounting treatment of share-based awards granted to retirement-eligible employees prior to our adoption of SFAS No. 123-R has not changed and financial statements for periods prior to adoption are not restated for the effects of adopting SFAS No. 123-R.
SFAS No. 123-R requires expected forfeitures to be included in determining share-based employee compensation expense. Prior to the adoption of SFAS No. 123-R, forfeiture benefits were recorded as a reduction to compensation expense when an employee left the firm and forfeited the award. In the first quarter of 2006, we recorded a benefit for expected forfeitures on all outstanding share-based awards. The transition impact of adopting SFAS No. 123-R as of the first day of our 2006 fiscal year, including the effect of accruing for expected forfeitures on outstanding share-based awards, was not material to our results of operations for that quarter.
SFAS No. 123-R requires the immediate expensing of share-based awards granted to retirement-eligible employees, including awards subject to non-compete agreements. Share-based awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R must continue to be amortized over the stated service period of the award (and accelerated if the employee actually retires). Consequently, our compensation and benefits expenses in fiscal 2006 (and, to a lesser extent, in fiscal 2007 and fiscal 2008) will include both the amortization (and acceleration) of awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R as well as the full grant-date fair value of new awards granted to such employees under SFAS No. 123-R. The estimated annual non-cash expense in fiscal 2006 associated with the continued amortization of share-based awards granted to retirement-eligible employees prior to the adoption of SFAS No. 123-R is approximately $650 million, of which $138 million and $375 million were recognized in the three and six months ended May 2006, respectively.
In June 2005, the EITF reached consensus on Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights,” which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. Goldman Sachs, as the general partner of numerous merchant banking and asset management partnerships, is required to adopt the provisions of EITF 04-5 (i) immediately for partnerships formed or modified after June 29, 2005 and (ii) in the first quarter of fiscal 2007 for partnerships formed on or before June 29, 2005 that have not been modified. We generally expect to provide limited partners in these funds with rights to remove Goldman Sachs as the general partner or to terminate the partnerships and, therefore, do not expect that EITF 04-5 will have a material effect on our financial condition, results of operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 permits an entity to measure at fair value any financial instrument that contains an embedded derivative that otherwise would require bifurcation. As permitted, we early adopted SFAS No. 155 in the first quarter of fiscal 2006. Adoption did not have a material effect on our financial condition, results of operations or cash flows.
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Effective for the first quarter of 2006, we adopted SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” which permits entities to elect to measure servicing assets and servicing liabilities at fair value and report changes in fair value in earnings. Goldman Sachs acquires residential mortgage servicing rights in connection with its mortgage securitization activities and has elected under SFAS No. 156 to account for these servicing rights at fair value. Adoption did not have a material effect on our financial condition, results of operations or cash flows.
In April 2006, the FASB issued FASB Staff Position (FSP) FIN No. 46-R-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46-R.” This FSP addresses how a reporting enterprise should determine the variability to be considered in applying FIN No. 46-R by requiring an analysis of the purpose for which an entity was created and the variability that the entity was designed to create. This FSP must be applied prospectively to all entities with which a reporting enterprise first becomes involved and to all entities previously required to be analyzed under FIN No. 46-R when a reconsideration event has occurred. In accordance with the transition provisions, we will adopt this FSP prospectively in the fourth quarter of fiscal 2006 and do not expect it to have a material effect on our financial condition, results of operations or cash flows.
Cautionary Statement Pursuant to the Private SecuritiesLitigation Reform Act of 1995
We have included in Parts I and II of this Quarterly Report on Form 10-Q, and from time to time our management may make, statements which may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside of our control. It is possible that our actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. Important factors that could cause actual results to differ from those in our specific forward-looking statements include, but are not limited to, those discussed under “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.
Statements about our investment banking transaction backlog also may constitute forward-looking statements. Such statements are subject to the risk that the terms of these transactions may be modified or that they may not be completed at all; therefore, the net revenues that we expect to earn from these transactions may differ, possibly materially, from those currently expected. Important factors that could result in a modification of the terms of a transaction or a transaction not being completed include, in the case of underwriting transactions, a decline in general economic conditions, volatility in the securities markets generally or an adverse development with respect to the issuer of the securities and, in the case of financial advisory transactions, a decline in the securities markets, an adverse development with respect to a party to the transaction or a failure to obtain a required regulatory approval. Other important factors that could adversely affect our investment banking transactions are described under “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.
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In addition to applying business judgment, senior management uses a number of quantitative tools to manage our exposure to market risk for “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” in the condensed consolidated statements of financial condition. These tools include:
See “Quantitative and Qualitative Disclosures About Market Risk” in Part II, Item 7A of the Annual Report on Form 10-K for a description of our risk management policies and procedures.
VaR
VaR is the potential loss in value of Goldman Sachs’ trading positions due to adverse market movements over a defined time horizon with a specified confidence level.
For the VaR numbers reported below, a one-day time horizon and a 95% confidence level were used. This means that there is a 1 in 20 chance that daily trading net revenues will fall below the expected daily trading net revenues by an amount at least as large as the reported VaR. Thus, shortfalls from expected trading net revenues on a single trading day greater than the reported VaR would be anticipated to occur, on average, about once a month. Shortfalls on a single day can exceed reported VaR by significant amounts. Shortfalls can also accumulate over a longer time horizon such as a number of consecutive trading days.
The modeling of the risk characteristics of our trading positions involves a number of assumptions and approximations. While management believes that these assumptions and approximations are reasonable, there is no standard methodology for estimating VaR, and different assumptions and/or approximations could produce materially different VaR estimates.
We use historical data to estimate our VaR and, to better reflect current asset volatilities, we generally weight historical data to give greater importance to more recent observations. Given its reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no sudden fundamental changes or shifts in market conditions. An inherent limitation of VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. Different VaR methodologies and distributional assumptions could produce a materially different VaR. Moreover, VaR calculated for a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or offset with hedges within one day. Changes in VaR between reporting periods are generally due to changes in levels of exposure, volatilities and/or correlations among asset classes.
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The following table sets forth the daily VaR:
Daily VaR (1) (in millions)
Our average daily VaR increased to $112 million for the second quarter of 2006 from $60 million in the same period last year. The increase was primarily due to higher levels of exposure to equity prices and interest rates.
The following chart presents our daily VaR during the last four quarters:
Daily VaR($ in millions)
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Trading Net Revenues Distribution
Substantially all of our inventory positions are marked-to-market on a daily basis and changes are recorded in net revenues. The following chart sets forth the frequency distribution of our daily trading net revenues for substantially all inventory positions included in VaR for the quarter ended May 2006:
Daily Trading Net Revenues($ in millions)
As part of our overall risk control process, daily trading net revenues are compared with VaR calculated as of the end of the prior business day. Trading losses incurred on a single day exceeded our 95% one-day VaR on three occasions during the quarter ended May 2006.
Other Market Risk Measures
Certain portfolios and individual positions are not included in VaR, where VaR is not the most appropriate measure of risk (e.g. due to transfer restrictions and/or illiquidity). The market risk associated with these positions is represented by the impact of a 10% decline in corresponding markets, equity prices or asset values as described below. The following table does not reflect diversification benefits across asset categories and, given the differing likelihood of such events occurring, these measures have not been aggregated:
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Trading Risk
Equity. The market risk for equity positions that are not included in VaR is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in equity markets. This sensitivity analysis is based on certain assumptions regarding the relationship between changes in stock price indices and changes in the fair value of the individual equity positions. Different assumptions could produce materially different risk estimates. As of May 2006, the sensitivity to a 10% equity market decline was $224 million compared with $221 million as of February 2006.
Debt. The market risk for debt positions that are not included in VaR is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in the asset value of such positions. The market values of the underlying positions are sensitive to changes in a number of factors, including discount rates and the projected timing and amount of future cash flows. As of May 2006, the sensitivity to a 10% decline in the asset value of these positions was $705 million compared with $658 million as of February 2006.
Non-trading Risk
SMFG. The market risk of our investment in the convertible preferred stock of SMFG, net of the economic hedge on the unrestricted shares of common stock underlying a portion of our investment, is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in the SMFG common stock price. As of May 2006, the sensitivity of our investment to a 10% decline in the SMFG common stock price was $231 million compared with $313 million as of February 2006. The change is primarily due to a decrease in the SMFG common stock price and the impact of partial hedging with respect to the second one-third installment of unrestricted shares underlying our investment, partially offset by the impact of the passage of time in respect of the transfer restrictions on the underlying common stock. This sensitivity should not be extrapolated to other movements in the SMFG common stock price, as the relationship between the fair value of our investment and the SMFG common stock price is nonlinear.
Other Equity. The market risk for equity positions in our non-trading portfolio (including our investment in the ordinary shares of ICBC, net of the economic interests assumed by investment funds that we manage) is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in equity markets. This sensitivity analysis is based on certain assumptions regarding the relationship between changes in stock price indices and changes in the fair value of the individual financial instruments in our non-trading portfolio. Different assumptions could produce materially different risk estimates. As of May 2006, the sensitivity of equity positions in our non-trading portfolio to a 10% equity market decline was $373 million compared with $209 million as of February 2006.
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Debt. The market risk for debt positions (primarily mezzanine instruments) in our non-trading portfolio is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in the asset values of such positions. The market values of the underlying positions are sensitive to changes in a number of factors, including, but not limited to, the operating cash flows and financial performance of the companies. As of May 2006, the sensitivity to a 10% decline in the asset values of debt positions in our non-trading portfolio was $96 million compared with $78 million as of February 2006.
Real Estate. The market risk for real estate positions in our non-trading portfolio is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in the asset values of such positions. The market values of the underlying positions are sensitive to changes in a number of factors, including, but not limited to, the operating cash flows and financial performance of the properties, trends within sectors and/or regions and underlying business models. As of May 2006, the sensitivity to a 10% decline in the asset values (including the impact of leverage in the underlying investments) of real estate positions in our non-trading portfolio was $201 million compared with $149 million as of February 2006.
Derivatives
Derivative contracts are instruments, such as futures, forwards, swaps or option contracts, that derive their value from underlying assets, indices, reference rates or a combination of these factors. Derivative instruments may be privately negotiated contracts, which are often referred to as OTC derivatives, or they may be listed and traded on an exchange.
Substantially all of our derivative transactions are entered into for trading purposes, to facilitate client transactions, to take proprietary positions or as a means of risk management. In addition to derivative transactions entered into for trading purposes, we enter into derivative contracts to hedge our net investment in non-U.S. operations, to hedge certain forecasted transactions and to manage the interest rate and currency exposure on a substantial portion of our long-term borrowings and certain short-term borrowings.
Derivatives are used in many of our businesses, and we believe that the associated market risk can only be understood relative to all of the underlying assets or risks being hedged, or as part of a broader trading strategy. Accordingly, the market risk of derivative positions is managed together with our nonderivative positions.
Fair values of our derivative contracts are reflected net of cash paid or received pursuant to credit support agreements and are reported on a net-by-counterparty basis in our condensed consolidated statements of financial condition when management believes a legal right of setoff exists under an enforceable netting agreement. For an OTC derivative, our credit exposure is directly with our counterparty and continues until the maturity or termination of such contract.
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The following table sets forth the distribution, by credit rating, of substantially all of our exposure with respect to OTC derivatives as of May 2006, after taking into consideration the effect of netting agreements. The categories shown reflect our internally determined public rating agency equivalents.
Over-the-Counter Derivative Credit Exposure($ in millions)
The following tables set forth our OTC derivative credit exposure, net of collateral, by remaining contractual maturity:
Exposure Net of Collateral(in millions)
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Derivative transactions may also involve legal risks including the risk that they are not authorized or appropriate for a counterparty, that documentation has not been properly executed or that executed agreements may not be enforceable against the counterparty. We attempt to minimize these risks by obtaining advice of counsel on the enforceability of agreements as well as on the authority of a counterparty to effect the derivative transaction. In addition, certain derivative transactions involve the risk that we may have difficulty obtaining, or be unable to obtain, the underlying security or obligation in order to satisfy any physical settlement requirement or that the derivative may have been assigned to a different counterparty without our knowledge or consent.
As of the end of the period covered by this report, an evaluation was carried out by Goldman Sachs’ management, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures were effective as of the end of the period covered by this report. In addition, no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II: OTHER INFORMATION
The following supplements and amends our discussion set forth under “Legal Proceedings” in Part I, Item 3 of our Annual Report on Form 10-K for the fiscal year ended November 25, 2005, as updated by Item 1 of Part II of our Quarterly Report on Form 10-Q for the quarter ended February 24, 2006.
IPO Process Matters
In the lawsuit alleging a conspiracy to fix at 7% the discount that underwriting syndicates receive from issuers of shares in certain offerings, on April 18, 2006, the district court denied class certification with respect to the damages claims asserted by the issuers of securities. The issuer plaintiffs have petitioned the U.S. Court of Appeals for the Second Circuit to review that certification decision on an interlocutory basis.
On April 20, 2006, plaintiffs announced that they had entered into a definitive settlement agreement with respect to their claims against J.P. Morgan Securities, Inc. arising from lawsuits alleging that (i) the prospectuses for certain offerings violated the federal securities laws by failing to disclose the existence of alleged arrangements to “tie” allocations to higher customer brokerage commission rates as well as purchase orders in the aftermarket, and (ii) such alleged underlying “tying” arrangements violated federal and state antitrust laws. The settlement, pursuant to which J.P. Morgan Securities, Inc. will pay $425 million, is subject to, among other things, documentation and court approval.
Research Independence Matters
On April 17, 2006, the federal district court granted defendants’ motion to dismiss the action relating to research coverage of Exodus Communications, Inc., with leave to replead. Plaintiff filed a second amended complaint on May 17, 2006.
Exodus Securities Litigation
In the class action relating to certain securities offerings by Exodus Communications, Inc., by a decision dated June 2, 2006, the district court granted summary judgment dismissing the complaint on the grounds that the plaintiff’s purchases of Exodus securities were not traceable. On May 5, 2006 and May 19, 2006, two new putative plaintiffs filed motions to intervene, respectively.
WorldCom Bondholders Litigation
Settlements of the remaining individual actions affecting Goldman, Sachs & Co. have now been concluded.
Global Crossing and Asia Global Crossing Securities Litigation
On March 23, 2006, the remaining underwriter defendants (including Goldman, Sachs & Co.) agreed in principle to settle all claims for a payment of $82.5 million, subject to, among other things, documentation and court approval.
Short Selling Litigation
Goldman, Sachs & Co. is one of numerous financial services firms that have been named as defendants in two purported class actions filed beginning on April 12, 2006 in the U.S. District Court for the Southern District of New York by customers who engaged in short-selling transactions in equity securities since April 12, 2000. The complaints generally allege that the customers were charged fees in connection with the short sales but that the applicable securities were not
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necessarily borrowed to effect delivery, resulting in failed deliveries. The complaints allege that this conduct constituted a conspiracy in violation of the federal antitrust laws, and also assert claims under the New York Business Law and common law.
The table below sets forth the information with respect to purchases made by or on behalf of The Goldman Sachs Group, Inc. or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) of our common stock during the three months ended May 26, 2006.
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Entry into a Material Definitive Agreement
On June 29, 2006, the Compensation Committee of the Board approved (i) acceleration of the delivery date of Henry M. Paulson, Jr.’s outstanding restricted stock units (all of which automatically vested upon his resignation, which occurred upon his confirmation as Secretary of the Treasury of the United States), (ii) purchase by Goldman Sachs of the investments made by Mr. Paulson and his wife in private investment funds managed by Goldman Sachs (based on net asset values), and (iii) payment of a cash bonus to Mr. Paulson for his leadership as Chief Executive Officer for the first half of fiscal 2006 of $18.7 million.
The Compensation Committee also authorized specified officers of Goldman Sachs to determine whether to (i) cash settle all of Mr. Paulson’s outstanding restricted stock units (based on fair market value) and stock options (based on intrinsic value), and (ii) purchase certain third party private investment funds owned by Mr. Paulson and his wife.
On the same date, the Board authorized specified officers of Goldman Sachs to determine whether to register for sale all or a portion of the shares of common stock of Group Inc. owned by Mr. Paulson and to enter into an underwriting agreement with respect to any such sale containing customary indemnification provisions.
Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers
On June 28, 2006, Mr. Paulson was confirmed by the United States Senate as Secretary of the Treasury and resigned as Chief Executive Officer and Chairman of the Board and Lloyd C. Blankfein was elected as Chief Executive Officer and Chairman of the Board. At the same time, Gary D. Cohn and Jon Winkelried each were elected as President, Co-Chief Operating Officer and a member of the Board. Also, John S. Weinberg became a Vice Chairman of Group Inc. (see below under “Other Events”). Messrs. Cohn, Winkelried and Weinberg have joined the Executive Office of Group Inc., reporting directly to Mr. Blankfein. They will work closely with him in the formulation and execution of Goldman Sachs’ global strategy. Mr. Weinberg will also continue in his role as a co-head of Goldman Sachs’ Investment Banking Division.
Mr. Blankfein, age 51, had been Group Inc.’s President and Chief Operating Officer since January 2004. Prior to that, from April 2002 until January 2004, he was a Vice Chairman of Group Inc., with management responsibility for Goldman Sachs’ Fixed Income, Currency and Commodities Division (“FICC”) and Equities Division. Prior to becoming a Vice Chairman, he had served as co-head of FICC since its formation in 1997. From 1994 to 1997, he headed or co-headed the Currency and Commodities Division. Mr. Blankfein is not on the board of any public company other than Group Inc. He is affiliated with certain non-profit organizations, including as a member of the Harvard University Committee on University Resources, a trustee of the New York Historical Society, an overseer of the Weill Medical College of Cornell University, a director of the Partnership for New York City and a director of The Robin Hood Foundation.
Mr. Cohn, age 45, had been the co-head of Goldman Sachs’ global securities businesses since January 2004. He also had been the co-head of Equities since 2003 and the co-head of FICC since September 2002. From March 2002 to September 2002, he served as co-chief operating officer of FICC. Prior to that, beginning in 1999, Mr. Cohn managed the FICC macro businesses. From 1996 to 1999, he was the global head of Goldman Sachs’ commodities business. Mr. Cohn is not on the board of any public company other than Group Inc. He is affiliated with certain non-profit organizations, including as a member of the Treasury Borrowing Advisory Committee of the Bond Market Association and a trustee of Gilmour Academy, NYU Child Study Center, NYU Hospital, NYU Medical School, Harlem Children’s Zone, Columbia Grammar and Preparatory School and American University.
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Mr. Winkelried, age 46, had been the co-head of Goldman Sachs’ Investment Banking Division since January 2005. From 2000 to 2005, he was co-head of FICC. From 1999 to 2000, he was head of FICC in Europe. From 1995 to 1999, he was responsible for Goldman Sachs’ leveraged finance business. Mr. Winkelried is not on the board of any public company other than Group Inc. He is affiliated with certain non-profit organizations, including as a trustee of The Pingry School and the University of Chicago.
Messrs. Blankfein, Cohn and Winkelried will each continue to participate in Goldman Sachs’ Restricted Partner Compensation Plan (“RPCP”) and each will remain a participating managing director (“PMD”). The RPCP and the employment agreements and other agreements and arrangements Goldman Sachs has entered into with its PMDs are described in Group Inc.’s proxy statement, dated February 27, 2006, and are exhibits to its reports filed with the Securities and Exchange Commission.
For a description of Goldman Sachs’ private investment funds, which permit employees of Goldman Sachs to participate in its merchant banking, venture capital and other similar activities, and for information with respect to distributions received by Mr. Blankfein from such funds during fiscal 2005, see page 36 of Group Inc.’s 2006 proxy statement. Distributions from the beginning of Goldman Sachs’ fiscal year 2006 through June 30, 2006 to Mr. Blankfein (or persons or entities affiliated with him) of profits earned on investments made by, and other income from, any such fund for which total distributions (including return of capital invested*) to Mr. Blankfein from the beginning of fiscal year 2005 through June 30, 2006 exceeded $60,000 were, in the aggregate, $3,710,376. Distributions from the beginning of Goldman Sachs’ fiscal year 2005 through June 30, 2006 to Mr. Cohn (or persons or entities affiliated with him) of profits earned on investments made by, and other income from, any such fund for which total distributions (including return of capital invested**) to Mr. Cohn exceeded $60,000 over such period were, in the aggregate, $1,960,947. Mr. Winkelried had no distributions of profits from any such fund for which total distributions (including return of capital invested**) to him exceeded $60,000 over such period.
A sibling of Mr. Winkelried, a non-executive employee of Goldman Sachs, received compensation for fiscal 2005 of less than $900,000, part of which was paid in equity. Upon joining Goldman Sachs in 2005, Mr. Winkelried’s sibling also received an equity award with a value of approximately $770,000, most of which was related to foregone equity awards with respect to previous employment. For fiscal 2006 Mr. Winkelried’s sibling’s annual base salary is less than $180,000.
Other Events
As described above, Mr. Weinberg has been appointed as a Vice Chairman of Group Inc.
Mr. Weinberg, age 48, has been co-head of Goldman Sachs’ Investment Banking Division since December 2002. From January 2002 to December 2002, he was co-head of the Investment Banking Division in the Americas. Prior to that, he served as co-head of the Investment Banking Services Department since 1997. He is affiliated with certain non-profit organizations, including as a board member at New York-Presbyterian Hospital, The Steppingstone Foundation and Greenwich Country Day School.
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Item 6: Exhibits
Exhibits:
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: June 30, 2006
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