UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549 FORM 10-Q
THE GOLDMAN SACHS GROUP, INC.QUARTERLY REPORT ON FORM 10-Q FOR THE FISCAL QUARTER ENDED AUGUST 25, 2006INDEX
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PART I: FINANCIAL INFORMATIONItem 1: Financial Statements (Unaudited)THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF EARNINGS(UNAUDITED)
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION(UNAUDITED)
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY(UNAUDITED)
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(UNAUDITED)
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)Note 1.Description of Business 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 andhigh-net-worthindividuals. The firm’s activities are divided into three segments: • Investment Banking. The firm provides a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals. • Trading and Principal Investments. The firm facilitates client transactions with a diverse group of corporations, financial institutions, governments and individuals and takes proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on such products. In addition, the firm engages in specialist and market-making activities on equities and options exchanges and clears client transactions on major stock, options and futures exchanges worldwide. In connection with the firm’s merchant banking and other investing activities, the firm makes principal investments directly and through funds that the firm raises and manages. • Asset Management and Securities Services. The firm provides investment advisory and financial planning services and offers investment products across all major asset classes to a diverse group of institutions and individuals worldwide, and provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide.Note 2.Significant Accounting PoliciesBasis 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 qualifyingspecial-purpose entity (QSPE) under generally accepted accounting principles. • Voting Interest Entities. Voting interest entities are entities in which (i) the total equity investment at risk is sufficient to enable the entity to finance its activities independently and (ii) the equity holders have the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities7
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) are consolidated in accordance with Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” as amended. ARB No. 51 states that the usual condition for a controlling financial interest in an entity is ownership of a majority voting interest. Accordingly, the firm consolidates voting interest entities in which it has a majority voting interest. • Variable Interest Entities. VIEs are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in a VIE is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. In accordance with Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 46-R, “Consolidation of Variable Interest Entities,” the firm consolidates VIEs of which it is the primary beneficiary. The firm determines whether it is the primary beneficiary of a VIE by first performing a qualitative analysis of the VIE that includes a review of, among other factors, its capital structure, contractual terms, which interests create or absorb variability, related party relationships and the design of the VIE. Where qualitative analysis is not conclusive, the firm performs a quantitative analysis. For purposes of allocating a VIE’s expected losses and expected residual returns to its variable interest holders, the firm utilizes the “top down” method. Under that method, the firm calculates its share of the VIE’s expected losses and expected residual returns using the specific cash flows that would be allocated to it, based on contractual arrangements and/or the firm’s position in the capital structure of the VIE, under various probability-weighted scenarios. • QSPEs. QSPEs are passive entities that are commonly used in mortgage and other securitization transactions. Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” sets forth the criteria an entity must satisfy to be a QSPE. These criteria include the types of assets a QSPE may hold, limits on asset sales, the use of derivatives and financial guarantees, and the level of discretion a servicer may exercise in attempting to collect receivables. These criteria may require management to make judgments about complex matters, including whether a derivative is considered passive and the degree of discretion a servicer may exercise. In accordance with SFAS No. 140 and FIN No. 46-R, the firm does not consolidate QSPEs. • Equity-Method Investments. When the firm does not have a controlling financial interest in an entity but exerts significant influence over the entity’s operating and financial policies (generally defined as owning a voting interest of 20% to 50%) and has an investment in common stock or in-substance common stock, the firm accounts for its investment in accordance with the equity method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” • Other. If the firm does not consolidate an entity or apply the equity method of accounting, the firm accounts for its investment at fair value. The firm also has formed numerous nonconsolidated investment funds with third-party investors that are typically organized as limited partnerships. The firm acts as general partner for these funds and does not hold a majority of the economic interests in any fund. For funds established on or before June 29, 2005 in which the firm holds more than a minor interest and for funds established or modified after June 29, 2005, the firm has provided the third-party investors with rights to remove the8
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) firm as the general partner or to terminate the funds (see “— Recent Accounting Developments” below for a discussion of the impact of Emerging Issues Task Force (EITF) Issue No. 04-5). These fund investments are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition. 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 August 2006 and August 2005 refer to the firm’s fiscal periods ended, or the dates, as the context requires, August 25, 2006 and August 26, 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 asnon-compensationexpenses, 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. • Cash Trading Instruments. Fair values of the firm’s 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-yield9
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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. The firm values these instruments initially at cost and generally does 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, the firm uses valuation methodologies such as the present value of known or estimated cash flows. Cash trading instruments owned by the firm (long positions) are marked to bid prices, and instruments sold but not yet purchased (short positions) are marked to offer prices. If liquidating a position is expected to affect its prevailing market price, the 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. Fair values of the firm’s derivative contracts consist ofexchange-traded andover-the-counter (OTC) derivatives and are reflected net of cash that the firm has paid and received (for example, option premiums or cash paid or received pursuant to credit support agreements). Fair values of the firm’s exchange-traded derivatives are generally determined from quoted market prices. OTC derivatives are valued using valuation models. The firm uses a variety of valuation models including the present value of known or estimated cash flows and option-pricing models. The valuation models used to derive the fair values of the firm’s 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. The firm generally uses similar models to value similar instruments. Where possible, the firm verifies the values produced by its 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, the firm continues to review and refine the models it uses. At the inception of an OTC derivative contract (day one), the firm values the contract at the model value if the firm 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.10
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) Where the firm cannot verify all of the significant model inputs to observable market data and verify the model to market transactions, the firm values the contract at the transaction price at inception and, consequently, records no day one gain or loss in accordance with 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” (see “— Recent Accounting Developments” below for a discussion of the impact of SFAS No. 157 on EITF Issue No. 02-3). Following day one, the firm adjusts the inputs to its 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 the firm cannot verify the model to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value. • Principal Investments. In valuing corporate and real estate principal investments, the firm’s portfolio is separated into investments in private companies (including the firm’s investment in the ordinary shares of Industrial and Commercial Bank of China Limited (ICBC)), investments in public companies (excluding the firm’s investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG)) and the firm’s investment in SMFG. The firm’s private principal investments, by their nature, have little or no price transparency. Such investments (including the firm’s 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 it is determined that the expected realizable value of the investment is less than the carrying value. In reaching that determination, many factors are considered 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. The firm’s 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. The firm’s 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 firm’s investment in the convertible preferred stock of SMFG is generally nontransferable, but is freely convertible into SMFG common stock. Restrictions on the firm’s ability to hedge or sell two-thirds of the common stock underlying its investment in SMFG lapsed in equal installments on February 7, 2005 and March 9, 2006. As of the date of this filing, the firm has fully hedged the first one-third installment of the unrestricted shares and has hedged a majority of the second one-third installment of the unrestricted shares. Restrictions on the firm’s ability to hedge or sell the remaining one-third installment lapse on February 7, 2007. As of the date of this filing, the conversion price of the firm’s SMFG preferred stock into shares of SMFG common stock was ¥319,700. This price is subject to11
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 ¥105,400). 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, 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, securities borrowed and loaned, and secured short and long-termborrowings. Interest income or expense on collateralized financing arrangements is recognized in net revenues over the life of the transaction. • Resale and Repurchase Agreements. Financial instruments purchased under agreements to resell and financial instruments sold under agreements to repurchase, principally U.S. government, federal agency and investment-grade foreign sovereign obligations, represent short-term collateralized financing transactions and are carried in the condensed consolidated statements of financial condition at their contractual amounts plus accrued interest. These amounts are presented on a net-by-counterparty basis when the requirements of FIN No. 41, “Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements,” or FIN No. 39, “Offsetting of Amounts Related to Certain Contracts,” are satisfied. The firm receives financial instruments purchased under agreements to resell, makes delivery of financial instruments sold under agreements to repurchase, monitors the market value of these financial instruments on a daily basis and delivers or obtains additional collateral as appropriate. • Securities Borrowed and Loaned. Securities borrowed and loaned are recorded based on the amount of cash collateral advanced or received. These transactions are generally collateralized by cash, securities or letters of credit. The firm receives securities borrowed, makes delivery of securities loaned, monitors the market value of securities borrowed and loaned, and delivers or obtains additional collateral as appropriate. • Secured Short and Long-Term Borrowings. The firm also obtains financing through the use of secured short and long-term borrowings. The firm pledges financial instruments and other assets as collateral for such borrowings. See Notes 3, 4 and 5 for further information regarding the firm’s secured short and long-term borrowings. 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.12
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) The following table sets forth the power generation revenues and costs directly associated with the firm’s consolidated power generation facilities:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)awards that require future service are amortized over the relevant service period. The firm adopted SFAS No. 123-Runder the modified prospective adoption method. Under that method of adoption, the provisions of SFAS No. 123-Rare generally applied only toshare-based awards granted subsequent to adoption. The accounting treatment ofshare-based awards granted toretirement-eligibleemployees prior to the firm’s adoption of SFAS No. 123-Rhas 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-Rand SFAS No. 123 are: First, SFAS No. 123-Rrequires expected forfeitures to be included in determiningshare-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 fiscal 2006, the firm recorded a benefit for expected forfeitures on all outstandingshare-based awards. The transition impact of adopting SFAS No. 123-Ras of the first day of the firm’s 2006 fiscal year, including the effect of accruing for expected forfeitures on outstanding share-basedawards, was not material to the firm’s results of operations for that quarter. Second, SFAS No. 123-Rrequires the immediate expensing ofshare-based awards granted toretirement-eligibleemployees, including awards subject tonon-compete agreements.Share-based awards granted toretirement-eligibleemployees prior to the adoption of SFAS No. 123-Rmust 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 toretirement-eligibleemployees prior to the adoption of SFAS No. 123-Ras well as the fullgrant-date fair value of new awards granted to such employees under SFAS No. 123-R.The estimated annualnon-cash expense in fiscal 2006 associated with the continued amortization ofshare-based awards granted toretirement-eligibleemployees prior to the adoption of SFAS No. 123-Ris approximately $650 million, of which $133 million and $508 million were recognized in the three and nine months ended August 2006, respectively. The firm began to account forshare-based awards in accordance with the fair value method prescribed by SFAS No. 123, “Accounting forStock-BasedCompensation,” as amended by SFAS No. 148, “Accounting forStock-BasedCompensation — Transition and Disclosure,” in 2003. Share-basedemployee awards granted for the year ended November 29, 2002 and prior years were accounted for under theintrinsic-value-basedmethod 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.14
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 nine months ended August 2005, resulting in pro forma net earnings and earnings per common share (EPS) as set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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) and deferred acquisition costs (DAC) 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-LivedAssets.” 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 astraight-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 astraight-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 astraight-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 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.16
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) Foreign Currency Translation Assets and liabilities denominated innon-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 anon-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 foreigncurrency-denominateddebt. 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 foreigncurrency-denominateddebt, 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 (see “— Recent Accounting Developments” below for a discussion of the impact of FIN No. 48 on SFAS No. 109). 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. Cash and Cash Equivalents The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business.17
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 Issue No. 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 Issue No. 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 fiscal 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-Rby 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-Rwhen a reconsideration event has occurred. As permitted, the firm early adopted FSP FIN No. 46-R-6in the third quarter of fiscal 2006. Adoption did not have a material effect on the firm’s financial condition, results of operations or cash flows. In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” FIN No. 48 requires that the firm determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets this recognition threshold, the position is measured to determine the amount of benefit to be recognized in the financial statements. The firm expects to adopt the provisions of FIN No. 48 beginning in the first quarter of fiscal 2008. The firm is currently evaluating the impact of adopting FIN No. 48 on its financial condition, results of operations and cash flows.18
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies that fair value is the amount that would be exchanged to sell an asset or transfer a liability, in an orderly transaction between market participants. SFAS No. 157 nullifies the consensus reached in EITF Issue No. 02-3prohibiting the recognition of day one gain or loss on derivative contracts (and hybrid instruments measured at fair value under SFAS No. 133 as modified by SFAS No. 155) where the firm cannot verify all of the significant model inputs to observable market data and verify the model to market transactions. However, SFAS No. 157 requires that a fair value measurement technique include an adjustment for risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model, if market participants would also include such an adjustment. In addition, SFAS No. 157 prohibits the recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available in an active market. The provisions of SFAS No. 157 are to be applied prospectively, except for changes in fair value measurements that result from the initial application of SFAS No. 157 to existing derivative financial instruments measured under EITF Issue No. 02-3, existing hybrid instruments measured at fair value, and block discounts, which are to be recorded as an adjustment to opening retained earnings in the year of adoption. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The firm is evaluating whether it will early adopt SFAS No. 157 as of the first quarter of fiscal 2007 as permitted, and is currently evaluating the impact adoption may have on its financial condition, results of operations and cash flows. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and132-R.” SFAS No. 158 requires an entity to recognize in its statement of financial condition the funded status of its defined benefit postretirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. SFAS No. 158 also requires an entity to recognize changes in the funded status of a defined benefit postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost. SFAS No. 158 is effective as of the end of the fiscal year ending after December 15, 2006. The firm will adopt SFAS No. 158 as of the end of fiscal 2007. The firm does not expect that the adoption of SFAS No. 158 will have a material effect on the firm’s financial condition, results of operations or cash flows.19
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 3.Financial Instruments 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:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 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. The firm enters into derivative transactions to facilitate client transactions, to take proprietary positions and as a means of risk management. Risk exposures are managed through diversification, by controlling position sizes and by entering into offsetting positions. For example, the firm may manage the risk related to a portfolio of common stock by entering into an offsetting position in a related equity-index futures contract. The firm applies hedge accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” to certain derivative contracts. The firm uses these derivatives to manage certain interest rate and currency exposures, including the firm’s net investment innon-U.S. operations. The firm designates certain interest rate swap contracts as fair value hedges. These interest rate swap contracts 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 a limited number of foreign currency forward contracts 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 foreign currency forward contracts used to hedge its net investment innon-U.S. operations. The firm applies a long-haul method to substantially all of its hedge accounting relationships to perform an ongoing assessment of the effectiveness of these relationships in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. The firm utilizes a dollar-offset method, which compares the change in the fair value of the hedging instrument to the change in the fair value of the hedged item, excluding the effect of the passage of time, to prospectively and retrospectively assess hedge effectiveness. The firm’s prospective dollar-offset assessment utilizes scenario analyses to test hedge effectiveness via simulations of numerous parallel and slope shifts of the relevant yield curve. Parallel shifts change the interest rate of all maturities by identical amounts. Slope shifts change the curvature of the yield curve. A hedging relationship is deemed to be effective if the fair values of the hedging instrument and the hedged item change inversely within a range of 80 to 125% in response to each of the simulated yield curve shifts. For fair value hedges, gains or losses on derivative transactions as well as the hedged item are recognized in “Interest expense” 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 for21
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)all hedges are generally included in “Interest expense.” 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 the passage of time on fair value hedges of the firm’s borrowings) were not material to the firm’s results of operations for the three and nine months ended August 2006. Gains and losses on derivatives used for trading purposes are generally included in “Trading and principal investments” in the condensed consolidated statements of earnings. 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 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:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)retained interests were approximately $613 million and $655 million for the nine months ended August 2006 and August 2005, respectively. As of August 2006 and November 2005, the firm held $8.28 billion and $6.07 billion of retained interests, respectively, including $6.26 billion and $5.62 billion, respectively, held in QSPEs. The fair value of retained interests valued using quoted market prices in active markets was $1.27 billion and $1.34 billion as of August 2006 and November 2005, respectively. 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:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 $7 billion and $5 billion as of August 2006 and November 2005, respectively. Variable Interest Entities (VIEs) The firm, in the ordinary course of 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. The firm has aggregated consolidated VIEs based on principal business activity, as reflected in the first column.
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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. The firm has aggregated nonconsolidated VIEs based on principal business activity, as reflected in the first column. The nature of the firm’s variable interests can take different forms, as described in the columns under maximum exposure to loss.
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 financial instruments in exchange for other financial instruments, 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 financial instruments as collateral principally through the use of resale agreements, securities borrowing agreements, derivative transactions, customer margin loans and other secured 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 financial instruments held as collateral. These financial instruments may be used to secure repurchase agreements, to enter into securities lending or derivative transactions, or to cover short positions. As of August 2006 and November 2005, the fair value of financial instruments received as collateral by the firm that it was permitted to sell or repledge was $691.85 billion and $629.94 billion, respectively, of which the firm sold or repledged $585.06 billion and $550.33 billion, respectively. The firm also pledges financial instruments it owns. Counterparties may or may not have the right to sell or repledge the financial instruments. Financial instruments 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 $39.94 billion and $38.98 billion as of August 2006 and November 2005, respectively. Financial instruments 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 $83.71 billion and $93.90 billion as of August 2006 and November 2005, respectively. In addition to repurchase and securities lending agreements, the firm also pledges financial instruments 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 $45.08 billion and $27.84 billion as collateral as of August 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.Note 4.Short-Term Borrowings The firm obtains short-term borrowings primarily through the use of promissory notes, commercial paper, secured debt and bank loans. As of August 2006 and November 2005, secured short-term borrowings were $18.85 billion and $7.97 billion, respectively. Unsecured short-term borrowings were $53.81 billion and $47.25 billion as of August 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.26
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) Short-term borrowings are set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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.
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)The effective weighted average interest rates for long-term borrowings are set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 6.Commitments, Contingencies and Guarantees Commitments Forward Secured Financings. The firm had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $53.31 billion and $49.93 billion as of August 2006 and November 2005, respectively. Commitments to Extend Credit. In connection with its lending activities, the firm had outstanding commitments to extend credit of $70.20 billion and $61.12 billion as of August 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 August 2006 and November 2005:Commitments to Extend Credit
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) subject to a maximum of $1.13 billion. The firm also uses other financial instruments to mitigate credit risks related to certain William Street commitments not covered by SMFG. • Other commercial lending commitments. In addition to the commitments issued under the William Street credit extension program, the firm extends other credit commitments, primarily in connection with contingent acquisition financing and other types of corporate lending. As part of its ongoing credit origination activities, the firm may reduce its credit risk on 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. • Warehouse financing. The firm provides financing for the warehousing of financial assets to be securitized, primarily in connection with CDOs and mortgage securitizations. These financings are expected to be repaid from the proceeds of the related securitizations for which the firm may or may not act as underwriter. These arrangements are secured by the warehoused assets, primarily consisting of mortgage-backed and other asset-backed securities, residential and commercial mortgages and corporate debt instruments. 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 $6.40 billion and $9.23 billion as of August 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 $4.56 billion and $3.54 billion in corporate and real estate investment funds as of August 2006 and November 2005, respectively. Construction-Related Commitments. As of August 2006 and November 2005, the firm had construction-related commitments of $1.62 billion and $579 million, respectively, including commitments of $1.26 billion and $481 million, respectively, related to the development of wind energy projects. Construction-related commitments also include outstanding commitments of $306 million and $47 million as of August 2006 and November 2005, respectively, related to the firm’s new world headquarters in New York City, which is expected to cost between $2.3 billion and $2.5 billion. Underwriting Commitments. As of August 2006, the firm had commitments to purchase $85 million of securities in connection with its underwriting activities. As of November 2005, the firm had no such commitments. Other. The firm had other purchase commitments of $828 million and $644 million as of August 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 agreements31
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)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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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)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. In the ordinary course of business, the firm provides other financial guarantees of the obligations of third parties (e.g., letters of credit and other guarantees to enable clients to complete transactions and merchant banking fund-related guarantees). These guarantees represent obligations to make payments to beneficiaries if the guaranteed party fails to fulfill its obligation under a contractual arrangement with that beneficiary. 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 August 2006 and November 2005:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)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 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 August 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 certainnon-U.S. tax laws. These indemnifications generally are standard contractual terms and are entered into in the ordinary 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 August 2006 and November 2005.Note 7.Shareholders’ Equity On September 11, 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 third quarter of fiscal 2006 to be paid on November 20, 2006, to common shareholders of record on October 23, 2006. During the third quarter of fiscal 2006, the firm repurchased 3.8 million shares of its common stock at a total cost of $573 million. In the first nine months of fiscal 2006, the firm repurchased a total of 29.5 million shares of its common stock at a total cost of $4.17 billion. The average price paid per share for repurchased shares was $148.90 and $141.40 for the three and nine months ended August 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 $375 million during the first nine months of fiscal 2006. On July 24, 2006, the firm issued an additional 20,000 shares of perpetual Floating RateNon-CumulativePreferred Stock, Series D.34
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) As of August 2006, the firm had 124,000 shares of perpetual non-cumulative preferred stock outstanding in four series as set forth in the following table:Preferred Stock by Series
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 8.Earnings Per Common ShareThe computations of basic and diluted earnings per common share are set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 9.Goodwill and Identifiable Intangible Assets Goodwill 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 GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) Identifiable Intangible Assets The following table sets forth the gross carrying amount, accumulated amortization and net carrying amount of identifiable intangible assets:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 12 years. Amortization expense associated with identifiable intangible assets was $69 million and $34 million for the three months ended August 2006 and August 2005, respectively, and $182 million and $127 million for the nine months ended August 2006 and August 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:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) Other Liabilities Other liabilities and accrued expenses primarily includes insurance-related liabilities, compensation and benefits, minority interest in consolidated entities, litigation liabilities, tax-related payables, deferred revenue and other payables. The following table sets forth the firm’s other liabilities and accrued expenses by type:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 11.Employee Benefit Plans 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 subsidiaries participate in various 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. The components of pension expense/(income) and postretirement expense are set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED)Note 12.Employee Incentive Plans 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 August 2006 and November 2005, 196.3 million and 196.6 million shares, respectively, were available for grant under the Amended SIP. 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 August 2006 and November 2005, (i) 28.3 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) 18.9 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:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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. The activity related to these stock options is set forth below:
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) The firm’s stock repurchase program is intended to maintain its 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 the firm’s common shareholders’ equity, its overall capital position, share-based awards and exercises of employee stock options, the prevailing market price of its common stock and general market conditions.Note 13.Affiliated Funds 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 $2.56 billion and $1.62 billion for the nine months ended August 2006 and August 2005, respectively. As of August 2006 and November 2005, the fees receivable from these funds were $383 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 $3.48 billion and $2.17 billion as of August 2006 and November 2005, respectively. In the ordinary 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.Note 14.Regulation 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 August 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-dealersand 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 August 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 August 2006 and November 2005, GS&Co. had tentative net capital and net capital in excess of both the minimum and the notification requirements. Goldman Sachs Bank USA (GS Bank), a wholly owned industrial loan corporation, is regulated by the Federal Deposit Insurance Corporation and the State of Utah Department of Financial Institutions and is subject to minimum capital requirements. As of August 2006, GS Bank was in compliance with all federal and state regulatory capital requirements. GS Bank had approximately $8 billion of interest-bearing deposits as of August 2006, which are included in “Payables to customers and counterparties” in the condensed consolidated statements of financial condition.44
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) The firm’s principalnon-U.S. regulated subsidiaries include Goldman Sachs International (GSI) and Goldman Sachs Japan Co., Ltd. (GSJCL). GSI, a regulated U.K. broker-dealer, is subject to the capital requirements of the U.K.’s Financial Services Authority. GSJCL, a Japanese regulated broker-dealer, is subject to the capital requirements of Japan’s Financial Services Agency. Prior to October 1, 2006, Goldman Sachs (Japan) Ltd. (GSJL) was the primary regulated subsidiary based in Japan. As of August 2006 and November 2005, GSI, GSJCL and GSJL were in compliance with their local capital adequacy requirements. Certain othernon-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 August 2006 and November 2005, these subsidiaries were in compliance with their local capital adequacy requirements.Note 15.Business Segments 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. Basis of Presentation 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.45
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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(UNAUDITED) 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 FirmTo 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 August 25, 2006, the related condensed consolidated statements of earnings for the three and nine months ended August 25, 2006 and August 26, 2005, the condensed consolidated statement of changes in shareholders’ equity for the nine months ended August 25, 2006, the condensed consolidated statements of cash flows for the nine months ended August 25, 2006 and August 26, 2005, and the condensed consolidated statements of comprehensive income for the three and nine months ended August 25, 2006 and August 26, 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 LLPNew York, New YorkSeptember 28, 200647
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Item 2:Management’s Discussion and Analysis of Financial Condition and Results of OperationsINDEX
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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: • Investment Banking. We provide a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals. • Trading and Principal Investments. We facilitate client transactions with a diverse group of corporations, financial institutions, governments and individuals and take proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on such products. In addition, we engage in specialist and market-making activities on equities and options exchanges and we clear client transactions on major stock, options and futures exchanges worldwide. In connection with our merchant banking and other investing activities, we make principal investments directly and through funds that we raise and manage. • Asset Management and Securities Services. We provide investment advisory and financial planning services and offer investment products across all major asset classes to a diverse group of institutions and individuals worldwide, and provide prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide. 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 August 2006 and August 2005 refer to our fiscal periods ended, or the dates, as the context requires, August 25, 2006 and August 26, 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.49
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Executive Overview Our diluted earnings per common share were $3.26, annualized return on average tangible common shareholders’ equity(1) was 24.9% and annualized return on average common shareholders’ equity was 20.9% for the third quarter of 2006. Excluding incremental non-cash expenses of $133 million related to the accounting for certain share-based awards under SFAS No. 123-R(2), diluted earnings per common share were $3.45(2), annualized return on average tangible common shareholders’ equity(1) was 26.5%(2) and annualized return on average common shareholders’ equity was 22.2%(2) for the third quarter of 2006. Diluted earnings per common share for the third quarter of 2005 were $3.25. Our third quarter results reflected solid performances in each of our three segments. Net revenues in Investment Banking increased compared with the third quarter of 2005, reflecting significantly higher net revenues in Underwriting, as both debt and equity underwriting results improved, as well as higher net revenues in Financial Advisory, reflecting increased client activity. Our investment banking backlog was essentially unchanged during the quarter (3). Strong net revenue growth in our Asset Management and Securities Services businesses primarily reflected significantly higher management and other fees as well as continued strength in our prime brokerage business. Assets under management increased significantly from a year ago, including net asset inflows of $30 billion during the quarter. Net revenues in Trading and Principal Investments were lower than a particularly strong third quarter of 2005. Net revenues in Principal Investments decreased reflecting a smaller gain related to our investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG) as well as lower net revenues from our other principal investments. In addition, net revenues in Equities were lower than the same prior year period, while net revenues in Fixed Income, Currency and Commodities (FICC) were higher than a strong third quarter of 2005. During the quarter, Equities operated in a less favorable environment as equity prices lacked direction and customer-driven activity declined from the first half of the year. In addition, although FICC performed well, the business operated in a less favorable environment, as customer-driven activity declined from the first half of the year and volatility levels were generally low. Our diluted earnings per common share were $13.12 for the nine months ended August 2006 compared with $7.89 for the same period last year. Annualized return on average tangible common shareholders’ equity(1) was 35.6% and annualized return on average common shareholders’ equity was 29.6%. Excluding incremental non-cash expenses of $508 million related to the accounting for certain share-based awards under SFAS No. 123-R(2), diluted earnings per common share were $13.83(2), annualized return on average tangible common shareholders’ equity(1) was 37.6% (2) and annualized return on average common shareholders’ equity was 31.4%(2) for the nine months ended August 2006. Our results for the first nine months of 2006 reflected strong net revenue growth in each of our three segments as compared with the same period last year. During the first nine months of 2006, each of our segments achieved record results reflecting generally favorable market conditions and strong customer activity. Trading and Principal Investments results reflected significantly higher net revenues in FICC and Equities and a strong performance in Principal Investments. Net revenues in FICC reflected particularly strong results across all major businesses, and net revenues in Equities reflected significant growth in our customer franchise business, while results in principal strategies, although strong, were lower than the same prior year period. In our trading businesses, we saw generally favorable trading and investing opportunities for our clients and ourselves, and consequently increased our market risk in the first half of the year. However, as the environment became more challenging during the third quarter of 2006, our market risk declined, reflecting fewer opportunities in the markets. In Investment Banking, net revenues reflected strong growth in Underwriting and Financial Advisory as industry-wide volumes across equity underwriting and mergers and acquisitions were significantly ahead of the same prior year period and debt underwriting volumes remained at high levels. In Asset Management and Securities50
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Services, revenue growth was driven by record assets under management and significantly higher incentive fees, as well as significantly higher global customer balances in Securities Services. We continued to focus on managing our capital base, with the goal of optimizing our returns while, at the same time, growing our businesses. During the third quarter of 2006, we repurchased 3.8 million shares of our common stock at a total cost of $573 million. In the first nine months of 2006, we repurchased 29.5 million shares of our common stock at a total cost of $4.17 billion. On September 11, 2006, the Board of Directors of Goldman Sachs authorized the repurchase of an additional 60.0 million shares of common stock pursuant to the existing repurchase program. 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 nine months 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 Form 10-K. (1) Annualized return on average tangible common shareholders’ equity is computed by dividing annualized net earnings applicable to common shareholders by average monthly tangible common shareholders’ equity. See “— Results of Operations — Financial Overview” below for further information regarding our calculation of annualized return on average tangible common shareholders’ equity. (2) Statement of Financial Accounting Standards (SFAS) No. 123-R,“Share-Based Payment,” focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for share-based payments. 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. We believe that presenting our results excluding the impact of the continued amortization of prior year share-based awards granted to retirement-eligible employees increases the comparability ofperiod-to-period operating results and allows for a more meaningful representation of the relationship of current period compensation to net revenues. The following tables set forth a reconciliation of diluted earnings per common share, common shareholders’ equity and net earnings applicable to common shareholders as reported, to these items excluding the impact of the continued amortization of prior year share-based awards granted to retirement-eligible employees:
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Business Environment Global economic conditions remained generally favorable during our third quarter of fiscal 2006, although economic growth in the U.S. and, to a lesser extent, in Europe, slowed from the first half of the year. Business and consumer confidence remained generally high across the major economies, although consumer confidence appeared to decline toward the end of our third fiscal quarter, particularly in the U.S. Concerns over inflationary pressures in the U.S. early in the fiscal quarter subsided toward the end of the quarter. In the equity markets, global equity prices lacked direction and generally ended only slightly above or below levels at the beginning of our fiscal quarter. In the fixed income markets, yield curves in both the U.S. and Europe flattened and corporate credit spreads remained narrow. Investment banking activity levels decreased during the fiscal quarter, as evidenced by lower industry-wide announced and completed mergers and acquisitions and equity underwritings. In the U.S., economic growth continued to slow from stronger levels seen in the beginning of the fiscal year, as consumer spending continued to decline, reflecting the effects of higher interest rates, high energy prices and the decline in the housing market. Unemployment remained at low levels, although it increased slightly during the fiscal quarter. While concerns over inflationary pressures near the end of our second fiscal quarter continued into June, growth in measures of core inflation subsided in July and August. The U.S. Federal Reserve raised its federal funds target rate by 25 basis points to 5.25% in June, its 17th consecutive increase, but held the target rate steady during its August meeting. Long-term bond yields fell, with the10-yearU.S. Treasury note yield ending the quarter down 27 basis points at 4.78%. In the equity markets, the S&P 500 Index and the Dow Jones Industrial Average ended the quarter essentially unchanged, while the NASDAQ Composite Index fell by 3%. In Europe, economic growth moderated slightly during our third fiscal quarter, but remained solid, with increasing industrial and construction activity, particularly in Germany. The modest decrease in economic growth was evident in surveys of business activity, which declined slightly during the quarter, but remained at high levels. In addition, consumer confidence remained at high levels, as private consumption and employment both increased during the quarter. The European Central Bank increased its main refinancing operations rate by 50 basis points during the fiscal quarter to 3.0%, its highest level in nearly five years. In the U.K., although financial conditions became less accommodative, the economy showed continued modest growth. The Bank of England raised its official bank rate by 25 basis points to 4.75%, its first change since August 2005. European equity markets ended the quarter modestly higher, while long-term yields remained essentially unchanged. In Japan, real gross domestic product growth softened during our third fiscal quarter, reflecting a slowdown in domestic demand, although growth in exports remained solid. Unemployment levels remained low and wages increased moderately. During the quarter, the Bank of Japan ended its five year zero interest rate policy and set the target overnight call rate at 0.25%. Despite a sharp decline early in the fiscal quarter, the Nikkei 225 Index ended the fiscal quarter essentially unchanged. In China, economic growth remained solid, driven by strength in both exports and domestic demand. The People’s Bank of China increased the one-year benchmark lending rate by 27 basis points to 6.12%. Elsewhere in Asia, growth in exports and domestic demand softened, but remained steady. Equity markets ended our fiscal quarter higher in Hong Kong, essentially unchanged in South Korea and China, and lower in Taiwan.53
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Critical Accounting PoliciesFair 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)
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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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Derivative Contracts. Derivative contracts consist of exchange-traded andover-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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could produce a materially different estimate of fair value. See “— Recent Accounting Developments” below for a discussion of the impact of SFAS No. 157 on EITF Issue No. 02-3. 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)
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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. 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)
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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 third quarter, the fair value of our investment (excluding the economic hedge on the unrestricted shares of common stock) increased 11% (expressed in Japanese yen), primarily reflecting an increase in the SMFG common stock price and, to a lesser extent, 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 selltwo-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 firstone-third installment of the unrestricted shares and have hedged a majority of the second one-thirdinstallment of the unrestricted shares. Restrictions on our ability to hedge or sell the remainingone-third installment lapse on February 7, 2007. As of the date of this filing, the conversion price of our SMFG preferred stock into shares of SMFG common stock was ¥319,700. 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 ¥105,400). 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 therevenue-producingunits. 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.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.59
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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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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)
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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 nine months of 2006, our ratio of compensation and benefits to net revenues was 49.8%. Excluding the $508 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 48.0% (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 quarters ended May 26, 2006 and 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. (1) Our ratio of compensation and benefits to net revenues, excluding the impact of the continued amortization of prior year share-based awards, is computed by dividing compensation and benefits, excluding the impact of the continued amortization of prior year share-based awards, by net revenues. We believe that presenting the ratio of compensation and benefits to net revenues excluding the impact of the continued amortization of prior year share-based awards granted to retirement-eligible employees increases the comparability ofperiod-to-period operating results and allows for a more meaningful representation of the relationship of current period compensation to net revenues. The following table sets forth the reconciliation of the ratio of compensation and benefits to net revenues, as reported, to the ratio of compensation and benefits to net revenues excluding the impact of the continued amortization of prior year share-based awards:
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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 August 2006 versus August 2005. Our net revenues were $7.46 billion for the third quarter of 2006, an increase of 2% compared with the third quarter of 2005, reflecting significantly higher net revenues in Investment Banking and Asset Management and Securities Services, partially offset by lower net revenues in Trading and Principal Investments. The increase in Investment Banking reflected significantly higher net revenues in Underwriting, as both debt and equity underwriting results improved, as well as higher net revenues in Financial Advisory, reflecting increased client activity. Strong net revenue growth in our Asset Management and Securities Services businesses primarily reflected significantly higher management and other fees as well as continued strength in our prime brokerage business. Assets under management increased significantly from a year ago, including net asset inflows of $30 billion during the quarter. Net revenues in Trading and Principal Investments were lower than a particularly strong third quarter of 2005. Net revenues in Principal Investments decreased reflecting a smaller gain related to our investment in the convertible preferred stock of SMFG as well as lower net revenues from our other principal investments. In addition, net revenues in Equities were lower than the same prior year period, while net revenues in FICC were higher than a strong third quarter of 2005. During the quarter, Equities operated in a less favorable environment as equity prices lacked direction and customer-driven activity declined from the first half of the year. In addition, although FICC performed well, the business operated in a less favorable environment, as customer-driven activity declined from the first half of the year and volatility levels were generally low. Nine Months Ended August 2006 versus August 2005. Our net revenues were $27.90 billion for the first nine months of 2006, an increase of 51% compared with the same period last year, reflecting strong net revenue growth in each of our three segments. Trading and Principal Investments results reflected significantly higher net revenues in FICC and Equities and a strong performance in Principal Investments. Net revenues in FICC reflected particularly strong results across all major businesses, and net revenues in Equities reflected significant growth in our customer franchise business, while results in principal strategies, although strong, were lower than the same prior year period. In our trading businesses, we saw generally favorable trading and investing opportunities for our clients and ourselves, and consequently increased our market risk in the first half of the year. However, as the environment became more challenging during the third quarter of 2006, our market risk declined, reflecting fewer opportunities in the markets. In Investment Banking, net revenues reflected strong growth in Underwriting and Financial Advisory as industry-wide volumes across equity underwriting and mergers and acquisitions were significantly ahead of the same prior year period and debt underwriting volumes remained at high levels. In Asset Management and Securities Services, revenue growth was driven by record assets under management and significantly higher incentive fees, as well as significantly higher global customer balances in Securities Services.64
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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 nine months of 2006, our ratio of compensation and benefits to net revenues was 49.8%. Excluding the $508 million impact of the continued amortization under SFAS No. 123-Rof prior yearshare-based awards granted to retirement-eligible employees, for the first nine months of 2006, our ratio of compensation and benefits to net revenues was 48.0%, down from 49.0% for the first six months of 2006. This lower compensation ratio reflects our strong net revenues in 2006 as well as greater visibility into expected compensation levels as year end approaches. See “— Use of Estimates” above for more information on our ratio of compensation and benefits to net revenues. The following table sets forth our operating expenses and number of employees:Operating Expenses and Employees($ 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)
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Non-compensation expenses were $1.59 billion, 29% higher than the third quarter of 2005. Excluding consolidated entities held for investment purposes, non-compensation expenses were 26% higher than the third quarter of 2005. More than 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 fiscal 2006. Nine Months Ended August 2006 versus August 2005.Operating expenses of $18.32 billion for the first nine months of 2006 increased 44% compared with the first nine months of 2005. Compensation and benefits expenses of $13.90 billion increased 50% compared with the first nine months of 2005, reflecting higher net revenues. The ratio of compensation and benefits to net revenues for the first nine months of 2006 was 49.8% compared with 50.0% for the same period last year. Excluding the $508 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 48.0% for the first nine months of 2006 compared with 50.0% for the first nine months of 2005. Employment levels increased 9% during the first nine months of 2006. See “— Use of Estimates” above for more information on our ratio of compensation and benefits to net revenues. Non-compensation expenses were $4.42 billion, 28% higher than the first nine months of 2005. Excluding consolidated entities held for investment purposes, non-compensation expenses were 23% higher than the first nine months of 2005. More than 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 fiscal 2006. Provision for Taxes The provision for taxes for the three and nine months ended August 2006 was $768 million and $3.19 billion, respectively. The effective income tax rate was 33.3% for the first nine months of 2006, down from 33.6% for the first six months of 2006 and up from 32.0% for fiscal year 2005. The increase in the effective tax rate for the first nine months of 2006 compared with fiscal year 2005 was primarily due to the impact of audit settlements in 2005 and lower estimated tax credits in 2006.67
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Segment Operating Results The following table sets forth the net revenues, operating expenses and pre-tax earnings of our segments:Segment Operating Results(in millions)
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The following table sets forth the operating results of our Investment Banking segment:Investment Banking Operating Results(in millions)
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Nine Months Ended August 2006 versus August 2005. Net revenues in Investment Banking of $4.29 billion for the first nine months of 2006 increased 57% compared with the same period last year, reflecting growth across all regions. Net revenues in Financial Advisory of $1.95 billion increased 44% 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 $2.33 billion increased 71% compared with the first nine months 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. Operating expenses of $3.22 billion for the nine months ended August 2006 increased 35% compared with the same period last year, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Pre-tax earnings were $1.06 billion compared with $331 million in the same period last year. Trading and Principal Investments Our Trading and Principal Investments segment is divided into three components: • FICC. We make markets in and trade interest rate and credit products, mortgage-backed securities and loans, currencies and commodities, structure and enter into a wide variety of derivative transactions and engage in proprietary trading and investing. • Equities. We make markets in, trade and act as a specialist for equities and equity-related products, structure and enter into equity derivative transactions, engage in proprietary trading and enter into insurance transactions. We also execute and clear client transactions on major stock, options and futures exchanges worldwide. • Principal Investments. We generate net revenues from our corporate and real estate merchant banking investments, including the increased share of the income and gains derived from our merchant banking funds when the return on a fund’s investments exceeds certain threshold returns (merchant banking overrides), as well as gains or losses related to our investment in the convertible preferred stock of SMFG. Substantially all of our inventory ismarked-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.70
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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)
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related to the insurance business, which was acquired in fiscal 2006. Pre-tax earnings of $1.52 billion decreased 17% compared with the third quarter of 2005. Nine Months Ended August 2006 versus August 2005. Net revenues in Trading and Principal Investments of $18.57 billion for the first nine months of 2006 increased 51% compared with the same period last year. Net revenues in FICC of $10.80 billion increased 63% compared with the first nine months of 2005, reflecting strong performances across all major businesses. During the first nine months of 2006, FICC operated in a generally favorable environment, although conditions became more challenging in the third quarter as customer-driven activity declined and volatility levels were low. Net revenues in Equities of $6.35 billion increased 50% compared with the same period last year, primarily reflecting significantly higher net revenues in derivatives and shares and the contribution from our insurance business, which was acquired in fiscal 2006, partially offset by lower net revenues in principal strategies. Although Equities operated in an environment characterized by strong customer-driven activity and generally higher equity prices during the first half of 2006, following more challenging conditions in May, equity markets generally lacked direction and customer-driven activity declined during our third quarter. Principal Investments recorded net revenues of $1.42 billion, reflecting a $605 million gain related to our investment in the convertible preferred stock of SMFG and $813 million in gains and overrides from other principal investments. Operating expenses of $11.90 billion for the nine months ended August 2006 increased 48% compared with the nine months ended August 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Excluding consolidated entities held for investment purposes, non-compensation expenses increased primarily due to higher brokerage, clearing and exchange fees, principally in Equities. In addition, other expenses increased primarily due to costs related to the insurance business, which was acquired in fiscal 2006. Pre-tax earnings of $6.67 billion increased 57% compared with the same period last year.Asset Management and Securities Services Our Asset Management and Securities Services segment is divided into two components: • Asset Management. Asset Management provides investment advisory and financial planning services and offers investment products across all major asset classes to a diverse group of institutions and individuals worldwide and primarily generates revenues in the form of management and incentive fees. • Securities Services. Securities Services provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide, and generates revenues primarily in the form of interest rate spreads or fees. 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.72
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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)
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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)
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asset inflows of $10 billion (1)and market appreciation of $27 billion, primarily in equity and fixed income assets. Securities Services net revenues of $1.68 billion increased 25% 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. Operating expenses of $3.16 billion for the nine months ended 2006 increased 40% compared with the nine months ended August 2005, primarily due to increased compensation and benefits expenses resulting from a higher accrual of discretionary compensation. Pre-tax earnings of $1.89 billion increased 50% compared with the same period last year.Capital and FundingCapital 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 27% to $162.82 billion as of August 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 $129.33 billion as of August 2006 from $100.01 billion as of November 2005. The weighted average maturity of our long-term borrowings as of August 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. (1) Includes the transfer of $8 billion of money market assets under management to interest-bearing deposits at Goldman Sachs Bank USA, a wholly owned subsidiary of Goldman Sachs. These deposits are not included in assets under management.75
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Total shareholders’ equity increased by 20% to $33.49 billion (common equity of $30.39 billion and preferred stock of $3.10 billion) as of August 2006 from $28.00 billion as of November 2005. On July 24, 2006, Goldman Sachs issued an additional 20,000 shares of perpetual Floating RateNon-CumulativePreferred Stock, Series D. As of August 2006, Goldman Sachs had 124,000 shares of perpetual non-cumulative preferred stock outstanding in four series as set forth in the following table:Preferred Stock by Series
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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:
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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-termborrowings also include the portion oflong-term borrowings maturing within one year of our financial statement date and certain long-termborrowings 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:Short-Term Borrowings(in millions)
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A large portion of our securedshort-term borrowings are similar in nature to our other collateralized financing sources such as financial instruments sold under agreements to repurchase. These securedshort-term borrowings provide Goldman Sachs with a more stable source of liquidity than unsecuredshort-term borrowings, as they are less sensitive to changes in our credit ratings due to underlying collateral. Our unsecuredshort-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 ourshort-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 ourshort-term borrowings.Credit Ratings We rely upon theshort-term andlong-term debt capital markets to fund a significant portion of ourday-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 August 2006:
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Contractual Obligations and Commitments Goldman Sachs has contractual obligations to make future payments underlong-term debt,long-term noncancelable lease agreements and purchase obligations and has commitments under a variety of commercial arrangements. The following table sets forth our contractual obligations by fiscal maturity date as of August 2006:Contractual Obligations(in millions)
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The following table sets forth our quarterly long-term borrowings maturity profile through the third fiscal quarter of 2012:Long-Term Borrowings Maturity Profile($ in millions) (1) Our long-term borrowings include extendible debt if the earliest maturity is one year or greater from our financial statement date. Extendible debt is categorized in the maturity profile at the earliest possible maturity even though the debt can be, and in the past generally has been, extended. As of August 2006, our future minimum rental payments, net of minimum sublease rentals, under noncancelable leases were $4.09 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. As of August 2006 and November 2005, we hadconstruction-relatedobligations of $1.62 billion and $579 million, respectively, including purchase obligations of $1.26 billion and $481 million, respectively, related to the development of wind energy projects.Construction-relatedobligations82
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also include outstanding purchase obligations of $306 million and $47 million as of August 2006 and November 2005, respectively, related to our new world headquarters in New York City, which is expected to cost between $2.3 billion and $2.5 billion. As of August 2006, we had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $53.31 billion. The following table sets forth our commitments as of August 2006:Commitments(in millions)
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assets, primarily consisting of mortgage-backed and other asset-backed securities, residential and commercial mortgages and corporate debt instruments. 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 bothfirm-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 — maintain substantial excess liquidity to meet a broad range of potential cash outflows in a stressed environment including financing obligations. • Asset-LiabilityManagement — ensure we fund our assets with appropriate financing. • Intercompany Funding — maintain parent company liquidity and manage the distribution of liquidity across the group structure. • Crisis Planning — ensure all funding and liquidity management is based onstress-scenarioplanning and feeds into our liquidity crisis plan. Excess Liquidity Maintenance of a Pool of Highly Liquid Securities. Our most important liquidity policy is topre-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 providesame-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 fromcredit-sensitivemarkets. 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: • The first days or weeks of a liquidity crisis are the most critical to a company’s survival. • Focus must be maintained on all potential cash and collateral outflows, not just disruptions to financing flows. Goldman Sachs’ businesses are diverse, and its cash needs are driven by many factors, including market movements, collateral requirements and client commitments, all of which can change dramatically in a difficult funding environment. • During a liquidity crisis, credit-sensitive funding, including unsecured debt and some types of secured financing agreements, may be unavailable and the terms or availability of other types of secured financing may change. • As a result of our policy topre-fund liquidity that we estimate may be needed in a crisis, we hold more unencumbered securities and larger unsecured debt balances than our businesses would otherwise require. We believe that our liquidity is stronger with greater balances of highly liquid unencumbered securities, even though it increases our unsecured liabilities.84
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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:
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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 $141.11 billion, $124.56 billion and $125.36 billion in the third quarter of 2006, second 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 ismarked-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 each would have been, on average, 5% lower 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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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: • the portion of financial instruments owned that we believe could not be funded on a secured basis in periods of market stress, assuming conservative loan values; • goodwill and identifiable intangible assets, property, leasehold improvements and equipment, and other illiquid assets; • derivative and other margin and collateral requirements; • anticipated draws on our unfunded loan commitments; and • capital or other forms of financing in our regulated subsidiaries that is in excess of their long-term financing requirements. See “— Intercompany Funding” below for a further discussion of how we fund our subsidiaries. Our total capital of $162.82 billion and $128.01 billion as of August 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. andnon-U.S. commercial paper and promissory note issuances, and other methods. We make extensive use of the repurchase agreement and securities lending markets and arrange for letters of credit to be issued on our behalf. Substantially all of our unsecured debt is issued without provisions that would, based solely upon an adverse change in our credit ratings, financial ratios, earnings, cash flows or 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.87
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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 principalnon-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 August 2006, Group Inc.’s equity investment in subsidiaries was $29.99 billion compared with its total shareholders’ equity of $33.49 billion. Group Inc. has provided substantial amounts of equity and subordinated indebtedness, directly or indirectly, to its regulated subsidiaries; for example, as of August 2006, Group Inc. had $17.48 billion of such equity and subordinated indebtedness invested in Goldman, Sachs & Co., its principal U.S. registered broker-dealer; $22.08 billion invested in Goldman Sachs International, a regulated U.K. broker-dealer; $2.44 billion invested in Goldman Sachs Execution & Clearing, L.P., a U.S. registeredbroker-dealer; and $2.61 billion invested in Goldman Sachs (Japan) Ltd., a regulated broker-dealer based in Tokyo. Group Inc. also had $52.84 billion of unsubordinated loans to these entities as of August 2006, as well as significant amounts of capital invested in and loans to its other regulated subsidiaries. Subsidiary Foreign Exchange Policies. Our capital invested innon-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.88
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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 conservativestress-scenarioplanning. 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 andasset-liabilitymanagement policies described above. Cash flow analysis may, however, be helpful in highlighting certain macro trends and strategic initiatives in our business. Nine Months Ended August 2006. Our cash and cash equivalents decreased by $198 million to $10.06 billion as of August 2006. We raised $44.73 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 $44.93 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients. Nine Months Ended August 2005. Our cash and cash equivalents increased by $2.53 billion to $6.90 billion as of August 2005. We raised $16.42 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 $13.89 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients.89
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Recent Accounting Developments 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-Rfocuses 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-Rare generally applied only to share-based awards granted subsequent to adoption. The accounting treatment of share-based awards granted toretirement-eligibleemployees 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 fiscal 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 $133 million and $508 million were recognized in the three and nine months ended August 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 Issue No. 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 Issue No. 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. Effective for the first quarter of fiscal 2006, we adopted SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” which permits entities90
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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. As permitted, we early adopted FSP FIN No. 46-R-6 in the third quarter of fiscal 2006. Adoption did not have a material effect on our financial condition, results of operations or cash flows. In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” FIN No. 48 requires that management determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets this recognition threshold, the position is measured to determine the amount of benefit to be recognized in the financial statements. We expect to adopt the provisions of FIN No. 48 beginning in the first quarter of fiscal 2008. We are currently evaluating the impact of adopting FIN No. 48 on our financial condition, results of operations and cash flows. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies that fair value is the amount that would be exchanged to sell an asset or transfer a liability, in an orderly transaction between market participants. SFAS No. 157 nullifies the consensus reached in EITF Issue No. 02-3prohibiting the recognition of day one gain or loss on derivative contracts (and hybrid instruments measured at fair value under SFAS No. 133 as modified by SFAS No. 155) where we cannot verify all of the significant model inputs to observable market data and verify the model to market transactions. However, SFAS No. 157 requires that a fair value measurement technique include an adjustment for risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model, if market participants would also include such an adjustment. In addition, SFAS No. 157 prohibits the recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available in an active market. The provisions of SFAS No. 157 are to be applied prospectively, except for changes in fair value measurements that result from the initial application of SFAS No. 157 to existing derivative financial instruments measured under EITF Issue No. 02-3, existing hybrid instruments measured at fair value, and block discounts, which are to be recorded as an adjustment to opening retained earnings in the year of adoption. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are evaluating whether we will early adopt SFAS No. 157 as of the first quarter of fiscal 2007 as permitted, and are currently evaluating the impact adoption may have on our financial condition, results of operations and cash flows. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and132-R.” SFAS No. 158 requires an entity to recognize in its statement of financial condition the funded status of its defined benefit postretirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. SFAS No. 158 also requires an entity to recognize changes in the funded status of a defined benefit postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost. SFAS No. 158 is effective as of the end of the fiscal year ending after December 15, 2006. We will adopt SFAS No. 158 as of the end of fiscal 2007. We do not expect that the adoption of SFAS No. 158 will have a material effect on our financial condition, results of operations or cash flows.91
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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 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 constituteforward-lookingstatements. 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.92
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Item 3: Quantitative and Qualitative Disclosures About Market Risk 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: • risk limits based on a summary measure of market risk exposure referred to as Value-at-Risk (VaR); • scenario analyses, stress tests and other analytical tools that measure the potential effects on our trading net revenues of various market events, including, but not limited to, a large widening of credit spreads, a substantial decline in equity markets and significant moves in selected emerging markets; and • inventory position limits for selected business units. 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.93
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The following table sets forth the daily VaR:Daily VaR (1)(in millions)
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Trading Net Revenues Distribution Substantially all of our inventory positions aremarked-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 August 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 did not exceed our 95% one-day VaR during the quarter ended August 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 related to our investment in the convertible preferred stock of SMFG is measured by estimating the potential reduction in net revenues associated with a 10% decline in the SMFG common stock price. The market risk related to the remaining positions is measured by estimating the potential reduction in net revenues associated with a 10% decline in asset values. The sensitivity analyses for equity and debt positions in our trading portfolio and equity, debt (primarily mezzanine instruments) and real estate positions in our non-trading portfolio are measured by the impact of a decline in the asset values (including the impact of leverage in the underlying investments for real estate positions in our non-trading portfolio) of such positions. The fair values of the underlying positions may be sensitive to changes in a number of factors, including, but not limited to, the financial performance of the companies or properties relative to budgets or projections, the projected timing and amount of future cash flows, discount rates, trends within sectors and/or regions, underlying business models and equity prices. The sensitivity analysis 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 by the impact of a decline in the SMFG common stock price. 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.95
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The following table sets forth market risk for positions not included in VaR. These measures do 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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The following table sets forth the distribution, by credit rating, of substantially all of our exposure with respect to OTC derivatives as of August 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)
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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.Item 4: Controls and Procedures 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.98
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PART II: OTHER INFORMATIONItem 1:Legal Proceedings 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 our Quarterly Reports on Form 10-Q for the quarters ended February 24, 2006 and May 26, 2006.Iridium Securities Litigation By a decision dated September 15, 2006, the federal district court denied the underwriter defendants’ motion for summary judgment as to claims under Section 11 of the Securities Act of 1933, but granted summary judgment dismissing claims under Section 12(2) of the Securities Act against Goldman, Sachs & Co. and all but one of the other underwriter defendants.Research Independence Matters On July 7, 2006, defendants moved to dismiss the second amended complaint in the action relating to research coverage of Exodus Communications, Inc. In the lawsuit alleging that The Goldman Sachs Group, Inc., Goldman, Sachs & Co. and Henry M. Paulson, Jr. violated the federal securities laws in connection with the firm’s research activities, the district court, in a decision dated September 29, 2006, granted Mr. Paulson’s motion to dismiss with leave to replead but otherwise denied the motion.Exodus Securities Litigation In the class action relating to certain securities offerings by Exodus Communications, Inc., by a decision dated August 14, 2006 the district court denied the motion to intervene by two proposed new plaintiffs and entered judgment dismissing the action. On August 30, 2006, the proposed new plaintiffs moved to vacate the judgment.Refco Securities Litigation In the action brought on behalf of customers that held securities custodied with certain Refco Inc. affiliates, Goldman, Sachs & Co. and other underwriters of Refco’s initial public offering were not included as defendants in the amended complaint filed on September 5, 2006.Fannie Mae Litigation Goldman, Sachs & Co. has been added as a defendant in amended complaints filed on August 14, 2006 and September 1, 2006, respectively, in a purported class action and a separate shareholder derivative action pending in the U.S. District Court for the District of Columbia, which generally arise from allegations concerning Fannie Mae’s accounting practices. The complaints’ allegations relating to Goldman, Sachs & Co. assert violations of the federal securities laws and common law in connection with certain Fannie Mae-sponsored REMIC transactions that were allegedly arranged by Goldman, Sachs & Co. The other defendants include Fannie Mae, certain of its past and present officers and directors, accountants and other financial services firms.99
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Item 2:Unregistered Sales of Equity Securities and Use of Proceeds 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 August 25, 2006.
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Item 6: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. THE GOLDMAN SACHS GROUP, INC. By: /s/ David A. Viniar Name: David A. Viniar Title: Chief Financial Officer By: /s/ Sarah E. Smith Name: Sarah E. Smith Title: Principal Accounting OfficerDate: October 3, 2006102
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