Form 10-Q
Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

or

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                             to

  

Commission File Number: 001-14965

The Goldman Sachs Group, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   13-4019460

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

200 West Street, New York, N.Y.  

10282

(Address of principal executive offices)   (Zip Code)

(212) 902-1000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x Yes ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

  Large accelerated filer  x                     Accelerated filer  ¨
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)        Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨ Yes x No

APPLICABLE ONLY TO CORPORATE ISSUERS

As of July 27, 2012, there were 479,416,563 shares of the registrant’s common stock outstanding.


Table of Contents

THE GOLDMAN SACHS GROUP, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2012

 

INDEX

 

Form 10-Q Item Number   Page No.  
PART I  

FINANCIAL INFORMATION

    2   
Item 1  

Financial Statements (Unaudited)

    2   
   

Condensed Consolidated Statements of Earnings for the three and six months ended June 30, 2012 and June 30, 2011

    2   
   

Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2012 and June 30, 2011

    3   
   

Condensed Consolidated Statements of Financial Condition as of June 30, 2012 and December 31, 2011

    4   
   

Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2012 and year ended December 31, 2011

    5   
   

Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and June 30, 2011

    6   
 

Notes to Condensed Consolidated Financial Statements

    7   
   

Note 1.       Description of Business

    7   
   

Note 2.       Basis of Presentation

    7   
   

Note 3.       Significant Accounting Policies

    8   
   

Note 4.      Financial  Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased, at Fair Value

    12   
   

Note 5.       Fair Value Measurements

    13   
   

Note 6.      Cash Instruments

    15   
   

Note 7.       Derivatives and Hedging Activities

    25   
   

Note 8.      Fair Value Option

    40   
   

Note 9.       Collateralized Agreements and Financings

    50   
   

Note 10.    Securitization Activities

    53   
   

Note 11.    Variable Interest Entities

    56   
   

Note 12.    Other Assets

    61   
   

Note 13.     Goodwill and Identifiable Intangible Assets

    62   
   

Note 14.    Deposits

    64   
   

Note 15.    Short-Term Borrowings

    65   
   

Note 16.    Long-Term Borrowings

    66   
   

Note 17.     Other Liabilities and Accrued Expenses

    70   
   

Note 18.     Commitments, Contingencies and Guarantees

    71   
   

Note 19.    Shareholders’ Equity

    77   
   

Note 20.     Regulation and Capital Adequacy

    80   
   

Note 21.    Earnings Per Common Share

    85   
   

Note 22.     Transactions with Affiliated Funds

    86   
   

Note 23.     Interest Income and Interest Expense

    87   
   

Note 24.    Income Taxes

    87   
   

Note 25.    Business Segments

    88   
   

Note 26.    Credit Concentrations

    92   
   

Note 27.    Legal Proceedings

    93   
   

Report of Independent Registered Public Accounting Firm

    107   
   

Statistical Disclosures

    108   
Item 2  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

    112   
Item 3  

Quantitative and Qualitative Disclosures About Market Risk

    179   
Item 4  

Controls and Procedures

    179   
PART II  

OTHER INFORMATION

    179   
Item 1  

Legal Proceedings

    179   
Item 2  

Unregistered Sales of Equity Securities and Use of Proceeds

    180   
Item 6  

Exhibits

    181   
SIGNATURES     182   

 

Exhibit 10.1 - Description of Compensation Arrangements with Executive Officer.

Exhibit 12.1 - Statement re: Computation of Ratios of Earnings to Fixed Charges and Ratios of Earnings to Combined Fixed Charges and Preferred Stock Dividends.

Exhibit 15.1 - Letter re: Unaudited Interim Financial Information.

Exhibit 31.1 - Rule 13a-14(a) Certifications.

Exhibit 32.1 - Section 1350 Certifications.

Exhibit 101 - Interactive Data.

 

      

 

  Goldman Sachs June 2012 Form 10-Q   1


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements (Unaudited)

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Earnings

(Unaudited)

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions, except per share amounts     2012        2011            2012        2011   

Revenues

         

Investment banking

    $1,206        $1,448            $  2,366        $  2,717   

Investment management

    1,266        1,188            2,371        2,362   

Commissions and fees

    799        894            1,659        1,913   

Market making

    2,097        1,736            6,002        6,198   

Other principal transactions

    169        602            2,107        3,214   

Total non-interest revenues

    5,537        5,868            14,505        16,404   

Interest income

    3,055        3,681            5,888        6,788   

Interest expense

    1,965        2,268            3,817        4,017   

Net interest income

    1,090        1,413            2,071        2,771   

Net revenues, including net interest income

    6,627        7,281            16,576        19,175   

Operating expenses

         

Compensation and benefits

    2,915        3,204            7,293        8,437   

Brokerage, clearing, exchange and distribution fees

    544        615            1,111        1,235   

Market development

    129        183            246        362   

Communications and technology

    202        210            398        408   

Depreciation and amortization

    409        372            842        962   

Occupancy

    214        252            426        519   

Professional fees

    213        263            447        496   

Insurance reserves

    121        117            278        205   

Other expenses

    465        453            939        899   

Total non-compensation expenses

    2,297        2,465            4,687        5,086   

Total operating expenses

    5,212        5,669            11,980        13,523   

Pre-tax earnings

    1,415        1,612            4,596        5,652   

Provision for taxes

    453        525            1,525        1,830   

Net earnings

    962        1,087            3,071        3,822   

Preferred stock dividends

    35        35            70        1,862   

Net earnings applicable to common shareholders

    $   927        $1,052            $  3,001        $  1,960   

Earnings per common share

         

Basic

    $  1.83        $  1.96            $    5.90        $    3.62   

Diluted

    1.78        1.85            5.72        3.40   

Dividends declared per common share

    $  0.46        $  0.35            $    0.81        $    0.70   

Average common shares outstanding

         

Basic

    501.5        531.9            506.1        536.2   

Diluted

    520.3        569.5            524.7        576.4   

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2   Goldman Sachs June 2012 Form 10-Q  

 


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions     2012         2011             2012         2011    

Net earnings

    $962         $1,087             $3,071         $3,822    

Other comprehensive income/(loss), net of tax:

         

Currency translation adjustment, net of tax

    (24)        (13)            (52)        (35)   

Pension and postretirement liability adjustments, net of tax

    —                             

Net unrealized gains/(losses) on available-for-sale securities, net of tax

    25         (6)            55         (29)   

Other comprehensive income/(loss)

           (17)            10         (61)   

Comprehensive income

    $963         $1,070             $3,081         $3,761    

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

  Goldman Sachs June 2012 Form 10-Q   3

 


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Financial Condition

(Unaudited)

 

   

As of

in millions, except share and per share amounts  

June 

2012 

 

December 

2011 

Assets

   

Cash and cash equivalents

  $  58,913    $  56,008 

Cash and securities segregated for regulatory and other purposes (includes $37,279 and $42,014 at fair value as of
June 2012 and December 2011, respectively)

  56,685    64,264 

Collateralized agreements:

   

Securities purchased under agreements to resell and federal funds sold (includes $167,344 and $187,789 at fair value as of June 2012 and December 2011, respectively)

  167,344    187,789 

Securities borrowed (includes $51,897 and $47,621 at fair value as of June 2012 and December 2011, respectively)

  167,516    153,341 

Receivables from brokers, dealers and clearing organizations

  19,146    14,204 

Receivables from customers and counterparties (includes $7,444 and $9,682 at fair value as of June 2012 and December 2011, respectively)

  67,674    60,261 

Financial instruments owned, at fair value (includes $67,004 and $53,989 pledged as collateral as of June 2012 and December 2011, respectively)

  387,196    364,206 

Other assets

  24,164    23,152 

Total assets

  $948,638    $923,225 

Liabilities and shareholders’ equity

   

Deposits (includes $5,646 and $4,526 at fair value as of June 2012 and December 2011, respectively)

  $  57,320    $  46,109 

Collateralized financings:

   

Securities sold under agreements to repurchase, at fair value

  160,442    164,502 

Securities loaned (includes $24 and $107 at fair value as of June 2012 and December 2011, respectively)

  9,448    7,182 

Other secured financings (includes $25,039 and $30,019 at fair value as of June 2012 and December 2011, respectively)

  28,790    37,364 

Payables to brokers, dealers and clearing organizations

  12,167    3,667 

Payables to customers and counterparties

  209,517    194,625 

Financial instruments sold, but not yet purchased, at fair value

  149,948    145,013 

Unsecured short-term borrowings, including the current portion of unsecured long-term borrowings (includes $16,928 and $17,854 at fair value as of June 2012 and December 2011, respectively)

  45,693    49,038 

Unsecured long-term borrowings (includes $12,644 and $17,162 at fair value as of June 2012 and December 2011, respectively)

  166,993    173,545 

Other liabilities and accrued expenses (includes $9,416 and $9,486 at fair value as of June 2012 and December 2011, respectively)

  35,465    31,801 

Total liabilities

  875,783    852,846 

Commitments, contingencies and guarantees

   

Shareholders’ equity

   

Preferred stock, par value $0.01 per share; aggregate liquidation preference of $4,850 and $3,100 as of June 2012 and December 2011, respectively

  4,850    3,100 

Common stock, par value $0.01 per share; 4,000,000,000 shares authorized, 808,306,923 and 795,555,310 shares issued as of June 2012 and December 2011, respectively, and 480,990,890 and 485,467,565 shares outstanding as of June 2012 and December 2011, respectively

   

Restricted stock units and employee stock options

  4,128    5,681 

Nonvoting common stock, par value $0.01 per share; 200,000,000 shares authorized, no shares issued and outstanding

  —    — 

Additional paid-in capital

  47,055    45,553 

Retained earnings

  61,412    58,834 

Accumulated other comprehensive loss

  (506)   (516)

Stock held in treasury, at cost, par value $0.01 per share; 327,316,035 and 310,087,747 shares as of June 2012 and
December 2011, respectively

  (44,092)   (42,281)

Total shareholders’ equity

  72,855    70,379 

Total liabilities and shareholders’ equity

  $948,638    $ 923,225 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

 

    Six Months Ended         Year Ended  
in millions  

June

2012

        

December

2011

 

Preferred stock

     

Balance, beginning of year

    $   3,100            $   6,957   

Issued

    1,750              

Repurchased

               (3,857

Balance, end of period

    4,850            3,100   

Common stock

     

Balance, beginning of year

    8            8   

Issued

                 

Balance, end of period

    8            8   

Restricted stock units and employee stock options

     

Balance, beginning of year

    5,681            7,706   

Issuance and amortization of restricted stock units and employee stock options

    899            2,863   

Delivery of common stock underlying restricted stock units

    (2,415         (4,791

Forfeiture of restricted stock units and employee stock options

    (36         (93

Exercise of employee stock options

    (1         (4

Balance, end of period

    4,128            5,681   

Additional paid-in capital

     

Balance, beginning of year

    45,553            42,103   

Issuance of common stock

               103   

Delivery of common stock underlying share-based awards

    2,432            5,160   

Cancellation of restricted stock units in satisfaction of withholding tax requirements

    (872         (1,911

Excess net tax benefit/(provision) related to share-based awards

    (57         138   

Cash settlement of share-based compensation

    (1         (40

Balance, end of period

    47,055            45,553   

Retained earnings

     

Balance, beginning of year

    58,834            57,163   

Net earnings

    3,071            4,442   

Dividends and dividend equivalents declared on common stock and restricted stock units

    (423         (769

Dividends on preferred stock

    (70         (2,002

Balance, end of period

    61,412            58,834   

Accumulated other comprehensive income/(loss)

     

Balance, beginning of year

    (516         (286

Other comprehensive income/(loss)

    10            (230

Balance, end of period

    (506         (516

Stock held in treasury, at cost

     

Balance, beginning of year

    (42,281         (36,295

Repurchased

    (1,869         (6,051

Reissued

    58            65   

Balance, end of period

    (44,092         (42,281

Total shareholders’ equity

    $ 72,855            $ 70,379   

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

  Goldman Sachs June 2012 Form 10-Q   5


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

        Six Months
    Ended June
in millions   2012     2011 

Cash flows from operating activities

   

Net earnings

    $   3,071      $   3,822 

Non-cash items included in net earnings

   

Depreciation and amortization

    842      966 

Share-based compensation

    890      1,985 

Changes in operating assets and liabilities

   

Cash and securities segregated for regulatory and other purposes

    7,579      (7,759)

Net receivables from brokers, dealers and clearing organizations

    3,559      (3,170)

Net payables to customers and counterparties

    7,949      3,884

Securities borrowed, net of securities loaned

    (11,909   (5,904)

Securities sold under agreements to repurchase, net of securities purchased under agreements to resell
and federal funds sold

    16,385      19,175 

Financial instruments owned, at fair value

    (22,954   (9,966)

Financial instruments sold, but not yet purchased, at fair value

    4,996      8,919 

Other, net

    (1,503   703 

Net cash provided by operating activities

    8,905      12,655 

Cash flows from investing activities

   

Purchase of property, leasehold improvements and equipment

    (542   (520)

Proceeds from sales of property, leasehold improvements and equipment

    28      33 

Business acquisitions, net of cash acquired

    (355   (247)

Proceeds from sales of investments

    290      966 

Purchase of available-for-sale securities

    (1,988   (1,122)

Proceeds from sales of available-for-sale securities

    1,386      1,339 

Net cash provided by/(used for) investing activities

    (1,181   449 

Cash flows from financing activities

   

Unsecured short-term borrowings, net

    (1,300   298 

Other secured financings (short-term), net

    (5,232   (461)

Proceeds from issuance of other secured financings (long-term)

    1,907      2,334 

Repayment of other secured financings (long-term), including the current portion

    (5,496   (5,363)

Proceeds from issuance of unsecured long-term borrowings

    15,677      17,470 

Repayment of unsecured long-term borrowings, including the current portion

    (22,062   (13,686)

Derivative contracts with a financing element, net

    964      244 

Deposits, net

    11,211      435 

Preferred stock repurchased

         (3,857)

Common stock repurchased

    (1,866   (2,980)

Dividends and dividend equivalents paid on common stock, preferred stock and restricted stock units

    (493   (2,326)

Proceeds from issuance of preferred stock, net of issuance costs

    1,750      — 

Proceeds from issuance of common stock, including stock option exercises

    46      123 

Excess tax benefit related to share-based compensation

    76      346 

Cash settlement of share-based compensation

    (1   (36)

Net cash used for financing activities

    (4,819   (7,459)

Net increase in cash and cash equivalents

    2,905      5,645 

Cash and cash equivalents, beginning of year

    56,008      39,788 

Cash and cash equivalents, end of period

    $ 58,913      $ 45,433 

SUPPLEMENTAL DISCLOSURES:

Cash payments for interest, net of capitalized interest, were $5.72 billion and $4.02 billion during the six months ended June 2012 and June 2011, respectively.

Cash payments for income taxes, net of refunds, were $671 million and $1.79 billion during the six months ended June 2012 and June 2011, respectively.

Non-cash activities:

The firm assumed $92 million of debt in connection with business acquisitions during the six months ended June 2012.

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

6   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 1. Description of Business

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 financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in all major financial centers around the world.

The firm reports its activities in the following four business segments:

Investment Banking

The firm provides a broad range of investment banking services to a diverse group of corporations, financial institutions, investment funds and governments. Services include advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, risk management, restructurings and spin-offs, and debt and equity underwriting of public offerings and private placements, as well as derivative transactions directly related to these activities.

Institutional Client Services

The firm facilitates client transactions and makes markets in fixed income, equity, currency and commodity products, primarily with institutional clients such as corporations, financial institutions, investment funds and governments. The firm also makes markets and clears client transactions on major stock, options and futures exchanges worldwide and provides financing, securities lending and prime brokerage services to institutional clients.

Investing & Lending

The firm invests in and originates loans to provide financing to clients. These investments and loans are typically longer-term in nature. The firm makes investments, directly and indirectly through funds that the firm manages, in debt securities, loans, public and private equity securities, real estate, consolidated investment entities and power generation facilities.

Investment Management

The firm provides investment management services and offers investment products (primarily through separately managed accounts and commingled vehicles, such as mutual funds and private investment funds) across all major asset classes to a diverse set of institutional and individual clients. The firm also offers wealth advisory services, including portfolio management and financial counseling, and brokerage and other transaction services to high-net-worth individuals and families.

 

Note 2. Basis of Presentation

Note 2.

Basis of Presentation

These condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP) and include the accounts of Group Inc. and all other entities in which the firm has a controlling financial interest. Intercompany transactions and balances have been eliminated.

These condensed consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements included in the firm’s Annual Report on Form 10-K for the year ended December 31, 2011. References to “the firm’s Annual Report on Form 10-K” are to the firm’s Annual Report on Form 10-K for the year ended December 31, 2011. The condensed consolidated financial information as of December 31, 2011 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.

All references to June 2012 and June 2011 refer to the firm’s periods ended, or the dates, as the context requires, June 30, 2012 and June 30, 2011, respectively. All references to March 2012 and December 2011 refer to the dates March 31, 2012 and December 31, 2011, respectively. Any reference to a future year refers to a year ending on December 31 of that year. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.

 

 

  Goldman Sachs June 2012 Form 10-Q   7


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 3. Significant Accounting Policies

Note 3.

Significant Accounting Policies

 

The firm’s significant accounting policies include when and how to measure the fair value of assets and liabilities, accounting for goodwill and identifiable intangible assets, and when to consolidate an entity. See Notes 5 through 8 for policies on fair value measurements, Note 13 for policies on goodwill and identifiable intangible assets, and below and Note 11 for policies on consolidation accounting. All other significant accounting policies are either discussed below or included in the following footnotes:

 

Financial Instruments Owned, at Fair Value

and Financial Instruments Sold, But Not Yet

Purchased, at Fair Value

     Note 4   

Fair Value Measurements

     Note 5   

Cash Instruments

     Note 6   

Derivatives and Hedging Activities

     Note 7   

Fair Value Option

     Note 8   

Collateralized Agreements and Financings

     Note 9   

Securitization Activities

     Note 10   

Variable Interest Entities

     Note 11   

Other Assets

     Note 12   

Goodwill and Identifiable Intangible Assets

     Note 13   

Deposits

     Note 14   

Short-Term Borrowings

     Note 15   

Long-Term Borrowings

     Note 16   

Other Liabilities and Accrued Expenses

     Note 17   

Commitments, Contingencies and Guarantees

     Note 18   

Shareholders’ Equity

     Note 19   

Regulation and Capital Adequacy

     Note 20   

Earnings Per Common Share

     Note 21   

Transactions with Affiliated Funds

     Note 22   

Interest Income and Interest Expense

     Note 23   

Income Taxes

     Note 24   

Business Segments

     Note 25   

Credit Concentrations

     Note 26   

Legal Proceedings

     Note 27   

Consolidation

The firm consolidates entities in which the firm has a controlling financial interest. The firm determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity (VIE).

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 power to direct the activities of the entity that most significantly impact its economic performance, the obligation to absorb the losses of the entity and the right to receive the residual returns of the entity. The usual condition for a controlling financial interest in a voting interest entity is ownership of a majority voting interest. If the firm has a majority voting interest in a voting interest entity, the entity is consolidated.

Variable Interest Entities. A VIE is an entity that lacks one or more of the characteristics of a voting interest entity. The firm has a controlling financial interest in a VIE when the firm has a variable interest or interests that provide it with (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. See Note 11 for further information about VIEs.

Equity-Method Investments. When the firm does not have a controlling financial interest in an entity but can exert significant influence over the entity’s operating and financial policies, the investment is accounted for either (i) under the equity method of accounting or (ii) at fair value by electing the fair value option available under U.S. GAAP. Significant influence generally exists when the firm owns 20% to 50% of the entity’s common stock or in-substance common stock.

 

 

8   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In general, the firm accounts for investments acquired subsequent to November 24, 2006, when the fair value option became available, at fair value. In certain cases, the firm applies the equity method of accounting to new investments that are strategic in nature or closely related to the firm’s principal business activities, when the firm has a significant degree of involvement in the cash flows or operations of the investee or when cost-benefit considerations are less significant. See Note 12 for further information about equity-method investments.

Investment Funds. The firm has formed numerous investment funds with third-party investors. These funds are typically organized as limited partnerships or limited liability companies for which the firm acts as general partner or manager. Generally, the firm does not hold a majority of the economic interests in these funds. These funds are usually voting interest entities and generally are not consolidated because third-party investors typically have rights to terminate the funds or to remove the firm as general partner or manager. Investments in these funds are included in “Financial instruments owned, at fair value.” See Notes 6, 18 and 22 for further information about investments in funds.

Use of Estimates

Preparation of these condensed consolidated financial statements requires management to make certain estimates and assumptions, the most important of which relate to fair value measurements, accounting for goodwill and identifiable intangible assets, discretionary compensation accruals and the provision for losses that may arise from litigation, regulatory proceedings and tax audits. These estimates and assumptions are based on the best available information but actual results could be materially different.

Revenue Recognition

Financial Assets and Financial Liabilities at Fair Value. Financial instruments owned, at fair value and Financial instruments sold, but not yet purchased, at fair value are recorded at fair value either under the fair value option or in accordance with other U.S. GAAP. In addition, the firm has elected to account for certain of its other financial assets and financial liabilities at fair value by electing the fair value option. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the measurement date. Financial assets are marked to bid prices and financial liabilities are marked to offer prices. Fair value measurements do not include transaction costs. Fair value gains or losses are generally included in “Market making” for positions in Institutional Client Services and “Other principal transactions” for positions in Investing & Lending. See Notes 5 through 8 for further information about fair value measurements.

Investment Banking. Fees from financial advisory assignments and underwriting revenues are recognized in earnings when the services related to the underlying transaction are completed under the terms of the assignment. Expenses associated with such transactions are deferred until the related revenue is recognized or the assignment is otherwise concluded. Expenses associated with financial advisory assignments are recorded as non-compensation expenses, net of client reimbursements. Underwriting revenues are presented net of related expenses.

Investment Management. The firm earns management fees and incentive fees for investment management services. Management fees are calculated as a percentage of net asset value, invested capital or commitments, and are recognized over the period that the related service is provided. Incentive fees are calculated as a percentage of a fund’s or separately managed account’s return, or excess return above a specified benchmark or other performance target. Incentive fees are generally based on investment performance over a 12-month period or over the life of a fund. Fees that are based on performance over a 12-month period are subject to adjustment prior to the end of the measurement period. For fees that are based on investment performance over the life of the fund, future investment underperformance may require fees previously distributed to the firm to be returned to the fund. Incentive fees are recognized only when all material contingencies have been resolved. Management and incentive fee revenues are included in “Investment management” revenues.

Commissions and Fees. The firm earns “Commissions and fees” from executing and clearing client transactions on stock, options and futures markets. Commissions and fees are recognized on the day the trade is executed.

 

 

  Goldman Sachs June 2012 Form 10-Q   9


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Transfers of Assets

Transfers of assets are accounted for as sales when the firm has relinquished control over the assets transferred. For transfers of assets accounted for as sales, any related gains or losses are recognized in net revenues. Assets or liabilities that arise from the firm’s continuing involvement with transferred assets are measured at fair value. For transfers of assets that are not accounted for as sales, the assets remain in “Financial instruments owned, at fair value” and the transfer is accounted for as a collateralized financing, with the related interest expense recognized over the life of the transaction. See Note 9 for further information about transfers of assets accounted for as collateralized financings and Note 10 for further information about transfers of assets accounted for as sales.

Receivables from Customers and Counterparties

Receivables from customers and counterparties generally relate to collateralized transactions. Such receivables are primarily comprised of customer margin loans, transfers of assets accounted for as secured loans rather than purchases and collateral posted in connection with certain derivative transactions. Certain of the firm’s receivables from customers and counterparties are accounted for at fair value under the fair value option, with changes in fair value generally included in “Market making” revenues. See Note 8 for further information about the fair values of these receivables. Receivables from customers and counterparties not accounted for at fair value are accounted for at amortized cost net of estimated uncollectible amounts. Interest on receivables from customers and counterparties is recognized over the life of the transaction and included in “Interest income.”

Insurance Activities

Certain of the firm’s insurance and reinsurance contracts are accounted for at fair value under the fair value option, with changes in fair value included in “Market making” revenues. See Note 8 for further information about the fair values of these insurance and reinsurance contracts.

Revenues from variable annuity and life insurance and reinsurance contracts not accounted for at fair value generally consist of fees assessed on contract holder account balances for mortality charges, policy administration fees and surrender charges. These revenues are recognized in earnings over the period that services are provided and are included in “Market making” revenues. Changes in reserves, including interest credited to policyholder account balances, are recognized in “Insurance reserves.”

Premiums earned for underwriting property catastrophe reinsurance are recognized in earnings over the coverage period, net of premiums ceded for the cost of reinsurance, and are included in “Market making” revenues. Expenses for liabilities related to property catastrophe reinsurance claims, including estimates of losses that have been incurred but not reported, are included in “Insurance reserves.”

Share-based Compensation

The cost of employee services received in exchange for a share-based award is generally measured based on the grant-date fair value of the award. Share-based awards that do not require future service (i.e., vested awards, including awards granted to retirement-eligible employees) are expensed immediately. Share-based awards that require future service are amortized over the relevant service period. Expected forfeitures are included in determining share-based employee compensation expense.

The firm pays cash dividend equivalents on outstanding restricted stock units (RSUs). Dividend equivalents paid on RSUs are generally charged to retained earnings. Dividend equivalents paid on RSUs expected to be forfeited are included in compensation expense. The firm accounts for the tax benefit related to dividend equivalents paid on RSUs as an increase to additional paid-in capital.

In certain cases, primarily related to conflicted employment (as outlined in the applicable award agreements), the firm may cash settle share-based compensation awards. For awards accounted for as equity instruments, additional paid-in capital is adjusted to the extent of the difference between the current value of the award and the grant-date value of the award.

 

 

10   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Foreign Currency Translation

Assets and liabilities denominated in non-U.S. currencies are translated at rates of exchange prevailing on the date of the condensed consolidated statements of financial condition and revenues and expenses are translated at average rates of exchange for the period. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are recognized in earnings. Gains or losses on translation of the financial statements of a non-U.S. operation, when the functional currency is other than the U.S. dollar, are included, net of hedges and taxes, in the condensed consolidated statements of comprehensive income.

Cash and Cash Equivalents

The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business. As of June 2012 and December 2011, “Cash and cash equivalents” included $8.02 billion and $7.95 billion, respectively, of cash and due from banks, and $50.89 billion and $48.05 billion, respectively, of interest-bearing deposits with banks.

Recent Accounting Developments

Reconsideration of Effective Control for Repurchase Agreements (ASC 860). In April 2011, the FASB issued ASU No. 2011-03, “Transfers and Servicing (Topic 860) — Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 changes the assessment of effective control by removing (i) the criterion that requires the transferor to have the ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee, and (ii) the collateral maintenance implementation guidance related to that criterion. ASU No. 2011-03 is effective for periods beginning after December 15, 2011. The firm adopted the standard on January 1, 2012. Adoption of ASU No. 2011-03 did not affect the firm’s financial condition, results of operations or cash flows.

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (ASC 820). In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurements and Disclosures (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU No. 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain principles related to measuring fair value, and requires additional disclosures about fair value measurements. ASU No. 2011-04 is effective for periods beginning after December 15, 2011. The firm adopted the standard on January 1, 2012. Adoption of ASU No. 2011-04 did not materially affect the firm’s financial condition, results of operations or cash flows.

Derecognition of in Substance Real Estate (ASC 360). In December 2011, the FASB issued ASU No. 2011-10, “Property, Plant, and Equipment (Topic 360) — Derecognition of in Substance Real Estate — a Scope Clarification.” ASU No. 2011-10 clarifies that in order to deconsolidate a subsidiary (that is in substance real estate) as a result of a parent no longer controlling the subsidiary due to a default on the subsidiary’s nonrecourse debt, the parent also must satisfy the sale criteria in ASC 360-20, “Property, Plant, and Equipment — Real Estate Sales.” The ASU is effective for fiscal years beginning on or after June 15, 2012. The firm will apply the provisions of the ASU to such events occurring on or after January 1, 2013. Adoption is not expected to materially affect the firm’s financial condition, results of operations or cash flows.

Disclosures about Offsetting Assets and Liabilities (ASC 210). In December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210) — Disclosures about Offsetting Assets and Liabilities.” ASU No. 2011-11 requires disclosure of the effect or potential effect of offsetting arrangements on the firm’s financial position as well as enhanced disclosure of the rights of setoff associated with the firm’s recognized assets and recognized liabilities. ASU No. 2011-11 is effective for periods beginning on or after January 1, 2013. Since these amended principles require only additional disclosures concerning offsetting and related arrangements, adoption will not affect the firm’s financial condition, results of operations or cash flows.

 

 

  Goldman Sachs June 2012 Form 10-Q   11


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 4. Financial Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased, at Fair Value

Note 4.

Financial Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased, at Fair Value

 

 

 

Financial instruments owned, at fair value and financial instruments sold, but not yet purchased, at fair value are accounted for at fair value either under the fair value option or in accordance with other U.S. GAAP. See Note 8 for further information about the fair value option. The table below presents 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. Financial instruments owned, at fair value included $6.96 billion and $4.86 billion as of June 2012 and December 2011, respectively, of securities accounted for as available-for-sale, substantially all of which are held in the firm’s insurance subsidiaries.

 

 

    As of June 2012          As of December 2011  
in millions   Financial
Instruments
Owned
     Financial
Instruments
Sold, But
Not Yet
Purchased
          Financial
Instruments
Owned
    

Financial
Instruments
Sold, But

Not Yet
Purchased

 

Commercial paper, certificates of deposit, time deposits and other money market instruments

    $  10,011         $          —             $  13,440         $          —   

U.S. government and federal agency obligations

    94,949         21,391             87,040         21,006   

Non-U.S. government and agency obligations

    63,890         37,736             49,205         34,886   

Mortgage and other asset-backed loans and securities:

            

Loans and securities backed by commercial real estate

    7,199         1             6,699         27   

Loans and securities backed by residential real estate

    8,467         4             7,592         3   

Bank loans and bridge loans

    20,770         2,412  2           19,745         2,756  2 

Corporate debt securities

    21,534         6,752             22,131         6,553   

State and municipal obligations

    3,493                     3,089         3   

Other debt obligations

    4,639                     4,362           

Equities and convertible debentures

    74,606         29,410             65,113         21,326   

Commodities

    6,330                     5,762           

Derivatives 1

    71,308         52,242             80,028         58,453   

Total

    $387,196         $149,948             $364,206         $145,013   

 

1.

Net of cash collateral received or posted under credit support agreements and reported on a net-by-counterparty basis when a legal right of setoff exists under an enforceable netting agreement.

 

2.

Includes the fair value of unfunded lending commitments for which the fair value option was elected.

 

12   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Gains and Losses from Market Making and Other Principal Transactions

The table below presents, by major product type, the firm’s “Market making” and “Other principal transactions” revenues. These gains/(losses) are primarily related to the firm’s financial instruments owned, at fair value and financial instruments sold, but not yet purchased, at fair value, including both derivative and non-derivative financial instruments. These gains/(losses) exclude related interest income and interest expense. See Note 23 for further information about interest income and interest expense.

The gains/(losses) in the table are not representative of the manner in which the firm manages its business activities because many of the firm’s market-making, client facilitation, and investing and lending strategies utilize financial instruments across various product types. Accordingly, gains or losses in one product type frequently offset gains or losses in other product types. For example, most of the firm’s longer-term derivatives are sensitive to changes in interest rates and may be economically hedged with interest rate swaps. Similarly, a significant portion of the firm’s cash instruments and derivatives has exposure to foreign currencies and may be economically hedged with foreign currency contracts.

 

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions   2012      2011          2012      2011  

Interest rates

    $  (565      $1,034            $1,324         $ 3,440   

Credit

    1,465         929            3,175         2,980   

Currencies

    776         (984         52         (2,590

Equities

    214         1,024            2,187         3,874   

Commodities

    105         (71         576         886   

Other

    271         406            795         822   

Total

    $2,266         $2,338            $8,109         $ 9,412   
Note 5. Fair Value Measurements

Note 5.

Fair Value Measurements

The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Financial assets are marked to bid prices and financial liabilities are marked to offer prices. Fair value measurements do not include transaction costs. The firm measures certain financial assets and financial liabilities as a portfolio (i.e., based on its net exposure to market and/or credit risks).

The best evidence of fair value is a quoted price in an active market. If quoted prices in active markets are not available, fair value is determined by reference to prices for similar instruments, quoted prices or recent transactions in less active markets, or internally developed models that primarily use market-based or independently sourced parameters as inputs including, but not limited to, interest rates, volatilities, equity or debt prices, foreign exchange rates, commodity prices, credit spreads and funding spreads.

U.S. GAAP has a three-level fair value hierarchy for disclosure of fair value measurements. The fair value hierarchy prioritizes inputs to the valuation techniques used to measure fair value, giving the highest priority to level 1 inputs and the lowest priority to level 3 inputs. A financial instrument’s level in the fair value hierarchy is based on the lowest level of input that is significant to its fair value measurement.

The fair value hierarchy is as follows:

Level 1. Inputs are unadjusted quoted prices in active markets to which the firm had access at the measurement date for identical, unrestricted assets or liabilities.

Level 2. Inputs to valuation techniques are observable, either directly or indirectly.

Level 3. One or more inputs to valuation techniques are significant and unobservable.

 

 

  Goldman Sachs June 2012 Form 10-Q   13


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The fair values for substantially all of the firm’s financial assets and financial liabilities are based on observable prices and inputs and are classified in levels 1 and 2 of the hierarchy. Certain level 2 and level 3 financial assets and financial liabilities may require appropriate valuation adjustments that a market participant would require to arrive at fair value for factors such as counterparty and the firm’s credit quality, funding risk, transfer restrictions, liquidity and bid/offer spreads. Valuation adjustments are generally based on market evidence.

See Notes 6 and 7 for further information about fair value measurements of cash instruments and derivatives, respectively, included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” and Note 8 for further information about fair value measurements of other financial assets and financial liabilities accounted for at fair value under the fair value option.

Financial assets and financial liabilities accounted for at fair value under the fair value option or in accordance with other U.S. GAAP are summarized below.

 

 

    As of  
$ in millions    

 

June

2012

  

  

    

 

March

2012

  

  

    

 

December

2011

  

  

Total level 1 financial assets

    $ 163,712         $ 159,906         $ 136,780   

Total level 2 financial assets

    552,082         566,165         587,416   

Total level 3 financial assets

    46,505         48,015         47,937   

Netting and collateral 1

    (111,139      (108,461      (120,821

Total financial assets at fair value

    $ 651,160         $ 665,625         $ 651,312   

Total assets

    $ 948,638         $ 950,932         $ 923,225   

Total level 3 financial assets as a percentage of Total assets

    4.9      5.0      5.2

Total level 3 financial assets as a percentage of Total financial assets at fair value

    7.1      7.2      7.4

Total level 3 financial liabilities at fair value
    $   23,127         $   23,941         $   25,498   

Total financial liabilities at fair value

    $ 380,087         $ 403,516         $ 388,669   

Total level 3 financial liabilities as a percentage of Total financial liabilities at fair value

    6.1      5.9      6.6

 

1.

Represents the impact on derivatives of cash collateral and counterparty netting across levels of the fair value hierarchy. Netting among positions classified in the same level is included in that level.

 

Level 3 financial assets as of June 2012 decreased compared with March 2012, primarily reflecting a decrease in derivative assets, bank loans and bridge loans and private equity investments. The decline in derivative assets primarily reflected transfers of certain credit derivatives to level 2 and unrealized losses on certain equity derivatives, partially offset by the impact of decreased counterparty netting. The decline in bank loans and bridge loans primarily reflected sales and settlements, partially offset by purchases. The decline in private equity investments primarily reflected transfers to level 2, partially offset by purchases.

Level 3 financial assets as of June 2012 also decreased compared with December 2011, reflecting a decrease in derivative assets, principally due to a decline in credit and currency derivative assets, partially offset by the impact of decreased counterparty netting. The decline in credit and currency derivative assets was principally due to transfers to level 2 and settlements, as well as unrealized losses on currency derivatives.

See Notes 6, 7 and 8 for further information about level 3 cash instruments, derivatives and other financial assets and financial liabilities accounted for at fair value under the fair value option, respectively, including information about significant unrealized gains or losses and transfers in or out of level 3.

 

 

14   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 6. Cash Instrument

Note 6.

Cash Instruments

 

Cash instruments include U.S. government and federal agency obligations, non-U.S. government and agency obligations, bank loans and bridge loans, corporate debt securities, equities and convertible debentures, and other non-derivative financial instruments owned and financial instruments sold, but not yet purchased. See below for the types of cash instruments included in each level of the fair value hierarchy and the valuation techniques and significant inputs used to determine their fair values. See Note 5 for an overview of the firm’s fair value measurement policies.

Level 1 Cash Instruments

Level 1 cash instruments include U.S. government obligations and most non-U.S. government obligations, actively traded listed equities and certain government agency obligations and money market instruments. These instruments are valued using quoted prices for identical unrestricted instruments in active markets.

The firm defines active markets for equity instruments based on the average daily trading volume both in absolute terms and relative to the market capitalization for the instrument. The firm defines active markets for debt instruments based on both the average daily trading volume and the number of days with trading activity.

Level 2 Cash Instruments

Level 2 cash instruments include commercial paper, certificates of deposit, time deposits, most government agency obligations, certain non-U.S. government obligations, most corporate debt securities, commodities, certain mortgage-backed loans and securities, certain bank loans and bridge loans, restricted or less liquid listed equities, most state and municipal obligations and certain lending commitments.

Valuations of level 2 cash instruments can be verified to quoted prices, recent trading activity for identical or similar instruments, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. Consideration is given to the nature of the quotations (e.g., indicative or firm) and the relationship of recent market activity to the prices provided from alternative pricing sources.

Valuation adjustments are typically made to level 2 cash instruments (i) if the cash instrument is subject to transfer restrictions and/or (ii) for other premiums and liquidity discounts that a market participant would require to arrive at fair value. Valuation adjustments are generally based on market evidence.

Level 3 Cash Instruments

Level 3 cash instruments have one or more significant valuation inputs that are not observable. Absent evidence to the contrary, level 3 cash instruments are initially valued at transaction price, which is considered to be the best initial estimate of fair value. Subsequently, the firm uses other methodologies to determine fair value, which vary based on the type of instrument. Valuation inputs and assumptions are changed when corroborated by substantive observable evidence, including values realized on sales of financial assets.

 

 

  Goldman Sachs June 2012 Form 10-Q   15


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents the valuation techniques and the nature of significant inputs generally used to determine

the fair values of each type of level 3 cash instrument.

 

 

Level 3 Cash Instrument    Valuation Techniques and Significant Inputs

 

Loans and securities backed by commercial real estate

 

Ÿ   Collateralized by a single commercial real estate property or a portfolio of properties

 

Ÿ   May include tranches of varying levels of subordination

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs for these valuations, which may be determined based on relative value analyses, include:

 

Ÿ   Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and changes in market indices such as the CMBX (an index that tracks the performance of commercial mortgage bonds)

 

Ÿ   Recovery rates implied by the value of the underlying collateral, which is mainly driven by current performance of the underlying collateral, capitalization rates and multiples

 

Ÿ   Timing of expected future cash flows (duration)

 

 

Loans and securities backed by residential real estate

 

Ÿ   Collateralized by portfolios of residential real estate

 

Ÿ   May include tranches of varying levels of subordination

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are determined based on relative value analyses, which incorporate comparisons to instruments with similar collateral and risk profiles, including relevant indices such as the ABX (an index that tracks the performance of subprime residential mortgage bonds). Significant inputs include:

 

Ÿ   Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral

 

Ÿ   Market yields implied by transactions of similar or related assets

 

Ÿ   Cumulative loss expectations, driven by default rates, home price projections, residential property liquidation timelines and related costs

 

Ÿ   Duration, driven by underlying loan prepayment speeds and residential property liquidation timelines

 

 

 

Bank loans and bridge loans

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are generally determined based on relative value analyses, which incorporate comparisons both to prices of credit default swaps that reference the same or similar underlying instrument or entity and to other debt instruments for the same issuer for which observable prices or broker quotations are available. Significant inputs include:

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and trends of market indices such as CDX and LCDX (indices that track the performance of corporate credit and loans, respectively)

 

Ÿ   Current performance and recovery assumptions and, where the firm uses credit default swaps to value the related cash instrument, the cost of borrowing the underlying reference obligation

 

Ÿ   Duration

 

 

Corporate debt securities

 

State and municipal obligations

 

Non-U.S. government and agency obligations

 

Other debt obligations

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are generally determined based on relative value analyses, which incorporate comparisons both to prices of credit default swaps that reference the same or similar underlying instrument or entity and to other debt instruments for the same issuer for which observable prices or broker quotations are available. Significant inputs include:

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and trends of market indices such as CDX, LCDX and MCDX (an index that tracks the performance of municipal obligations)

 

Ÿ   Current performance and recovery assumptions and, where the firm uses credit default swaps to value the related cash instrument, the cost of borrowing the underlying reference obligation

 

Ÿ   Duration

 

 

Equities and convertible debentures (including private equity investments and investments in real estate entities)

  

 

Recent third-party completed or pending transactions (e.g., merger proposals, tender offers, debt restructurings) are considered to be the best evidence for any change in fair value. When these are not available, the following valuation methodologies are used, as appropriate:

 

Ÿ   Industry multiples and public comparables

 

Ÿ   Transactions in similar instruments

 

Ÿ   Discounted cash flow techniques

 

Ÿ   Third-party appraisals

 

The firm also considers changes in the outlook for the relevant industry and financial performance of the issuer as compared to projected performance. Significant inputs include:

 

Ÿ   Market and transaction multiples

 

Ÿ   Discount rates, long-term growth rates, earnings compound annual growth rates and capitalization rates

 

Ÿ   For equity instruments with debt-like features: market yields implied by transactions of similar or related assets, current performance and recovery assumptions, and duration

 

16   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Significant Unobservable Inputs

The table below presents the ranges of significant unobservable inputs used to value the firm’s level 3 cash instruments. These ranges represent the significant unobservable inputs that were used in the valuation of each type of cash instrument. These inputs are not representative of the inputs that could have been used in the valuation of any one cash instrument. For example, the highest multiple

presented in the table for private equity investments is appropriate for valuing a specific private equity investment but may not be appropriate for valuing any other private equity investment. Accordingly, the ranges of inputs presented below do not represent uncertainty in, or possible ranges of, fair value measurements of the firm’s level 3 cash instruments.

 

 

Level 3 Cash Instrument   

Significant Unobservable Inputs

by Valuation Technique

   Range of Significant Unobservable
Inputs as of June 2012

 

Loans and securities backed by commercial real estate

 

•  Collateralized by a single commercial real estate property or a portfolio of properties

 

•  May include tranches of varying levels of subordination

 

  

 

Discounted cash flows:

 

•  Yield

 

•  Recovery rate 1

 

•  Duration (years) 2

  

 

 

4.4% to 35.8%

 

20.0% to 100.0%

 

0.3 to 7.3

 

Loans and securities backed by residential real estate

 

•  Collateralized by portfolios of residential real estate

 

•  May include tranches of varying levels of subordination

 

  

 

Discounted cash flows:

 

•  Yield

 

•  Cumulative loss rate

 

•  Duration (years) 2

 

  

 

 

2.8% to 29.2%

 

0.0% to 61.5%

 

0.3 to 10.3

 

Bank loans and bridge loans

  

 

Discounted cash flows:

 

•  Yield

 

•  Recovery rate 1

 

•  Duration (years) 2

 

  

 

 

0.8% to 32.7%

 

15.0% to 100.0%

 

0.4 to 7.6

 

Corporate debt securities

 

State and municipal obligations

 

Non-U.S. government and agency obligations

 

Other debt obligations

 

  

 

Discounted cash flows:

 

•  Yield

 

•  Recovery rate 1

 

•  Duration (years) 2

  

 

 

1.8% to 35.3%

 

0.0% to 100.0%

 

0.6 to 17.4

 

Equities and convertible debentures (including private equity investments and investments in real estate entities)

  

 

Comparable multiples:

 

•  Multiples

 

Discounted cash flows:

 

•  Yield/discount rate

 

•  Long-term growth rate/compound annual growth rate

 

•  Capitalization rate

 

•  Recovery rate 1

 

•  Duration (years) 2

 

  

 

 

0.7x to 24.1x

 

 

10.0% to 32.6%

 

 

(3.2)% to 26.0%

 

5.5% to 11.9%

 

45.0% to 100.0%

 

0.8 to 8.5

 

1.

A measure of expected future cash flows, expressed as a percentage of notional or face value of the instrument.

 

2.

Duration is an estimate of the timing of future cash flows and, in certain cases, may incorporate the impact of other unobservable inputs (e.g., prepayment speeds).

 

Increases in yield, discount rate, capitalization rate, duration or cumulative loss rate used in the valuation of the firm’s level 3 cash instruments would result in a lower fair value measurement; while increases in recovery rate, multiples, long-term growth rate or compound annual

growth rate would result in a higher fair value measurement. Due to the distinctive nature of each of the firm’s level 3 cash instruments, the interrelationship of inputs is not necessarily uniform within each product type.

 

 

  Goldman Sachs June 2012 Form 10-Q   17


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Fair Value of Cash Instruments by Level

 

The tables below present, by level within the fair value hierarchy, cash instrument assets and liabilities, at fair value. Cash instrument assets and liabilities are included in

“Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” respectively.

 

 

    Cash Instrument Assets at Fair Value  as of June 2012  
in millions   Level 1          Level 2          Level 3          Total  

Commercial paper, certificates of deposit, time deposits
and other money market instruments

    $    1,463             $    8,541             $         7             $  10,011   

U.S. government and federal agency obligations

    40,737             54,212             —             94,949   

Non-U.S. government and agency obligations

    47,601             16,281             8             63,890   

Mortgage and other asset-backed loans and securities 1:

                

Loans and securities backed by commercial real estate

    —             4,033             3,166             7,199   

Loans and securities backed by residential real estate

    —             6,835             1,632             8,467   

Bank loans and bridge loans

    —             10,309             10,461             20,770   

Corporate debt securities 2

    183             18,984             2,367             21,534   

State and municipal obligations

    —             2,946             547             3,493   

Other debt obligations 2

    —             2,882             1,757             4,639   

Equities and convertible debentures

    50,909 3           9,277 4           14,420 5           74,606   

Commodities

    —             6,330             —             6,330   

Total

    $140,893             $140,630             $34,365             $315,888   
    Cash Instrument Liabilities at Fair  Value as of June 2012  
in millions   Level 1          Level 2          Level 3          Total  

U.S. government and federal agency obligations

    $  20,909             $       482             $       —             $  21,391   

Non-U.S. government and agency obligations

    36,657             1,079             —             37,736   

Mortgage and other asset-backed loans and securities:

                

Loans and securities backed by commercial real estate

    —             1             —             1   

Loans and securities backed by residential real estate

    —             4             —             4   

Bank loans and bridge loans

    —             1,702             710             2,412   

Corporate debt securities 6

    14             6,717             21             6,752   

Equities and convertible debentures

    28,799 3           603 4           8             29,410   

Total

    $  86,379             $  10,588             $     739             $  97,706   

 

1.

Includes $309 million and $689 million of collateralized debt obligations (CDOs) backed by real estate in level 2 and level 3, respectively.

 

2.

Includes $954 million and $1.29 billion of CDOs and collateralized loan obligations (CLOs) backed by corporate obligations in level 2 and level 3, respectively.

 

3.

Consists of listed equity securities.

 

4.

Principally consists of restricted or less liquid listed securities.

 

5.

Includes $12.66 billion of private equity investments, $1.29 billion of real estate investments and $469 million of convertible debentures.

 

6.

Includes $6 million and $11 million of CDOs and CLOs backed by corporate obligations in level 2 and level 3, respectively.

 

18   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

    Cash Instrument Assets at Fair Value as of December 2011  
in millions   Level 1        Level 2        Level 3        Total  

Commercial paper, certificates of deposit, time deposits
and other money market instruments

    $    3,255           $  10,185           $       —           $  13,440   

U.S. government and federal agency obligations

    29,263           57,777                     87,040   

Non-U.S. government and agency obligations

    42,854           6,203           148           49,205   

Mortgage and other asset-backed loans and securities 1:
Loans and securities backed by commercial real estate

              3,353           3,346           6,699   

Loans and securities backed by residential real estate

              5,883           1,709           7,592   

Bank loans and bridge loans

              8,460           11,285           19,745   

Corporate debt securities 2

    133           19,518           2,480           22,131   

State and municipal obligations

              2,490           599           3,089   

Other debt obligations 2

              2,911           1,451           4,362   

Equities and convertible debentures

    39,955  3         11,491  4         13,667  5         65,113   

Commodities

              5,762                     5,762   

Total

    $115,460           $134,033           $34,685           $284,178   
    Cash Instrument Liabilities at Fair Value as of December 2011  
in millions   Level 1        Level 2        Level 3        Total  

U.S. government and federal agency obligations

    $  20,940           $         66           $       —           $  21,006   

Non-U.S. government and agency obligations

    34,339           547                     34,886   

Mortgage and other asset-backed loans and securities:
Loans and securities backed by commercial real estate

              27                     27   

Loans and securities backed by residential real estate

              3                     3   

Bank loans and bridge loans

              1,891           865           2,756   

Corporate debt securities 6

              6,522           31           6,553   

State and municipal obligations

              3                     3   

Equities and convertible debentures

    20,069  3         1,248  4         9           21,326   

Total

    $  75,348           $  10,307           $     905           $  86,560   

 

1.

Includes $213 million and $595 million of CDOs backed by real estate in level 2 and level 3, respectively.

 

2.

Includes $403 million and $1.19 billion of CDOs and CLOs backed by corporate obligations in level 2 and level 3, respectively.

 

3.

Consists of listed equity securities.

 

4.

Principally consists of restricted or less liquid listed securities.

 

5.

Includes $12.07 billion of private equity investments, $1.10 billion of real estate investments and $497 million of convertible debentures.

 

6.

Includes $27 million of CDOs and CLOs backed by corporate obligations in level 3.

Transfers Between Levels of the Fair Value Hierarchy

Transfers between levels of the fair value hierarchy are reported at the beginning of the reporting period in which they occur. Transfers of cash instruments between level 1 and level 2 during the three months ended June 2012 were $2.26 billion, primarily reflecting transfers to level 2 of certain non-U.S. government obligations due to the level of market activity in these instruments.

Transfers of cash instruments between level 1 and level 2 during the six months ended June 2012 were $2.55 billion, primarily reflecting transfers to level 2 of certain non-U.S. government obligations due to the level of market activity in these instruments, and transfers to level 2 of certain public equity investments principally due to the impact of transfer restrictions. See level 3 rollforwards below for further information about transfers between level 2 and level 3.

 

 

  Goldman Sachs June 2012 Form 10-Q   19


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Rollforward

 

If a cash instrument asset or liability was transferred to level 3 during a reporting period, its entire gain or loss for the period is included in level 3.

Level 3 cash instruments are frequently economically hedged with level 1 and level 2 cash instruments and/or level 1, level 2 or level 3 derivatives. Accordingly, gains or losses that are reported in level 3 can be partially offset by gains or losses attributable to level 1 or level 2 cash

instruments and/or level 1, level 2 or level 3 derivatives. As a result, gains or losses included in the level 3 rollforward below do not necessarily represent the overall impact on the firm’s results of operations, liquidity or capital resources.

The tables below present changes in fair value for all cash instrument assets and liabilities categorized as level 3 as of the end of the period.

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Three Months Ended June 2012  
in millions   Balance,
beginning
of period
    Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases 1     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Balance,
end of

period

 

Commercial paper, certificates of deposit, time deposits and other money market instruments

    $         8        $   —        $   —        $     —          $       (1     $      —        $      —        $       —        $         7   

Non-U.S. government and agency obligations

    105        (4     (1     —          (20     (70            (2     8   

Mortgage and other asset-backed loans and securities:

Loans and securities backed by commercial real estate

    3,156        70        46        502          (494     (274     233        (73     3,166   

Loans and securities backed by residential real estate

    1,610        79        28        301          (237     (254     119        (14     1,632   

Bank loans and bridge loans

    11,051        122        20        1,685          (1,113     (1,035     691        (960     10,461   

Corporate debt securities

    2,512        83        (28     453          (397     (177     135        (214     2,367   

State and municipal obligations

    612        4        5        13          (67     (3     5        (22     547   

Other debt obligations

    1,549        13        18        423          (214     (43     17        (6     1,757   

Equities and convertible debentures

    14,874        (4     357        792          (182     (408     272        (1,281     14,420   

Total

    $35,477        $363  2      $445  2      $4,169          $(2,725     $(2,264     $1,472        $(2,572     $34,365   
    Level 3 Cash Instrument Liabilities at Fair Value for the Three Months Ended June 2012  
in millions   Balance,
beginning
of period
    Net
realized
(gains)/
losses
    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases 1     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Balance,
end of

period

 

Total

    $     747        $    5        $  37        $  (151)         $      51        $    103        $     46        $     (99     $     739   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $59 million, $409 million and $340 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain/(loss) on level 3 cash instruments of $408 million (reflecting $445 million on cash instrument assets and $(37) million on cash instrument liabilities) for the three months ended June 2012 primarily consisted of gains on private equity investments, where valuations were generally corroborated through market transactions in similar instruments during the quarter.

Transfers into level 3 during the three months ended June 2012 primarily reflected transfers from level 2 of certain bank loans and bridge loans, private equity investments and loans and securities backed by commercial real estate, principally due to less market activity in these instruments.

 

 

20   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Transfers out of level 3 during the three months ended June 2012 primarily reflected transfers to level 2 of certain private equity investments and bank loans and bridge loans. Transfers of private equity investments to level 2 were principally due to improved transparency of market

prices as a result of market transactions in these financial instruments. Transfers of bank loans and bridge loans to level 2 were principally due to market transactions in these instruments and unobservable inputs no longer being significant to the valuation of certain loans.

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Six Months Ended June 2012  
in millions   Balance,
beginning
of period
    Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases  1     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Balance,
end of

period

 

Commercial paper, certificates of deposit, time deposits and other money market instruments

    $       —        $   —        $      —        $       8          $       (1     $       —        $      —        $       —        $         7   

Non-U.S. government and agency obligations

    148        (56     1        —          (16     (70     5        (4     8   

Mortgage and other asset-backed loans and securities:

Loans and securities backed by commercial real estate

    3,346        121        116        829          (1,007     (517     359        (81     3,166   

Loans and securities backed by residential real estate

    1,709        109        63        514          (406     (390     59        (26     1,632   

Bank loans and bridge loans

    11,285        334        77        2,153          (2,235     (1,409     1,297        (1,041     10,461   

Corporate debt securities

    2,480        175        89        658          (662     (325     267        (315     2,367   

State and municipal obligations

    599        10        5        20          (65     (10     6        (18     547   

Other debt obligations

    1,451        69        30        445          (283     (78     127        (4     1,757   

Equities and convertible debentures

    13,667        27        644        1,410          (219     (587     842        (1,364     14,420   

Total

    $34,685        $789  2      $1,025  2      $6,037          $(4,894     $(3,386     $2,962        $(2,853     $34,365   
    Level 3 Cash Instrument Liabilities at Fair Value for the Six Months Ended June 2012  
in millions   Balance,
beginning
of period
    Net
realized
(gains)/
losses
    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases  1     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Balance,
end of

period

 

Total

    $     905        $  (22     $       (2     $   (311)         $    100        $    141        $    118        $    (190     $     739   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $187 million, $960 million and $667 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain on level 3 cash instruments of $1.03 billion (reflecting $1.03 billion on cash instrument assets and $2 million on cash instrument liabilities) for the six months ended June 2012 primarily consisted of gains on private equity investments, where valuations were generally corroborated by market transactions in similar instruments.

Transfers into level 3 during the six months ended June 2012 primarily reflected transfers from level 2 of certain bank loans and bridge loans and private equity investments, principally due to less market activity in these instruments.

Transfers out of level 3 during the six months ended June 2012 primarily reflected transfers to level 2 of certain private equity investments and bank loans and bridge loans. Transfers of private equity investments to level 2 were principally due to improved transparency of market prices as a result of market transactions in these financial instruments. Transfers of bank loans and bridge loans to level 2 were principally due to market transactions in these instruments and unobservable inputs no longer being significant to the valuation of certain loans.

 

 

  Goldman Sachs June 2012 Form 10-Q   21


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Three Months Ended June 2011  
in millions   Balance,
beginning
of period
     Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases  1      Sales     Settlements     Net
transfers
in and/or
(out) of
level 3
   

Balance,
end of

period

 

Mortgage and other asset-backed loans
and securities:

Loans and securities backed by
commercial real estate

    $  3,713         $  27        $  88        $    305           $   (476     $    (246     $   128        $  3,539   

Loans and securities backed by
residential real estate

    2,756         59        20        382           (187     (171     (30     2,829   

Bank loans and bridge loans

    9,929         189        220        1,249           (559     (524     (321     10,183   

Corporate debt securities

    3,138         93        14        404           (627     (127     (148     2,747   

State and municipal obligations

    742         1        4        26           (119     (2     (9     643   

Other debt obligations

    1,483         51        20        158           (316     (90     166        1,472   

Equities and convertible debentures

    11,765         89        380        332           (208     (218     1,312        13,452   

Total

    $33,526         $509  2      $746  2      $2,856           $(2,492     $(1,378     $1,098        $34,865   
    Level 3 Cash Instrument Liabilities at Fair Value for the Three Months Ended June 2011  
in millions   Balance,
beginning
of period
     Net
realized
(gains)/
losses
    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases  1      Sales     Settlements     Net
transfers
in and/or
(out) of
level 3
   

Balance,
end of

period

 

Total

    $     482         $    1        $  95        $   (130)          $    201        $     (21     $    (16     $     612   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $277 million, $606 million and $372 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain/(loss) on level 3 cash instruments of $651 million (reflecting $746 million on cash instrument assets and $(95) million on cash instrument liabilities) for the three months ended June 2011 primarily consisted of unrealized gains on private equity investments, and bank loans and bridge loans, where prices were generally corroborated through market transactions for similar assets during the period.

Significant transfers in or out of level 3 during the three months ended June 2011 included:

 

Ÿ  

Equities and convertible debentures: net transfer into level 3 of $1.31 billion, principally due to transfers into level 3 of certain private equity investments due to

   

reduced transparency of market prices, partially offset by transfers to level 2 of certain private equity investments due to improved transparency of market prices as a result of market transactions in these financial instruments.

 

Ÿ  

Bank loans and bridge loans: net transfer out of level 3 of $321 million, principally due to transfers to level 2 of certain loans due to improved transparency of market prices as a result of market transactions in these financial instruments, partially offset by transfers to level 3 of certain loans due to reduced transparency of market prices as a result of less market activity in these financial instruments.

 

 

22   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Six Months Ended June 2011  
in millions   Balance,
beginning
of period
     Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases  1      Sales     Settlements     Net
transfers
in and/or
(out) of
level 3
   

Balance,
end of

period

 

Mortgage and other asset-backed loans
and securities:

Loans and securities backed by
commercial real estate

    $  3,976         $  83        $   189        $    668           $   (848     $   (398     $(131     $  3,539   

Loans and securities backed by
residential real estate

    2,501         125        124        836           (426     (462     131        2,829   

Bank loans and bridge loans

    9,905         344        721        2,269           (802     (1,330     (924     10,183   

Corporate debt securities

    2,737         209        148        1,154           (889     (173     (439     2,747   

State and municipal obligations

    754         3        4        29           (135     (3     (9     643   

Other debt obligations

    1,274         87        48        441           (306     (153     81        1,472   

Equities and convertible debentures

    11,060         61        679        2,055           (700     (437     734        13,452   

Total

    $32,207         $912  2      $1,913  2      $7,452           $(4,106     $(2,956     $(557     $34,865   
    Level 3 Cash Instrument Liabilities at Fair Value for the Six Months Ended June 2011  
in millions   Balance,
beginning
of period
     Net
realized
(gains)/
losses
    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases  1      Sales     Settlements     Net
transfers
in and/or
(out) of
level 3
   

Balance,
end of

period

 

Total

    $     446         $ (15     $     67        $  (193)          $    325        $     (15     $    (3     $     612   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $688 million, $1.38 billion and $758 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain/(loss) on level 3 cash instruments of $1.85 billion (reflecting $1.91 billion on cash instrument assets and $(67) million on cash instrument liabilities) for the six months ended June 2011 primarily consisted of unrealized gains on bank loans and bridge loans, reflecting generally favorable credit markets, primarily during the first quarter of 2011, and private equity investments, where prices were generally corroborated through market transactions for similar assets during the period.

Significant transfers in or out of level 3 during the six months ended June 2011 included:

 

Ÿ  

Bank loans and bridge loans: net transfer out of level 3 of $924 million, principally due to transfers to level 2 of certain loans due to improved transparency of market prices as a result of market transactions in these financial instruments, partially offset by transfers to

   

level 3 of certain loans due to reduced transparency of market prices as a result of less market activity in these financial instruments.

 

Ÿ  

Equities and convertible debentures: net transfer into level 3 of $734 million, principally due to transfers to level 3 of certain private equity investments due to reduced transparency of market prices, partially offset by transfers to level 2 of certain private equity investments due to improved transparency of market prices as a result of market transactions in these financial instruments.

 

Ÿ  

Corporate debt securities: net transfer out of level 3 of $439 million, principally due to transfers to level 2 of certain corporate debt securities due to increased transparency of market prices as a result of market transactions in these financial instruments.

 

 

  Goldman Sachs June 2012 Form 10-Q   23


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Investments in Funds That Calculate Net Asset

Value Per Share

Cash instruments at fair value include investments in funds that are valued based on the net asset value per share (NAV) of the investment fund. The firm uses NAV as its measure of fair value for fund investments when (i) the fund investment does not have a readily determinable fair value and (ii) the NAV of the investment fund is calculated in a manner consistent with the measurement principles of investment company accounting, including measurement of the underlying investments at fair value.

The firm’s investments in funds that calculate NAV primarily consist of investments in firm-sponsored funds where the firm co-invests with third-party investors. The private equity, private debt and real estate funds are primarily closed-end funds in which the firm’s investments are not eligible for redemption. Distributions will be received from these funds as the underlying assets are liquidated and it is estimated that substantially all of the underlying assets of existing funds will be liquidated over

the next 10 years. The firm continues to manage its existing funds taking into account the transition periods under the Volcker Rule of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), although the rules have not yet been finalized.

The firm’s investments in hedge funds are generally redeemable on a quarterly basis with 91 days’ notice, subject to a maximum redemption level of 25% of the firm’s initial investments at any quarter-end. The firm currently plans to comply with the Volcker Rule by redeeming certain of its interests in hedge funds. The firm redeemed approximately $250 million and $500 million of these interests in hedge funds during the three and six months ended June 2012, respectively.

The table below presents the fair value of the firm’s investments in, and unfunded commitments to, funds that calculate NAV.

 

 

    As of June 2012          As of December 2011  
in millions   Fair Value of
Investments
       Unfunded
Commitments
          Fair Value of
Investments
       Unfunded
Commitments
 

Private equity funds 1

    $  7,939           $2,970             $  8,074           $3,514   

Private debt funds 2

    3,540           3,066             3,596           3,568   

Hedge funds 3

    2,706                       3,165             

Real estate funds 4

    1,755           1,312             1,531           1,613   

Total

    $15,940           $7,348             $16,366           $8,695   

 

1.

These funds primarily invest in a broad range of industries worldwide in a variety of situations, including leveraged buyouts, recapitalizations and growth investments.

 

2.

These funds generally invest in loans and other fixed income instruments and are focused on providing private high-yield capital for mid- to large-sized leveraged and management buyout transactions, recapitalizations, financings, refinancings, acquisitions and restructurings for private equity firms, private family companies and corporate issuers.

 

3.

These funds are primarily multi-disciplinary hedge funds that employ a fundamental bottom-up investment approach across various asset classes and strategies including long/short equity, credit, convertibles, risk arbitrage, special situations and capital structure arbitrage.

 

4.

These funds invest globally, primarily in real estate companies, loan portfolios, debt recapitalizations and direct property.

 

24   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 7. Derivatives and Hedging Activities

Note 7.

Derivatives and Hedging Activities

Derivative Activities

Derivatives are instruments that derive their value from underlying asset prices, indices, reference rates and other inputs, or a combination of these factors. Derivatives may be privately negotiated contracts, which are usually referred to as over-the-counter (OTC) derivatives, or they may be listed and traded on an exchange (exchange-traded).

Market-Making. As a market maker, the firm enters into derivative transactions to provide liquidity and to facilitate the transfer and hedging of risk. In this capacity, the firm typically acts as principal and is consequently required to commit capital to provide execution. As a market maker, it is essential to maintain an inventory of financial instruments sufficient to meet expected client and market demands.

Risk Management. The firm also enters into derivatives to actively manage risk exposures that arise from market-making and investing and lending activities in derivative and cash instruments. The firm’s holdings and exposures are hedged, in many cases, on either a portfolio or risk-specific basis, as opposed to an instrument-by-instrument basis. The offsetting impact of this economic hedging is reflected in the same business segment as the related revenues. In addition, the firm may enter into derivatives designated as hedges under U.S. GAAP. These derivatives are used to manage foreign currency exposure on the net investment in certain non-U.S. operations and to manage interest rate exposure in certain fixed-rate unsecured long-term and short-term borrowings, and certificates of deposit.

The firm enters into various types of derivatives, including:

 

Ÿ  

Futures and Forwards. Contracts that commit counterparties to purchase or sell financial instruments, commodities or currencies in the future.

 

Ÿ  

Swaps. Contracts that require counterparties to exchange cash flows such as currency or interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, financial instruments, commodities, currencies or indices.

 

Ÿ  

Options. Contracts in which the option purchaser has the right, but not the obligation, to purchase from or sell to the option writer financial instruments, commodities or currencies within a defined time period for a specified price.

Derivatives are accounted for at fair value, net of cash collateral received or posted under credit support agreements. Derivatives are reported on a net-by-counterparty basis (i.e., the net payable or receivable for derivative assets and liabilities for a given counterparty) when a legal right of setoff exists under an enforceable netting agreement. Derivative assets and liabilities are included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” respectively.

Substantially all gains and losses on derivatives not designated as hedges under ASC 815 are included in “Market making” and “Other principal transactions.”

 

 

  Goldman Sachs June 2012 Form 10-Q   25


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents the fair value of derivatives on a net-by-counterparty basis.

 

    As of June 2012          As of December 2011  
in millions   Derivative
Assets
     Derivative
Liabilities
          Derivative
Assets
      

Derivative

Liabilities

 

Exchange-traded

  $  4,334        $  3,957             $  5,880           $  3,172   

Over-the-counter

  66,974        48,285             74,148           55,281   

Total

  $71,308        $52,242             $80,028           $58,453   

 

The table below presents the fair value and the number of derivative contracts by major product type on a gross basis. Gross fair values in the table below exclude the effects of both netting under enforceable netting agreements and

netting of cash collateral received or posted under credit support agreements, and therefore are not representative of the firm’s exposure.

 

 

    As of June 2012          As of December 2011  
in millions, except number of contracts  

Derivative

Assets

    

Derivative

Liabilities

     Number of
Contracts
         

Derivative

Assets

    

Derivative

Liabilities

    Number of
Contracts
 

Derivatives not accounted for as hedges

Interest rates

    $ 615,146         $ 573,246         298,856             $ 624,189         $ 582,608        287,351   

Credit

    114,777         98,762         361,895             150,816         130,659        362,407   

Currencies

    73,084         62,940         241,085             88,654         71,736        203,205   

Commodities

    31,640         33,663         84,926             35,966         38,050        93,755   

Equities

    58,406         50,084         303,491             64,135         51,928        332,273   

Subtotal

    893,053         818,695         1,290,253             963,760         874,981        1,278,991   

Derivatives accounted for as hedges

Interest rates

    23,346         73         1,451             21,981         13        1,125   

Currencies

    67         70         73             124         21        71   

Subtotal

    23,413         143         1,524             22,105         34        1,196   

Gross fair value of derivatives

    $ 916,466         $ 818,838         1,291,777             $ 985,865         $ 875,015        1,280,187   

Counterparty netting 1

    (736,148      (736,148                   (787,733      (787,733        

Cash collateral netting 2

    (109,010      (30,448                   (118,104      (28,829        

Fair value included in financial instruments owned

    $   71,308                               $   80,028                    

Fair value included in financial instruments sold,
but not yet purchased

             $   52,242                               $   58,453           

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

26   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Valuation Techniques for Derivatives

Price transparency of derivatives can generally be characterized by product type.

Interest Rate. In general, the prices and other inputs used to value interest rate derivatives are transparent, even for long-dated contracts. Interest rate swaps and options denominated in the currencies of leading industrialized nations are characterized by high trading volumes and tight bid/offer spreads. Interest rate derivatives that reference indices, such as an inflation index, or the shape of the yield curve (e.g., 10-year swap rate vs. 2-year swap rate) are more complex, but the prices and other inputs are generally observable.

Credit. Price transparency for credit default swaps, including both single names and baskets of credits, varies by market and underlying reference entity or obligation. Credit default swaps that reference indices, large corporates and major sovereigns generally exhibit the most price transparency. For credit default swaps with other underliers, price transparency varies based on credit rating, the cost of borrowing the underlying reference obligations, and the availability of the underlying reference obligations for delivery upon the default of the issuer. Credit default swaps that reference loans, asset-backed securities and emerging market debt instruments tend to have less price transparency than those that reference corporate bonds. In addition, more complex credit derivatives, such as those sensitive to the correlation between two or more underlying reference obligations, generally have less price transparency.

Currency. Prices for currency derivatives based on the exchange rates of leading industrialized nations, including those with longer tenors, are generally transparent. The primary difference between the price transparency of developed and emerging market currency derivatives is that emerging markets tend to be observable for contracts with shorter tenors.

Commodity. Commodity derivatives include transactions referenced to energy (e.g., oil and natural gas), metals (e.g., precious and base) and soft commodities (e.g., agricultural). Price transparency varies based on the underlying commodity, delivery location, tenor and product quality (e.g., diesel fuel compared to unleaded gasoline). In general, price transparency for commodity derivatives is greater for contracts with shorter tenors and contracts that are more closely aligned with major and/or benchmark commodity indices.

Equity. Price transparency for equity derivatives varies by market and underlier. Options on indices and the common stock of corporates included in major equity indices exhibit the most price transparency. Equity derivatives generally have observable market prices, except for contracts with long tenors or reference prices that differ significantly from current market prices. More complex equity derivatives, such as those sensitive to the correlation between two or more individual stocks, generally have less price transparency.

Liquidity is essential to observability of all product types. If transaction volumes decline, previously transparent prices and other inputs may become unobservable. Conversely, even highly structured products may at times have trading volumes large enough to provide observability of prices and other inputs. See Note 5 for an overview of the firm’s fair value measurement policies.

Level 1 Derivatives

Level 1 derivatives include short-term contracts for future delivery of securities when the underlying security is a level 1 instrument, and exchange-traded derivatives if they are actively traded and are valued at their quoted market price.

Level 2 Derivatives

Level 2 derivatives include exchange-traded derivatives that are not actively traded and OTC derivatives for which all significant valuation inputs are corroborated by market evidence.

Level 2 exchange-traded derivatives are valued using models that calibrate to market-clearing levels of OTC derivatives. Inputs to the valuations of level 2 OTC derivatives can be verified to market transactions, broker or dealer quotations or other alternative pricing sources with reasonable levels of price transparency. Consideration is given to the nature of the quotations (e.g., indicative or firm) and the relationship of recent market activity to the prices provided from alternative pricing sources.

Where models are used, the selection of a particular model to value an OTC derivative depends on the contractual terms of and specific risks inherent in the instrument, as well as the availability of pricing information in the market. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, loss severity rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, model selection does not involve significant management judgment because outputs of models can be calibrated to market-clearing levels.

 

 

  Goldman Sachs June 2012 Form 10-Q   27


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Derivatives

Level 3 OTC derivatives are valued using models which utilize observable level 1 and/or level 2 inputs, as well as unobservable level 3 inputs.

 

Ÿ  

For the majority of the firm’s interest rate and currency derivatives classified within level 3, significant unobservable inputs include correlations of certain currencies and interest rates (e.g., the correlation between Euro inflation and Euro interest rates) and specific interest rate volatilities.

 

Ÿ  

For level 3 credit derivatives, significant level 3 inputs include illiquid credit spreads, which are unique to specific reference obligations and reference entities, recovery rates, certain correlations required to value credit and mortgage derivatives (e.g., the likelihood of default of the underlying reference obligation relative to one another) and the basis, or price difference, of certain reference obligations to benchmark indices.

 

Ÿ  

For level 3 equity derivatives, significant level 3 inputs generally include equity volatility inputs for options that are very long-dated and/or have strike prices that differ significantly from current market prices. In addition, the valuation of certain structured trades requires the use of level 3 inputs for the correlation of the price performance of two or more individual stocks or the correlation of the price performance for a basket of stocks to another asset class such as commodities.

 

Ÿ  

For level 3 commodity derivatives, significant level 3 inputs include volatilities for options with strike prices that differ significantly from current market prices and prices or spreads for certain products for which the product quality or physical location of the commodity is not aligned with benchmark indices.

Subsequent to the initial valuation of a level 3 OTC derivative, the firm updates the level 1 and level 2 inputs to reflect observable market changes and any resulting gains and losses are recorded in level 3. Level 3 inputs are changed when corroborated by evidence such as similar market transactions, third-party pricing services and/or broker or dealer quotations or other empirical market data. In circumstances where the firm cannot verify the model value by reference to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value. See below for further information about unobservable inputs used in the valuation of level 3 derivatives.

Valuation Adjustments

Valuation adjustments are integral to determining the fair value of derivatives and are used to adjust the mid-market valuations, produced by derivative pricing models, to the appropriate exit price valuation. These adjustments incorporate bid/offer spreads, the cost of liquidity, credit valuation adjustments (CVA) and funding valuation adjustments, which account for the credit and funding risk inherent in derivative portfolios. Market-based inputs are generally used when calibrating valuation adjustments to market-clearing levels.

In addition, for derivatives that include significant unobservable inputs, the firm makes model or exit price adjustments to account for the valuation uncertainty present in the transaction.

 

 

28   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Significant Unobservable Inputs

The table below presents the ranges of significant unobservable inputs used to value the firm’s level 3 derivatives. These ranges represent the significant unobservable inputs that were used in the valuation of each type of derivative. These inputs are not representative of the inputs that could have been used in the valuation of any one derivative. For example, the highest correlation presented

in the table for interest rate derivatives is appropriate for valuing a specific interest rate derivative but may not be appropriate for valuing any other interest rate derivative. Accordingly, the ranges of inputs presented below do not represent uncertainty in, or possible ranges of, fair value measurements of the firm’s level 3 derivatives.

 

 

Significant

Unobservable Inputs

 

Derivative

Product Type

 

Range of Significant

Unobservable Inputs

as of June 2012

 

Sensitivity of Fair Value Measurement to Changes in Significant

Unobservable Inputs 1

Correlation

 

Interest rates

 

Credit

 

Currencies

 

Equities

 

Various 2

 

14% to 70%

 

5% to 99%

 

65% to 87%

 

49% to 99%

 

(51)% to 66%

 

For contracts where the holder benefits from the convergence of the underlying asset or index prices (e.g., interest rates, credit spreads, foreign exchange rates, inflation rates and equity prices), an increase in correlation generally results in a higher fair value measurement.

Volatility

 

Interest rates

 

Commodities

 

Equities

 

32% to 88%

 

7% to 85%

 

7% to 98%

 

In general, for purchased options an increase in volatility results in a higher fair value measurement.

Credit spreads

 

 

 

Recovery rates

 

 

Basis

 

Credit

 

 

 

Credit

 

 

Credit

 

89 basis points (bps) to 1,975 bps

 

 

0% to 90%

 

 

1 point to 11 points

 

 

In general, the fair value of purchased credit protection increases as credit spreads increase, recovery rates decrease or basis widens.

 

Credit spreads, recovery rates and basis are strongly related to distinctive risk factors of the underlying reference obligations, which include reference entity-specific factors such as leverage, volatility and industry, market-based risk factors, such as borrowing costs or liquidity of the underlying reference obligation and macro-economic conditions.

Spread per million British Thermal units (MMBTU) of natural gas

  Commodities   $(0.83) to $3.52  

For contracts where the holder is receiving a commodity, an increase in the spread (price difference from a benchmark index due to differences in quality or delivery location) or price generally results in a higher fair value measurement.

       

Price per megawatt hour of power

 

  Commodities   $11.93 to $67.91    

 

1.

Represents the directional sensitivity of the firm’s level 3 fair value measurements to changes in significant unobservable inputs, in isolation. Due to the distinctive nature of each of the firm’s level 3 derivatives, the interrelationship of inputs is not necessarily uniform within each product type.

 

2.

Represents correlation across derivative product types.

 

  Goldman Sachs June 2012 Form 10-Q   29


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Fair Value of Derivatives by Level

The tables below present the fair value of derivatives on a gross basis by level and major product type. Gross fair values in the tables below exclude the effects of both netting under enforceable netting agreements and netting of cash

received or posted under credit support agreements both in and across levels of the fair value hierarchy, and therefore are not representative of the firm’s exposure.

 

 

    Derivative Assets at Fair Value as of June 2012  
in millions   Level 1     Level 2     Level 3    

Cross-Level

Netting

    Total  

Interest rates

    $  34        $ 638,196        $     262        $       —        $ 638,492   

Credit

           104,133        10,644               114,777   

Currencies

           71,893        1,258               73,151   

Commodities

           30,832        808               31,640   

Equities

    163        57,113        1,130               58,406   

Gross fair value of derivative assets

    197        902,167        14,102               916,466   

Counterparty netting 1

           (730,418     (3,601     (2,129 3      (736,148

Subtotal

    $197        $ 171,749        $10,501        $(2,129     $ 180,318   

Cash collateral netting 2

                                    (109,010

Fair value included in financial instruments owned

                                    $   71,308   
    Derivative Liabilities at Fair Value as of June 2012  
in millions   Level 1     Level 2     Level 3    

Cross-Level

Netting

    Total  

Interest rates

    $27        $ 572,677        $    615        $       —        $ 573,319   

Credit

           94,237        4,525               98,762   

Currencies

           61,944        1,066               63,010   

Commodities

           32,615        1,048               33,663   

Equities

    47        48,359        1,678               50,084   

Gross fair value of derivative liabilities

    74        809,832        8,932               818,838   

Counterparty netting 1

           (730,418     (3,601     (2,129 3      (736,148

Subtotal

    $74        $   79,414        $ 5,331        $(2,129     $   82,690   

Cash collateral netting 2

                                    (30,448

Fair value included in financial instruments sold,
but not yet purchased

                                    $   52,242   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

3.

Represents the netting of receivable balances with payable balances for the same counterparty across levels of the fair value hierarchy under enforceable netting agreements.

 

30   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

    Derivative Assets at Fair Value as of December 2011  
in millions   Level 1     Level 2     Level 3    

Cross-Level

Netting

    Total  

Interest rates

    $33        $ 645,923        $     214        $      —        $ 646,170   

Credit

           137,110        13,706               150,816   

Currencies

           86,752        2,026               88,778   

Commodities

           35,062        904               35,966   

Equities

    24        62,684        1,427               64,135   

Gross fair value of derivative assets

    57        967,531        18,277               985,865   

Counterparty netting 1

           (778,639     (6,377     (2,717 3      (787,733

Subtotal

    $57        $ 188,892        $11,900        $(2,717     $ 198,132   

Cash collateral netting 2

                                    (118,104

Fair value included in financial instruments owned

                                    $80,028   

 

    Derivative Liabilities at Fair Value as of December 2011  
in millions   Level 1     Level 2     Level 3    

Cross-Level

Netting

    Total  

Interest rates

    $  24        $ 582,012        $     585        $      —        $ 582,621   

Credit

           123,253        7,406               130,659   

Currencies

           70,573        1,184               71,757   

Commodities

           36,541        1,509               38,050   

Equities

    185        49,884        1,859               51,928   

Gross fair value of derivative liabilities

    209        862,263        12,543               875,015   

Counterparty netting 1

           (778,639     (6,377     (2,717 3      (787,733

Subtotal

    $209        $   83,624        $  6,166        $(2,717     $   87,282   

Cash collateral netting 2

                                    (28,829

Fair value included in financial instruments sold,
but not yet purchased

                                    $58,453   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

3.

Represents the netting of receivable balances with payable balances for the same counterparty across levels of the fair value hierarchy under enforceable netting agreements.

 

  Goldman Sachs June 2012 Form 10-Q   31


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Rollforward

If a derivative was transferred to level 3 during a reporting period, its entire gain or loss for the period is included in level 3. Transfers between levels are reported at the beginning of the reporting period in which they occur.

Gains and losses on level 3 derivatives should be considered in the context of the following:

 

Ÿ  

A derivative with level 1 and/or level 2 inputs is classified in level 3 in its entirety if it has at least one significant level 3 input.

 

Ÿ  

If there is one significant level 3 input, the entire gain or loss from adjusting only observable inputs (i.e., level 1 and level 2 inputs) is classified as level 3.

Ÿ  

Gains or losses that have been reported in level 3 resulting from changes in level 1 or level 2 inputs are frequently offset by gains or losses attributable to level 1 or level 2 derivatives and/or level 1, level 2 and level 3 cash instruments. As a result, gains/(losses) included in the level 3 rollforward below do not necessarily represent the overall impact on the firm’s results of operations, liquidity or capital resources.

The tables below present changes in fair value for all derivatives categorized as level 3 as of the end of the period.

 

 

    Level 3 Derivative Assets and Liabilities at Fair Value for the Three Months Ended June 2012  
in millions  

Asset/

(liability)
balance,
beginning
of period

   

Net

realized
gains/
(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases     Sales     Settlements    

Transfers
into

level 3

   

Transfers

out of

level 3

   

Asset/

(liability)

balance,
end of

period

 

Interest rates — net

    $  (240     $   (7     $ (81     $    8        $    (8     $    (6     $   13        $     (32     $  (353

Credit — net

    6,502        94        697        92        (25     (403     325        (1,163     6,119   

Currencies — net

    390        (5     (65            (3     83        (10 3      (198     192   

Commodities — net

    (99     16        113        31        (101     (43     (155 3      (2     (240

Equities — net

    (520     76        (20     92        (338     (23     (16 3      201  4      (548

Total derivatives — net

    $6,033        $174  1      $644  1,2      $223        $(475     $(392     $157        $(1,194     $5,170   

 

1.

The aggregate amounts include approximately $696 million and $122 million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

3.

Reflects a net transfer to level 3 of derivative liabilities.

 

4.

Reflects a net transfer to level 2 of derivative liabilities.

 

The net unrealized gain on level 3 derivatives of $644 million for the three months ended June 2012 was primarily attributable to the impact of lower interest rates, changes in foreign exchange rates and wider credit spreads on certain credit derivatives.

Transfers into level 3 derivatives during the three months ended June 2012 primarily reflected transfers of certain credit derivative assets and certain commodity derivative liabilities from level 2, principally due to unobservable inputs becoming significant to the valuation of these derivatives.

Transfers out of level 3 derivatives during the three months ended June 2012 primarily reflected transfers of certain credit derivative assets to level 2, principally due to unobservable inputs no longer being significant to the valuation of these derivatives.

 

 

32   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Derivative Assets and Liabilities at Fair Value for the Six Months Ended June 2012  
in millions  

Asset/

(liability)
balance,
beginning
of period

   

Net

realized
gains/
(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases     Sales     Settlements    

Transfers
into

level 3

   

Transfers

out of

level 3

   

Asset/

(liability)

balance,
end of

period

 

Interest rates — net

    $  (371     $ (35     $  (68     $    6        $    (8     $ 139        $  25        $  (41     $  (353

Credit — net

    6,300        101        488        127        (78     (899     175        (95     6,119   

Currencies — net

    842        (15     (220     6        (3     (182     (3 3      (233     192   

Commodities — net

    (605     9        322        187        (152     (25     4        20  4      (240

Equities — net

    (432     41        (108     134        (393     138        1        71  4      (548

Total derivatives — net

    $5,734        $101  1      $ 414  1,2      $460        $(634     $(829     $202        $(278     $5,170   

 

1.

The aggregate amounts include approximately $468 million and $47 million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

3.

Reflects a net transfer to level 3 of derivative liabilities.

 

4.

Reflects a net transfer to level 2 of derivative liabilities.

 

The net unrealized gain on level 3 derivatives of $414 million for the six months ended June 2012 was primarily attributable to the impact of lower interest rates and changes in foreign exchange rates on certain credit derivatives and changes in commodity prices on certain commodity derivatives, partially offset by the impact of changes in foreign exchange rates on certain currency derivatives.

Transfers into level 3 derivatives during the six months ended June 2012 primarily reflected transfers of certain credit derivative assets from level 2, primarily due to unobservable inputs becoming significant to the valuation of these derivatives.

Transfers out of level 3 derivatives during the six months ended June 2012 primarily reflected transfers of certain currency derivative assets to level 2, primarily due to unobservable correlation inputs no longer being significant to the valuation of these derivatives.

 

 

     Level 3 Derivative Assets and Liabilities at Fair Value for the Three Months Ended June 2011  
in millions   

Asset/

(liability)
balance,
beginning
of period

    

Net

realized
gains/
(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases    Sales    Settlements      Net
transfers
in and/or
(out) of
level 3
    

Asset/

(liability)

balance,
end of

period

 

Interest rates — net

     $     (97      $  (18     $  (10   $    9    $   —       $   14         $  (90      $  (192

Credit — net

     6,591         95        568      99    (262)      (145      (927      6,019   

Currencies — net

     1,132         (22     (17   7    (8)      2         29         1,123   

Commodities — net

     193         (131     (159   118    (91)      143         111         184   

Equities — net

     (1,016      (84     74      181    (214)      45         111         (903

Total derivatives — net

     $ 6,803         $(160 1      $ 456  1,2    $414    $(575)      $   59         $(766      $6,231   

 

1.

The aggregate amounts include approximately $138 million and $158 million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

The net unrealized gain on level 3 derivatives of $456 million for the three months ended June 2011 primarily reflected an unrealized gain on credit derivatives attributable to changes in interest rates. This gain was partially offset by an unrealized loss on commodity derivatives, primarily due to changes in the volatility inputs used to value these derivatives.

Significant transfers in or out of level 3 derivatives during the three months ended June 2011 included:

 

Ÿ  

Credit — net: net transfer out of level 3 of $927 million, principally due to increased transparency of market prices for certain derivatives as a result of market transactions in these financial instruments, as well as unobservable inputs no longer being significant to the valuation of certain derivatives.

 

 

  Goldman Sachs June 2012 Form 10-Q   33


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

     Level 3 Derivative Assets and Liabilities at Fair Value for the Six Months Ended June 2011  
in millions   

Asset/

(liability)
balance,
beginning
of period

    

Net

realized
gains/
(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases    Sales    Settlements      Net
transfers
in and/or
(out) of
level 3
    

Asset/

(liability)

balance,
end of

period

 

Interest rates — net

     $   194         $  (36     $  (33   $    9    $    (2)      $   20         $(344      $  (192

Credit — net

     7,040         136        388      140    (334)      (465      (886      6,019   

Currencies — net

     1,098         (31     (180   35    (12)      (51      264         1,123   

Commodities — net

     220         (223     (33   277    (122)      78         (13      184   

Equities — net

     (990      21        (49   315    (373)      4         169         (903

Total derivatives — net

     $7,562         $(133 1      $   93  1,2    $776    $(843)      $(414      $(810      $6,231   

 

1.

The aggregate amounts include approximately $(52) million and $12 million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

The net unrealized gain on level 3 derivatives of $93 million for the six months ended June 2011 primarily reflected an unrealized gain on credit derivatives, primarily attributable to changes in interest rates, partially offset by an unrealized loss on currency derivatives, primarily due to changes in foreign exchange rates.

Significant transfers in or out of level 3 derivatives during the six months ended June 2011 included:

 

Ÿ  

Credit — net: net transfer out of level 3 of $886 million, principally due to increased transparency of market prices for certain derivatives as a result of market transactions in these financial instruments, as well as unobservable inputs no longer being significant to the valuation of certain derivatives.

Impact of Credit Spreads on Derivatives

On an ongoing basis, the firm realizes gains or losses relating to changes in credit risk through the unwind of derivative contracts and changes in credit mitigants.

The net gain/(loss), including hedges, attributable to the impact of changes in credit exposure and credit spreads (counterparty and the firm’s) on derivatives was $(160) million and $156 million for the three months ended June 2012 and June 2011, respectively, and $(339) million and $131 million for the six months ended June 2012 and June 2011, respectively.

Bifurcated Embedded Derivatives

The table below presents derivatives, primarily interest rate and equity products, that have been bifurcated from their related borrowings. These derivatives are recorded at fair value and included in “Unsecured short-term borrowings” and “Unsecured long-term borrowings.” See Note 8 for further information.

 

   

As of

in millions, except number of contracts  

June

2012

  

December

2011

Fair value of assets

  $422    $422

Fair value of liabilities

  313    304

Net

  $109    $118

Number of contracts

  377    333
 

 

34   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

OTC Derivatives

The tables below present the fair values of OTC derivative assets and liabilities by tenor and by product type. Tenor is based on expected duration for mortgage-related credit

derivatives and generally on remaining contractual maturity for other derivatives.

 

 

in millions      OTC Derivatives as of June 2012  

Assets

 

Product Type

    

0 - 12

Months

      

1 - 5

Years

      

5 Years or

Greater

       Total  

Interest rates

       $11,617           $29,892           $  80,928           $ 122,437   

Credit

       2,031           15,665           10,106           27,802   

Currencies

       8,394           8,068           13,249           29,711   

Commodities

       5,192           5,148           224           10,564   

Equities

       4,268           8,029           7,410           19,707   

Netting across product types 1

       (2,371        (5,434        (5,452        (13,257

Subtotal

       $29,131           $61,368           $106,465           196,964   

Cross maturity netting 2

                                        (20,980

Cash collateral netting 3

                                        (109,010

Total

                                        $   66,974   

Liabilities

 

Product Type

    

0 - 12

Months

      

1 - 5

Years

      

5 Years or

Greater

       Total  

Interest rates

       $  7,063           $17,705           $32,509           $ 57,277   

Credit

       1,059           6,997           3,731           11,787   

Currencies

       7,461           5,470           6,600           19,531   

Commodities

       4,568           4,944           2,661           12,173   

Equities

       3,226           4,742           4,234           12,202   

Netting across product types 1

       (2,371        (5,434        (5,452        (13,257

Subtotal

       $21,006           $34,424           $44,283           99,713   

Cross maturity netting 2

                                        (20,980

Cash collateral netting 3

                                        (30,448

Total

                                        $ 48,285   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty across product types within a tenor category under enforceable netting agreements. Receivable and payable balances with the same counterparty in the same product type and tenor category are netted within such product type and tenor category.

 

2.

Represents the netting of receivable balances with payable balances for the same counterparty across tenor categories under enforceable netting agreements.

 

3.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

  Goldman Sachs June 2012 Form 10-Q   35


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

in millions      OTC Derivatives as of December 2011  

Assets

 

Product Type

     0 - 12
Months
       1 - 5
Years
       5 Years or
Greater
       Total  

Interest rates

       $10,931           $32,194           $  82,480           $ 125,605   

Credit

       3,054           15,468           13,687           32,209   

Currencies

       11,253           11,592           16,023           38,868   

Commodities

       5,286           5,931           147           11,364   

Equities

       6,663           7,768           7,468           21,899   

Netting across product types 1

       (3,071        (6,033        (6,027        (15,131

Subtotal

       $34,116           $66,920           $113,778           214,814   

Cross maturity netting 2

                                        (22,562

Cash collateral netting 3

                                        (118,104

Total

                                        $   74,148   

Liabilities

 

Product Type

     0 - 12
Months
       1 - 5
Years
       5 Years or
Greater
       Total  

Interest rates

       $  5,787           $18,607           $37,739           $  62,133   

Credit

       1,200           6,957           3,894           12,051   

Currencies

       9,826           5,514           6,502           21,842   

Commodities

       6,322           5,174           2,727           14,223   

Equities

       3,290           4,018           4,246           11,554   

Netting across product types 1

       (3,071        (6,033        (6,027        (15,131

Subtotal

       $23,354           $34,237           $49,081           106,672   

Cross maturity netting 2

                                        (22,562

Cash collateral netting 3

                                        (28,829

Total

                                        $  55,281   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty across product types within a tenor category under enforceable netting agreements. Receivable and payable balances with the same counterparty in the same product type and tenor category are netted within such product type and tenor category.

 

2.

Represents the netting of receivable balances with payable balances for the same counterparty across tenor categories under enforceable netting agreements.

 

3.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

36   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Derivatives with Credit-Related Contingent Features

Certain of the firm’s derivatives have been transacted under bilateral agreements with counterparties who may require the firm to post collateral or terminate the transactions based on changes in the firm’s credit ratings. The firm assesses the impact of these bilateral agreements by determining the collateral or termination payments that would occur assuming downgrade by all rating agencies. A downgrade by any one rating agency, depending on the agency’s relative ratings of the firm at the time of the downgrade, may have an impact which is comparable to the impact of a downgrade by all rating agencies. The table below presents the aggregate fair value of net derivative liabilities under such agreements (excluding application of collateral posted to reduce these liabilities), the related aggregate fair value of the assets posted as collateral, and the additional collateral or termination payments that could have been called at the reporting date by counterparties in the event of a one-notch and two-notch downgrade in the firm’s credit ratings.

 

    

As of

in millions   

June

2012

  

December

2011

Net derivative liabilities under bilateral agreements

   $31,542    $35,066

Collateral posted

   27,324    29,002

Additional collateral or termination payments for a one-notch downgrade

   1,344    1,303

Additional collateral or termination payments for a two-notch downgrade

   2,456    2,183

Credit Derivatives

The firm enters into a broad array of credit derivatives in locations around the world to facilitate client transactions and to manage the credit risk associated with market-making and investing and lending activities. Credit derivatives are actively managed based on the firm’s net risk position.

Credit derivatives are individually negotiated contracts and can have various settlement and payment conventions. Credit events include failure to pay, bankruptcy, acceleration of indebtedness, restructuring, repudiation and dissolution of the reference entity.

Credit Default Swaps. Single-name credit default swaps protect the buyer against the loss of principal on one or more bonds, loans or mortgages (reference obligations) in the event the issuer (reference entity) of the reference obligations suffers a credit event. The buyer of protection pays an initial or periodic premium to the seller and receives

protection for the period of the contract. If there is no credit event, as defined in the contract, the seller of protection makes no payments to the buyer of protection. However, if a credit event occurs, the seller of protection is required to make a payment to the buyer of protection, which is calculated in accordance with the terms of the contract.

Credit Indices, Baskets and Tranches. Credit derivatives may reference a basket of single-name credit default swaps or a broad-based index. If a credit event occurs in one of the underlying reference obligations, the protection seller pays the protection buyer. The payment is typically a pro-rata portion of the transaction’s total notional amount based on the underlying defaulted reference obligation. In certain transactions, the credit risk of a basket or index is separated into various portions (tranches), each having different levels of subordination. The most junior tranches cover initial defaults and once losses exceed the notional amount of these junior tranches, any excess loss is covered by the next most senior tranche in the capital structure.

Total Return Swaps. A total return swap transfers the risks relating to economic performance of a reference obligation from the protection buyer to the protection seller. Typically, the protection buyer receives from the protection seller a floating rate of interest and protection against any reduction in fair value of the reference obligation, and in return the protection seller receives the cash flows associated with the reference obligation, plus any increase in the fair value of the reference obligation.

Credit Options. In a credit option, the option writer assumes the obligation to purchase or sell a reference obligation at a specified price or credit spread. The option purchaser buys the right, but does not assume the obligation, to sell the reference obligation to, or purchase it from, the option writer. The payments on credit options depend either on a particular credit spread or the price of the reference obligation.

The firm economically hedges its exposure to written credit derivatives primarily by entering into offsetting purchased credit derivatives with identical underlyings. Substantially all of the firm’s purchased credit derivative transactions are with financial institutions and are subject to stringent collateral thresholds. In addition, upon the occurrence of a specified trigger event, the firm may take possession of the reference obligations underlying a particular written credit derivative, and consequently may, upon liquidation of the reference obligations, recover amounts on the underlying reference obligations in the event of default.

 

 

  Goldman Sachs June 2012 Form 10-Q   37


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

As of June 2012, written and purchased credit derivatives had total gross notional amounts of $1.88 trillion and $1.98 trillion, respectively, for total net notional purchased protection of $104.96 billion. As of December 2011, written and purchased credit derivatives had total gross notional amounts of $1.96 trillion and $2.08 trillion, respectively, for total net notional purchased protection of $116.93 billion.

The table below presents certain information about credit derivatives. In the table below:

 

Ÿ  

fair values exclude the effects of both netting under enforceable netting agreements and netting of cash received or posted under credit support agreements, and therefore are not representative of the firm’s credit exposure;

Ÿ  

tenor is based on expected duration for mortgage-related credit derivatives and on remaining contractual maturity for other credit derivatives; and

 

Ÿ  

the credit spread on the underlying, together with the tenor of the contract, are indicators of payment/performance risk. The firm is less likely to pay or otherwise be required to perform where the credit spread and the tenor are lower.

 

 

    Maximum Payout/Notional Amount
of Written Credit Derivatives by Tenor
    Maximum Payout/Notional
Amount of Purchased
Credit Derivatives
    Fair Value of
Written Credit Derivatives
 
$ in millions   0 - 12
Months
   

1 - 5

Years

   

5 Years

or Greater

    Total     Offsetting
Purchased
Credit
Derivatives  1
    Other
Purchased
Credit
Derivatives  2
    Asset     Liability    

Net

Asset/

(Liability)

 

As of June 2012

                 

Credit spread on underlying

(basis points)

                 

0-250

    $344,928        $   847,916        $133,022        $1,325,866        $1,253,917        $154,994        $19,651        $  14,741        $   4,910   

251-500

    36,864        194,491        52,876        284,231        254,000        38,128        4,567        15,036        (10,469

501-1,000

    22,312        121,283        22,111        165,706        151,798        22,862        959        14,478        (13,519

Greater than 1,000

    16,052        74,458        9,280        99,790        83,707        21,142        579        30,654        (30,075

Total

    $420,156        $1,238,148        $217,289        $1,875,593        $1,743,422        $237,126        $25,756        $  74,909        $(49,153

As of December 2011

                 

Credit spread on underlying

(basis points)

                 

0-250

    $282,851        $   794,193        $141,688        $1,218,732        $1,122,296        $180,316        $17,572        $  16,907        $      665   

251-500

    42,682        269,687        69,864        382,233        345,942        47,739        4,517        20,810        (16,293

501-1,000

    29,377        140,389        21,819        191,585        181,003        23,176        138        15,398        (15,260

Greater than 1,000

    30,244        114,103        22,995        167,342        147,614        28,734        512        57,201        (56,689

Total

    $385,154        $1,318,372        $256,366        $1,959,892        $1,796,855        $279,965        $22,739        $110,316        $(87,577

 

1.

Offsetting purchased credit derivatives represent the notional amount of purchased credit derivatives to the extent they economically hedge written credit derivatives with identical underlyings.

 

2.

This purchased protection represents the notional amount of purchased credit derivatives in excess of the notional amount included in “Offsetting Purchased Credit Derivatives.”

Hedge Accounting

The firm applies hedge accounting for (i) certain interest rate swaps used to manage the interest rate exposure of certain fixed-rate unsecured long-term and short-term borrowings and certain fixed-rate certificates of deposit and (ii) certain foreign currency forward contracts and foreign currency-denominated debt used to manage foreign currency exposures on the firm’s net investment in certain non-U.S. operations.

To qualify for hedge accounting, the derivative hedge must be highly effective at reducing the risk from the exposure being hedged. Additionally, the firm must formally document the hedging relationship at inception and test the hedging relationship at least on a quarterly basis to ensure the derivative hedge continues to be highly effective over the life of the hedging relationship.

 

 

38   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Interest Rate Hedges

The firm designates certain interest rate swaps as fair value hedges. These interest rate swaps hedge changes in fair value attributable to the relevant benchmark interest rate (e.g., London Interbank Offered Rate (LIBOR)), effectively converting a substantial portion of fixed-rate obligations into floating-rate obligations.

The firm applies a statistical method that utilizes regression analysis in assessing the effectiveness of its fair value hedging relationships in achieving offsetting changes in the fair values of the hedging instrument and the risk being hedged (i.e., interest rate risk). An interest rate swap is considered highly effective in offsetting changes in fair value attributable to changes in the hedged risk when the regression analysis results in a coefficient of determination of 80% or greater and a slope between 80% and 125%.

For qualifying fair value hedges, gains or losses on derivatives are included in “Interest expense.” The change in fair value of the hedged item attributable to the risk being hedged is reported as an adjustment to its carrying value and is subsequently amortized into interest expense over its remaining life. Gains or losses resulting from hedge ineffectiveness are included in “Interest expense.” When a derivative is no longer designated as a hedge, any remaining difference between the carrying value and par value of the hedged item is amortized to interest expense over the remaining life of the hedged item using the effective interest method. See Note 23 for further information about interest income and interest expense.

The table below presents the gains/(losses) from interest rate derivatives accounted for as hedges, the related hedged borrowings and bank deposits, and the hedge ineffectiveness on these derivatives.

 

    Three Months
Ended June
    Six Months
Ended June
 
in millions   2012     2011     2012     2011  

Interest rate hedges

    $ 1,792        $    836        $(446     $(1,822

Hedged borrowings and bank deposits

    (2,160     (1,250     (382     913   

Hedge ineffectiveness 1

    (368     (414     (828     (909

 

1.

Primarily consisted of amortization of prepaid credit spreads resulting from the passage of time.

Net Investment Hedges

The firm seeks to reduce the impact of fluctuations in foreign exchange rates on its net investment in certain non-U.S. operations through the use of foreign currency forward contracts and foreign currency-denominated debt. For foreign currency forward contracts designated as hedges, the effectiveness of the hedge is assessed based on the overall changes in the fair value of the forward contracts (i.e., based on changes in forward rates). For foreign currency-denominated debt designated as a hedge, the effectiveness of the hedge is assessed based on changes in spot rates.

For qualifying net investment hedges, the gains or losses on the hedging instruments, to the extent effective, are included in “Currency translation adjustment, net of tax” within the condensed consolidated statements of comprehensive income.

The table below presents the gains/(losses) from net investment hedging.

 

    Three Months
Ended June
    Six Months
Ended June
 
in millions   2012     2011     2012     2011  

Currency hedges

    $ 209        $(178     $   (3     $(403

Foreign currency-denominated debt

    (108     (94     113        (12

The gain/(loss) related to ineffectiveness and the gain/(loss) reclassified to earnings from accumulated other comprehensive income was not material for the three and six months ended June 2012 and June 2011.

As of June 2012 and December 2011, the firm had designated $3.00 billion and $3.11 billion, respectively, of foreign currency-denominated debt, included in “Unsecured long-term borrowings” and “Unsecured short-term borrowings,” as hedges of net investments in non-U.S. subsidiaries.

 

 

  Goldman Sachs June 2012 Form 10-Q   39


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 8. Fair Value Option

Note 8.

Fair Value Option

Other Financial Assets and Financial Liabilities at

Fair Value

In addition to all cash and derivative instruments included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” the firm has elected to account for certain of its other financial assets and financial liabilities at fair value under the fair value option.

The primary reasons for electing the fair value option are to:

 

Ÿ  

reflect economic events in earnings on a timely basis;

 

Ÿ  

mitigate volatility in earnings from using different measurement attributes (e.g., transfers of financial instruments owned accounted for as financings are recorded at fair value whereas the related secured financing would be recorded on an accrual basis absent electing the fair value option); and

 

Ÿ  

address simplification and cost-benefit considerations (e.g., accounting for hybrid financial instruments at fair value in their entirety versus bifurcation of embedded derivatives and hedge accounting for debt hosts).

Hybrid financial instruments are instruments that contain bifurcatable embedded derivatives and do not require settlement by physical delivery of non-financial assets (e.g., physical commodities). If the firm elects to bifurcate the embedded derivative from the associated debt, the derivative is accounted for at fair value and the host contract is accounted for at amortized cost, adjusted for the effective portion of any fair value hedges. If the firm does not elect to bifurcate, the entire hybrid financial instrument is accounted for at fair value under the fair value option.

Other financial assets and financial liabilities accounted for at fair value under the fair value option include:

 

Ÿ  

resale and repurchase agreements;

 

Ÿ  

securities borrowed and loaned within Fixed Income, Currency and Commodities Client Execution;

 

Ÿ  

certain other secured financings, primarily transfers of assets accounted for as financings rather than sales and certain other nonrecourse financings;

Ÿ  

certain unsecured short-term borrowings, consisting of all promissory notes and commercial paper and certain hybrid financial instruments;

 

Ÿ  

certain unsecured long-term borrowings, including prepaid commodity transactions and certain hybrid financial instruments;

 

Ÿ  

certain receivables from customers and counterparties, including certain margin loans and transfers of assets accounted for as secured loans rather than purchases;

 

Ÿ  

certain insurance and reinsurance contract assets and liabilities and certain guarantees;

 

Ÿ  

certain subordinated liabilities issued by consolidated VIEs; and

 

Ÿ  

certain time deposits issued by the firm’s bank subsidiaries (deposits with no stated maturity are not eligible for a fair value option election), including structured certificates of deposit, which are hybrid financial instruments.

These financial assets and financial liabilities at fair value are generally valued based on discounted cash flow techniques, which incorporate inputs with reasonable levels of price transparency, and are generally classified as level 2 because the inputs are observable. Valuation adjustments may be made for liquidity and for counterparty and the firm’s credit quality.

See below for information about the significant inputs used to value other financial assets and financial liabilities at fair value, including the ranges of significant unobservable inputs used to value the level 3 instruments within these categories. These ranges represent the significant unobservable inputs that were used in the valuation of each type of other financial assets and financial liabilities at fair value. These inputs are not representative of the inputs that could have been used in the valuation of any one instrument. For example, the highest funding spread presented below for resale and repurchase agreements is appropriate for valuing a specific agreement in that category but may not be appropriate for valuing any other agreements in that category. Accordingly, the range of inputs presented below do not represent uncertainty in, or possible ranges of, fair value measurements of the firm’s level 3 other financial assets and financial liabilities.

 

 

40   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Resale and Repurchase Agreements and Securities Borrowed and Loaned. The significant inputs to the valuation of resale and repurchase agreements and securities borrowed and loaned are collateral funding spreads, the amount and timing of expected future cash flows and interest rates. The ranges of significant unobservable inputs used to value level 3 resale and repurchase agreements as of June 2012 are as follows:

 

Ÿ  

Yield: 2.1% to 5.3%

 

Ÿ  

Duration: 1.1 to 5.1 years

 

Ÿ  

Funding spreads: 69 bps to 361 bps

Generally, increases in yield, duration or funding spreads, in isolation, would result in a lower fair value measurement. Due to the distinctive nature of each of the firm’s level 3 resale and repurchase agreements, the interrelationship of inputs is not necessarily uniform across such agreements.

See Note 9 for further information about collateralized agreements.

Other Secured Financings. The significant inputs to the valuation of other secured financings at fair value are the amount and timing of expected future cash flows, interest rates, collateral funding spreads, the fair value of the collateral delivered by the firm (which is determined using the amount and timing of expected future cash flows, market prices, market yields and recovery assumptions) and the frequency of additional collateral calls. The ranges of significant unobservable inputs used to value level 3 other secured financings as of June 2012 are as follows:

 

Ÿ  

Yield: 4.7% to 20.0%

 

Ÿ  

Duration: 0.3 to 10.0 years

 

Ÿ  

Funding spreads: 26 bps to 77 bps

Generally, increases in yield, duration or funding spreads, in isolation, would result in a lower fair value measurement. Due to the distinctive nature of each of the firm’s level 3 other secured financings, the interrelationship of inputs is not necessarily uniform across such financings.

See Note 9 for further information about collateralized financings.

Unsecured Short-term and Long-term Borrowings. The significant inputs to the valuation of unsecured short-term and long-term borrowings at fair value are the amount and timing of expected future cash flows, interest rates, the credit spreads of the firm, as well as commodity prices in the case of prepaid commodity transactions. The inputs used to value the embedded derivative component of hybrid financial instruments are consistent with the inputs used to value the firm’s other derivative instruments. See Note 7 for further information about derivatives. See Notes 15 and 16 for further information about unsecured short-term and long-term borrowings, respectively.

Certain of the firm’s unsecured short-term and long-term instruments are included in level 3, substantially all of which are hybrid financial instruments. As the significant unobservable inputs used to value hybrid financial instruments primarily relate to the embedded derivative component of these borrowings, these inputs are incorporated in the firm’s derivative disclosures related to unobservable inputs in Note 7.

Insurance and Reinsurance Contracts.    Insurance and reinsurance contracts at fair value are included in “Receivables from customers and counterparties” and “Other liabilities and accrued expenses.” The insurance and reinsurance contracts for which the firm has elected the fair value option are contracts that can be settled only in cash and that qualify for the fair value option because they are recognized financial instruments. These contracts are valued using market transactions and other market evidence where possible, including market-based inputs to models, calibration to market-clearing transactions or other alternative pricing sources with reasonable levels of price transparency. Significant level 2 inputs are interest rates, inflation rates, volatilities, and policy lapse and projected mortality assumptions. Significant level 3 inputs are funding spreads. When unobservable inputs to a valuation model are significant to the fair value measurement of an instrument, the instrument is classified in level 3. The range of significant unobservable inputs used to value level 3 insurance and reinsurance contracts as of June 2012 is as follows:

 

Ÿ  

Funding spreads: 82 bps to 118 bps

Generally, an increase in funding spreads would result in a lower fair value measurement.

 

 

  Goldman Sachs June 2012 Form 10-Q   41


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Receivables from Customers and Counterparties. Receivables from customers and counterparties at fair value, excluding insurance and reinsurance contracts, are primarily comprised of transfers of assets accounted for as secured loans rather than purchases. The significant inputs to the valuation of such receivables are commodity prices, interest rates, the amount and timing of expected future cash flows and funding spreads. The range of significant unobservable inputs used to value level 3 receivables from customers and counterparties as of June 2012 is as follows:

 

Ÿ  

Funding spreads: 126 bps to 156 bps

Generally, an increase in funding spreads would result in a lower fair value measurement.

Receivables from customers and counterparties not accounted for at fair value are accounted for at amortized cost net of estimated uncollectible amounts, which generally approximates fair value. Such receivables are primarily comprised of customer margin loans. While these margin loans are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these margin loans

been included in the firm’s fair value hierarchy, substantially all would have been classified in level 2 as of June 2012.

Deposits. The significant inputs to the valuation of time deposits are interest rates and the amount and timing of future cash flows. The inputs used to value the embedded derivative component of hybrid financial instruments are consistent with the inputs used to value the firm’s other derivative instruments. See Note 7 for further information about derivatives. See Note 14 for further information about deposits.

The firm’s deposits that are included in level 3 are hybrid financial instruments. As the significant unobservable inputs used to value hybrid financial instruments primarily relate to the embedded derivative component of these deposits, these inputs are incorporated in the firm’s derivative disclosures related to unobservable inputs in Note 7.

Fair Value of Other Financial Assets and Financial

Liabilities by Level

The tables below present, by level within the fair value hierarchy, other financial assets and financial liabilities accounted for at fair value under the fair value option.

 

 

    Other Financial Assets at Fair Value as of June 2012
in millions   Level 1        Level 2        Level 3        Total

Securities segregated for regulatory and other purposes 1

    $22,622           $  14,657           $      —         $  37,279

Securities purchased under agreements to resell

              166,321           1,023         167,344

Securities borrowed

              51,897                   51,897

Receivables from customers and counterparties

              6,828           616         7,444

Total

    $22,622           $239,703           $1,639         $263,964
    Other Financial Liabilities at Fair Value as of June 2012
in millions   Level 1        Level 2        Level 3        Total

Deposits

    $       —           $    5,467           $     179         $    5,646

Securities sold under agreements to repurchase

              158,387           2,055         160,442

Securities loaned

              24                   24

Other secured financings

              23,857           1,182         25,039

Unsecured short-term borrowings

              14,202           2,726         16,928

Unsecured long-term borrowings

              10,698           1,946         12,644

Other liabilities and accrued expenses

              447           8,969         9,416

Total

    $       —           $213,082           $17,057         $230,139

 

1.

Includes securities segregated for regulatory and other purposes accounted for at fair value under the fair value option, which consists of securities borrowed and resale agreements. The table above includes $22.62 billion of level 1 and $526 million of level 2 securities segregated for regulatory and other purposes accounted for at fair value under other U.S. GAAP, principally consisting of U.S. Treasury securities, money market instruments and insurance separate account assets.

 

42   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

   

   Other Financial Assets at Fair Value as of December 2011   

in millions   Level 1      Level 2      Level 3      Total

Securities segregated for regulatory and other purposes 1

  $21,263      $  20,751      $        —      $  42,014

Securities purchased under agreements to resell

       187,232      557      187,789

Securities borrowed

       47,621           47,621

Receivables from customers and counterparties

       8,887      795      9,682

Total

  $21,263      $264,491      $  1,352      $287,106
   

Other Financial Liabilities at Fair Value as of December 2011

in millions   Level 1      Level 2      Level 3      Total

Deposits

  $        —      $    4,513      $       13      $    4,526

Securities sold under agreements to repurchase

       162,321      2,181      164,502

Securities loaned

       107           107

Other secured financings

       28,267      1,752      30,019

Unsecured short-term borrowings

       14,560      3,294      17,854

Unsecured long-term borrowings

       14,971      2,191      17,162

Other liabilities and accrued expenses

       490      8,996      9,486

Total

  $        —      $225,229      $18,427      $243,656

 

1.

Includes securities segregated for regulatory and other purposes accounted for at fair value under the fair value option, which consists of securities borrowed and resale agreements. The table above includes $21.26 billion of level 1 and $528 million of level 2 securities segregated for regulatory and other purposes accounted for at fair value under other U.S. GAAP, principally consisting of U.S. Treasury securities, money market instruments and insurance separate account assets.

 

  Goldman Sachs June 2012 Form 10-Q   43


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Rollforward

If a financial asset or financial liability was transferred to level 3 during a reporting period, its entire gain or loss for the period is included in level 3. Transfers between levels are recognized at the beginning of the reporting period in which they occur.

The tables below present changes in fair value for other financial assets and financial liabilities accounted for at fair value under the fair value option categorized as level 3 as of the end of the period. Level 3 other financial assets and

liabilities are frequently economically hedged with cash instruments and derivatives. Accordingly, gains or losses that are reported in level 3 can be partially offset by gains or losses attributable to level 1, 2 or 3 cash instruments or derivatives. As a result, gains or losses included in the level 3 rollforward below do not necessarily represent the overall impact on the firm’s results of operations, liquidity or capital resources.

 

 

    Level 3 Other Financial Assets at Fair Value for the Three Months Ended June 2012  
in millions   Balance,
beginning
of period
   

Net
realized
gains/

(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases     Sales     Issues     Settlements    

Transfers

into
level 3

    Transfers
out of
level 3
    Balance,
end of
period
 

Securities purchased under agreements to resell

    $     956        $   1        $(52     $394        $—        $   —        $(276     $   —        $    —        $  1,023   

Receivables from customers and counterparties

    431               (7                          (7     199               616   

Total

    $  1,387        $   1  1      $(59 1      $394        $—        $   —        $(283     $199        $    —        $  1,639   

 

1.

The aggregate amounts include gains/(losses) of approximately $(63) million and $5 million reported in “Market making” and “Interest income,” respectively.

 

    Level 3 Other Financial Liabilities at Fair Value for the Three Months Ended June 2012  
in millions   Balance,
beginning
of period
   

Net
realized
(gains)/

losses

   

Net unrealized
(gains)/losses
relating to
instruments
still held at

period-end

    Purchases     Sales     Issues     Settlements    

Transfers

into
level 3

    Transfers
out of
level 3
    Balance,
end of
period
 

Deposits

    $       96        $  —        $   2        $   —        $—        $  81        $    —        $   —        $    —        $     179   

Securities sold under agreements to repurchase, at fair value

    2,048                                           7                      2,055   

Other secured financings

    1,282        3                             69        (172                   1,182   

Unsecured short-term borrowings

    3,375        (31     (63                   231        (497     87        (376     2,726   

Unsecured long-term borrowings

    2,310        5        (72                   91        (36     43        (395     1,946   

Other liabilities and accrued expenses

    8,965        (2     97                             (91                   8,969   

Total

    $18,076        $(25 1      $(36 1      $   —        $—        $472        $(789     $130        $(771     $17,057   

 

1.

The aggregate amounts include gains/(losses) of approximately $88 million, $(23) million and $(4) million reported in “Market making,” “Other principal transactions” and “Interest expense,” respectively.

 

The net unrealized loss on level 3 other financial assets of $59 million for the three months ended June 2012 primarily reflected the impact of changes in foreign exchange rates on certain resale agreements. The net unrealized gain on other financial liabilities of $36 million for the three months ended June 2012 primarily reflected gains on certain equity-linked notes, principally due to a decline in global equity prices, partially offset by losses on certain insurance liabilities, principally due to a decline in interest rates.

Transfers into level 3 related to other financial assets during the three months ended June 2012 reflected transfers from level 2 of certain receivables, principally due to less market activity in these instruments.

Transfers into level 3 related to other financial liabilities during the three months ended June 2012 primarily reflected transfers from level 2 of certain hybrid financial instruments, principally due to reduced transparency of the correlation and volatility inputs used to value these instruments.

Transfers out of level 3 related to other financial liabilities during the three months ended June 2012 primarily reflected transfers to level 2 of certain hybrid financial instruments, principally due to unobservable inputs no longer being significant to the valuation of certain instruments, and increased transparency of the correlation and volatility inputs used to value certain instruments.

 

 

44   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Other Financial Assets at Fair Value for the Six Months Ended June 2012  
in millions   Balance,
beginning
of period
   

Net
realized
gains/

(losses)

    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases     Sales     Issues      Settlements    

Transfers

into
level 3

    Transfers
out of
level 3
    Balance,
end of
period
 

Securities purchased under agreements to resell

    $     557        $   2        $ (22     $   929        $  —        $  —         $   (443     $  —        $       —        $  1,023   

Receivables from customers and counterparties

    795               2        199                       (7            (373     616   

Total

    $  1,352        $   2  1      $ (20 1      $1,128        $  —        $  —         $   (450     $  —        $   (373     $  1,639   

 

1.

The aggregate amounts include gains/(losses) of approximately $(27) million and $9 million reported in “Market making” and “Interest income,” respectively.

 

    Level 3 Other Financial Liabilities at Fair Value for the Six Months Ended June 2012  
in millions   Balance,
beginning
of period
   

Net
realized
(gains)/

losses

   

Net unrealized
(gains)/losses
relating to
instruments
still held at

period-end

    Purchases     Sales     Issues      Settlements    

Transfers

into
level 3

    Transfers
out of
level 3
    Balance,
end of
period
 

Deposits

    $       13        $  —        $   (4     $     —        $  —        $170         $       —        $  —        $       —        $     179   

Securities sold under agreements to repurchase, at fair value

    2,181                                            (126                   2,055   

Other secured financings

    1,752        7                             92         (630            (39     1,182   

Unsecured short-term borrowings

    3,294        (44     57        (13            365         (575     179        (537     2,726   

Unsecured long-term borrowings

    2,191        16        90                      245         (128     178        (646     1,946   

Other liabilities and accrued expenses

    8,996        (2     150                              (175                   8,969   

Total

    $18,427        $(23 1      $293  1      $    (13     $  —        $872         $(1,634     $357        $(1,222     $17,057   

 

1.

The aggregate amounts include losses of approximately $230 million, $32 million and $8 million reported in “Market making,” “Other principal transactions” and “Interest expense,” respectively.

 

The net unrealized loss on level 3 other financial liabilities at fair value of $293 million for the six months ended June 2012 primarily reflected losses on certain insurance liabilities, reflecting the impact of changes in foreign exchange rates and a decrease in interest rates, and losses on certain hybrid financial instruments, principally due to tightening credit spreads.

Transfers out of level 3 related to other financial assets during the six months ended June 2012 reflected transfers to level 2 of certain insurance receivables primarily due to increased transparency of the mortality inputs used to value these receivables.

Transfers into level 3 related to other financial liabilities during the six months ended June 2012 primarily reflected transfers from level 2 of certain hybrid financial instruments, principally due to decreased transparency of the correlation and volatility inputs used to value these instruments.

Transfers out of level 3 related to other financial liabilities during the six months ended June 2012 primarily reflected transfers to level 2 of certain hybrid financial instruments, principally due to increased transparency of the correlation and volatility inputs used to value certain instruments, and unobservable inputs no longer being significant to the valuation of certain instruments.

 

 

  Goldman Sachs June 2012 Form 10-Q   45


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Other Financial Assets at Fair Value for the Three Months Ended June 2011  
in millions   Balance,
beginning
of period
    Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases      Sales      Issues      Settlements     

Net
transfers

in and/or
(out) of
level 3

    

Balance,
end of

period

 

Securities purchased under agreements to resell

    $     158        $ —        $   —        $181         $  —         $   —         $     (40      $   —         $     299   

Receivables from customers and
counterparties

    322               5                                (6              321   

Total

    $     480        $ —  1      $    5  1      $181         $  —         $   —         $     (46      $   —         $     620   

 

1.

The aggregate amounts include gains of approximately $5 million reported in “Market making.”

 

    Level 3 Other Financial Liabilities at Fair Value for the Three Months Ended June 2011  
in millions   Balance,
beginning
of period
    Net
realized
(gains)/
losses
   

Net unrealized
(gains)/losses
relating to
instruments
still held at

period-end

    Purchases      Sales      Issues      Settlements     

Net

transfers

in and/or

(out) of

level 3

    

Balance,
end of

period

 

Securities sold under agreements to repurchase, at fair value

    $  1,946        $ —        $   —        $   —         $  —         $130         $       —         $   —         $  2,076   

Other secured financings

    7,107        9        (5                     261         (2,091      16         5,297   

Unsecured short-term borrowings

    3,209        (41     82        (23              179         (438      133         3,101   

Unsecured long-term borrowings

    2,404        6        117        (34              22         (2      41         2,554   

Other liabilities and accrued expenses

    6,852               150                                (58              6,944   

Total

    $21,518        $(26 1      $344  1      $ (57      $  —         $592         $(2,589      $190         $19,972   

 

1.

The aggregate amounts include losses of approximately $255 million, $60 million and $3 million reported in “Market making,” “Other principal transactions” and “Interest expense,” respectively.

There were no significant transfers in or out of level 3 during the three months ended June 2011.

 

46   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

    Level 3 Other Financial Assets at Fair Value for the Six Months Ended June 2011  
in millions   Balance,
beginning
of period
    Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases      Sales      Issues      Settlements     

Net
transfers

in and/or
(out) of
level 3

    

Balance,
end of

period

 

Securities purchased under agreements to resell

    $     100        $  2        $    —        $   245         $  —         $      —         $     (48      $    —         $     299   

Receivables from customers and counterparties

    298               21        14                         (12              321   

Total

    $     398        $  2  1      $    21  1      $   259         $  —         $      —         $     (60      $    —         $     620   

 

1.

The aggregate amounts include gains of approximately $21 million and $2 million reported in “Market making” and “Other principal transactions,” respectively.

 

    Level 3 Other Financial Liabilities at Fair Value for the Six Months Ended June 2011  
in millions   Balance,
beginning
of period
    Net
realized
(gains)/
losses
   

Net unrealized
(gains)/losses
relating to
instruments
still held at

period-end

    Purchases      Sales      Issues      Settlements     

Net

transfers

in and/or

(out) of

level 3

    

Balance,
end of

period

 

Securities sold under agreements to repurchase, at fair value

    $  2,060        $—        $    —        $      —         $  —         $   194         $   (178      $    —         $  2,076   

Other secured financings

    8,349        9        4                        274         (3,356      17         5,297   

Unsecured short-term borrowings

    3,476        68        (174     (31              541         (666      (113      3,101   

Unsecured long-term borrowings

    2,104        10        162        (50              291         (73      110         2,554   

Other liabilities and accrued expenses

    2,409               303        4,337                         (105              6,944   

Total

    $18,398        $87  1      $ 295  1      $4,256         $  —         $1,300         $(4,378      $   14         $19,972   

 

1.

The aggregate amounts include gains/(losses) of approximately $(419) million, $44 million and $(7) million reported in “Market making,” “Other principal transactions” and “Interest expense,” respectively.

 

Significant transfers in or out of level 3 during the six months ended June 2011 included:

 

Ÿ  

Unsecured short-term borrowings and Unsecured long-term borrowings: net transfer out of level 3 of $113 million and net transfer into level 3 of

   

$110 million, respectively, principally due to a transfer of approximately $230 million from level 3 Unsecured short-term borrowings to level 3 Unsecured long-term borrowings related to an extension in the tenor of certain borrowings.

 

 

  Goldman Sachs June 2012 Form 10-Q   47


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Gains and Losses on Other Financial Assets and

Financial Liabilities at Fair Value

The “Fair Value Option” columns in the table below present the gains and losses recognized as a result of the firm electing to apply the fair value option to certain financial assets and financial liabilities. These gains and losses are included in “Market making” and “Other principal transactions.”

The amounts in the table exclude contractual interest, which is included in “Interest income” and “Interest expense,” for all instruments other than hybrid financial instruments. See Note 23 for further information about interest income and interest expense. The table also excludes gains and losses related to financial instruments owned, at fair value and financial instruments sold, but not yet purchased, at fair value.

Included in the “Other” columns in the table below are:

 

Ÿ  

Gains and losses on the embedded derivative component of hybrid financial instruments included in unsecured short-term borrowings and unsecured long-term borrowings. These gains and losses would have been recognized under other U.S. GAAP even if the firm had not elected to account for the entire hybrid instrument at fair value.

Ÿ  

Gains and losses on secured financings related to transfers of assets accounted for as financings rather than sales. These gains and losses are offset by gains and losses on the related instruments included in “Financial instruments owned, at fair value” and “Receivables from customers and counterparties.”

 

Ÿ  

Gains and losses on receivables from customers and counterparties related to transfers of assets accounted for as receivables rather than purchases. These gains and losses are offset by gains and losses on the related financial instruments included in “Other secured financings.”

 

Ÿ  

Gains and losses on subordinated liabilities issued by consolidated VIEs, which are included in “Other liabilities and accrued expenses.” These gains and losses are offset by gains and losses on the financial assets held by the consolidated VIEs.

 

 

    Gains/(Losses) on Other Financial Assets and Financial Liabilities at Fair Value  
    Three Months Ended June          Six Months Ended June  
    2012     2011          2012     2011  
in millions  

Fair

Value
Option

    Other    

Fair

Value

Option

    Other          

Fair

Value
Option

    Other    

Fair

Value

Option

    Other  

Receivables from customers and counterparties 1

    $  (15     $(398     $  (6     $200             $      9        $   61        $   (5     $    519   

Other secured financings

    15        546        29        (510          (11     (369     33        (925

Unsecured short-term borrowings

    4        759        24        327             (38     (94     31        103   

Unsecured long-term borrowings

    49        13        68        432             (182     (355     71        (839

Other liabilities and accrued expenses 2

    (90     1        (64     (20          (192     42        (253     67   

Other 3

    (78     (2     10                    (95     3        45          

Total

    $(115     $ 919        $ 61        $429             $(509     $(712     $  (78     $(1,075

 

1.

Primarily consists of gains/(losses) on certain transfers accounted for as receivables rather than purchases and certain reinsurance contracts.

 

2.

Primarily consists of gains/(losses) on certain insurance contracts.

 

3.

Primarily consists of gains/(losses) on resale and repurchase agreements, securities borrowed and loaned and deposits.

 

Excluding the gains and losses on the instruments accounted for under the fair value option described above, “Market making” and “Other principal transactions”

primarily represents gains and losses on “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value.”

 

 

48   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Loans and Lending Commitments

The table below presents the difference between the aggregate fair value and the aggregate contractual principal amount for loans and long-term receivables for which the fair value option was elected.

 

   

As of

in millions  

June

2012

   December
2011

Aggregate contractual principal amount
of performing loans and long-term
receivables in excess of the
related fair value

  $  3,184    $  3,826

Aggregate contractual principal amount
of loans on nonaccrual status and/or more
than 90 days past due in excess
of the related fair value

 

20,936

   23,034

Total 1

  $24,120    $26,860

Aggregate fair value of loans on nonaccrual status and/or more than 90 days past due

  $  1,890    $  3,174

 

1.

The aggregate contractual principal exceeds the related fair value primarily because the firm regularly purchases loans, such as distressed loans, at values significantly below contractual principal amounts.

As of June 2012 and December 2011, the fair value of unfunded lending commitments for which the fair value option was elected was a liability of $2.56 billion and $2.82 billion, respectively, and the related total contractual amount of these lending commitments was $64.91 billion and $66.12 billion, respectively. See Note 18 for further information about lending commitments.

Long-term Debt Instruments

The aggregate contractual principal amount of long-term debt instruments (principal and non-principal protected) for which the fair value option was elected exceeded the related fair value by $450 million and $932 million as of June 2012 and December 2011, respectively. Of these amounts, $236 million and $693 million as of June 2012 and December 2011, respectively, related to unsecured long-term borrowings and the remainder related to long-term other secured financings.

Impact of Credit Spreads on Loans and Lending Commitments

The estimated net gain attributable to changes in instrument-specific credit spreads on loans and lending commitments for which the fair value option was elected was $270 million and $53 million for the three months ended June 2012 and June 2011, respectively, and $1.24 billion and $809 million for the six months ended June 2012 and June 2011, respectively. Changes in the fair value of loans and lending commitments are primarily attributable to changes in instrument-specific credit spreads. Substantially all of the firm’s performing loans and lending commitments are floating-rate.

Impact of Credit Spreads on Borrowings

The table below presents the net gains/(losses) attributable to the impact of changes in the firm’s own credit spreads on borrowings for which the fair value option was elected. The firm calculates the fair value of borrowings by discounting future cash flows at a rate which incorporates the firm’s credit spreads.

 

 

    Three Months
Ended June
         Six Months
Ended June
 
in millions   2012      2011           2012      2011  

Net gains/(losses) including hedges

    $  6         $85             $(218      $126   

Net gains/(losses) excluding hedges

    57         75             (232      119   
 

 

  Goldman Sachs June 2012 Form 10-Q   49


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 9. Collateralized Agreements and Financings

Note 9.

Collateralized Agreements and Financings

 

Collateralized agreements are securities purchased under agreements to resell (resale agreements or reverse repurchase agreements) and securities borrowed. Collateralized financings are securities sold under agreements to repurchase (repurchase agreements), securities loaned and other secured financings. The firm enters into these transactions in order to, among other things, facilitate client activities, invest excess cash, acquire securities to cover short positions and finance certain firm activities.

Collateralized agreements and financings are presented on a net-by-counterparty basis when a legal right of setoff exists. Interest on collateralized agreements and collateralized financings is recognized over the life of the transaction and included in “Interest income” and “Interest expense,” respectively. See Note 23 for further information about interest income and interest expense.

The table below presents the carrying value of resale and repurchase agreements and securities borrowed and loaned transactions.

 

    As of  
in millions    

 

June

2012

  

  

    

 

December

2011

  

  

Securities purchased under
agreements to resell 1

    $167,344         $187,789   

Securities borrowed 2

    167,516         153,341   

Securities sold under
agreements to repurchase 1

    160,442         164,502   

Securities loaned 2

    9,448         7,182   

 

1.

Resale and repurchase agreements are carried at fair value under the fair value option. See Note 8 for further information about the valuation techniques and significant inputs used to determine fair value.

 

2.

As of June 2012 and December 2011, $51.90 billion and $47.62 billion of securities borrowed and $24 million and $107 million of securities loaned were at fair value, respectively.

Resale and Repurchase Agreements

A resale agreement is a transaction in which the firm purchases financial instruments from a seller, typically in exchange for cash, and simultaneously enters into an agreement to resell the same or substantially the same financial instruments to the seller at a stated price plus accrued interest at a future date.

A repurchase agreement is a transaction in which the firm sells financial instruments to a buyer, typically in exchange for cash, and simultaneously enters into an agreement to repurchase the same or substantially the same financial instruments from the buyer at a stated price plus accrued interest at a future date.

The financial instruments purchased or sold in resale and repurchase agreements typically include U.S. government and federal agency, and investment-grade sovereign obligations.

The firm receives financial instruments purchased under resale agreements, makes delivery of financial instruments sold under repurchase agreements, monitors the market value of these financial instruments on a daily basis, and delivers or obtains additional collateral due to changes in the market value of the financial instruments, as appropriate. For resale agreements, the firm typically requires delivery of collateral with a fair value approximately equal to the carrying value of the relevant assets in the condensed consolidated statements of financial condition.

Even though repurchase and resale agreements involve the legal transfer of ownership of financial instruments, they are accounted for as financing arrangements because they require the financial instruments to be repurchased or resold at the maturity of the agreement. However, “repos to maturity” are accounted for as sales. A repo to maturity is a transaction in which the firm transfers a security under an agreement to repurchase the security where the maturity date of the repurchase agreement matches the maturity date of the underlying security. Therefore, the firm effectively no longer has a repurchase obligation and has relinquished control over the underlying security and, accordingly, accounts for the transaction as a sale. The firm had no repos to maturity outstanding as of June 2012 or December 2011.

 

 

50   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Securities Borrowed and Loaned Transactions

In a securities borrowed transaction, the firm borrows securities from a counterparty in exchange for cash. When the firm returns the securities, the counterparty returns the cash. Interest is generally paid periodically over the life of the transaction.

In a securities loaned transaction, the firm lends securities to a counterparty typically in exchange for cash or securities, or a letter of credit. When the counterparty returns the securities, the firm returns the cash or securities posted as collateral. Interest is generally paid periodically over the life of the transaction.

The firm receives securities borrowed, makes delivery of securities loaned, monitors the market value of these securities on a daily basis, and delivers or obtains additional collateral due to changes in the market value of the securities, as appropriate. For securities borrowed transactions, the firm typically requires delivery of collateral with a fair value approximately equal to the carrying value of the securities borrowed transaction.

Securities borrowed and loaned within Fixed Income, Currency and Commodities Client Execution are recorded at fair value under the fair value option.

Securities borrowed and loaned within Securities Services are recorded based on the amount of cash collateral advanced or received plus accrued interest. As these arrangements generally can be terminated on demand, they exhibit little, if any, sensitivity to changes in interest rates. Therefore, the carrying value of such arrangements approximates fair value. While these arrangements are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these arrangements been included in the firm’s fair value hierarchy, they would have been classified in level 2 as of June 2012.

As of June 2012 and December 2011, the firm had $14.13 billion and $20.22 billion, respectively, of securities received under resale agreements and securities borrowed transactions that were segregated to satisfy certain regulatory requirements. These securities are included in “Cash and securities segregated for regulatory and other purposes.”

Other Secured Financings

In addition to repurchase agreements and securities lending transactions, the firm funds certain assets through the use of other secured financings and pledges financial instruments and other assets as collateral in these transactions. These other secured financings consist of:

 

Ÿ  

liabilities of consolidated VIEs;

 

Ÿ  

transfers of assets accounted for as financings rather than sales (primarily collateralized central bank financings, pledged commodities, bank loans and mortgage whole loans); and

 

Ÿ  

other structured financing arrangements.

Other secured financings include arrangements that are nonrecourse. As of June 2012 and December 2011, nonrecourse other secured financings were $2.29 billion and $3.14 billion, respectively.

The firm has elected to apply the fair value option to the following other secured financings because the use of fair value eliminates non-economic volatility in earnings that would arise from using different measurement attributes:

 

Ÿ  

transfers of assets accounted for as financings rather than sales; and

 

Ÿ  

certain other nonrecourse financings.

See Note 8 for further information about other secured financings that are accounted for at fair value. Other secured financings that are not recorded at fair value are generally short-term and recorded based on the amount of cash received plus accrued interest, which generally approximates fair value. While these financings are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these financings been included in the firm’s fair value hierarchy, they would have primarily been classified in level 2 as of June 2012.

 

 

  Goldman Sachs June 2012 Form 10-Q   51


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents information about other secured financings. In the table below:

 

Ÿ  

short-term secured financings include financings maturing within one year of the financial statement date and financings that are redeemable within one year of the financial statement date at the option of the holder;

Ÿ  

long-term secured financings that are repayable prior to maturity at the option of the firm are reflected at their contractual maturity dates; and

 

Ÿ  

long-term secured financings that are redeemable prior to maturity at the option of the holders are reflected at the dates such options become exercisable.

 

 

 

    As of June 2012          As of December 2011  
$ in millions   U.S.
Dollar
    Non-U.S.
Dollar
    Total           U.S.
Dollar
    Non-U.S.
Dollar
    Total  

Other secured financings (short-term):
At fair value

    $11,884        $5,400        $17,284             $18,519        $  5,140        $23,659   

At amortized cost

    108        2,053        2,161             155        5,371        5,526   

Interest rates 1

    3.66     0.13                  3.85     0.22        

Other secured financings (long-term):
At fair value

    6,194        1,561        7,755             4,305        2,055        6,360   

At amortized cost

    859        731        1,590             1,024        795        1,819   

Interest rates 1

    2.65     2.95                  1.88     3.28        

Total 2

    $19,045        $9,745        $28,790             $24,003        $13,361        $37,364   

Amount of other secured financings collateralized by:
Financial instruments 3

    $18,733        $9,335        $28,068             $23,703        $12,169        $35,872   

Other assets 4

    312        410        722             300        1,192        1,492   

 

1.

The weighted average interest rates exclude secured financings at fair value and include the effect of hedging activities. See Note 7 for further information about hedging activities.

 

2.

Includes $6.55 billion and $9.36 billion related to transfers of financial assets accounted for as financings rather than sales as of June 2012 and December 2011, respectively. Such financings were collateralized by financial assets included in “Financial instruments owned, at fair value” of $6.80 billion and $9.51 billion as of June 2012 and December 2011, respectively.

 

3.

Includes $14.35 billion and $14.82 billion of other secured financings collateralized by financial instruments owned, at fair value as of June 2012 and December 2011, respectively, and includes $13.72 billion and $21.06 billion of other secured financings collateralized by financial instruments received as collateral and repledged as of June 2012 and December 2011, respectively.

 

4.

Primarily real estate and cash.

 

The table below presents other secured financings by maturity.

 

in millions    

 

As of

June 2012

  

  

Other secured financings (short-term)

    $19,445   

Other secured financings (long-term):

2013

    1,875   

2014

    3,932   

2015

    1,179   

2016

    513   

2017

    208   

2018-thereafter

    1,638   

Total other secured financings (long-term)

    9,345   

Total other secured financings

    $28,790   

The aggregate contractual principal amount of other secured financings (long-term) for which the fair value option was elected exceeded the related fair value by $214 million and $239 million, as of June 2012 and December 2011, respectively.

 

 

52   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Collateral Received and Pledged

The firm receives financial instruments (e.g., U.S. government and federal agency, other sovereign and corporate obligations, as well as equities and convertible debentures) as collateral, primarily in connection with resale agreements, securities borrowed, derivative transactions and customer margin loans.

In many cases, the firm is permitted to deliver or repledge these financial instruments when entering into repurchase agreements and securities lending agreements, primarily in connection with secured client financing activities. The firm is also permitted to deliver or repledge these financial instruments in connection with other secured financings, collateralizing derivative transactions and meeting firm or customer settlement requirements.

The table below presents financial instruments at fair value received as collateral that were available to be delivered or repledged and were delivered or repledged by the firm.

 

   

As of

in millions  

June

2012

  

December

2011

Collateral available to be delivered
or repledged

  $596,775    $622,926

Collateral that was delivered or repledged

  432,141    454,604

The firm also pledges certain financial instruments owned, at fair value in connection with repurchase agreements, securities lending agreements and other secured financings, and other assets (primarily real estate and cash) in connection with other secured financings to counterparties who may or may not have the right to deliver or repledge them. The table below presents information about assets pledged by the firm.

 

   

As of

in millions  

June

2012

  

December

2011

Financial instruments owned, at fair value pledged to counterparties that:

    

Had the right to deliver or repledge

  $  67,004    $  53,989

Did not have the right to deliver or repledge

  110,434    110,949

Other assets pledged to counterparties that:

    

Did not have the right to deliver or repledge

  2,719    3,444
Note 10. Securitization Activities

Note 10.

Securitization Activities

The firm securitizes residential and commercial mortgages, corporate bonds, loans and other types of financial assets by selling these assets to securitization vehicles (e.g., trusts, corporate entities and limited liability companies) and acts as underwriter of the beneficial interests that are sold to investors. The firm’s residential mortgage securitizations are substantially all in connection with government agency securitizations.

Beneficial interests issued by securitization entities are debt or equity securities that give the investors rights to receive all or portions of specified cash inflows to a securitization vehicle and include senior and subordinated shares of principal, interest and/or other cash inflows. The proceeds from the sale of beneficial interests are used to pay the transferor for the financial assets sold to the securitization vehicle or to purchase securities which serve as collateral.

The firm accounts for a securitization as a sale when it has relinquished control over the transferred assets. Prior to securitization, the firm accounts for assets pending transfer at fair value and therefore does not typically recognize significant gains or losses upon the transfer of assets. Net revenues from underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.

For transfers of assets that are not accounted for as sales, the assets remain in “Financial instruments owned, at fair value” and the transfer is accounted for as a collateralized financing, with the related interest expense recognized over the life of the transaction. See Notes 9 and 23 for further information about collateralized financings and interest expense, respectively.

The firm generally receives cash in exchange for the transferred assets but may also have continuing involvement with transferred assets, including ownership of beneficial interests in securitized financial assets, primarily in the form of senior or subordinated securities. The firm may also purchase senior or subordinated securities issued by securitization vehicles (which are typically VIEs) in connection with secondary market-making activities.

 

 

  Goldman Sachs June 2012 Form 10-Q   53


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The primary risks included in beneficial interests and other interests from the firm’s continuing involvement with securitization vehicles are the performance of the underlying collateral, the position of the firm’s investment in the capital structure of the securitization vehicle and the market yield for the security. These interests are accounted for at fair value and are included in “Financial instruments owned, at fair value” and are generally classified in level 2 of the fair value hierarchy. See Notes 5 through 8 for further information about fair value measurements.

The table below presents the amount of financial assets securitized and the cash flows received on retained interests in securitization entities in which the firm had continuing involvement.

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions   2012     2011          2012     2011  

Residential mortgages

    $8,278        $14,602            $19,267        $22,305   

Commercial mortgages

    1,623                   1,623        325   

Other financial assets

           49                   81   

Total

    $9,901        $14,651            $20,890        $22,711   

Cash flows on retained interests

    $   144        $     148            $     226        $     367   

The table below presents the firm’s continuing involvement in nonconsolidated securitization entities to which the firm sold assets, as well as the total outstanding principal amount of transferred assets in which the firm has continuing involvement. In this table:

 

Ÿ  

the outstanding principal amount is presented for the purpose of providing information about the size of the securitization entities in which the firm has continuing involvement and is not representative of the firm’s risk of loss;

 

Ÿ  

for retained or purchased interests, the firm’s risk of loss is limited to the fair value of these interests; and

 

Ÿ  

purchased interests represent senior and subordinated interests, purchased in connection with secondary market-making activities, in securitization entities in which the firm also holds retained interests.

 

 

    As of June 2012          As of December 2011
in millions   Outstanding
Principal
Amount
     Fair Value of
Retained
Interests
    

Fair Value of

Purchased
Interests

          Outstanding
Principal
Amount
     Fair Value of
Retained
Interests
    

Fair Value of

Purchased
Interests

U.S. government agency-issued collateralized mortgage obligations 1

    $63,892         $3,749         $   —             $70,448         $5,038       $   —

Other residential mortgage-backed 2

    4,057         101                     4,459         101       3

Commercial mortgage-backed 3

    3,743         36         46             3,398         606       331

CDOs, CLOs and other 4

    8,808         32         241             9,972         32       211

Total 5

    $80,500         $3,918         $287             $88,277         $5,777       $545

 

1.

Outstanding principal amount and fair value of retained interests primarily relate to securitizations during 2012 and 2011 as of June 2012, and securitizations during 2011 and 2010 as of December 2011.

 

2.

Outstanding principal amount and fair value of retained interests as of both June 2012 and December 2011 primarily relate to prime and Alt-A securitizations during 2007 and 2006.

 

3.

As of June 2012, the outstanding principal amount and the fair value of retained interests primarily relate to securitizations during 2012 and 2006. As of December 2011, the outstanding principal amount primarily relates to securitizations during 2010, 2007 and 2006 and the fair value of retained interests primarily relates to securitizations during 2010.

 

4.

Outstanding principal amount and fair value of retained interests as of both June 2012 and December 2011 primarily relate to CDO and CLO securitizations during 2007 and 2006.

 

5.

Outstanding principal amount includes $814 million and $774 million as of June 2012 and December 2011, respectively, related to securitization entities in which the firm’s only continuing involvement is retained servicing which is not a variable interest.

 

54   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In addition to the interests in the table above, the firm had other continuing involvement in the form of derivative transactions and guarantees with certain nonconsolidated VIEs. The carrying value of these derivatives and guarantees was a net asset of $29 million and a net liability of $52 million as of June 2012 and December 2011, respectively. The notional amounts of these derivatives and guarantees are included in maximum exposure to loss in the nonconsolidated VIE tables in Note 11.

The table below presents the weighted average key economic assumptions used in measuring the fair value of retained interests and the sensitivity of this fair value to immediate adverse changes of 10% and 20% in those assumptions.

 

 

    As of June 2012             As of December 2011  
  Type of Retained Interests          Type of Retained Interests  
$ in millions   Mortgage-Backed        Other 1          Mortgage-Backed      Other 1  

Fair value of retained interests

    $3,886           $    32               $5,745         $    32   

Weighted average life (years)

    8.2           2.5               7.1         4.7   

Constant prepayment rate 2

    14.4        N.M.               14.1      N.M.   

Impact of 10% adverse change 2

    $    (55        N.M.               $    (55      N.M.   

Impact of 20% adverse change 2

    (96        N.M.               (108      N.M.   

Discount rate 3

    5.8        N.M.               5.4      N.M.   

Impact of 10% adverse change

    $  (105        N.M.               $  (125      N.M.   

Impact of 20% adverse change

    (186        N.M.               (240      N.M.   

 

1.

Due to the nature and current fair value of certain of these retained interests, the weighted average assumptions for constant prepayment and discount rates and the related sensitivity to adverse changes are not meaningful as of June 2012 and December 2011. The firm’s maximum exposure to adverse changes in the value of these interests is the carrying value of $32 million as of both June 2012 and December 2011.

 

2.

Constant prepayment rate is included only for positions for which constant prepayment rate is a key assumption in the determination of fair value.

 

3.

The majority of mortgage-backed retained interests are U.S. government agency-issued collateralized mortgage obligations, for which there is no anticipated credit loss. For the remainder of retained interests, the expected credit loss assumptions are reflected in the discount rate.

 

The preceding table does not give effect to the offsetting benefit of other financial instruments that are held to mitigate risks inherent in these retained interests. Changes in fair value based on an adverse variation in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value is

not usually linear. In addition, the impact of a change in a particular assumption in the preceding table is calculated independently of changes in any other assumption. In practice, simultaneous changes in assumptions might magnify or counteract the sensitivities disclosed above.

 

 

  Goldman Sachs June 2012 Form 10-Q   55


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 11. Variable Interest Entities

Note 11.

Variable Interest Entities

 

VIEs generally finance the purchase of assets by issuing debt and equity securities that are either collateralized by or indexed to the assets held by the VIE. The debt and equity securities issued by a VIE may include tranches of varying levels of subordination. The firm’s involvement with VIEs includes securitization of financial assets, as described in Note 10, and investments in and loans to other types of VIEs, as described below. See Note 10 for additional information about securitization activities, including the definition of beneficial interests. See Note 3 for the firm’s consolidation policies, including the definition of a VIE.

The firm is principally involved with VIEs through the following business activities:

Mortgage-Backed VIEs and Corporate CDO and CLO VIEs. The firm sells residential and commercial mortgage loans and securities to mortgage-backed VIEs and corporate bonds and loans to corporate CDO and CLO VIEs and may retain beneficial interests in the assets sold to these VIEs. The firm purchases and sells beneficial interests issued by mortgage-backed and corporate CDO and CLO VIEs in connection with market-making activities. In addition, the firm may enter into derivatives with certain of these VIEs, primarily interest rate swaps, which are typically not variable interests. The firm generally enters into derivatives with other counterparties to mitigate its risk from derivatives with these VIEs.

Certain mortgage-backed and corporate CDO and CLO VIEs, usually referred to as synthetic CDOs or credit-linked note VIEs, synthetically create the exposure for the beneficial interests they issue by entering into credit derivatives, rather than purchasing the underlying assets. These credit derivatives may reference a single asset, an index, or a portfolio/basket of assets or indices. See Note 7 for further information about credit derivatives. These VIEs use the funds from the sale of beneficial interests and the premiums received from credit derivative counterparties to purchase securities which serve to collateralize the beneficial interest holders and/or the credit derivative counterparty. These VIEs may enter into other derivatives, primarily interest rate swaps, which are typically not variable interests. The firm may be a counterparty to derivatives with these VIEs and generally enters into derivatives with other counterparties to mitigate its risk.

Real Estate, Credit-Related and Other Investing VIEs. The firm purchases equity and debt securities issued by and makes loans to VIEs that hold real estate, performing and nonperforming debt, distressed loans and equity securities.

Other Asset-Backed VIEs. The firm structures VIEs that issue notes to clients and purchases and sells beneficial interests issued by other asset-backed VIEs in connection with market-making activities. In addition, the firm may enter into derivatives with certain other asset-backed VIEs, primarily total return swaps on the collateral assets held by these VIEs under which the firm pays the VIE the return due to the note holders and receives the return on the collateral assets owned by the VIE. The firm generally can be removed as the total return swap counterparty. The firm generally enters into derivatives with other counterparties to mitigate its risk from derivatives with these VIEs. The firm typically does not sell assets to the other asset-backed VIEs it structures.

Power-Related VIEs. The firm purchases debt and equity securities issued by and may provide guarantees to VIEs that hold power-related assets. The firm typically does not sell assets to or enter into derivatives with these VIEs.

Investment Funds. The firm purchases equity securities issued by and may provide guarantees to certain of the investment funds it manages. The firm typically does not sell assets to or enter into derivatives with these VIEs.

Principal-Protected Note VIEs. The firm structures VIEs that issue principal-protected notes to clients. These VIEs own portfolios of assets, principally with exposure to hedge funds. Substantially all of the principal protection on the notes issued by these VIEs is provided by the asset portfolio rebalancing that is required under the terms of the notes. The firm enters into total return swaps with these VIEs under which the firm pays the VIE the return due to the principal-protected note holders and receives the return on the assets owned by the VIE. The firm may enter into derivatives with other counterparties to mitigate the risk it has from the derivatives it enters into with these VIEs. The firm also obtains funding through these VIEs.

 

 

56   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

VIE Consolidation Analysis

A variable interest in a VIE is an investment (e.g., debt or equity securities) or other interest (e.g., derivatives or loans and lending commitments) in a VIE that will absorb portions of the VIE’s expected losses and/or receive portions of the VIE’s expected residual returns.

The firm’s variable interests in VIEs include senior and subordinated debt in residential and commercial mortgage-backed and other asset-backed securitization entities, CDOs and CLOs; loans and lending commitments; limited and general partnership interests; preferred and common equity; derivatives that may include foreign currency, equity and/or credit risk; guarantees; and certain of the fees the firm receives from investment funds. Certain interest rate, foreign currency and credit derivatives the firm enters into with VIEs are not variable interests because they create rather than absorb risk.

The enterprise with a controlling financial interest in a VIE is known as the primary beneficiary and consolidates the VIE. The firm determines whether it is the primary beneficiary of a VIE by performing an analysis that principally considers:

 

Ÿ  

which variable interest holder has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance;

 

Ÿ  

which variable interest holder has the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE;

 

Ÿ  

the VIE’s purpose and design, including the risks the VIE was designed to create and pass through to its variable interest holders;

 

Ÿ  

the VIE’s capital structure;

 

Ÿ  

the terms between the VIE and its variable interest holders and other parties involved with the VIE; and

 

Ÿ  

related-party relationships.

The firm reassesses its initial evaluation of whether an entity is a VIE when certain reconsideration events occur. The firm reassesses its determination of whether it is the primary beneficiary of a VIE on an ongoing basis based on current facts and circumstances.

Nonconsolidated VIEs

The firm’s exposure to the obligations of VIEs is generally limited to its interests in these entities. In certain instances, the firm provides guarantees, including derivative guarantees, to VIEs or holders of variable interests in VIEs.

The tables below present information about nonconsolidated VIEs in which the firm holds variable interests. Nonconsolidated VIEs are aggregated based on principal business activity. The nature of the firm’s variable interests can take different forms, as described in the rows under maximum exposure to loss. In the tables below:

 

Ÿ  

The maximum exposure to loss excludes the benefit of offsetting financial instruments that are held to mitigate the risks associated with these variable interests.

 

Ÿ  

For retained and purchased interests and loans and investments, the maximum exposure to loss is the carrying value of these interests.

 

Ÿ  

For commitments and guarantees, and derivatives, the maximum exposure to loss is the notional amount, which does not represent anticipated losses and also has not been reduced by unrealized losses already recorded. As a result, the maximum exposure to loss exceeds liabilities recorded for commitments and guarantees, and derivatives provided to VIEs.

The carrying values of the firm’s variable interests in nonconsolidated VIEs are included in the consolidated statement of financial condition as follows:

 

Ÿ  

Substantially all assets held by the firm related to mortgage-backed, corporate CDO and CLO and other asset-backed VIEs and investment funds are included in “Financial instruments owned, at fair value.” Substantially all liabilities held by the firm related to corporate CDO and CLO and other asset-backed VIEs are included in “Financial instruments sold, but not yet purchased, at fair value.”

 

 

  Goldman Sachs June 2012 Form 10-Q   57


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Ÿ  

Assets and liabilities held by the firm related to real estate, credit-related and other investing VIEs are primarily included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” and “Other liabilities and accrued expenses,” respectively.

Ÿ  

Assets and liabilities held by the firm related to power-related VIEs are primarily included in “Other assets” and “Other liabilities and accrued expenses,” respectively.

 

 

    Nonconsolidated VIEs
    As of June 2012
in millions   Mortgage-
backed
    Corporate
CDOs and
CLOs
   Real estate,
credit-
related and
other
investing
   Other
asset-
backed
   Power-
related
   Investment
funds
   Total

Assets in VIE

    $92,926  2    $19,107    $9,103    $3,588    $534    $2,466    $127,724

Carrying Value of the Firm’s Variable Interests

                  

Assets

    5,484      920    1,514    258    298    5    8,479

Liabilities

         30    6    17          53

Maximum Exposure to Loss in Nonconsolidated VIEs

                  

Retained interests

    3,886      32                3,918

Purchased interests

    1,477      398       238          2,113

Commitments and guarantees 1

         1    380       4       385

Derivatives 1

    2,072      6,761       1,100          9,933

Loans and investments

    120         1,514       298    5    1,937

Total

    $  7,555  2    $  7,192    $1,894    $1,338    $302    $       5    $  18,286
    Nonconsolidated VIEs
    As of December 2011
in millions   Mortgage-
backed
    Corporate
CDOs and
CLOs
   Real estate,
credit-
related and
other
investing
   Other
asset-
backed
  

Power-

related

   Investment
funds
   Total

Assets in VIE

    $94,047  2    $20,340    $8,974    $4,593    $519    $2,208    $130,681

Carrying Value of the Firm’s Variable Interests

                  

Assets

    7,004      911    1,495    352    289    5    10,056

Liabilities

         63    3    24    2       92

Maximum Exposure to Loss in Nonconsolidated VIEs

                  

Retained interests

    5,745      32                5,777

Purchased interests

    962      368       333          1,663

Commitments and guarantees 1

         1    373       46       420

Derivatives 1

    2,469      7,529       1,221          11,219

Loans and investments

    82         1,495       288    5    1,870

Total

    $  9,258  2    $  7,930    $1,868    $1,554    $334    $       5    $  20,949

 

1.

The aggregate amounts include $3.67 billion and $4.17 billion as of June 2012 and December 2011, respectively, related to guarantees and derivative transactions with VIEs to which the firm transferred assets.

 

2.

Assets in VIE and maximum exposure to loss include $7.95 billion and $2.58 billion, respectively, as of June 2012, and $6.15 billion and $2.62 billion, respectively, as of December 2011, related to CDOs backed by mortgage obligations.

 

58   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Consolidated VIEs

The tables below present the carrying amount and classification of assets and liabilities in consolidated VIEs, excluding the benefit of offsetting financial instruments that are held to mitigate the risks associated with the firm’s variable interests. Consolidated VIEs are aggregated based on principal business activity and their assets and liabilities are presented net of intercompany eliminations. The majority of the assets in principal-protected notes VIEs are intercompany and are eliminated in consolidation.

Substantially all the assets in consolidated VIEs can only be used to settle obligations of the VIE.

The tables below exclude VIEs in which the firm holds a majority voting interest if (i) the VIE meets the definition of a business and (ii) the VIE’s assets can be used for purposes other than the settlement of its obligations.

The liabilities of real estate, credit-related and other investing VIEs and CDOs, mortgage-backed and other asset-backed VIEs do not have recourse to the general credit of the firm.

 

 

    Consolidated VIEs
    As of June 2012
in millions   Real estate,
credit-related
and other
investing
  

CDOs,

mortgage-backed
and other
asset-backed

  

Principal-
protected

notes

   Total

Assets

          

Cash and cash equivalents

  $   201    $     40    $     —    $   241

Cash and securities segregated for regulatory and other purposes

  102       55    157

Receivables from brokers, dealers and clearing organizations

  3          3

Receivables from customers and counterparties

     13       13

Financial instruments owned, at fair value

  2,156    616    161    2,933

Other assets

  1,279    406       1,685

Total

  $3,741    $1,075    $216    $5,032

Liabilities

          

Other secured financings

  $   716    $   612    $   196    $1,524

Financial instruments sold, but not yet purchased, at fair value

        3    3

Unsecured short-term borrowings, including the current portion of unsecured
long-term borrowings

        2,235    2,235

Unsecured long-term borrowings

  4       262    266

Other liabilities and accrued expenses

  1,772    40       1,812

Total

  $2,492    $   652    $2,696    $5,840

 

  Goldman Sachs June 2012 Form 10-Q   59


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

    Consolidated VIEs
    As of December 2011
in millions   Real estate,
credit-related
and other
investing
  

CDOs,

mortgage-backed
and other
asset-backed

  

Principal-
protected

notes

   Total

Assets

          

Cash and cash equivalents

  $   660    $  51    $       1    $   712

Cash and securities segregated for regulatory and other purposes

  139          139

Receivables from brokers, dealers and clearing organizations

  4          4

Receivables from customers and counterparties

     16       16

Financial instruments owned, at fair value

  2,369    352    112    2,833

Other assets

  1,552    437       1,989

Total

  $4,724    $856    $   113    $5,693

Liabilities

          

Other secured financings

  $1,418    $298    $3,208    $4,924

Payables to customers and counterparties

     9       9

Financial instruments sold, but not yet purchased, at fair value

        2    2

Unsecured short-term borrowings, including the current portion of
unsecured long-term borrowings

  185       1,941    2,126

Unsecured long-term borrowings

  4       269    273

Other liabilities and accrued expenses

  2,046    40       2,086

Total

  $3,653    $347    $5,420    $9,420

 

60   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 12. Other Assets

Note 12.

Other Assets

 

Other assets are generally less liquid, non-financial assets. The table below presents other assets by type.

 

    As of
in millions  

June

2012

  

December

2011

Property, leasehold improvements and equipment 1

  $  8,616    $  8,697

Goodwill and identifiable intangible assets 2

  5,400    5,468

Income tax-related assets 3

  5,757    5,017

Equity-method investments 4

  672    664

Miscellaneous receivables and other

  3,719    3,306

Total

  $24,164    $23,152

 

1.

Net of accumulated depreciation and amortization of $8.82 billion and $8.46 billion as of June 2012 and December 2011, respectively.

 

2.

See Note 13 for further information about goodwill and identifiable intangible assets.

 

3.

See Note 24 for further information about income taxes.

 

4.

Excludes investments accounted for at fair value under the fair value option where the firm would otherwise apply the equity method of accounting of $4.60 billion and $4.17 billion as of June 2012 and December 2011, respectively, which are included in “Financial instruments owned, at fair value.” The firm has generally elected the fair value option for such investments acquired after the fair value option became available.

Property, Leasehold Improvements and Equipment

Property, leasehold improvements and equipment included $6.24 billion and $6.48 billion as of June 2012 and December 2011, respectively, related to property, leasehold improvements and equipment that the firm uses in connection with its operations. The remainder is held by investment entities, including VIEs, consolidated by the firm.

Substantially all property and equipment are depreciated on a straight-line basis over the useful life of the asset. Leasehold improvements are amortized on a straight-line basis over the useful life of the improvement or the term of the lease, whichever is shorter. Certain costs of software developed or obtained for internal use are capitalized and amortized on a straight-line basis over the useful life of the software.

Property, leasehold improvements and equipment are tested for impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable. The firm’s policy for impairment testing of property, leasehold improvements and equipment is the same as is used for identifiable intangible assets with finite lives. See Note 13 for further information.

Impairments

As a result of a decline in the market conditions in which certain of the firm’s consolidated investments operate, during the first half of 2012 the firm tested certain commodity-related intangible assets, property, leasehold improvements and equipment, and other assets for impairment in accordance with ASC 360. The carrying value of these assets exceeded the projected undiscounted cash flows over the estimated remaining useful lives of these assets; as such, the firm determined the assets were impaired and recorded an impairment loss of $159 million ($133 million related to property, leasehold improvements and equipment, $20 million related to commodity-related intangible assets and $6 million related to other assets), substantially all of which was included in “Depreciation and amortization.” These impairment losses were included in the firm’s Investing & Lending segment and represented the excess of the carrying values of these assets over their estimated fair values, substantially all of which are level 3 measurements, using a combination of discounted cash flow analyses and relative value analyses, including the estimated cash flows expected to be received from the disposition of certain of these assets.

In the first quarter of 2011, the firm classified certain assets as held for sale, primarily related to Litton Loan Servicing LP (Litton) and recognized impairment losses of approximately $220 million, principally in the firm’s Institutional Client Services segment. These impairment losses, which were included in “Depreciation and amortization,” represent the excess of (i) the carrying value of these assets over (ii) their estimated fair value less estimated cost to sell. These assets were sold in the third quarter of 2011. The firm received total consideration that approximated the firm’s adjusted carrying value for Litton. See Note 18 for further information about the sale of Litton.

 

 

  Goldman Sachs June 2012 Form 10-Q   61


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 13. Goodwill and Identifiable Intangible Assets

Note 13.

Goodwill and Identifiable Intangible Assets

 

The tables below present the carrying values of goodwill and identifiable intangible assets, which are included in “Other assets.”

 

   

Goodwill

   

As of

in millions  

June

2012

 

December

2011

Investment Banking:

   

Financial Advisory

  $     98   $   104

Underwriting

  183   186

Institutional Client Services:

   

Fixed Income, Currency and Commodities Client Execution

  268   284

Equities Client Execution

  2,388   2,390

Securities Services

  104   117

Investing & Lending

  147   147

Investment Management

  591   574

Total

  $3,779   $3,802
   

Identifiable Intangible Assets

   

As of

in millions  

        June

2012

 

December

2011

Investment Banking:

   

Financial Advisory

  $       1   $       4

Underwriting

    1

Institutional Client Services:

   

Fixed Income, Currency and Commodities Client Execution

  465   488

Equities Client Execution

  687   677

Investing & Lending

  331   369

Investment Management

  137   127

Total

  $1,621   $1,666

 

Goodwill

Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date.

Goodwill is assessed annually for impairment or more frequently if events occur or circumstances change that indicate an impairment may exist. Qualitative factors are assessed to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If results of the qualitative assessment are not conclusive, a quantitative goodwill impairment test is performed.

The quantitative goodwill impairment test consists of two steps.

 

Ÿ  

The first step compares the estimated fair value of each reporting unit with its estimated net book value (including goodwill and identified intangible assets). If the reporting unit’s fair value exceeds its estimated net book value, goodwill is not impaired.

 

Ÿ  

If the estimated fair value of a reporting unit is less than its estimated net book value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. An impairment loss is equal to the excess of the carrying amount of goodwill over its fair value.

Goodwill was tested for impairment, using a quantitative test, during the fourth quarter of 2011 and goodwill was not impaired.

To estimate the fair value of each reporting unit, both relative value and residual income valuation techniques are used because the firm believes market participants would use these techniques to value the firm’s reporting units.

Relative value techniques apply average observable price-to-earnings multiples of comparable competitors to certain reporting units’ net earnings. For other reporting units, fair value is estimated using price-to-book multiples based on residual income techniques, which consider a reporting unit’s return on equity in excess of the firm’s cost of equity capital. The net book value of each reporting unit reflects the estimated amount of shareholders’ equity required to support the activities of the reporting unit.

 

 

62   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Identifiable Intangible Assets

The table below presents the gross carrying amount, accumulated amortization and net carrying amount of

identifiable intangible assets and their weighted average remaining lives.

 

 

         As of  
$ in millions        

June

2012

    

Weighted Average
Remaining Lives

(years)

  

December

2011

 

 

Customer lists

  

 

Gross carrying amount

 

 

 

 

$ 1,143

 

  

       

 

 

 

$ 1,119

 

  

     Accumulated amortization     (632           (593
     Net carrying amount     511       9      526   

 

 

Commodities-related intangibles 1

  

 

Gross carrying amount

 

 

 

 

509

 

  

       

 

 

 

595

 

  

     Accumulated amortization     (184           (237
     Net carrying amount     325       10      358   

 

 

Broadcast royalties 2

  

 

Gross carrying amount

 

 

 

 

560

 

  

       

 

 

 

560

 

  

     Accumulated amortization     (154           (123
     Net carrying amount     406       7      437   

 

 

Insurance-related intangibles 3

  

 

Gross carrying amount

 

 

 

 

301

 

  

       

 

 

 

292

 

  

     Accumulated amortization     (161           (146
     Net carrying amount     140       6      146   

 

 

Other 4

  

 

Gross carrying amount

 

 

 

 

1,007

 

  

       

 

 

 

950

 

  

     Accumulated amortization     (768           (751
     Net carrying amount     239       11      199   

 

 

Total

  

 

Gross carrying amount

 

 

 

 

3,520

 

  

       

 

 

 

3,516

 

  

     Accumulated amortization     (1,899           (1,850
     Net carrying amount     $ 1,621       8      $ 1,666   

 

1.

Primarily includes commodity-related customer contracts and relationships, permits and access rights.

 

2.

Represents television broadcast royalties held by a consolidated VIE.

 

3.

Represents value of business acquired related to the firm’s insurance businesses.

 

4.

Primarily includes the firm’s New York Stock Exchange (NYSE) Designated Market Maker (DMM) rights and exchange-traded fund lead market maker rights.

 

Substantially all of the firm’s identifiable intangible assets are considered to have finite lives and are amortized (i) over their estimated lives, (ii) based on economic usage for certain commodity-related intangibles or (iii) in proportion

to estimated gross profits or premium revenues. Amortization expense for identifiable intangible assets is included in “Depreciation and amortization.”

 

 

  Goldman Sachs June 2012 Form 10-Q   63


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The tables below present amortization expense for identifiable intangible assets for the three and six months ended June 2012 and June 2011, and the estimated future amortization expense through 2017 for identifiable intangible assets as of June 2012.

 

   

Three Months

Ended June

  

Six Months

Ended June

in millions   2012    2011    2012    2011

Amortization expense

  $76    $66    $146    $123

 

in millions   

As of

June 2012

Estimated future amortization expense:

  

Remainder of 2012

   $146

2013

   249

2014

   214

2015

   180

2016

   177

2017

   173

Identifiable intangible assets are tested for recoverability whenever events or changes in circumstances indicate that an asset’s or asset group’s carrying value may not be recoverable.

If a recoverability test is necessary, the carrying value of an asset or asset group is compared to the total of the undiscounted cash flows expected to be received over the remaining useful life and from the disposition of the asset or asset group.

 

Ÿ  

If the total of the undiscounted cash flows exceeds the carrying value, the asset or asset group is not impaired.

 

Ÿ  

If the total of the undiscounted cash flows is less than the carrying value, the asset or asset group is not fully recoverable and an impairment loss is recognized as the difference between the carrying amount of the asset or asset group and its estimated fair value.

See Note 12 for information about impairments of the firm’s identifiable intangible assets.

Note 14. Deposits

Note 14.

Deposits

The table below presents deposits held in U.S. and non-U.S. offices. Substantially all U.S. deposits were held at Goldman Sachs Bank USA (GS Bank USA) and were interest-bearing and substantially all non-U.S. deposits were held at Goldman Sachs Bank (Europe) plc (GS Bank Europe) and Goldman Sachs International Bank (GSIB) and were interest-bearing.

 

    As of  
in millions  

June

2012

   

December

2011

 

U.S. offices

    $49,385        $38,477   

Non-U.S. offices

    7,935        7,632   

Total

    $57,320  1      $46,109  1 

The table below presents maturities of time deposits held in U.S. and non-U.S. offices.

 

    As of June 2012  
in millions   U.S.     Non-U.S.     Total  

Remainder of 2012

    $  1,329        $2,498        $  3,827   

2013

    4,489        94        4,583   

2014

    2,598               2,598   

2015

    2,187               2,187   

2016

    1,185               1,185   

2017

    1,390               1,390   

2018 - thereafter

    3,803               3,803   

Total

    $16,981  2      $2,592  3      $19,573  1 

 

1.

Includes $5.65 billion and $4.53 billion as of June 2012 and December 2011, respectively, of time deposits accounted for at fair value under the fair value option.

 

2.

Includes $80 million greater than $100,000, of which $35 million matures within three months, $5 million matures within three to six months, $29 million matures within six to twelve months, and $11 million matures after twelve months.

 

3.

Substantially all were greater than $100,000.

As of June 2012, demand deposits were $37.75 billion, which were recorded based on the amount of cash received plus accrued interest, which approximates fair value. In addition, the firm designates certain derivatives as fair value hedges on substantially all of its time deposits for which it has not elected the fair value option. Accordingly, $13.92 billion of time deposits were effectively converted from fixed-rate obligations to floating-rate obligations and were recorded at amounts that generally approximate fair value. While these demand deposits and time deposits are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these deposits been included in the firm’s fair value hierarchy, they would have been classified in level 2.

 

 

64   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 15. Short-Term Borrowings

Note 15.

Short-Term Borrowings

 

Short-term borrowings were comprised of the following:

 

   

As of

in millions  

June

2012

  

December

2011

Other secured financings (short-term)

  $19,445    $29,185

Unsecured short-term borrowings

  45,693    49,038

Total

  $65,138    $78,223

See Note 9 for further information about other secured financings.

Unsecured short-term borrowings include the portion of unsecured long-term borrowings maturing within one year of the financial statement date and unsecured long-term borrowings that are redeemable within one year of the financial statement date at the option of the holder.

The firm accounts for promissory notes, commercial paper and certain hybrid financial instruments at fair value under the fair value option. See Note 8 for further information about unsecured short-term borrowings that are accounted for at fair value. Short-term borrowings that are not recorded at fair value are recorded based on the amount of cash received plus accrued interest, and such amounts approximate fair value due to the short-term nature of the obligations. While these short-term borrowings are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these borrowings been included in the firm’s fair value hierarchy, substantially all would have been classified in level 2 as of June 2012.

The table below presents unsecured short-term borrowings.

 

    As of  
$ in millions  

June

2012

   

December

2011

 

Current portion of unsecured long-term borrowings 1

    $26,893        $28,836   

Hybrid financial instruments

    12,356        11,526   

Promissory notes

    145        1,328   

Commercial paper

    641        1,491   

Other short-term borrowings

    5,658        5,857   

Total

    $45,693        $49,038   

Weighted average interest rate 2

    1.49     1.89

 

1.

As of June 2012, no borrowings guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program (TLGP) were outstanding and the program had expired for new issuances. Includes $8.53 billion as of December 2011, guaranteed by the FDIC under the TLGP.

 

2.

The weighted average interest rates for these borrowings include the effect of hedging activities and exclude financial instruments accounted for at fair value under the fair value option. See Note 7 for further information about hedging activities.

 

 

  Goldman Sachs June 2012 Form 10-Q   65


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 16. Long-Term Borrowings

Note 16.

Long-Term Borrowings

Long-term borrowings were comprised of the following:

 

    As of  
in millions  

June

2012

      

December

2011

 

Other secured financings (long-term)

    $    9,345           $    8,179   

Unsecured long-term borrowings

    166,993           173,545   

Total

    $176,338           $181,724   

 

See Note 9 for further information about other secured financings. The table below presents unsecured long-term

borrowings extending through 2061 and consisting principally of senior borrowings.

 

 

    As of June 2012          As of December 2011  
in millions  

U.S.

Dollar

      

Non-U.S.

Dollar

       Total          

U.S.

Dollar

      

Non-U.S.

Dollar

       Total  

Fixed-rate obligations 1

    $  90,691           $34,798           $125,489             $  84,058           $38,569           $122,627   

Floating-rate obligations 2

    20,880           20,624           41,504             23,436           27,482           50,918   

Total

    $111,571           $55,422           $166,993             $107,494           $66,051           $173,545   

 

1.

Interest rates on U.S. dollar-denominated debt ranged from 0.20% to 10.04% (with a weighted average rate of 5.54%) and 0.10% to 10.04% (with a weighted average rate of 5.62%) as of June 2012 and December 2011, respectively. Interest rates on non-U.S. dollar-denominated debt ranged from 0.50% to 14.85% (with a weighted average rate of 4.72%) and 0.85% to 14.85% (with a weighted average rate of 4.75%) as of June 2012 and December 2011, respectively.

 

2.

Floating interest rates generally are based on LIBOR or the federal funds target rate. Equity-linked and indexed instruments are included in floating-rate obligations.

 

66   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents unsecured long-term borrowings by maturity date. In the table below:

 

Ÿ  

unsecured long-term borrowings maturing within one year of the financial statement date and unsecured long-term borrowings that are redeemable within one year of the financial statement date at the option of the holder are included as unsecured short-term borrowings;

 

Ÿ  

unsecured long-term borrowings that are repayable prior to maturity at the option of the firm are reflected at their contractual maturity dates; and

 

Ÿ  

unsecured long-term borrowings that are redeemable prior to maturity at the option of the holders are reflected at the dates such options become exercisable.

 

in millions   

As of

June 2012

2013

   $    8,733

2014

   20,725

2015

   19,156

2016

   21,055

2017

   18,559

2018 - thereafter

   78,765

Total 1

   $166,993

 

1.

Includes $10.76 billion related to interest rate hedges on certain unsecured long-term borrowings, by year of maturity as follows: $222 million in 2013, $714 million in 2014, $601 million in 2015, $1.20 billion in 2016, $1.35 billion in 2017 and $6.67 billion in 2018 and thereafter.

The aggregate contractual principal amount of unsecured long-term borrowings (principal and non-principal protected) for which the fair value option was elected exceeded the related fair value by $236 million and $693 million as of June 2012 and December 2011, respectively.

The firm designates certain derivatives as fair value hedges to effectively convert a substantial portion of its fixed-rate unsecured long-term borrowings which are not accounted for at fair value into floating-rate obligations. Accordingly, excluding the cumulative impact of changes in the firm’s credit spreads, the carrying value of unsecured long-term borrowings approximated fair value as of June 2012 and December 2011. While these unsecured long-term borrowings are carried at amounts that approximate fair value, they are not accounted for at fair value under the fair value option or at fair value in accordance with other U.S. GAAP and therefore are not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these borrowings been included in the firm’s fair value hierarchy, substantially all would have been classified in level 2 as of June 2012. For unsecured long-term borrowings for which the firm did not elect the fair value option, the cumulative impact due to changes in the firm’s own credit spreads would be a reduction in the carrying value of total unsecured long-term borrowings of less than 4% as of both June 2012 and December 2011. See Note 7 for further information about hedging activities.

The table below presents unsecured long-term borrowings, after giving effect to hedging activities that converted a substantial portion of fixed-rate obligations to floating-rate obligations.

 

   

As of

in millions  

June

2012

  

December

2011

Fixed-rate obligations

    

At fair value

  $       178    $         76

At amortized cost 1

  26,850    28,773

Floating-rate obligations

    

At fair value

  12,466    17,086

At amortized cost 1

  127,499    127,610

Total

  $166,993    $173,545

 

1.

The weighted average interest rates on the aggregate amounts were 2.58% (5.20% related to fixed-rate obligations and 2.07% related to floating-rate obligations) and 2.59% (5.18% related to fixed-rate obligations and 2.03% related to floating-rate obligations) as of June 2012 and December 2011, respectively. These rates exclude financial instruments accounted for at fair value under the fair value option.

 

 

  Goldman Sachs June 2012 Form 10-Q   67


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Subordinated Borrowings

Unsecured long-term borrowings include subordinated debt and junior subordinated debt. Junior subordinated debt is junior in right of payment to other subordinated borrowings, which are junior to senior borrowings. As of

June 2012 and December 2011, subordinated debt had maturities ranging from 2015 to 2038 and 2017 to 2038, respectively. The table below presents subordinated borrowings.

 

 

    As of June 2012          As of December 2011  
$ in millions  

Par

Amount

      

Carrying

Amount

       Rate 1          

Par

Amount

      

Carrying

Amount

       Rate 1  

Subordinated debt

    $14,369           $17,393           4.25          $14,310           $17,362           4.39 % 

Junior subordinated debt

    3,335           4,826           2.79          5,085           6,533           2.43

Total subordinated borrowings

    $17,704           $22,219           3.97          $19,395           $23,895           3.87

 

1.

Weighted average interest rate after giving effect to fair value hedges used to convert these fixed-rate obligations into floating-rate obligations. See Note 7 for further information about hedging activities. See below for information about interest rates on junior subordinated debt.

 

Junior Subordinated Debt

Junior Subordinated Debt Issued to APEX Trusts. In 2007, Group Inc. issued a total of $2.25 billion of remarketable junior subordinated debt to Goldman Sachs Capital II and Goldman Sachs Capital III (APEX Trusts), Delaware statutory trusts. The APEX Trusts issued $2.25 billion of guaranteed perpetual Normal Automatic Preferred Enhanced Capital Securities (APEX) to third parties and a de minimis amount of common securities to Group Inc. Group Inc. also entered into contracts with the APEX Trusts to sell $2.25 billion of Group Inc. perpetual non-cumulative preferred stock (the stock purchase contracts). See Note 19 for more information about the preferred stock that Group Inc. has issued and will issue in connection with the stock purchase contracts.

The firm accounted for the stock purchase contracts as equity instruments and, accordingly, recorded the cost of the stock purchase contracts as a reduction to additional paid-in capital.

During the first quarter of 2012, pursuant to a remarketing provided for by the initial terms of the junior subordinated debt, Goldman Sachs Capital II sold all of its $1.75 billion of junior subordinated debt to Murray Street Investment Trust I (Murray Street Trust), a new trust sponsored by the firm. On June 1, 2012, pursuant to the stock purchase contracts, Goldman Sachs Capital II used the proceeds of this sale to purchase shares of Group Inc.’s Perpetual Non-Cumulative Preferred Stock, Series E (Series E Preferred Stock).

 

In connection with the remarketing of the junior subordinated debt to the Murray Street Trust, pursuant to the terms of the junior subordinated debt, the interest rate and other terms were modified. Following such sale, the firm pays interest semi-annually on the $1.75 billion of junior subordinated debt held by the Murray Street Trust at a fixed annual rate of 4.647% and the debt matures on March 9, 2017. To fund the purchase of the junior subordinated debt, the Murray Street Trust issued $1.75 billion of senior guaranteed trust securities. The Murray Street Trust is required to pay distributions on its senior guaranteed trust securities in the same amounts and on the same dates that it is scheduled to receive interest on the junior subordinated debt it holds, and is required to redeem its senior guaranteed trust securities upon the maturity or earlier redemption of the junior subordinated debt it holds. Group Inc. fully and unconditionally guarantees the payment of these distribution and redemption amounts when due on a senior basis and, as such, the $1.75 billion of junior subordinated debt held by the Murray Street Trust for the benefit of investors is no longer classified as junior subordinated debt. If the firm were to defer payment of interest on the junior subordinated debt securities and the Murray Street Trust was therefore unable to make scheduled distributions to the holders of the senior guaranteed trust securities, under the guarantee, Group Inc. would be obligated to make those payments to the holders of the senior guaranteed trust securities.

 

 

68   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The firm paid interest quarterly on $500 million of junior subordinated debt issued to Goldman Sachs Capital III at a rate per annum equal to three-month LIBOR plus 0.57% and the debt was scheduled to mature on September 1, 2043. In addition, the firm made contract payments at a rate of 0.20% per annum on the stock purchase contracts held by Goldman Sachs Capital III.

On July 20, 2012, Goldman Sachs Capital III sold all of its $500 million principal amount of junior subordinated debt to Vesey Street Investment Trust I, a new trust sponsored by the firm (Vesey Street Trust and, together with Murray Street Trust, 2012 Trusts), in a remarketing provided for by the initial terms of the debt. In connection with this remarketing, the interest rate and other terms were modified. Following such sale, the firm pays interest semi-annually on the junior subordinated debt held by the Vesey Street Trust at a fixed annual rate of 4.404% and the debt matures on September 1, 2016. To fund the purchase of the junior subordinated debt, the Vesey Street Trust issued $500 million of senior guaranteed trust securities. The Vesey Street Trust is required to pay distributions on its senior guaranteed trust securities in the same amounts and on the same dates that it is scheduled to receive interest on the junior subordinated debt it holds, and is required to redeem its senior guaranteed trust securities upon the maturity or earlier redemption of the junior subordinated debt it holds. Group Inc. fully and unconditionally guarantees the payment of these distribution and redemption amounts when due on a senior basis. If the firm were to defer payment of interest on the junior subordinated debt securities and the Vesey Street Trust was therefore unable to make scheduled distributions to the holders of the senior guaranteed trust securities, under the guarantee Group Inc. would be obligated to make those payments to the holders of the senior guaranteed trust securities.

The firm has the right to defer payments on the junior subordinated debt, subject to limitations. During any such extension period, the firm will not be permitted to, among other things, pay dividends on or make certain repurchases of its common or preferred stock.

The APEX Trusts and the 2012 Trusts are wholly-owned finance subsidiaries of the firm for regulatory and legal purposes but are not consolidated for accounting purposes.

In connection with the APEX issuance, the firm covenanted in favor of certain of its debtholders, who were initially and are currently the holders of Group Inc.’s 6.345% Junior Subordinated Debentures due February 15, 2034, that, subject to certain exceptions, the firm would not redeem or purchase (i) Group Inc.’s junior subordinated debt originally issued to the APEX Trusts prior to the applicable stock purchase date or (ii) APEX or shares of Group Inc.’s Series E Preferred Stock or Perpetual Non-Cumulative Preferred Stock, Series F (Series F Preferred Stock) prior to the date that is ten years after the applicable stock purchase date, unless the applicable redemption or purchase price does not exceed a maximum amount determined by reference to the aggregate amount of net cash proceeds that the firm has received from the sale of qualifying equity securities during the 180-day period preceding the redemption or purchase.

Junior Subordinated Debt Issued in Connection with Trust Preferred Securities. Group Inc. issued $2.84 billion of junior subordinated debentures in 2004 to Goldman Sachs Capital I (Trust), a Delaware statutory trust. The Trust issued $2.75 billion of guaranteed preferred beneficial interests to third parties and $85 million of common beneficial interests to Group Inc. and used the proceeds from the issuances to purchase the junior subordinated debentures from Group Inc. The Trust is a wholly-owned finance subsidiary of the firm for regulatory and legal purposes but is not consolidated for accounting purposes.

The firm pays interest semi-annually on the debentures at an annual rate of 6.345% and the debentures mature on February 15, 2034. The coupon rate and the payment dates applicable to the beneficial interests are the same as the interest rate and payment dates for the debentures. The firm has the right, from time to time, to defer payment of interest on the debentures, and therefore cause payment on the Trust’s preferred beneficial interests to be deferred, in each case up to ten consecutive semi-annual periods. During any such extension period, the firm will not be permitted to, among other things, pay dividends on or make certain repurchases of its common stock. The Trust is not permitted to pay any distributions on the common beneficial interests held by Group Inc. unless all dividends payable on the preferred beneficial interests have been paid in full.

 

 

  Goldman Sachs June 2012 Form 10-Q   69


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 17. Other Liabilities and Accrued Expenses

Note 17.

Other Liabilities and Accrued Expenses

 

The table below presents other liabilities and accrued expenses by type.

 

    As of
in millions  

June

2012

  

December

2011

Compensation and benefits

  $  6,051    $  5,701

Insurance-related liabilities

  20,527    18,614

Noncontrolling interests 1

  1,223    1,450

Income tax-related liabilities 2

  2,153    533

Employee interests in consolidated funds

  281    305

Subordinated liabilities issued by
consolidated VIEs

  987    1,090

Accrued expenses and other

  4,243    4,108

Total

  $35,465    $31,801

 

1.

Includes $1.05 billion and $1.17 billion related to consolidated investment funds as of June 2012 and December 2011, respectively.

 

2.

See Note 24 for further information about income taxes.

The table below presents insurance-related liabilities by type.

 

    As of
in millions  

June

2012

  

December

2011

Separate account liabilities

  $  3,242    $  3,296

Liabilities for future benefits and unpaid claims

  16,198    14,213

Contract holder account balances

  838    835

Reserves for guaranteed minimum death and income benefits

  249    270

Total

  $20,527    $18,614

Separate account liabilities are supported by separate account assets, representing segregated contract holder funds under variable annuity and life insurance contracts. Separate account assets are included in “Cash and securities segregated for regulatory and other purposes.”

Liabilities for future benefits and unpaid claims include liabilities arising from reinsurance provided by the firm to other insurers. The firm had a receivable of $1.51 billion and $1.30 billion as of June 2012 and December 2011, respectively, related to such reinsurance contracts, which is reported in “Receivables from customers and counterparties.” In addition, the firm has ceded risks to reinsurers related to certain of its liabilities for future benefits and unpaid claims and had a receivable of $632 million and $648 million as of June 2012 and December 2011, respectively, related to such reinsurance contracts, which is reported in “Receivables from customers and counterparties.” Contracts to cede risks to reinsurers do not relieve the firm of its obligations to contract holders. Liabilities for future benefits and unpaid claims include $8.75 billion carried at fair value under the fair value option as of both June 2012 and December 2011.

Reserves for guaranteed minimum death and income benefits represent a liability for the expected value of guaranteed benefits in excess of projected annuity account balances. These reserves are based on total payments expected to be made less total fees expected to be assessed over the life of the contract.

 

 

70   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 18. Commitments, Contingencies and Guarantees

Note 18.

Commitments, Contingencies and Guarantees

Commitments

The table below presents the firm’s commitments.

 

   

Commitment Amount by Period

of Expiration as of June 2012

        

Total Commitments

as of

 
in millions  

Remainder

2012

    

2013-

2014

    

2015-

2016

    

2017-

Thereafter

         

June

2012

    

December

2011

 

Commitments to extend credit 1

Commercial lending: 2

Investment-grade

    $  3,989         $11,968         $30,920         $  8,851             $  55,728         $  51,281   

Non-investment-grade

    907         4,779         7,295         4,979             17,960         14,217   

Warehouse financing

    150         560                             710         247   

Total commitments to extend credit

    5,046         17,307         38,215         13,830             74,398         65,745   

Contingent and forward starting resale and securities borrowing agreements 3

    64,579         314                             64,893         54,522   

Forward starting repurchase and secured lending agreements 3

    8,785                                     8,785         17,964   

Underwriting commitments

    36                                     36           

Letters of credit 4

    487         282         5         5             779         1,353   

Investment commitments

    983         4,155         141         2,530             7,809         9,118   

Other

    3,817         149         64         9             4,039         5,342   

Total commitments

    $83,733         $22,207         $38,425         $16,374             $160,739         $154,044   

 

1.

Commitments to extend credit are presented net of amounts syndicated to third parties.

 

2.

Includes commitments associated with the former William Street credit extension program.

 

3.

These agreements generally settle within three business days.

 

4.

Consists of commitments under letters of credit issued by various banks which the firm provides to counterparties in lieu of securities or cash to satisfy various collateral and margin deposit requirements.

Commitments to Extend Credit

The firm’s commitments to extend credit are agreements to lend with fixed termination dates and depend on the satisfaction of all contractual conditions to borrowing. The total commitment amount does not necessarily reflect actual future cash flows because the firm may syndicate all or substantial portions of these commitments and commitments can expire unused or be reduced or cancelled at the counterparty’s request.

The firm generally accounts for commitments to extend credit at fair value. Losses, if any, are generally recorded, net of any fees in “Other principal transactions.”

Certain lending commitments, entered into during 2012, were held for investment and therefore were accounted for on an accrual basis. As of June 2012, approximately $9.35 billion of the firm’s lending commitments were held for investment. As of June 2012, the carrying value and the estimated fair value of such lending commitments were liabilities of $40 million and $266 million, respectively. As these lending commitments are not accounted for at fair

value under the fair value option or at fair value in accordance with other U.S. GAAP, their fair value is not included in the firm’s fair value hierarchy in Notes 6, 7 and 8. Had these commitments been included in the firm’s fair value hierarchy, they would have primarily been classified in level 3 as of June 2012.

Commercial Lending. The firm’s commercial lending commitments are extended to investment-grade and non-investment-grade corporate borrowers. Commitments to investment-grade corporate borrowers are principally used for operating liquidity and general corporate purposes. The firm also extends lending commitments in connection with contingent acquisition financing and other types of corporate lending as well as commercial real estate financing. Commitments that are extended for contingent acquisition financing are often intended to be short-term in nature, as borrowers often seek to replace them with other funding sources.

 

 

  Goldman Sachs June 2012 Form 10-Q   71


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Sumitomo Mitsui Financial Group, Inc. (SMFG) provides the firm with credit loss protection on certain approved loan commitments (primarily investment-grade commercial lending commitments). The notional amount of such loan commitments was $32.77 billion and $31.94 billion as of June 2012 and December 2011, respectively. The credit loss protection on loan commitments provided by SMFG is generally limited to 95% of the first loss the firm realizes on such commitments, up to a maximum of approximately $950 million. In addition, subject to the satisfaction of certain conditions, upon the firm’s request, SMFG will provide protection for 70% of additional losses on such commitments, up to a maximum of $1.13 billion, of which $300 million of protection had been provided as of both June 2012 and December 2011. The firm also uses other financial instruments to mitigate credit risks related to certain commitments not covered by SMFG.

Warehouse Financing. The firm provides financing to clients who warehouse financial assets. These arrangements are secured by the warehoused assets, primarily consisting of commercial mortgage loans.

Contingent and Forward Starting Resale and Securities Borrowing Agreements/Forward Starting Repurchase and Secured Lending Agreements

The firm enters into resale and securities borrowing agreements and repurchase and secured lending agreements that settle at a future date. The firm also enters into commitments to provide contingent financing to its clients and counterparties through resale agreements. The firm’s funding of these commitments depends on the satisfaction of all contractual conditions to the resale agreement and these commitments can expire unused.

Investment Commitments

The firm’s investment commitments consist of commitments to invest in private equity, real estate and other assets directly and through funds that the firm raises and manages. These commitments include $1.31 billion and $1.62 billion as of June 2012 and December 2011, respectively, related to real estate private investments and $6.49 billion and $7.50 billion as of June 2012 and December 2011, respectively, related to corporate and other private investments. Of these amounts, $7.08 billion and $8.38 billion as of June 2012 and December 2011, respectively, relate to commitments to invest in funds managed by the firm, which will be funded at market value on the date of investment.

Leases

The firm has contractual obligations under long-term noncancelable lease agreements, principally for office space, expiring on various dates through 2069. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other charges. The table below presents future minimum rental payments, net of minimum sublease rentals.

 

in millions     
 
As of
June 2012
  
  

Remainder of 2012

     $   223   

2013

     429   

2014

     389   

2015

     347   

2016

     318   

2017

     304   

2018 - thereafter

     1,227   

Total

     $3,237   

Operating leases include office space held in excess of current requirements. Rent expense relating to space held for growth is included in “Occupancy.” The firm records a liability, based on the fair value of 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 on termination.

 

 

72   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Contingencies

Legal Proceedings. See Note 27 for information about legal proceedings, including certain mortgage-related matters.

Certain Mortgage-Related Contingencies. There are multiple areas of focus by regulators, governmental agencies and others within the mortgage market that may impact originators, issuers, servicers and investors. There remains significant uncertainty surrounding the nature and extent of any potential exposure for participants in this market.

 

Ÿ  

Representations and Warranties. The firm has not been a significant originator of residential mortgage loans. The firm did purchase loans originated by others and generally received loan-level representations of the type described below from the originators. During the period 2005 through 2008, the firm sold approximately $10 billion of loans to government-sponsored enterprises and approximately $11 billion of loans to other third parties. In addition, the firm transferred loans to trusts and other mortgage securitization vehicles. As of June 2012 and December 2011, the outstanding balance of the loans transferred to trusts and other mortgage securitization vehicles during the period 2005 through 2008 was approximately $38 billion and $42 billion, respectively. This amount reflects paydowns and cumulative losses of approximately $87 billion ($19 billion of which are cumulative losses) as of June 2012 and approximately $83 billion ($17 billion of which are cumulative losses) as of December 2011. A small number of these Goldman Sachs-issued securitizations with an outstanding principal balance of $582 million and total paydowns and cumulative losses of $1.48 billion ($491 million of which are cumulative losses) as of June 2012, and an outstanding principal balance of $635 million and total paydowns and cumulative losses of $1.42 billion ($465 million of which are cumulative losses) as of December 2011, were structured with credit protection obtained from monoline insurers. In connection with both sales of loans and securitizations, the firm provided loan level representations of the type described below and/or assigned the loan level representations from the party from whom the firm purchased the loans.

The loan level representations made in connection with the sale or securitization of mortgage loans varied among transactions but were generally detailed representations applicable to each loan in the portfolio and addressed matters relating to the property, the borrower and the note. These representations generally included, but were not limited to, the following: (i) certain attributes of the borrower’s financial status; (ii) loan-to-value ratios, owner occupancy status and certain other characteristics of the property; (iii) the lien position; (iv) the fact that the loan was originated in compliance with law; and (v) completeness of the loan documentation.

To date, repurchase claims and actual repurchases of residential mortgage loans based upon alleged breaches of representations have not been significant and have mainly involved government-sponsored enterprises. During both the three and six months ended June 2012 and June 2011, the firm repurchased loans with an unpaid principal balance of less than $10 million. The loss related to the repurchase of these loans was not material for both the three and six months ended June 2012 and June 2011.

Ultimately, the firm’s exposure to claims for repurchase of residential mortgage loans based on alleged breaches of representations will depend on a number of factors including the following: (i) the extent to which these claims are actually made; (ii) the extent to which there are underlying breaches of representations that give rise to valid claims for repurchase; (iii) in the case of loans originated by others, the extent to which the firm could be held liable and, if it is, the firm’s ability to pursue and collect on any claims against the parties who made representations to the firm; (iv) macro-economic factors, including developments in the residential real estate market; and (v) legal and regulatory developments.

Based upon the large number of defaults in residential mortgages, including those sold or securitized by the firm, there is a potential for increasing claims for repurchases. However, the firm is not in a position to make a meaningful estimate of that exposure at this time.

 

 

  Goldman Sachs June 2012 Form 10-Q   73


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Ÿ  

Foreclosure and Other Mortgage Loan Servicing Practices and Procedures. The firm had received a number of requests for information from regulators and other agencies, including state attorneys general and banking regulators, as part of an industry-wide focus on the practices of lenders and servicers in connection with foreclosure proceedings and other aspects of mortgage loan servicing practices and procedures. The requests sought information about the foreclosure and servicing protocols and activities of Litton, a residential mortgage servicing subsidiary sold by the firm to Ocwen Financial Corporation (Ocwen) in the third quarter of 2011. The firm is cooperating with the requests and these inquiries may result in the imposition of fines or other regulatory action. In the third quarter of 2010, prior to the firm’s sale of Litton, Litton had temporarily suspended evictions and foreclosure and real estate owned sales in a number of states, including those with judicial foreclosure procedures. Litton resumed these activities beginning in the fourth quarter of 2010.

In connection with the sale of Litton, the firm provided customary representations and warranties, and indemnities for breaches of these representations and warranties, to Ocwen. These indemnities are subject to various limitations, and are capped at approximately $50 million. The firm has not yet received any claims relating to these indemnities. The firm also agreed to provide specific indemnities to Ocwen related to claims made by third parties with respect to servicing activities during the period that Litton was owned by the firm and which are in excess of the related reserves accrued for such matters by Litton at the time of the sale. These indemnities are capped at approximately $125 million. The firm has recorded a reserve for the portion of these potential losses that it believes is probable and can be reasonably estimated. As of June 2012, the firm had not received material claims with respect to these indemnities and had not made material payments in connection with these claims.

The firm further agreed to provide indemnities to Ocwen not subject to a cap, which primarily relate to potential liabilities constituting fines or civil monetary penalties which could be imposed in settlements with certain terms with U.S. states attorneys general or in consent orders with certain terms with the Federal Reserve, the Office of Thrift Supervision, the Office of the Comptroller of the Currency, the FDIC or the New York State Department of Financial Services, in each case relating to Litton’s foreclosure and servicing practices while it was owned by the firm. Under the Litton sale agreement the firm also retained liabilities associated with claims related to

Litton’s failure to maintain lender-placed mortgage insurance, obligations to repurchase certain loans from Freddie Mac, subpoenas from one of Litton’s regulators, and fines or civil penalties imposed by the Federal Reserve or the New York State Department of Financial Services in connection with certain compliance matters. Management is unable to develop an estimate of the maximum potential amount of future payments under these indemnities because the firm has received no claims under these indemnities other than an immaterial amount with respect to Freddie Mac repurchase requests. However, management does not believe, based on currently available information, that any payments under these indemnities will have a material adverse effect on the firm’s financial condition.

On September 1, 2011, Group Inc. and GS Bank USA entered into a Consent Order (the Order) with the Board of Governors of the Federal Reserve System (Federal Reserve Board) relating to the servicing of residential mortgage loans. The terms of the Order are substantially similar and, in many respects, identical to the orders entered into with the Federal Reserve Board by other large U.S. financial institutions. The Order sets forth various allegations of improper conduct in servicing by Litton, requires that Group Inc. and GS Bank USA cease and desist such conduct, and requires that Group Inc. and GS Bank USA, and their boards of directors, take various affirmative steps. The Order requires (i) Group Inc. and GS Bank USA to engage a third-party consultant to conduct a review of certain foreclosure actions or proceedings that occurred or were pending between January 1, 2009 and December 31, 2010; (ii) the adoption of policies and procedures related to management of third parties used to outsource residential mortgage servicing, loss mitigation or foreclosure; (iii) a “validation report” from an independent third-party consultant regarding compliance with the Order for the first year; and (iv) submission of quarterly progress reports as to compliance with the Order by the boards of directors (or committees thereof) of Group Inc. and GS Bank USA.

In addition, on September 1, 2011, GS Bank USA entered into an Agreement on Mortgage Servicing Practices with the New York State Department of Financial Services, Litton and Ocwen relating to the servicing of residential mortgage loans, and, in a related agreement with the New York State Department of Financial Services, Group Inc. agreed to forgive 25% of the unpaid principal balance on certain delinquent first lien residential mortgage loans owned by Group Inc. or a subsidiary, totaling approximately $13 million in principal forgiveness.

 

 

74   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Guaranteed Minimum Death and Income Benefits. In connection with its insurance business, the firm is contingently liable to provide guaranteed minimum death and income benefits to certain contract holders and has established a reserve related to $5.39 billion and $5.52 billion of contract holder account balances as of June 2012 and December 2011, respectively, for such benefits. The weighted average attained age of these contract holders was 69 years for both June 2012 and December 2011.

The net amount at risk, representing guaranteed minimum death and income benefits in excess of contract holder account balances, was $1.35 billion and $1.51 billion as of June 2012 and December 2011, respectively. See Note 17 for further information about the reserves recorded in “Other liabilities and accrued expenses” related to guaranteed minimum death and income benefits.

Guarantees

The firm enters into various derivatives that meet the definition of a guarantee under U.S. GAAP, including written equity and commodity put options, written currency contracts and interest rate caps, floors and swaptions. Disclosures about derivatives are not required if they may be cash settled and the firm has no basis to conclude it is probable that the counterparties held the underlying instruments at inception of the contract. The firm has concluded that these conditions have been met for certain large, internationally active commercial and investment bank counterparties and certain other counterparties. Accordingly, the firm has not included such contracts in the table below.

The firm, in its capacity as an agency lender, indemnifies most of its securities lending customers against losses incurred in the event that borrowers do not return securities and the collateral held is insufficient to cover the market value of the securities borrowed.

In the ordinary course of business, the firm provides other financial guarantees of the obligations of third parties (e.g., standby letters of credit and other guarantees to enable clients to complete transactions and 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 table below presents certain information about derivatives that meet the definition of a guarantee and certain other guarantees. The maximum payout in the table below is based on the notional amount of the contract and therefore does not represent anticipated losses. See Note 7 for further information about credit derivatives that meet the definition of a guarantee which are not included below.

Because derivatives are accounted for at fair value, the carrying value is considered the best indication of payment/performance risk for individual contracts. However, the carrying values below exclude the effect of a legal right of setoff that may exist under an enforceable netting agreement and the effect of netting of cash collateral posted under credit support agreements.

 

 

 

    As of June 2012
           Maximum Payout/Notional Amount by Period of Expiration
in millions  

Carrying
Value of

Net Liability

    Remainder
of 2012
     2013-
2014
     2015-
2016
     2017-
Thereafter
     Total

Derivatives 1

    $11,966        $391,536         $329,049         $65,849         $63,693       $850,127

Securities lending indemnifications 2

           30,192                               30,192

Other financial guarantees 3

    209        296         757         1,224         1,092       3,369

 

1.

These derivatives are risk managed together with derivatives that do not meet the definition of a guarantee, and therefore these amounts do not reflect the firm’s overall risk related to its derivative activities. As of December 2011, the carrying value of the net liability related to derivative guarantees was $11.88 billion.

 

2.

Collateral held by the lenders in connection with securities lending indemnifications was $31.06 billion as of June 2012. Because the contractual nature of these arrangements requires the firm to obtain collateral with a market value that exceeds the value of the securities lent to the borrower, there is minimal performance risk associated with these guarantees.

 

3.

Other financial guarantees excludes certain commitments to issue standby letters of credit that are included in “Commitments to extend credit.” See table in “Commitments” above for a summary of the firm’s commitments. As of December 2011, the carrying value of the net liability related to other financial guarantees was $205 million.

 

  Goldman Sachs June 2012 Form 10-Q   75


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Guarantees of Securities Issued by Trusts. The firm has established trusts, including Goldman Sachs Capital I, the APEX Trusts, the 2012 Trusts, and other entities for the limited purpose of issuing securities to third parties, lending the proceeds to the firm and entering into contractual arrangements with the firm and third parties related to this purpose. The firm does not consolidate these entities. See Note 16 for further information about the transactions involving Goldman Sachs Capital I, the APEX Trusts, and the 2012 Trusts.

The firm effectively provides for the full and unconditional guarantee of the securities issued by these entities. Timely payment by the firm of amounts due to these entities under the guarantee, borrowing, preferred stock and related contractual arrangements will be sufficient to cover payments due on the securities issued by these entities.

Management believes that it is unlikely that any circumstances will occur, such as nonperformance on the part of paying agents or other service providers, that would make it necessary for the firm to make payments related to these entities other than those required under the terms of the guarantee, borrowing, preferred stock and related contractual arrangements and in connection with certain expenses incurred by these entities.

Indemnities and Guarantees of Service Providers. In the ordinary course of business, the firm indemnifies and guarantees certain service providers, such as clearing and custody agents, trustees and administrators, against specified potential losses in connection with their acting as an agent of, or providing services to, the firm or its affiliates.

The firm may also be liable to some clients for losses caused by acts or omissions of third-party service providers, including sub-custodians and third-party brokers. 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 material liabilities related to these guarantees and indemnifications have been recognized in the condensed consolidated statements of financial condition as of June 2012 and December 2011.

Other Representations, Warranties and Indemnifications. The firm provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. The firm may also provide indemnifications protecting against changes in or adverse application of certain U.S. tax laws in connection with ordinary-course transactions such as securities issuances, borrowings or derivatives.

In addition, the firm may provide indemnifications to some counterparties to protect them in the event additional taxes are owed or payments are withheld, due either to a change in or an adverse application of certain non-U.S. tax laws.

These indemnifications generally are standard contractual terms and are entered into in the 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 material liabilities related to these arrangements have been recognized in the condensed consolidated statements of financial condition as of June 2012 and December 2011.

 

 

76   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Guarantees of Subsidiaries. Group Inc. fully and unconditionally guarantees the securities issued by GS Finance Corp., a wholly-owned finance subsidiary of the firm.

Group Inc. has guaranteed the payment obligations of Goldman, Sachs & Co. (GS&Co.), GS Bank USA, GS Bank Europe and Goldman Sachs Execution & Clearing, L.P. (GSEC), subject to certain exceptions.

In November 2008, the firm contributed subsidiaries into GS Bank USA, and Group Inc. agreed to guarantee the reimbursement of certain losses, including credit-related losses, relating to assets held by the contributed entities. In connection with this guarantee, Group Inc. also agreed to pledge to GS Bank USA certain collateral, including interests in subsidiaries and other illiquid assets.

In addition, Group Inc. guarantees many of the obligations of its other consolidated subsidiaries on a transaction-by-transaction basis, as negotiated with counterparties. Group Inc. is unable to develop an estimate of the maximum payout under its subsidiary guarantees; however, because these guaranteed obligations are also obligations of consolidated subsidiaries included in the table above, Group Inc.’s liabilities as guarantor are not separately disclosed.

Group Inc. has established a program for the issuance of securities by Goldman Sachs Secured Finance Limited insured by GS Secured Guaranty Company Limited (SGCL), a wholly-owned subsidiary of Group Inc. that is a financial guaranty insurer organized under the laws of Bermuda. The funds raised by SGCL are used to enter into repurchase transactions with GS&Co. and Goldman Sachs International (GSI). Group Inc. has fully and unconditionally guaranteed the securities issued by Goldman Sachs Secured Finance Limited, as well as the obligations of GS&Co. and GSI under their respective repurchase transactions. Group Inc. has not guaranteed the obligations of SGCL. The assets and liabilities of SGCL are legally separated from other assets and liabilities of the firm. The assets of SGCL will not be available to any holder of its capital stock until the claims of creditors have been paid.

Note 19. Shareholders’ Equity

Note 19.

Shareholders’ Equity

Common Equity

On July 16, 2012, Group Inc. declared a dividend of $0.46 per common share to be paid on September 27, 2012 to common shareholders of record on August 30, 2012.

The firm’s share repurchase program is intended to help maintain the appropriate level of common equity and to substantially offset increases in share count over time resulting from employee share-based compensation. The repurchase program is effected primarily through regular open-market purchases, the amounts and timing of which are determined primarily by the firm’s current and projected capital positions (i.e., comparisons of the firm’s desired level and composition of capital to its actual level and composition of capital) and the issuance of shares resulting from employee share-based compensation, but which may also be influenced by general market conditions and the prevailing price and trading volumes of the firm’s common stock. Any repurchase of the firm’s common stock requires approval by the Federal Reserve Board.

During the three and six months ended June 2012, the firm repurchased 14.3 million and 17.6 million shares of its common stock at an average cost per share of $104.81 and $106.01, for a total cost of $1.50 billion and $1.86 billion, respectively, under the share repurchase program. In addition, pursuant to the terms of certain share-based compensation plans, employees may remit shares to the firm or the firm may cancel RSUs to satisfy minimum statutory employee tax withholding requirements. Under these plans, during the six months ended June 2012, employees remitted 33,477 shares with a total value of $3 million and the firm cancelled 8.1 million of RSUs with a total value of $872 million.

 

 

  Goldman Sachs June 2012 Form 10-Q   77


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Preferred Equity

The table below presents perpetual preferred stock issued and outstanding.

 

 

Series    Shares
Authorized
     Shares
Issued
     Shares
Outstanding
     Dividend Rate   

Redemption
Value

(in millions)

 

A

     50,000         30,000         29,999      

3 month LIBOR + 0.75%,

with floor of 3.75% per annum

     $   750   

B

     50,000         32,000         32,000       6.20% per annum      800   

C

     25,000         8,000         8,000      

3 month LIBOR + 0.75%,

with floor of 4.00% per annum

     200   

D

     60,000         54,000         53,999      

3 month LIBOR + 0.67%,

with floor of 4.00% per annum

     1,350   

E

     17,500         17,500         17,500      

3 month LIBOR + 0.77%,

with floor of 4.00% per annum

     1,750   
       202,500         141,500         141,498              $4,850   

 

Each share of non-cumulative Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock issued and outstanding has a par value of $0.01, has a liquidation preference of $25,000, is represented by 1,000 depositary shares and is redeemable at the firm’s option, subject to the approval of the Federal Reserve Board, at a redemption price equal to $25,000 plus declared and unpaid dividends.

All series of preferred stock are pari passu and have a preference over the firm’s common stock on liquidation. Dividends on each series of preferred stock, if declared, are payable quarterly in arrears. The firm’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event that the firm fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period.

In 2007, the Board authorized 17,500 shares of Series E Preferred Stock, and 5,000 shares of Series F Preferred Stock, in connection with the APEX Trusts. On June 1, 2012, Group Inc. issued 17,500 shares of Series E Preferred Stock to Goldman Sachs Capital II pursuant to the stock purchase contracts held by Goldman Sachs Capital II. Each share of Series E Preferred Stock issued and outstanding has a par value of $0.01, has a liquidation

preference of $100,000 and is redeemable at the option of the firm at any time subject to approval from the Federal Reserve Board and to certain covenant restrictions governing the firm’s ability to redeem or purchase the preferred stock without issuing common stock or other instruments with equity-like characteristics. See Note 16 for further information about the APEX Trusts.

Under the stock purchase contracts with Goldman Sachs Capital III, Group Inc. will issue $500 million of Series F Preferred Stock on September 4, 2012 comprised of one share for each $100,000 liquidation amount of APEX issued by Goldman Sachs Capital III. When issued, each share of Series F Preferred Stock will have a par value of $0.01 and a liquidation preference of $100,000 per share.

Dividends on Series F Preferred Stock, if declared, will be payable quarterly at a rate per annum equal to the greater of (i) three-month LIBOR plus 0.77% and (ii) 4.00%.

The Series F Preferred Stock may be redeemed at the option of the firm on September 4, 2012 or any day thereafter, subject to approval from the Federal Reserve Board and to certain covenant restrictions governing the firm’s ability to redeem or purchase the preferred stock without issuing common stock or other instruments with equity-like characteristics.

 

 

78   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In March 2011, the firm provided notice to Berkshire Hathaway Inc. and certain of its subsidiaries (collectively, Berkshire Hathaway) that it would redeem in full the 50,000 shares of the firm’s 10% Cumulative Perpetual Preferred Stock, Series G (Series G Preferred Stock) held by Berkshire Hathaway for the stated redemption price of $5.50 billion ($110,000 per share), plus accrued and unpaid dividends. In connection with this notice, the firm recognized a preferred dividend of $1.64 billion (calculated as the difference between the carrying value and the redemption value of the preferred stock), which was recorded as a reduction to earnings applicable to common

shareholders for the first quarter of 2011. The redemption also resulted in the acceleration of $24 million of preferred dividends related to the period from April 1, 2011 to the redemption date, which was included in the firm’s results during the three months ended March 2011. The Series G Preferred Stock was redeemed on April 18, 2011. Berkshire Hathaway continues to hold a five-year warrant, issued in October 2008, to purchase up to 43.5 million shares of common stock at an exercise price of $115.00 per share.

The table below presents preferred dividends declared on preferred stock.

 

 

 

    

Three Months Ended June

    

Six Months Ended June

 
    

2012

       2011     

2012

       2011  
      per share    in millions         per share      in millions      per share    in millions         per share      in millions  

Series A

   $239.58    $  7          $231.77         $  7       $479.16    $14          $   471.35         $  14   

Series B

   387.50    12          387.50         13       775.00    24          775.00         25   

Series C

   255.56    2          247.22         2       511.12    4          502.78         4   

Series D

   255.56    14          247.22         13       511.12    28          502.78         27   

Series G

                                         2,500.00         125  1 

Total

        $35                   $35            $70                   $195   

 

1.

Excludes preferred dividends related to the redemption of the firm’s Series G Preferred Stock.

Accumulated Other Comprehensive Income/(Loss)

The tables below present accumulated other comprehensive income/(loss) by type.

 

 

    As of June 2012  
in millions   Currency
translation
adjustment,
net of tax
    

Pension and
postretirement

liability adjustments,
net of tax

     Net unrealized
gains/(losses) on
available-for-sale
securities, net of tax
    

Accumulated other
comprehensive
income/(loss),

net of tax

 

Balance, beginning of year

    $(225      $(374      $  83         $(516

Other comprehensive income/(loss)

    (52      7         55         10   

Balance, end of period

    $(277      $(367      $138  1       $(506
    As of December 2011  
in millions   Currency
translation
adjustment,
net of tax
    

Pension and
postretirement

liability adjustments,
net of tax

    

Net unrealized

gains/(losses) on
available-for-sale
securities, net of tax

    

Accumulated other
comprehensive
income/(loss),

net of tax

 

Balance, beginning of year

    $(170      $(229      $113         $(286

Other comprehensive loss

    (55      (145      (30      (230

Balance, end of year

    $(225      $(374      $  83  1       $(516

 

1.

Substantially all consists of net unrealized gains on securities held by the firm’s insurance subsidiaries as of both June 2012 and December 2011.

 

  Goldman Sachs June 2012 Form 10-Q   79


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 20. Regulation and Capital Adequacy

Note 20.

Regulation and Capital Adequacy

 

The Federal Reserve Board is the primary regulator of Group Inc., a bank holding company and a financial holding company under the U.S. Bank Holding Company Act of 1956. As a bank holding company, the firm is subject to consolidated regulatory capital requirements that are computed in accordance with the Federal Reserve Board’s generally applicable risk-based capital requirements (which are based on the ‘Basel 1’ Capital Accord of the Basel Committee on Banking Supervision (Basel Committee)). These capital requirements are expressed as capital ratios that compare measures of capital to risk-weighted assets (RWAs). The firm’s U.S. bank depository institution subsidiaries, including GS Bank USA, are subject to similar capital requirements.

Under the Federal Reserve Board’s capital adequacy requirements and the regulatory framework for prompt corrective action that is applicable to GS Bank USA, the firm and its U.S. bank depository institution subsidiaries must meet specific capital requirements that involve quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory reporting practices. The firm and its U.S. bank depository institution subsidiaries’ capital amounts, as well as GS Bank USA’s prompt corrective action classification, are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Many of the firm’s subsidiaries, including GS&Co. and the firm’s other broker-dealer subsidiaries, are subject to separate regulation and capital requirements as described below.

Group Inc.

Federal Reserve Board regulations require bank holding companies to maintain a minimum Tier 1 capital ratio of 4% and a minimum total capital ratio of 8%. The required minimum Tier 1 capital ratio and total capital ratio in order to be considered a “well-capitalized” bank holding company under the Federal Reserve Board guidelines are 6% and 10%, respectively. Bank holding companies may be expected to maintain ratios well above the minimum levels, depending on their particular condition, risk profile and growth plans. The minimum Tier 1 leverage ratio is 3% for bank holding companies that have received the highest supervisory rating under Federal Reserve Board guidelines or that have implemented the Federal Reserve Board’s risk-based capital measure for market risk. Other bank holding companies must have a minimum Tier 1 leverage ratio of 4%.

The table below presents information regarding Group Inc.’s regulatory capital ratios.

 

 

 

    As of  
$ in millions    

 

June

2012

  

  

    
 
December
2011
  
  

Tier 1 capital

    $  64,444         $  63,262   

Tier 2 capital

    $  13,304         $  13,881   

Total capital

    $  77,748         $  77,143   

Risk-weighted assets

    $428,589         $457,027   

Tier 1 capital ratio

    15.0      13.8

Total capital ratio

    18.1      16.9

Tier 1 leverage ratio

    7.0      7.0

RWAs under the Federal Reserve Board’s generally applicable risk-based capital requirements are calculated based on the amount of market risk and credit risk. RWAs for market risk are determined by reference to the firm’s Value-at-Risk (VaR) models, supplemented by other measures to capture risks not reflected in VaR models. Credit risk for on-balance sheet assets is based on the balance sheet value. For off-balance sheet exposures, including OTC derivatives and commitments, a credit equivalent amount is calculated based on the notional amount of each trade. All such assets and amounts are then assigned a risk weight depending on, among other things, whether the counterparty is a sovereign, bank or qualifying securities firm or other entity (or if collateral is held, depending on the nature of the collateral).

Tier 1 leverage ratio is defined as Tier 1 capital under Basel 1 divided by average adjusted total assets (which includes adjustments for disallowed goodwill and intangible assets, and the carrying value of equity investments in non-financial companies that are subject to deductions from Tier 1 capital).

 

 

80   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Regulatory Reform

The firm is currently working to implement the requirements set out in the Federal Reserve Board’s Risk-Based Capital Standards: Advanced Capital Adequacy Framework — Basel 2, as applicable to Group Inc. as a bank holding company (Basel 2), which are based on the advanced approaches under the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee. U.S. banking regulators have incorporated the Basel 2 framework into the existing risk-based capital requirements by requiring that internationally active banking organizations, such as Group Inc., adopt Basel 2, once approved to do so by regulators. The firm’s capital adequacy ratio will also be impacted by the further changes outlined below under the Basel 2.5 framework, provisions of the Dodd-Frank Act, and the Basel 3 framework.

In June 2012, the U.S. federal bank regulatory agencies (the Agencies) issued revised rules which modify their market risk regulatory capital requirements for banking organizations that have significant trading activities. These modifications are designed to address the adjustments to the market risk regulatory capital framework that were announced by the Basel Committee in June 2010 (Basel 2.5), as well as the prohibition on the use of external credit ratings, as required by the Dodd-Frank Act. These changes will be implemented in January 2013 and will result in increased regulatory capital requirements for market risk.

In addition, in June 2012, the Agencies proposed further modifications to their capital adequacy regulations to address aspects of both the Dodd-Frank Act and the guidelines issued by the Basel Committee in December 2010 (Basel 3). If enacted as proposed, the most significant changes that would impact the firm include (i) revisions to the definition of Tier 1 capital, including new deductions from Tier 1 capital, (ii) higher minimum capital and leverage ratios, (iii) the introduction of a new minimum ratio of Tier 1 common equity to RWAs, (iv) new capital conservation and counter-cyclical capital buffers, (v) an additional leverage ratio, which includes measures of off-balance sheet exposures, and (vi) revisions to the methodology for calculating RWAs, particularly for credit risk capital requirements on derivatives. Among the consequences of these proposals would be the phase out of Tier 1 capital treatment for the firm’s junior subordinated debt issued to trusts over a three-year period beginning on January 1, 2013.

In accordance with the “Collins Amendment” of the Dodd-Frank Act, the Agencies’ generally applicable risk-based capital requirements will act as a floor for the firm’s capital ratios, such that the firm’s requirement would be the lower of the ratios calculated under Basel 3 or the generally applicable risk-based capital requirements. The June 2012 proposals include provisions which, if enacted as proposed, would modify the generally applicable risk-based capital requirements.

The Basel Committee has published its final provisions for assessing the global systemic importance of banking institutions and the range of additional Tier 1 common equity that should be maintained by banking institutions deemed to be globally systemically important. The additional capital for these institutions would initially range from 1% to 2.5% of Tier 1 common equity and could be as much as 3.5% for a bank that increases its systemic footprint (e.g., by increasing total assets). The firm was one of 29 institutions identified by the Financial Stability Board (established at the direction of the leaders of the Group of 20) as globally systemically important under the Basel Committee’s methodology. Therefore, depending upon the manner and timing of the U.S. banking regulators’ implementation of the Basel Committee’s methodology, the firm expects that the minimum Tier 1 common ratio requirement applicable to the firm will include this additional capital assessment. The final determination of whether an institution is classified as globally systemically important and the calculation of the required additional capital amount is expected to be disclosed by the Basel Committee no later than November 2014 based on data through the end of 2013.

In June 2012, the Basel Committee also released a consultation paper proposing approaches for calculating incremental capital requirements for domestic systemically important banks. The recommendation is complementary to the framework outlined above for global systemically important banks, but is more principles-based in order to provide an appropriate degree of national discretion. These proposals may impact the regulatory capital requirements of GS Bank USA, but the exact impact will depend on the final framework and how it is implemented by the U.S. banking regulators.

 

 

  Goldman Sachs June 2012 Form 10-Q   81


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In May 2012, the Basel Committee released a consultation paper proposing a “Fundamental Review of the Trading Book.” The paper proposes a series of comprehensive changes to the regulatory capital requirements for market risk which, if enacted by the U.S. banking regulators, would likely replace the Basel 2.5 requirements that, as outlined above, become effective in January 2013.

In addition to the higher risk-based capital and leverage requirements already outlined above, the Federal Reserve Board has proposed regulations designed to strengthen the regulation and supervision of large bank holding companies and systemically important nonbank financial firms. These proposals address risk-based capital and leverage requirements, liquidity requirements, stress tests and single counterparty limits. Although many of the proposals mirror initiatives to which bank holding companies are already subject, their full impact on the firm will not be known with certainty until the rules are finalized.

The Dodd-Frank Act contains provisions that require the registration of all swap dealers, major swap participants, security-based swap dealers, and/or major security-based swap participants. Entities that register under these provisions will be subject to regulatory capital requirements, which have not yet been finalized by the CFTC and SEC. Nevertheless, the firm expects that this will result in modifications to the regulatory capital requirements of some of its entities, and will result in some of its other entities becoming subject to regulatory capital requirements for the first time.

The interaction among the Dodd-Frank Act, the Basel Committee’s proposed changes and other proposed or announced changes from other governmental entities and regulators (including the European Union (EU) and the U.K.’s Financial Services Authority (FSA)) adds further uncertainty to the firm’s future capital and liquidity requirements and those of the firm’s subsidiaries.

Bank Subsidiaries

GS Bank USA, an FDIC-insured, New York State-chartered bank and a member of the Federal Reserve System, is supervised and regulated by the Federal Reserve Board, the FDIC, the New York State Department of Financial Services and the Bureau of Consumer Financial Protection, and is subject to minimum capital requirements (described below) that are calculated in a manner similar to those applicable to bank holding companies. GS Bank USA computes its capital ratios in accordance with the regulatory capital guidelines currently applicable to state member banks, which are based on Basel 1 as implemented by the Federal Reserve Board, for purposes of assessing the adequacy of its capital. Under the regulatory framework for prompt corrective action that is applicable to GS Bank USA, in order to be considered a “well-capitalized” depository institution, GS Bank USA must maintain a Tier 1 capital ratio of at least 6%, a total capital ratio of at least 10% and a Tier 1 leverage ratio of at least 5%. GS Bank USA has agreed with the Federal Reserve Board to minimum capital ratios in excess of these “well-capitalized” levels. Accordingly, for a period of time, GS Bank USA is expected to maintain a Tier 1 capital ratio of at least 8%, a total capital ratio of at least 11% and a Tier 1 leverage ratio of at least 6%. As noted in the table below, GS Bank USA was in compliance with these minimum capital requirements as of June 2012 and December 2011.

The table below presents information regarding GS Bank USA’s regulatory capital ratios under Basel 1 as implemented by the Federal Reserve Board.

 

 

 

    As of  
$ in millions  

June

2012

    

December

2011

 

Tier 1 capital

  $ 19,951       $ 19,251   

Tier 2 capital

  $ 23       $ 6   

Total capital

  $ 19,974       $ 19,257   

Risk-weighted assets

  $ 108,750       $ 112,824   

Tier 1 capital ratio

    18.3      17.1

Total capital ratio

    18.4      17.1

Tier 1 leverage ratio

    18.1      18.5
 

 

82   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

GS Bank USA is currently working to implement the Basel 2 framework, as implemented by the Federal Reserve Board. Similar to the firm’s requirement as a bank holding company, GS Bank USA is required to adopt Basel 2, once approved to do so by regulators. In addition, the capital requirements for GS Bank USA are expected to be impacted by the June 2012 proposed modifications to the Agencies’ capital adequacy regulations outlined above. If enacted as proposed, these proposals would also change the regulatory framework for prompt corrective action that is applicable to GS Bank USA. The firm also expects that GS Bank USA will be impacted by aspects of the Dodd-Frank Act, including new stress tests.

The deposits of GS Bank USA are insured by the FDIC to the extent provided by law. The Federal Reserve Board requires depository institutions to maintain cash reserves with a Federal Reserve Bank. The amount deposited by the firm’s depository institution held at the Federal Reserve Bank was approximately $43.27 billion and $40.06 billion as of June 2012 and December 2011, respectively, which exceeded required reserve amounts by $42.92 billion and $39.51 billion as of June 2012 and December 2011, respectively.

Transactions between GS Bank USA and its subsidiaries and Group Inc. and its subsidiaries and affiliates (other than, generally, subsidiaries of GS Bank USA) are regulated by the Federal Reserve Board. These regulations generally limit the types and amounts of transactions (including loans to and borrowings from GS Bank USA) that may take place and generally require those transactions to be on an arm’s-length basis.

GSIB, a wholly-owned credit institution, regulated by the FSA, and GS Bank Europe, a wholly-owned credit institution, regulated by the Central Bank of Ireland, are both subject to minimum capital requirements. As of June 2012 and December 2011, GSIB and GS Bank Europe were in compliance with all regulatory capital requirements.

Broker-Dealer Subsidiaries

The firm’s U.S. regulated broker-dealer subsidiaries include GS&Co. and GSEC. GS&Co. and GSEC are registered U.S. broker-dealers and futures commission merchants, and are subject to regulatory capital requirements, including those imposed by the SEC, the U.S. Commodity Futures Trading Commission (CFTC), Chicago Mercantile Exchange, the Financial Industry Regulatory Authority, Inc. (FINRA) and the National Futures Association. Rule 15c3-1 of the SEC and Rule 1.17 of the CFTC specify uniform minimum net capital requirements, as defined, for their registrants, and also effectively require that a significant part of the registrants’ assets be kept in relatively liquid form. 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 June 2012 and December 2011, GS&Co. had regulatory net capital, as defined by Rule 15c3-1, of $13.79 billion and $11.24 billion, respectively, which exceeded the amount required by $12.01 billion and $9.34 billion, respectively. As of June 2012 and December 2011, GSEC had regulatory net capital, as defined by Rule 15c3-1, of $2.14 billion and $2.10 billion, respectively, which exceeded the amount required by $2.03 billion and $2.00 billion, respectively.

 

 

  Goldman Sachs June 2012 Form 10-Q   83


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

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 June 2012 and December 2011, GS&Co. had tentative net capital and net capital in excess of both the minimum and the notification requirements.

Insurance Subsidiaries

The firm has U.S. insurance subsidiaries that are subject to state insurance regulation and oversight in the states in which they are domiciled and in the other states in which they are licensed. In addition, certain of the firm’s insurance subsidiaries outside of the U.S. are regulated by the FSA and certain are regulated by the Bermuda Monetary Authority. The firm’s insurance subsidiaries were in compliance with all regulatory capital requirements as of June 2012 and December 2011.

Other Non-U.S. Regulated Subsidiaries

The firm’s principal non-U.S. regulated subsidiaries include GSI and Goldman Sachs Japan Co., Ltd. (GSJCL). GSI, the firm’s regulated U.K. broker-dealer, is subject to the capital requirements imposed by the FSA. GSJCL, the firm’s regulated Japanese broker-dealer, is subject to the capital requirements imposed by Japan’s Financial Services Agency. As of June 2012 and December 2011, GSI and GSJCL were in compliance with their local capital adequacy requirements. Certain other non-U.S. subsidiaries of the firm are also subject to capital adequacy requirements promulgated by authorities of the countries in which they operate. As of June 2012 and December 2011, these subsidiaries were in compliance with their local capital adequacy requirements.

Restrictions on Payments

The regulatory requirements referred to above restrict Group Inc.’s ability to withdraw capital from its regulated subsidiaries. As of June 2012 and December 2011, Group Inc. was required to maintain approximately $32.40 billion and $25.53 billion, respectively, of minimum equity capital in these regulated subsidiaries. This minimum equity capital requirement includes certain restrictions imposed by federal and state laws as to the payment of dividends to Group Inc. by its regulated subsidiaries. In addition to limitations on the payment of dividends imposed by federal and state laws, the Federal Reserve Board, the FDIC and the New York State Department of Financial Services have authority to prohibit or to limit the payment of dividends by the banking organizations they supervise (including GS Bank USA) if, in the relevant regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in the light of the financial condition of the banking organization.

 

 

84   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 21. Earnings Per Common Share

Note 21.

Earnings Per Common Share

 

Basic earnings per common share (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 RSUs 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 for stock warrants and options and for RSUs for which future service is required as a condition to the delivery of the underlying common stock.

The table below presents the computations of basic and diluted EPS.

 

 

 

 

    Three Months
Ended June
         Six Months
Ended June
 
in millions, except per share amounts   2012           2011           2012      2011  

Numerator for basic and diluted EPS — net earnings applicable to common shareholders

    $   927              $1,052             $3,001         $1,960   

Denominator for basic EPS — weighted average number of common shares

    501.5              531.9             506.1         536.2   

Effect of dilutive securities:

            

RSUs

    11.2              14.3             10.2         13.4   

Stock options and warrants

    7.6              23.3             8.4         26.8   

Dilutive potential common shares

    18.8              37.6             18.6         40.2   

Denominator for diluted EPS — weighted average number of common shares and dilutive potential common shares

    520.3              569.5             524.7         576.4   

Basic EPS

    $  1.83              $  1.96             $  5.90         $  3.62   

Diluted EPS

    1.78              1.85             5.72         3.40   

 

In the table above, unvested share-based payment awards that have non-forfeitable rights to dividends or dividend equivalents are treated as a separate class of securities in calculating EPS. The impact of applying this methodology was a reduction in basic EPS of $0.02 for both the three months ended June 2012 and June 2011, and $0.03 and $0.04 for the six months ended June 2012 and June 2011, respectively.

The diluted EPS computations in the table above do not include the following:

 

 

 

 

    Three Months
Ended June
         Six Months
Ended June
 
in millions       2012                2011               2012          2011  

Number of antidilutive RSUs and common shares underlying antidilutive stock options and warrants

    52.6               6.5             52.6         6.3   

 

  Goldman Sachs June 2012 Form 10-Q   85


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 22. Transactions with Affiliated Funds

Note 22.

Transactions with Affiliated Funds

 

The firm has formed numerous nonconsolidated investment funds with third-party investors. As the firm generally acts as the investment manager for these funds, it is entitled to receive management fees and, in certain cases, advisory fees or incentive fees from these funds. Additionally, the firm invests alongside the third-party investors in certain funds.

The tables below present fees earned from affiliated funds, fees receivable from affiliated funds and the aggregate carrying value of the firm’s interests in affiliated funds.

 

 

   

Three Months

Ended June

       

Six Months

Ended June

 
in millions       2012          2011              2012          2011   

Fees earned from affiliated funds

    $751        $688            $1,345        $1,441   

 

 

    As of  
in millions  

June

2012

   

December

2011

 

Fees receivable from funds

    $     707        $     721   

Aggregate carrying value of interests in funds

    14,863        14,960   

The firm has provided voluntary financial support to certain of its funds that have experienced significant reductions in capital and liquidity or had limited access to the debt markets during the financial crisis. As of June 2012 and December 2011, the firm had exposure to these funds in the form of loans and guarantees of $269 million and $289 million, respectively, primarily related to certain real estate funds. In addition, as of June 2012 and December 2011, the firm had no outstanding commitments to extend credit to these funds.

The firm may provide additional voluntary financial support to these funds if, for example, they were to experience significant financial distress; however, such amounts are not expected to be material to the firm. In the ordinary course of business, the firm may also engage in other activities with these funds, including, among others, securities lending, trade execution, market making, custody, and acquisition and bridge financing. See Note 18 for the firm’s investment commitments related to these funds.

 

 

86   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 23. Interest Income and Interest Expense

Note 23.

Interest Income and Interest Expense

 

Interest income is recorded on an accrual basis based on contractual interest rates. The table below presents the

sources of interest income and interest expense.

 

 

 

 

   

Three Months

Ended June

      

Six Months

Ended June

in millions   2012    2011        2012    2011

Interest income

            

Deposits with banks

  $      35     $     27        $     73     $     56

Securities borrowed, securities purchased under agreements to resell and federal funds sold

  39     233        25     402

Financial instruments owned, at fair value

  2,568     2,948        5,010     5,463

Other interest 1

  413     473        780     867

Total interest income

  3,055     3,681        5,888     6,788

Interest expense

            

Deposits

  95     68        186     140

Securities loaned and securities sold under agreements to repurchase

  216     236        427     437

Financial instruments sold, but not yet purchased, at fair value

  664     763        1,189     1,259

Short-term borrowings 2

  152     122        320     251

Long-term borrowings 2

  891     856        1,900     1,642

Other interest 3

  (53)    223        (205)    288

Total interest expense

  1,965     2,268        3,817     4,017

Net interest income

  $1,090     $1,413        $2,071     $2,771

 

1.

Includes interest income on customer debit balances and other interest-earning assets.

 

2.

Includes interest on unsecured borrowings and other secured financings.

 

3.

Includes rebates received and interest expense on customer credit balances and other interest-bearing liabilities.

 

 

Note 24. Income Taxes

Note 24.

Income Taxes

 

Provision for Income Taxes

Income taxes are provided for using the asset and liability method under which deferred tax assets and liabilities are recognized for temporary differences between the financial reporting and tax bases of assets and liabilities. The firm reports interest expense related to income tax matters in “Provision for taxes” and income tax penalties in “Other expenses.”

Deferred Income Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities. These temporary differences result in taxable or deductible amounts in future years and are measured using the tax rates and laws that will be in effect when such differences are expected to reverse. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. Tax assets and liabilities are presented as a component of “Other assets” and “Other liabilities and accrued expenses,” respectively.

 

 

  Goldman Sachs June 2012 Form 10-Q   87


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Unrecognized Tax Benefits

The firm recognizes tax positions in the financial statements only when it is more likely than not that the position will be sustained on examination by the relevant taxing authority based on the technical merits of the position. A position that meets this standard is measured at the largest amount of benefit that will more likely than not be realized on settlement. A liability is established for differences between positions taken in a tax return and amounts recognized in the financial statements.

Regulatory Tax Examinations

The firm is subject to examination by the U.S. Internal Revenue Service (IRS) and other taxing authorities in jurisdictions where the firm has significant business operations, such as the United Kingdom, Japan, Hong Kong, Korea and various states, such as New York. The tax years under examination vary by jurisdiction. The firm believes that during 2012, certain audits have a reasonable possibility of being completed. The firm does not expect completion of these audits to have a material impact on the firm’s financial condition but it may be material to operating results for a particular period, depending, in part, on the operating results for that period.

The table below presents the earliest tax years that remain subject to examination by major jurisdiction.

 

 

Jurisdiction   

As of

June 2012

 

U.S. Federal 1

     2005   

New York State and City 2

     2004   

United Kingdom

     2007   

Japan 3

     2008   

Hong Kong

     2005   

Korea

     2008   

 

1.

IRS examination of fiscal 2008 through calendar 2010 began during 2011. IRS examination of fiscal 2005, 2006 and 2007 began during 2008. IRS examination of fiscal 2003 and 2004 has been completed, but the liabilities for those years are not yet final.

 

2.

New York State and City examination of fiscal 2004, 2005 and 2006 began in 2008.

 

3.

Japan National Tax Agency examination of fiscal 2005 through 2009 began during the first quarter of 2010. The examinations have been completed, but the liabilities for 2008 and 2009 are not yet final.

All years subsequent to the above remain open to examination by the taxing authorities. The firm believes that the liability for unrecognized tax benefits it has established is adequate in relation to the potential for additional assessments.

Note 25. Business Segments

Note 25.

Business Segments

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 and benefits expenses in the firm’s segments reflect, among other factors, the overall performance of the firm as well as the performance of individual businesses. 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 firm allocates assets (including allocations of excess liquidity and cash, secured client financing and other assets), revenues and expenses among the four reportable business segments. Due to the integrated nature of these segments, estimates and judgments are made in allocating certain assets, revenues and expenses. Transactions between segments are based on specific criteria or approximate third-party rates. Total operating expenses include corporate items that have not been allocated to individual business segments. The allocation process is based on the manner in which management views the business of the firm.

 

 

88   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Management believes that the following information provides a reasonable representation of each segment’s

contribution to consolidated pre-tax earnings and total assets.

 

 

 

        

For the Three Months Ended

or as of June

  

For the Six Months Ended

or as of June

in millions        2012       2011    2012    2011

Investment Banking

   Net revenues   $    1,203       $    1,448    $    2,357    $    2,717
    

Operating expenses

  869       981    1,735    1,904
    

Pre-tax earnings

  $       334       $       467    $       622    $       813
    

Segment assets

  $    2,135       $    1,921    $    2,135    $    1,921

Institutional Client Services

   Net revenues 1   $    3,889       $    3,515    $    9,598    $  10,162
    

Operating expenses

  2,947       3,040    6,830    7,624
    

Pre-tax earnings

  $       942       $       475    $    2,768    $    2,538
    

Segment assets

  $842,689       $824,572    $842,689    $824,572

Investing & Lending

   Net revenues   $       203       $    1,044    $    2,114    $    3,749
    

Operating expenses

  256       547    1,214    1,778
    

Pre-tax earnings/(loss)

  $        (53)      $       497    $       900    $    1,971
    

Segment assets

  $  90,784       $  94,837    $  90,784    $  94,837

Investment Management

   Net revenues   $    1,332       $    1,274    $    2,507    $    2,547
    

Operating expenses

  1,070       1,056    2,060    2,123
    

Pre-tax earnings

  $       262       $       218    $       447    $       424
    

Segment assets

  $  13,030       $  15,580    $  13,030    $  15,580

Total

   Net revenues   $    6,627       $    7,281    $  16,576    $  19,175
    

Operating expenses

  5,212       5,669    11,980    13,523
    

Pre-tax earnings

  $    1,415       $    1,612    $    4,596    $    5,652
    

Total assets

  $948,638       $936,910    $948,638    $936,910

 

1.

Includes $22 million and $21 million for the three months ended June 2012 and June 2011, respectively, and $51 million and $50 million for the six months ended June 2012 and June 2011, respectively, of realized gains on available-for-sale securities held in the firm’s insurance subsidiaries.

 

 

  Goldman Sachs June 2012 Form 10-Q   89


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Total operating expenses in the table above include the following expenses that have not been allocated to the firm’s segments:

 

Ÿ  

net provisions for a number of litigation and regulatory proceedings of $67 million and $45 million for the three months ended June 2012 and June 2011, respectively, and $126 million and $69 million for the six months ended June 2012 and June 2011, respectively;

 

Ÿ  

charitable contributions of $12 million and $25 million for the six months ended June 2012 and June 2011, respectively; and

 

Ÿ  

real estate-related exit costs of $3 million for both the three and six months ended June 2012.

The tables below present the amounts of net interest income or interest expense included in net revenues, and the amounts of depreciation and amortization expense included in pre-tax earnings.

 

 

    Three Months
Ended June
         Six Months
Ended June
 
in millions     2012        2011             2012        2011   

Investment Banking

    $      (3     $      —             $      (9     $      —   

Institutional Client Services

    1,015        918             1,986        2,132   

Investing & Lending

    34        442             7        535   

Investment Management

    44        53             87        104   

Total net interest

    $1,090        $1,413             $2,071        $2,771   
    Three Months
Ended June
         Six Months
Ended June
 
in millions     2012        2011             2012        2011   

Investment Banking

    $     39        $     38             $     81        $     89   

Institutional Client Services

    205        192             371        523   

Investing & Lending

    104        94             287        262   

Investment Management

    61        48             103        92   

Total depreciation and amortization

    $   409        $   372             $   842        $   966   

Geographic Information

Due to the highly integrated nature of international financial markets, the firm manages its businesses based on the profitability of the enterprise as a whole. The methodology for allocating profitability to geographic regions is dependent on estimates and management judgment because a significant portion of the firm’s activities require cross-border coordination in order to facilitate the needs of the firm’s clients.

Geographic results are generally allocated as follows:

 

Ÿ  

Investment Banking: location of the client and investment banking team.

 

Ÿ  

Institutional Client Services: Fixed Income, Currency and Commodities Client Execution, and Equities (excluding Securities Services): location of the market-making desk; Securities Services: location of the primary market for the underlying security.

 

Ÿ  

Investing & Lending: Investing: location of the investment; Lending: location of the client.

 

Ÿ  

Investment Management: location of the sales team.

 

 

90   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents the total net revenues and pre-tax earnings of the firm by geographic region allocated based on the methodology referred to above, as well as the

percentage of total net revenues and pre-tax earnings (excluding Corporate) for each geographic region.

 

 

 

    Three Months Ended June         Six Months Ended June  
$ in millions           2012                  2011                  2012                  2011   

Net revenues

Americas 1

    $3,906        59         $4,825        66         $  9,693        59         $11,664        61

EMEA 2

    1,792        27            1,751        24            4,500        27            4,625        24   

Asia 3

    929        14            705        10            2,383        14            2,886        15   

Total net revenues

    $6,627        100         $7,281        100         $16,576        100         $19,175        100

Pre-tax earnings/(loss)

Americas 1

    $   815        55         $1,202        73         $  2,542        54         $  3,475        61

EMEA 2

    508        34            483        29            1,570        33            1,571        27   

Asia 3

    162        11            (28     (2         625        13            700        12   

Subtotal

    1,485        100         1,657        100         4,737        100         5,746        100

Corporate 4

    (70                 (45                 (141                 (94        

Total pre-tax earnings

    $1,415                    $1,612                    $  4,596                    $  5,652           

 

1.

Substantially all relates to the U.S.

 

2.

EMEA (Europe, Middle East and Africa).

 

3.

Asia also includes Australia and New Zealand.

 

4.

Consists of net provisions for a number of litigation and regulatory proceedings of $67 million and $45 million for the three months ended June 2012 and June 2011, respectively, and $126 million and $69 million for the six months ended June 2012 and June 2011, respectively; charitable contributions of $12 million and $25 million for the six months ended June 2012 and June 2011, respectively; and real estate-related exit costs of $3 million for both the three and six months ended June 2012.

 

  Goldman Sachs June 2012 Form 10-Q   91


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 26. Credit Concentrations

Note 26.

Credit Concentrations

 

Credit concentrations may arise from market making, client facilitation, investing, underwriting, lending and collateralized transactions and may be impacted by changes in economic, industry or political factors. The firm seeks to mitigate credit risk by actively monitoring exposures and obtaining collateral from counterparties as deemed appropriate.

While the firm’s activities expose it to many different industries and counterparties, the firm routinely executes a high volume of transactions with asset managers, investment funds, commercial banks, brokers and dealers, clearing houses and exchanges, which results in significant credit concentrations.

In the ordinary course of business, the firm may also be subject to a concentration of credit risk to a particular counterparty, borrower or issuer, including sovereign issuers, or to a particular clearing house or exchange.

The table below presents the credit concentrations in assets held by the firm. As of June 2012 and December 2011, the firm did not have credit exposure to any other counterparty that exceeded 2% of total assets.

 

 

    As of  
$ in millions  

June

2012

   

December

2011

 

U.S. government and federal agency obligations 1

    $113,037        $103,468   

% of total assets

    11.9     11.2

Non-U.S. government and agency obligations 1, 2

    $  63,890        $  49,025   

% of total assets

    6.7     5.3

 

1.

Included in “Financial instruments owned, at fair value” and “Cash and securities segregated for regulatory and other purposes.”

 

2.

Principally related to Germany, Japan and the United Kingdom as of both June 2012 and December 2011.

To reduce credit exposures, the firm may enter into agreements with counterparties that permit the firm to offset receivables and payables with such counterparties and/or enable the firm to obtain collateral on an upfront or contingent basis. Collateral obtained by the firm related to derivative assets is principally cash and is held by the firm or a third-party custodian. Collateral obtained by the firm related to resale agreements and securities borrowed transactions is primarily U.S. government and federal agency obligations and Non-U.S. government and agency obligations. See Note 9 for further information about collateralized agreements and financings.

The table below presents U.S. government and federal agency obligations, and Non-U.S. government and agency obligations that collateralize resale agreements and securities borrowed transactions (including those in “Cash and securities segregated for regulatory and other purposes”). Because the firm’s primary credit exposure on such transactions is to the counterparty to the transaction, the firm would be exposed to the collateral issuer only in the event of counterparty default.

 

 

    As of  
in millions    

 

June

2012

  

  

   

 

December

2011

  

  

U.S. government and federal agency obligations

    $  89,955        $  94,603   

Non-U.S. government and agency obligations 1

    106,783        110,178   

 

1.

Principally consisting of securities issued by the governments of Germany and France.

 

 

92   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 27. Legal Proceedings

Note 27.

Legal Proceedings

 

The firm is involved in a number of judicial, regulatory and arbitration proceedings (including those described below) concerning matters arising in connection with the conduct of the firm’s businesses. Many of these proceedings are in early stages, and many of these cases seek an indeterminate amount of damages.

Under ASC 450 an event is “reasonably possible” if “the chance of the future event or events occurring is more than remote but less than likely” and an event is “remote” if “the chance of the future event or events occurring is slight.” Thus, references to the upper end of the range of reasonably possible loss for cases in which the firm is able to estimate a range of reasonably possible loss mean the upper end of the range of loss for cases for which the firm believes the risk of loss is more than slight. The amounts reserved against such matters are not significant as compared to the upper end of the range of reasonably possible loss.

With respect to proceedings described below for which management has been able to estimate a range of reasonably possible loss where (i) plaintiffs have claimed an amount of money damages, (ii) the firm is being sued by purchasers in an underwriting and is not being indemnified by a party that the firm believes will pay any judgment, or (iii) the purchasers are demanding that the firm repurchase securities, management has estimated the upper end of the range of reasonably possible loss as being equal to (a) in the case of (i), the amount of money damages claimed, (b) in the case of (ii), the amount of securities that the firm sold in the underwritings and (c) in the case of (iii), the price that purchasers paid for the securities less the estimated value, if any, as of June 2012 of the relevant securities, in each of cases (i), (ii) and (iii), taking into account any factors believed to be relevant to the particular proceeding. As of the date hereof, the firm has estimated the upper end of the range of reasonably possible loss for such proceedings and for any other proceedings described below where management has been able to estimate a range of reasonably possible loss to be approximately $3.4 billion in the aggregate.

Management is generally unable to estimate a range of reasonably possible loss for proceedings other than those included in the estimate above, including where (i) plaintiffs have not claimed an amount of money damages, unless management can otherwise determine an appropriate amount, (ii) the proceedings are in early stages, (iii) there is uncertainty as to the likelihood of a class being certified or the ultimate size of the class, (iv) there is uncertainty as to the outcome of pending appeals or motions, (v) there are significant factual issues to be resolved, and/or (vi) there are novel legal issues presented. However, for these cases, management does not believe, based on currently available information, that the outcomes of such proceedings will have a material adverse effect on the firm’s financial condition, though the outcomes could be material to the firm’s operating results for any particular period, depending, in part, upon the operating results for such period.

IPO Process Matters. Group Inc. and GS&Co. are among the numerous financial services companies that have been named as defendants in a variety of lawsuits alleging improprieties in the process by which those companies participated in the underwriting of public offerings in recent years.

 

 

  Goldman Sachs June 2012 Form 10-Q   93


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

GS&Co. was among numerous underwriting firms named as defendants in a number of complaints filed commencing October 3, 2007, in the U.S. District Court for the Western District of Washington alleging violations of Section 16 of the Exchange Act in connection with offerings of securities for 15 issuers during 1999 and 2000. The complaints generally asserted that the underwriters, together with each issuer’s directors, officers and principal shareholders, entered into purported agreements to tie allocations in the offerings to increased brokerage commissions and aftermarket purchase orders. The complaints further alleged that, based upon these and other purported agreements, the underwriters violated the reporting provisions of, and are subject to short-swing profit recovery under, Section 16 of the Exchange Act. The district court granted defendants’ motions to dismiss on the grounds that the plaintiff’s demands were inadequate with respect to certain actions and that the remaining actions were time-barred. On December 2, 2010, the appellate court affirmed in part and reversed in part, upholding the dismissal of seven of the actions in which GS&Co. is a defendant that were dismissed based on the deficient demands but remanding the remaining eight actions in which GS&Co. is a defendant that were dismissed as time-barred for consideration of other bases for dismissal. On March 26, 2012, the U.S. Supreme Court vacated the appellate court’s determination that the actions were timely and remanded the actions to determine if the claims were subject to equitable tolling in further proceedings consistent with the Supreme Court’s opinion. On July 8, 2012, pursuant to the plaintiff’s notices of voluntary dismissal, all of the actions were dismissed with prejudice as to the deficiency of the demand letters and without prejudice as to all other issues, bringing this matter to conclusion.

GS&Co. has been named as a defendant in an action commenced on May 15, 2002 in New York Supreme Court, New York County, by an official committee of unsecured creditors on behalf of eToys, Inc., alleging that the firm intentionally underpriced eToys, Inc.’s initial public offering. The action seeks, among other things, unspecified compensatory damages resulting from the alleged lower amount of offering proceeds. On appeal from rulings on GS&Co.’s motion to dismiss, the New York Court of Appeals dismissed claims for breach of contract, professional malpractice and unjust enrichment, but permitted claims for breach of fiduciary duty and fraud to continue. On remand, the lower court granted GS&Co.’s motion for summary judgment and, on December 8, 2011, the appellate court affirmed the lower court’s decision. The creditors’ motion for reargument or to appeal to the

New York Court of Appeals was denied on May 10, 2012, and on June 8, 2012 the creditors sought leave to appeal directly from that court.

Group Inc. and certain of its affiliates have, together with various underwriters in certain offerings, received subpoenas and requests for documents and information from various governmental agencies and self-regulatory organizations in connection with investigations relating to the public offering process. Goldman Sachs has cooperated with these investigations.

World Online Litigation. In March 2001, a Dutch shareholders’ association initiated legal proceedings for an unspecified amount of damages against GSI and others in Amsterdam District Court in connection with the initial public offering of World Online in March 2000, alleging misstatements and omissions in the offering materials and that the market was artificially inflated by improper public statements and stabilization activities. Goldman Sachs and ABN AMRO Rothschild served as joint global coordinators of the approximately €2.9 billion offering. GSI underwrote 20,268,846 shares and GS&Co. underwrote 6,756,282 shares for a total offering price of approximately €1.16 billion.

The district court rejected the claims against GSI and ABN AMRO, but found World Online liable in an amount to be determined. On appeal, the Netherlands Court of Appeals affirmed in part and reversed in part the decision of the district court, holding that certain of the alleged disclosure deficiencies were actionable as to GSI and ABN AMRO. On further appeal, the Netherlands Supreme Court affirmed the rulings of the Court of Appeals, except that it found certain additional aspects of the offering materials actionable and held that individual investors could potentially hold GSI and ABN AMRO responsible for certain public statements and press releases by World Online and its former CEO. The parties entered into a definitive settlement agreement, dated July 15, 2011, and GSI has paid the full amount of its proposed contribution, approximately €48 million, into an escrow account. In the first quarter of 2012, GSI entered into a settlement agreement, subject to certain conditions, with respect to a claim filed by another shareholders’ association relating to approximately €4 million of World Online shares. GSI and other syndicate members are discussing the possibility of settlement with other groups of shareholders that have made demands for compensation of alleged damages, and GSI has reserved the full amount of its expected contribution to the settlements.

 

 

94   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Research Matters. Group Inc. and certain of its affiliates are subject to a number of investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations relating to research practices, including, among other things, research analysts’ methods for obtaining receipt and distribution of information and communications among research analysts, sales and trading personnel and clients. On June 9, 2011, pursuant to a settlement, a consent order was entered by the Massachusetts Securities Division pursuant to which GS&Co. paid a $10 million civil penalty and agreed to various undertakings regarding certain of its research practices. On April 12, 2012, the SEC and FINRA issued orders in connection with GS&Co.’s settlement of charges relating to matters similar to those involved in the Massachusetts settlement. Pursuant to these settlements, GS&Co. paid $11 million to each of the SEC and FINRA and agreed to various undertakings with regard to its policies and procedures.

Adelphia Communications Fraudulent Conveyance Litigation. GS&Co. is named a defendant in two adversary proceedings commenced in the U.S. Bankruptcy Court for the Southern District of New York, one on July 6, 2003 by a creditors committee, and the second on or about July 31, 2003 by an equity committee of Adelphia Communications, Inc. Those proceedings were consolidated in a single amended complaint filed by the Adelphia Recovery Trust on October 31, 2007. The complaint seeks, among other things, to recover, as fraudulent conveyances, approximately $62.9 million allegedly paid to GS&Co. by Adelphia Communications, Inc. and its affiliates in respect of margin calls made in the ordinary course of business on accounts owned by members of the family that formerly controlled Adelphia Communications, Inc. The district court assumed jurisdiction over the action and, on April 8, 2011, granted GS&Co.’s motion for summary judgment. The plaintiff appealed on May 6, 2011.

Specialist Matters. Spear, Leeds & Kellogg Specialists LLC (SLKS) and certain affiliates have received requests for information from various governmental agencies and self-regulatory organizations as part of an industry-wide investigation relating to activities of floor specialists in recent years. Goldman Sachs has cooperated with the requests.

On March 30, 2004, certain specialist firms on the NYSE, including SLKS, without admitting or denying the allegations, entered into a final global settlement with the SEC and the NYSE covering certain activities during the years 1999 through 2003. The SLKS settlement involves, among other things, (i) findings by the SEC and the NYSE that SLKS violated certain federal securities laws and NYSE rules, and in some cases failed to supervise certain individual specialists, in connection with trades that allegedly disadvantaged customer orders, (ii) a cease and desist order against SLKS, (iii) a censure of SLKS, (iv) SLKS’ agreement to pay an aggregate of $45.3 million in disgorgement and a penalty to be used to compensate customers, (v) certain undertakings with respect to SLKS’ systems and procedures, and (vi) SLKS’ retention of an independent consultant to review and evaluate certain of SLKS’ compliance systems, policies and procedures. Comparable findings were made and sanctions imposed in the settlements with other specialist firms. The settlement did not resolve the related private civil actions against SLKS and other firms or regulatory investigations involving individuals or conduct on other exchanges. On May 26, 2011, the SEC issued an order directing the undistributed settlement funds to be transferred to the U.S. Treasury; the funds will accordingly not be allocated to any settlement fund for the civil actions described below.

SLKS, Spear, Leeds & Kellogg, L.P. and Group Inc. are among numerous defendants named in purported class actions brought beginning in October 2003 on behalf of investors in the U.S. District Court for the Southern District of New York alleging violations of the federal securities laws and state common law in connection with NYSE floor specialist activities. The actions, which have been consolidated, seek unspecified compensatory damages, restitution and disgorgement on behalf of purchasers and sellers of unspecified securities between October 17, 1998 and October 15, 2003. By a decision dated March 14, 2009, the district court granted plaintiffs’ motion for class certification. The defendants’ petition with the U.S. Court of Appeals for the Second Circuit seeking review of the certification ruling was denied, and the specialist defendants’ petition for a rehearing and/or rehearing en banc was denied on February 24, 2010. On December 5, 2011, the parties reached a settlement in principle, subject to documentation and court approval. The firm has reserved the full amount of its proposed contribution to the settlement.

 

 

  Goldman Sachs June 2012 Form 10-Q   95


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Fannie Mae Litigation. GS&Co. was added as a defendant in an amended complaint filed on August 14, 2006 in a purported class action pending in the U.S. District Court for the District of Columbia. The complaint asserts violations of the federal securities laws generally arising from allegations concerning Fannie Mae’s accounting practices in connection with certain Fannie Mae-sponsored REMIC transactions that were allegedly arranged by GS&Co. The complaint does not specify a dollar amount of damages. The other defendants include Fannie Mae, certain of its past and present officers and directors, and accountants. By a decision dated May 8, 2007, the district court granted GS&Co.’s motion to dismiss the claim against it. The time for an appeal will not begin to run until disposition of the claims against other defendants. A motion to stay the action filed by the Federal Housing Finance Agency (FHFA), which took control of the foregoing action following Fannie Mae’s conservatorship, was denied on November 14, 2011.

Beginning in September 2006, Group Inc. and/or GS&Co. were named as defendants in four Fannie Mae shareholder derivative actions in the U.S. District Court for the District of Columbia. The complaints, for which Fannie Mae’s conservator, FHFA, has been substituted for plaintiffs, generally allege that the Goldman Sachs defendants aided and abetted a breach of fiduciary duty by Fannie Mae’s directors and officers in connection with certain Fannie Mae-sponsored REMIC transactions, and one of the complaints also asserts a breach of contract claim. The complaints also name as defendants certain former officers and directors of Fannie Mae as well as an outside accounting firm. The complaints seek, inter alia, unspecified damages. The Goldman Sachs defendants were dismissed without prejudice from the first filed of these actions, and the remaining claims in that action were dismissed for failure to make a demand on Fannie Mae’s board of directors. That dismissal has been affirmed on appeal. The remaining three actions have been dismissed without prejudice to the possible reassertion of the claims in the future.

Compensation-Related Litigation. On January 17, 2008, Group Inc., its Board, executive officers and members of its management committee were named as defendants in a purported shareholder derivative action in the U.S. District Court for the Eastern District of New York predicting that the firm’s 2008 Proxy Statement would violate the federal securities laws by undervaluing certain stock option awards and alleging that senior management received excessive compensation for 2007. The complaint seeks, among other things, an equitable accounting for the allegedly excessive compensation. Plaintiff’s motion for a preliminary injunction to prevent the 2008 Proxy Statement from using options valuations that the plaintiff alleges are incorrect and to require the amendment of SEC Form 4s filed by certain of the executive officers named in the complaint to reflect the stock option valuations alleged by the plaintiff was denied, and plaintiff’s appeal from this denial was dismissed. On February 13, 2009, the plaintiff filed an amended complaint, which added purported direct (i.e., non-derivative) claims based on substantially the same theory. The plaintiff filed a further amended complaint on March 24, 2010, and the defendants’ motion to dismiss this further amended complaint was granted on the ground that dismissal of the shareholder plaintiff’s prior action relating to the firm’s 2007 Proxy Statement based on the failure to make a demand to the Board precluded relitigation of demand futility. On December 19, 2011, the appellate court vacated the order of dismissal, holding only that preclusion principles did not mandate dismissal and remanding for consideration of the alternative grounds for dismissal. On April 18, 2012, plaintiff disclosed that he no longer is a Group Inc. shareholder and thus lacks standing to continue to prosecute the action, as well as the New York state action described below.

On March 24, 2009, the same plaintiff filed an action in New York Supreme Court, New York County against Group Inc., its directors and certain senior executives alleging violation of Delaware statutory and common law in connection with substantively similar allegations regarding stock option awards. On January 7, 2011, the plaintiff filed an amended complaint. Defendants moved to dismiss the amended complaint, and the parties subsequently agreed to stay the state court action pending the final resolution of the appeal from the dismissal of the federal court action in respect of the firm’s 2008 Proxy Statement described above, as well as any remanded proceedings further adjudicating defendants’ motion to dismiss.

 

 

96   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Purported shareholder derivative actions were commenced in New York Supreme Court, New York County and the Delaware Court of Chancery beginning on December 14, 2009, alleging that the Board breached its fiduciary duties in connection with setting compensation levels for the year 2009 and that such levels were excessive. The complaints name as defendants Group Inc., the Board and certain senior executives. The complaints sought, inter alia, unspecified damages, restitution of certain compensation paid, and an order requiring the firm to adopt corporate reforms. On September 21, 2011, the New York court dismissed the plaintiffs’ claims as moot based on a motion filed by the plaintiffs indicating that they no longer intend to pursue their claims. The New York court also denied the plaintiffs’ application for an award of attorneys’ fees in connection with bringing the suit, and plaintiffs have appealed. In the actions brought in the Delaware Court of Chancery, the defendants moved to dismiss, and the plaintiffs amended their complaint on April 28, 2010 to include, among other things, the allegations included in the SEC’s action described in the “Mortgage-Related Matters” section below. By a decision dated October 12, 2011, the Delaware court dismissed plaintiffs’ second amended complaint. The Delaware Supreme Court affirmed the dismissal on May 3, 2012.

Group Inc. and certain of its affiliates are subject to a number of investigations and reviews from various governmental agencies and self-regulatory organizations regarding the firm’s compensation processes. The firm is cooperating with the investigations and reviews.

Mortgage-Related Matters. On April 16, 2010, the SEC brought an action (SEC Action) under the U.S. federal securities laws in the U.S. District Court for the Southern District of New York against GS&Co. and Fabrice Tourre, one of its employees, in connection with a CDO offering made in early 2007 (ABACUS 2007-AC1 transaction), alleging that the defendants made materially false and misleading statements to investors and seeking, among other things, unspecified monetary penalties. Investigations of GS&Co. by FINRA and of GSI by the FSA were subsequently initiated, and Group Inc. and certain of its affiliates have received subpoenas and requests for information from other regulators, regarding CDO offerings, including the ABACUS 2007-AC1 transaction, and related matters.

On July 14, 2010, GS&Co. entered into a consent agreement with the SEC, settling all claims made against GS&Co. in the SEC Action (SEC Settlement), pursuant to which GS&Co. paid $550 million of disgorgement and civil penalties, and which was approved by the U.S. District Court for the Southern District of New York on July 20, 2010.

On January 6, 2011, ACA Financial Guaranty Corp. filed an action against GS&Co. in respect of the ABACUS 2007-AC1 transaction in New York Supreme Court, New York County. The complaint includes allegations of fraudulent inducement, fraudulent concealment and unjust enrichment and seeks at least $30 million in compensatory damages, at least $90 million in punitive damages and unspecified disgorgement. On March 8, 2011, GS&Co. filed a motion to compel arbitration and/or to dismiss the complaint. On April 25, 2011, the plaintiff filed an amended complaint and, on June 3, 2011, GS&Co. moved to dismiss the amended complaint. By a decision dated April 23, 2012, the court granted the motion to dismiss as to the unjust enrichment claim and denied the motion as to the other claims, and on May 29, 2012, GS&Co. appealed the decision to the extent that its motion was denied and filed counterclaims for breach of contract and fraudulent inducement, and third-party claims against ACA Management, LLC for breach of contract, unjust enrichment and indemnification.

Beginning April 22, 2010, a number of putative shareholder derivative actions were filed in New York Supreme Court, New York County, and the U.S. District Court for the Southern District of New York against Group Inc., the Board and certain officers and employees of Group Inc. and its affiliates in connection with mortgage-related matters between 2004 and 2007, including the ABACUS 2007-AC1 transaction and other CDO offerings. These derivative complaints generally included allegations of breach of fiduciary duty, corporate waste, abuse of control, mismanagement, unjust enrichment, misappropriation of information, securities fraud and insider trading, and challenge the accuracy and adequacy of Group Inc.’s disclosure. These derivative complaints sought, among other things, declaratory relief, unspecified compensatory damages, restitution and certain corporate governance reforms. In addition, as described in the “Compensation-Related Litigation” section above, the plaintiffs in the compensation-related Delaware Court of Chancery actions twice amended their complaint, including to assert allegations similar to those in the derivative claims referred to above, the Delaware court granted the defendants’ motion to dismiss the second amended complaint and the Delaware Supreme Court affirmed the dismissal on May 3, 2012.

 

 

  Goldman Sachs June 2012 Form 10-Q   97


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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The federal court cases were consolidated, plaintiffs filed a consolidated amended complaint on August 1, 2011, and, on October 6, 2011, the defendants moved to dismiss the action. On June 25, 2012, in light of the decision of the Delaware Supreme Court, the parties in the New York state action stipulated to a voluntary dismissal, which the court has entered.

Since July 1, 2011, two putative shareholder derivative actions have been filed in the U.S. District Court for the Southern District of New York against Group Inc., the Board and certain officers and employees of Group Inc. and Litton in connection with the servicing of residential mortgage loans and other mortgage-related activities beginning in January 2009. The complaints generally include allegations of breach of fiduciary duty, waste, abuse of control, and mismanagement and seek, among other things, declaratory relief, unspecified damages and certain governance reforms. The district court consolidated the actions, and, on December 20, 2011, the plaintiffs filed a consolidated amended complaint. On January 31, 2012, the defendants moved to dismiss.

In addition, the Board has received books and records demands from two shareholders for materials relating to, among other subjects, the firm’s mortgage servicing and foreclosure activities, participation in federal programs providing assistance to financial institutions and homeowners and loan sales to Fannie Mae and Freddie Mac.

 

Since April 23, 2010, the Board has received letters from shareholders demanding that the Board take action to address alleged misconduct by GS&Co., the Board and certain officers and employees of Group Inc. and its affiliates. The demands generally allege misconduct in connection with the firm’s securitization practices, including the ABACUS 2007-AC1 transaction, the alleged failure by Group Inc. to adequately disclose the SEC investigation that led to the SEC Action, and Group Inc.’s 2009 compensation practices. The demands include a letter from a Group Inc. shareholder, which previously made a demand that the Board investigate and take action in connection with auction products matters, and expanded its demand to address the foregoing matters. The Board has rejected these demands. In August 2011, the shareholder made a books and records demand for materials related to the Board’s rejection of the shareholder’s demand letter in connection with auction products matters. An additional demand that the Board investigate and take action was received from another shareholder in June 2012, relating to the firm’s mortgage-related activities.

In addition, beginning April 26, 2010, a number of purported securities law class actions have been filed in the U.S. District Court for the Southern District of New York challenging the adequacy of Group Inc.’s public disclosure of, among other things, the firm’s activities in the CDO market and the SEC investigation that led to the SEC Action. The purported class action complaints, which name as defendants Group Inc. and certain officers and employees of Group Inc. and its affiliates, have been consolidated, generally allege violations of Sections 10(b) and 20(a) of the Exchange Act and seek unspecified damages. Plaintiffs filed a consolidated amended complaint on July 25, 2011. On October 6, 2011, the defendants moved to dismiss, and by a decision, dated June 21, 2012, the district court dismissed the claims based on Group Inc.’s not disclosing that it had received a “Wells” notice from the staff of the SEC related to the ABACUS 2007-AC1 transaction, but permitted the plaintiffs’ other claims to proceed.

 

 

 

98   Goldman Sachs June 2012 Form 10-Q  


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Notes to Condensed Consolidated Financial Statements

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GS&Co., Goldman Sachs Mortgage Company (GSMC) and GS Mortgage Securities Corp. (GSMSC) and three current or former Goldman Sachs employees are defendants in a putative class action commenced on December 11, 2008 in the U.S. District Court for the Southern District of New York brought on behalf of purchasers of various mortgage pass-through certificates and asset-backed certificates issued by various securitization trusts established by the firm and underwritten by GS&Co. in 2007. The complaint generally alleges that the registration statement and prospectus supplements for the certificates violated the federal securities laws, and seeks unspecified compensatory damages and rescission or rescissionary damages. The defendants’ motion to dismiss the second amended complaint was granted with leave to replead certain claims. On March 31, 2010, the plaintiff filed a third amended complaint relating to two offerings, which the defendants moved to dismiss. This motion to dismiss was denied as to the plaintiff’s Section 12(a)(2) claims and granted as to the plaintiff’s Section 11 claims, and the plaintiff’s motion for reconsideration was denied. The plaintiff filed a motion for entry of final judgment or certification of an interlocutory appeal as to plaintiff’s Section 11 claims, which was denied. The plaintiff then filed a motion for leave to amend to reinstate the damages claims based on allegations that it had sold its securities, which was denied. On May 5, 2011, the court granted plaintiff’s motion for entry of a final judgment dismissing all its claims. The plaintiff has appealed the dismissal with respect to all of the offerings included in its original complaint. On June 3, 2010, another investor (who had unsuccessfully sought to intervene in the action) filed a separate putative class action asserting substantively similar allegations relating to an additional offering pursuant to the 2007 registration statement. The district court twice granted defendants’ motions to dismiss this separate action, both times with leave to replead. On July 9, 2012, plaintiff filed a second amended complaint. These trusts issued, and GS&Co. underwrote, approximately $785 million principal amount of certificates to all purchasers in the offering at issue in this amended complaint.

Group Inc., GS&Co., GSMC and GSMSC are among the defendants in a separate putative class action commenced on February 6, 2009 in the U.S. District Court for the Southern District of New York brought on behalf of purchasers of various mortgage pass-through certificates and asset-backed certificates issued by various securitization trusts established by the firm and underwritten by GS&Co. in 2006. The other original defendants include three current or former Goldman Sachs employees and various rating agencies. The second amended complaint generally alleges that the registration statement and prospectus supplements for the certificates violated the federal securities laws, and seeks unspecified compensatory and rescissionary damages. Defendants moved to dismiss the second amended complaint. On January 12, 2011, the district court granted the motion to dismiss with respect to offerings in which plaintiff had not purchased securities as well as all claims against the rating agencies, but denied the motion to dismiss with respect to a single offering in which the plaintiff allegedly purchased securities. These trusts issued, and GS&Co. underwrote, approximately $698 million principal amount of certificates to all purchasers in the offerings at issue in the complaint (excluding those offerings for which the claims have been dismissed). On February 2, 2012, the district court granted the plaintiff’s motion for class certification and on June 13, 2012, the U.S. Court of Appeals for the Second Circuit granted defendants’ petition to review that ruling. On July 31, 2012, the parties reached a settlement, subject to court approval. The firm has reserved the full amount of the proposed settlement.

On September 30, 2010, a putative class action was filed in the U.S. District Court for the Southern District of New York against GS&Co., Group Inc. and two former GS&Co. employees on behalf of investors in $821 million of notes issued in 2006 and 2007 by two synthetic CDOs (Hudson Mezzanine 2006-1 and 2006-2). The complaint, which was amended on February 4, 2011, asserts federal securities law and common law claims, and seeks unspecified compensatory, punitive and other damages. The defendants moved to dismiss on April 5, 2011, and the motion was granted as to plaintiff’s claim of market manipulation and denied as to the remainder of plaintiff’s claims by a decision dated March 21, 2012. On May 21, 2012, the defendants counterclaimed for breach of contract and fraud.

 

 

  Goldman Sachs June 2012 Form 10-Q   99


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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

GS&Co., GSMC and GSMSC are among the defendants in a lawsuit filed in August 2011 by CIFG Assurance of North America, Inc. (CIFG) in the New York Supreme Court. The complaint alleges that CIFG was fraudulently induced to provide credit enhancement for a 2007 securitization sponsored by GSMC, and seeks, among other things, the repurchase of $24.7 million in aggregate principal amount of mortgages that CIFG had previously stated to be non-conforming, an accounting for any proceeds associated with mortgages discharged from the securitization and unspecified compensatory damages. On October 17, 2011, the Goldman Sachs defendants moved to dismiss. By a decision dated May 1, 2012, the court dismissed the fraud and accounting claims but denied the motion as to certain breach of contract claims that were also alleged. On June 6, 2012, the Goldman Sachs defendants filed counterclaims for breach of contract. In addition, the parties have each appealed the court’s May 1, 2012 decision to the extent adverse. The parties have been ordered to mediate, and proceedings in the trial court have been stayed pending mediation.

Various alleged purchasers of, and counterparties involved in transactions relating to, mortgage pass-through certificates, CDOs and other mortgage-related products (including certain Allstate affiliates, Asset Management Fund and related entities, Basis Yield Alpha Fund (Master), Cambridge Place Investment Management Inc., the Charles Schwab Corporation, the Federal Home Loan Banks of Boston, Chicago, Indianapolis and Seattle, the FHFA (as conservator for Fannie Mae and Freddie Mac), Heungkuk Life Insurance Co. Limited (Heungkuk), Landesbank Baden-Württemberg, Massachusetts Mutual Life Insurance Company, MoneyGram Payment Systems, Inc., the National Credit Union Administration, Phoenix Light SF Limited, Stichting Pensioenfonds ABP, The Union Central Life Insurance Company, Ameritas Life Insurance Corp., Acacia Life Insurance Company, Watertown Savings Bank, The Western and Southern Life Insurance Co., John Hancock and related parties, and Royal Park Investments SA/NV) have filed complaints in state and federal court or initiated arbitration proceedings against firm affiliates, generally alleging that the offering documents for the securities that they purchased contained untrue statements of material facts and material omissions and generally seeking rescission and/or damages. Certain of these complaints allege fraud and seek punitive damages. Certain of these complaints also name other firms as defendants.

 

A number of other entities (including American International Group, Inc. (AIG), Bayerische Landesbank, Deutsche Bank National Trust Company, Deutsche Zentral-Genossenschaftbank, Erste Abwicklungsanstalt and related parties, HSH Nordbank, IKB Deutsche Industriebank AG, John Hancock and related parties, M&T Bank, Norges Bank Investment Management, Prudential Insurance Company of America and related parties, and Sealink Funding Limited) have threatened to assert claims of various types against the firm in connection with various mortgage-related transactions, and the firm has entered into agreements with a number of these entities to toll the relevant statute of limitations.

As of the date hereof, the aggregate notional amount of mortgage-related securities sold to plaintiffs in active cases brought against the firm where those plaintiffs are seeking rescission of such securities was approximately $17.6 billion (which does not reflect adjustment for any subsequent paydowns or distributions or any residual value of such securities, statutory interest or any other adjustments that may be claimed). This amount does not include the threatened claims noted above, potential claims by these or other purchasers in the same or other mortgage-related offerings that have not actually been brought against the firm, or claims that have been dismissed (including claims by Landesbank Baden-Württemberg, which were dismissed pursuant to a judgment of the district court that was affirmed on appeal by a summary order dated April 19, 2012).

In June 2011, Heungkuk filed a criminal complaint against certain past and present employees of the firm in South Korea relating to its purchase of a CDO securitization from Goldman Sachs. The filing does not represent any judgment by a governmental entity, but starts a process whereby the prosecutor investigates the complaint and determines whether to take action.

On September 1, 2011, Group Inc. and GS Bank USA entered into a Consent Order with the Federal Reserve Board relating to the servicing of residential mortgage loans. In addition, on September 1, 2011, GS Bank USA entered into an Agreement on Mortgage Servicing Practices with the New York State Department of Financial Services, Litton and Ocwen, in connection with which Group Inc. agreed to forgive 25% of the unpaid principal balance on certain delinquent first lien residential mortgage loans owned by Group Inc. or a subsidiary, totaling approximately $13 million in principal forgiveness. See Note 18 for further information about these settlements.

 

 

100   Goldman Sachs June 2012 Form 10-Q  


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Notes to Condensed Consolidated Financial Statements

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Group Inc., GS&Co. and GSMC are among the numerous financial services firms named as defendants in a qui tam action originally filed by a relator on April 7, 2010 purportedly on behalf of the City of Chicago and State of Illinois in Cook County, Illinois Circuit Court asserting claims under the Illinois Whistleblower Reward and Protection Act and Chicago False Claims Act, based on allegations that defendants had falsely certified compliance with various Illinois laws, which were purportedly violated in connection with mortgage origination and servicing activities. The complaint, which was originally filed under seal, seeks treble damages and civil penalties. Plaintiff filed an amended complaint on December 28, 2011, naming GS&Co. and GSMC, among others, as additional defendants and a second amended complaint on February 8, 2012. On March 12, 2012, the action was removed to the U.S. District Court for the Northern District of Illinois, and on April 4, 2012, plaintiff filed a motion to remand to state court.

The firm has also received, and continues to receive, requests for information and/or subpoenas from federal, state and local regulators and law enforcement authorities, relating to the mortgage-related securitization process, subprime mortgages, CDOs, synthetic mortgage-related products, particular transactions involving these products, and servicing and foreclosure activities, and is cooperating with these regulators and other authorities, including in some cases agreeing to the tolling of the relevant statute of limitations. See also “Financial Crisis-Related Matters” below.

On February 24, 2012, GS&Co. received a “Wells” notice from the staff of the SEC with respect to the disclosures contained in the offering documents used in connection with a late 2006 offering of approximately $1.3 billion of subprime residential mortgage-backed securities underwritten by GS&Co. On August 6, 2012, GS&Co. was notified by the SEC staff that the investigation into this offering has been completed as to GS&Co. and that the staff does not intend to recommend any enforcement action by the SEC against GS&Co. with respect to this offering.

The firm expects to be the subject of additional putative shareholder derivative actions, purported class actions, rescission and “put back” claims and other litigation, additional investor and shareholder demands, and additional regulatory and other investigations and actions with respect to mortgage-related offerings, loan sales, CDOs, and servicing and foreclosure activities. See Note 18 for further information regarding mortgage-related contingencies.

Auction Products Matters. On August 21, 2008, GS&Co. entered into a settlement in principle with the Office of the Attorney General of the State of New York and the Illinois Securities Department (on behalf of the North American Securities Administrators Association) regarding auction rate securities. Under the agreement, Goldman Sachs agreed, among other things, (i) to offer to repurchase at par the outstanding auction rate securities that its private wealth management clients purchased through the firm prior to February 11, 2008, with the exception of those auction rate securities where auctions were clearing, (ii) to continue to work with issuers and other interested parties, including regulatory and governmental entities, to expeditiously provide liquidity solutions for institutional investors, and (iii) to pay a $22.5 million fine. The settlement is subject to approval by the various states. GS&Co. has entered into consent orders with New York, Illinois and most other states and is in the process of doing so with the remaining states.

On September 4, 2008, Group Inc. was named as a defendant, together with numerous other financial services firms, in two complaints filed in the U.S. District Court for the Southern District of New York alleging that the defendants engaged in a conspiracy to manipulate the auction securities market in violation of federal antitrust laws. The actions were filed, respectively, on behalf of putative classes of issuers of and investors in auction rate securities and seek, among other things, treble damages in an unspecified amount. Defendants’ motion to dismiss was granted on January 26, 2010. On March 1, 2010, the plaintiffs appealed from the dismissal of their complaints.

 

 

  Goldman Sachs June 2012 Form 10-Q   101


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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Beginning in February 2012, GS&Co. was named as respondent in three FINRA arbitrations filed, respectively, by the cities of Houston, Texas and Reno, Nevada and a California school district, based on GS&Co.’s role as underwriter and broker-dealer of the claimants’ issuances of an aggregate of over $1.7 billion of auction rate securities from 2004 through 2007 (in the Houston arbitration, two other financial services firms were named as respondents as well). Each claimant alleges that GS&Co. failed to disclose that it had a practice of placing cover bids on auctions, and failed to offer the claimant the option of a formulaic maximum rate (rather than a fixed maximum rate), and that, as a result, the claimant was forced to engage in a series of expensive refinancing and conversion transactions after the failure of the auction market (at an estimated cost, in the case of Houston, of approximately $90 million). Houston and Reno also allege that GS&Co. advised them to enter into interest rate swaps in connection with their auction rate securities issuances, causing them to incur additional losses (including, in the case of Reno, a swap termination obligation of over $8 million). The claimants assert claims for breach of fiduciary duty, fraudulent concealment, negligent misrepresentation, breach of contract, violations of the Exchange Act and state securities laws, and breach of duties under the rules of the Municipal Securities Rulemaking Board and the NASD, and seek unspecified damages. GS&Co. has moved in federal court to enjoin the Reno and California school district arbitrations pursuant to an exclusive forum selection clause in the transaction documents.

Private Equity-Sponsored Acquisitions Litigation. Group Inc. and “GS Capital Partners” are among numerous private equity firms and investment banks named as defendants in a federal antitrust action filed in the U.S. District Court for the District of Massachusetts in December 2007. As amended, the complaint generally alleges that the defendants have colluded to limit competition in bidding for private equity-sponsored acquisitions of public companies, thereby resulting in lower prevailing bids and, by extension, less consideration for shareholders of those companies in violation of Section 1 of the U.S. Sherman Antitrust Act and common law. The complaint seeks, among other things, treble damages in an unspecified amount. Defendants moved to dismiss on August 27, 2008. The district court dismissed claims relating to certain transactions that were the subject of releases as part of the settlement of shareholder actions challenging such transactions, and by an order dated December 15, 2008 otherwise denied the motion to dismiss. On April 26, 2010, the plaintiffs moved for leave to proceed with a second phase of discovery encompassing additional transactions. On August 18, 2010, the court permitted discovery on eight additional transactions, and the plaintiffs filed a fourth amended complaint on October 7, 2010. On January 13, 2011, the court granted defendants’ motion to dismiss certain aspects of the fourth amended complaint. On March 1, 2011, the court granted the motion filed by certain defendants, including Group Inc., to dismiss another claim of the fourth amended complaint on the grounds that the transaction was the subject of a release as part of the settlement of a shareholder action challenging the transaction. On June 14, 2012, the plaintiffs filed a fifth amended complaint encompassing additional transactions. On July 18, 2012, the court granted defendants’ motion to dismiss certain newly asserted claims on the grounds that certain transactions are subject to releases as part of settlements of shareholder actions challenging those transactions, and denied defendants’ motion to dismiss certain additional claims as time-barred. On July 23, 2012, the defendants filed motions for summary judgment.

 

 

102   Goldman Sachs June 2012 Form 10-Q  


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Notes to Condensed Consolidated Financial Statements

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IndyMac Pass-Through Certificates Litigation. GS&Co. is among numerous underwriters named as defendants in a putative securities class action filed on May 14, 2009 in the U.S. District Court for the Southern District of New York. As to the underwriters, plaintiffs allege that the offering documents in connection with various securitizations of mortgage-related assets violated the disclosure requirements of the federal securities laws. The defendants include IndyMac-related entities formed in connection with the securitizations, the underwriters of the offerings, certain ratings agencies which evaluated the credit quality of the securities, and certain former officers and directors of IndyMac affiliates. On November 2, 2009, the underwriters moved to dismiss the complaint. The motion was granted in part on February 17, 2010 to the extent of dismissing claims based on offerings in which no plaintiff purchased, and the court reserved judgment as to the other aspects of the motion. By a decision dated June 21, 2010, the district court formally dismissed all claims relating to offerings in which no named plaintiff purchased certificates (including all offerings underwritten by GS&Co.), and both granted and denied the defendants’ motions to dismiss in various other respects. On May 17, 2010, four additional investors filed a motion seeking to intervene in order to assert claims based on additional offerings (including two underwritten by GS&Co.). The defendants opposed the motion on the ground that the putative intervenors’ claims were time-barred and, on June 21, 2011, the court denied the motion to intervene with respect to, among others, the claims based on the offerings underwritten by GS&Co. Certain of the putative intervenors (including those seeking to assert claims based on two offerings underwritten by GS&Co.) have appealed.

GS&Co. underwrote approximately $751 million principal amount of securities to all purchasers in the offerings at issue in the May 2010 motion to intervene. On July 11, 2008, IndyMac Bank was placed under an FDIC receivership, and on July 31, 2008, IndyMac Bancorp, Inc. filed for Chapter 7 bankruptcy in the U.S. Bankruptcy Court in Los Angeles, California.

MF Global Securities Litigation. GS&Co. is among numerous underwriters named as defendants in class action complaints filed in the U.S. District Court for the Southern District of New York commencing November 18, 2011. These complaints generally allege that the offering materials for two offerings of MF Global Holdings Ltd. convertible notes (aggregating approximately $575 million in principal amount) in February 2011 and July 2011, among other things, failed to describe adequately the extent of MF Global’s exposure to European sovereign debt, in violation of the disclosure requirements of the federal securities laws. GS&Co. underwrote an aggregate principal amount of approximately $214 million of the notes. On October 31, 2011, MF Global Holdings Ltd. filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court in Manhattan, New York.

GS&Co. has also received inquiries from various governmental and regulatory bodies and self-regulatory organizations concerning certain transactions with MF Global prior to its bankruptcy filing. Goldman Sachs is cooperating with all such inquiries.

 

 

  Goldman Sachs June 2012 Form 10-Q   103


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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Employment-Related Matters. On September 15, 2010, a putative class action was filed in the U.S. District for the Southern District of New York by three former female employees alleging that Group Inc. and GS&Co. have systematically discriminated against female employees in respect of compensation, promotion, assignments, mentoring and performance evaluations. The complaint alleges a class consisting of all female employees employed at specified levels by Group Inc. and GS&Co. since July 2002, and asserts claims under federal and New York City discrimination laws. The complaint seeks class action status, injunctive relief and unspecified amounts of compensatory, punitive and other damages. Group Inc. and GS&Co. filed a motion to stay the claims of one of the named plaintiffs and to compel individual arbitration with that individual, based on an arbitration provision contained in an employment agreement between Group Inc. and the individual. On April 28, 2011, the magistrate judge to whom the district judge assigned the motion denied the motion. On July 7, 2011, the magistrate judge denied Group Inc.’s and GS&Co.’s motion for reconsideration of the magistrate judge’s decision, and on July 21, 2011 Group Inc. and GS&Co. appealed the magistrate judge’s decision to the district court, which affirmed the decision on November 15, 2011. Group Inc. and GS&Co. have appealed that decision to the U.S. Court of Appeals for the Second Circuit. On June 13, 2011, Group Inc. and GS&Co. moved to strike the class allegations of one of the three named plaintiffs based on her failure to exhaust administrative remedies. On September 29, 2011, the magistrate judge recommended denial of the motion to strike and Group Inc. and GS&Co. filed their objections to that recommendation with the district judge presiding over the case on October 11, 2011. By a decision dated January 10, 2012, the district court denied the motion to strike. On July 22, 2011, Group Inc. and GS&Co. moved to strike all of the plaintiffs’ class allegations, and for partial summary judgment as to plaintiffs’ disparate impact claims. By a decision dated January 19, 2012, the magistrate judge recommended that defendants’ motion be denied as premature. The defendants filed objections to that recommendation with the district judge and on July 17, 2012, the district court issued a decision granting in part Group Inc.’s and GS&Co.’s motion to strike plaintiffs’ class allegations on the ground that plaintiffs lacked standing to pursue certain equitable remedies and denying in part Group Inc.’s and GS&Co.’s motion to strike plaintiffs’ class allegations in their entirety as premature.

Hellenic Republic (Greece) Matters. Group Inc. and certain of its affiliates have been subject to a number of investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations in connection with the firm’s transactions with the Hellenic Republic (Greece), including financing and swap transactions, as well as trading and research activities with respect to Greek sovereign debt. Goldman Sachs has cooperated with the investigations and reviews.

Investment Management Services. Group Inc. and certain of its affiliates are parties to various civil litigation and arbitration proceedings and other disputes with clients relating to losses allegedly sustained as a result of the firm’s investment management services. These claims generally seek, among other things, restitution or other compensatory damages and, in some cases, punitive damages. In addition, Group Inc. and its affiliates are subject from time to time to investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations in connection with the firm’s investment management services. Goldman Sachs is cooperating with all such investigations and reviews.

Goldman Sachs Asset Management International (GSAMI) is the defendant in an action filed on July 9, 2012 with the High Court of Justice in London by certain entities representing Vervoer, a Dutch pension fund, alleging that GSAMI was negligent in performing its duties as investment manager in connection with the allocation of the plaintiffs’ funds among asset managers in accordance with asset allocations provided by plaintiffs and that GSAMI breached its contractual and common law duties to the plaintiffs. Specifically, plaintiffs allege that GSAMI provided inadequate disclosure, caused their assets to be invested in unsuitable products for an extended period, thereby causing in excess of €81 million in losses, and caused them to be under-exposed for a period of time to certain other investments that performed well, thereby resulting in foregone potential gains. The plaintiffs are seeking unspecified monetary damages.

 

 

104   Goldman Sachs June 2012 Form 10-Q  


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Financial Advisory Services. Group Inc. and certain of its affiliates are parties to various civil litigation and arbitration proceedings and other disputes with clients and third parties relating to the firm’s financial advisory activities. These claims generally seek, among other things, compensatory damages and, in some cases, punitive damages, and in certain cases allege that the firm did not appropriately disclose or deal with conflicts of interest. In addition, Group Inc. and its affiliates are subject from time to time to investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations in connection with conflicts of interest. Goldman Sachs is cooperating with all such investigations and reviews.

Group Inc., GS&Co. and The Goldman, Sachs & Co. L.L.C. are defendants in an action brought by the founders and former majority shareholders of Dragon Systems, Inc. (Dragon) on November 18, 2008, alleging that the plaintiffs incurred losses due to GS&Co.’s financial advisory services provided in connection with the plaintiffs’ exchange of their purported $300 million interest in Dragon for stock of Lernout & Hauspie Speech Products, N.V. (L&H) in 2000. L&H filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court in Wilmington, Delaware on November 29, 2000. The action is pending in the United States District Court for the District of Massachusetts. The complaint, which was amended in November 2011 following the 2009 dismissal of certain of the plaintiffs’ initial claims, seeks unspecified compensatory, punitive and other damages, and alleges breach of fiduciary duty, breach of contract, breach of implied covenant of good faith and fair dealing, violation of state unfair trade practices laws, negligence, negligent and intentional misrepresentation, gross negligence, willful misconduct and bad faith. Former minority shareholders of Dragon have brought a similar action against GS&Co. with respect to their purported $49 million interest in Dragon, and this action has been consolidated with the action described above for purposes of discovery. All parties have moved for summary judgment.

Sales, Trading and Clearance Practices. Group Inc. and certain of its affiliates are subject to a number of investigations and reviews, certain of which are industry-wide, by various governmental and regulatory bodies and self-regulatory organizations relating to the sales, trading and clearance of corporate and government securities and other financial products, including compliance with the SEC’s short sale rule, algorithmic and quantitative trading, futures trading, transaction reporting, securities lending practices, trading and clearance of credit derivative instruments, commodities trading, private placement practices and compliance with the U.S. Foreign Corrupt Practices Act.

The European Commission announced in April 2011 that it is initiating proceedings to investigate further numerous financial services companies, including Group Inc., in connection with the supply of data related to credit default swaps and in connection with profit sharing and fee arrangements for clearing of credit default swaps, including potential anti-competitive practices. These proceedings are ongoing. The firm has received civil investigative demands from the U.S. Department of Justice (DOJ) for information on similar matters.

Goldman Sachs is cooperating with the investigations and reviews.

Insider Trading Investigations. From time to time, the firm and its employees are the subject of or otherwise involved in regulatory investigations relating to insider trading, the potential misuse of material nonpublic information and the effectiveness of the firm’s insider trading controls and information barriers. It is the firm’s practice to fully cooperate with any such investigations.

 

 

  Goldman Sachs June 2012 Form 10-Q   105


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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

EU Price-Fixing Matter. On July 5, 2011, the European Commission issued a Statement of Objections to Group Inc. raising allegations of an industry-wide conspiracy to fix prices for power cables including by an Italian cable company in which certain Goldman Sachs-affiliated investment funds held ownership interests from 2005 to 2009. The Statement of Objections proposes to hold Group Inc. jointly and severally liable for some or all of any fine levied against the cable company under the concept of parental liability under EU competition law.

Municipal Securities Matters. Group Inc. and certain of its affiliates are subject to a number of investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations relating to transactions involving municipal securities, including wall-cross procedures and conflict of interest disclosure with respect to state and municipal clients, the trading and structuring of municipal derivative instruments in connection with municipal offerings, political contribution rules, underwriting of Build America Bonds and the possible impact of credit default swap transactions on municipal issuers. Goldman Sachs is cooperating with the investigations and reviews.

Group Inc., Goldman Sachs Mitsui Marine Derivative Products, L.P. (GSMMDP) and GS Bank USA are among numerous financial services firms that have been named as defendants in numerous substantially identical individual antitrust actions filed beginning on November 12, 2009 that have been coordinated with related antitrust class action litigation and individual actions, in which no Goldman Sachs affiliate is named, for pre-trial proceedings in the U.S. District Court for the Southern District of New York. The plaintiffs include individual California municipal entities and three New York non-profit entities. All of these

complaints against Group Inc., GSMMDP and GS Bank USA generally allege that the Goldman Sachs defendants participated in a conspiracy to arrange bids, fix prices and divide up the market for derivatives used by municipalities in refinancing and hedging transactions from 1992 to 2008. The complaints assert claims under the federal antitrust laws and either California’s Cartwright Act or New York’s Donnelly Act, and seek, among other things, treble damages under the antitrust laws in an unspecified amount and injunctive relief. On April 26, 2010, the Goldman Sachs defendants’ motion to dismiss complaints filed by several individual California municipal plaintiffs was denied. On August 19, 2011, Group Inc., GSMMDP and GS Bank USA were voluntarily dismissed without prejudice from all actions except one brought by a California municipal entity.

Financial Crisis-Related Matters. Group Inc. and certain of its affiliates are subject to a number of investigations and reviews by various governmental and regulatory bodies and self-regulatory organizations and litigation relating to the 2008 financial crisis, including the establishment and unwind of credit default swaps between Goldman Sachs and AIG and other transactions with, and in the securities of, AIG, The Bear Stearns Companies Inc., Lehman Brothers Holdings Inc. and other firms. Goldman Sachs is cooperating with the investigations and reviews.

In the second quarter of 2011, a Staff Report of the Senate Permanent Subcommittee on Investigations concerning the key causes of the financial crisis was issued. Goldman Sachs and another financial institution were used as case studies with respect to the role of investment banks. The report was referred to the DOJ and the SEC for review. The firm is cooperating with the investigations arising from this referral, which are ongoing.

 

 

106   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and the 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 June 30, 2012, the related condensed consolidated statements of earnings for the three and six months ended June 30, 2012 and 2011, the condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2012 and 2011, the condensed consolidated statement of changes in shareholders’ equity for the six months ended June 30, 2012, and the condensed consolidated statements of cash flows for the six months ended June 30, 2012 and 2011. 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 previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition as of December 31, 2011, and the related consolidated statements of earnings, comprehensive income, changes in shareholders’ equity and cash flows for the year then ended (not presented herein), and in our report dated February 28, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of December 31, 2011, and the condensed consolidated statement of changes in shareholders’ equity for the year ended December 31, 2011, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived.

/s/ PRICEWATERHOUSECOOPERS LLP

New York, New York

August 8, 2012

 

 

  Goldman Sachs June 2012 Form 10-Q   107


Table of Contents

Statistical Disclosures

 

Distribution of Assets, Liabilities and Shareholders’ Equity

The tables below present a summary of consolidated average balances and interest rates.

 

    Three Months Ended June  
    2012     2011  
in millions, except rates  

Average

balance

    Interest    

Average

rate

(annualized)

   

Average

balance

    Interest    

Average

rate

(annualized)

 

Assets

           

Deposits with banks

    $  49,094        $      35        0.29     $  37,466        $     27        0.29

U.S.

    45,400        30        0.27        30,364        22        0.29   

Non-U.S.

    3,694        5        0.54        7,102        5        0.28   

Securities borrowed, securities purchased under agreements to resell, at fair value, and federal funds sold

    347,586        39        0.05        353,754        233        0.26   

U.S.

    196,637        (112     (0.23     228,216        (68     (0.12

Non-U.S.

    150,949        151        0.40        125,538        301        0.96   

Financial instruments owned, at fair value 1, 2

    304,927        2,568        3.39        293,698        2,948        4.03   

U.S.

    187,548        1,727        3.70        187,298        2,115        4.53   

Non-U.S.

    117,379        841        2.88        106,400        833        3.14   

Other interest-earning assets 3

    135,156        413        1.23        144,598        473        1.31   

U.S.

    88,840        250        1.13        100,190        256        1.02   

Non-U.S.

    46,316        163        1.42        44,408        217        1.96   

Total interest-earning assets

    836,763        3,055        1.47        829,516        3,681        1.78   

Cash and due from banks

    7,047                        4,219                   

Other non-interest-earning assets 2

    107,761                        114,532                   

Total assets

    $951,571                        $948,267                   

Liabilities

           

Interest-bearing deposits

    $  54,114        $     95        0.71     $  38,568        $     68        0.71

U.S.

    46,355        85        0.74        31,836        59        0.74   

Non-U.S.

    7,759        10        0.52        6,732        9        0.54   

Securities loaned and securities sold under agreements to repurchase, at fair value

    178,800        216        0.49        178,297        236        0.53   

U.S.

    119,099        96        0.32        113,271        66        0.23   

Non-U.S.

    59,701        120        0.81        65,026        170        1.05   

Financial instruments sold, but not yet purchased 1, 2

    99,141        664        2.69        110,293        763        2.77   

U.S.

    42,496        192        1.82        58,367        278        1.91   

Non-U.S.

    56,645        472        3.35        51,926        485        3.75   

Commercial paper

    1,072        1        0.26        1,372        1        0.27   

U.S.

    69               0.69        95               0.20   

Non-U.S.

    1,003        1        0.23        1,277        1        0.28   

Other borrowings 4, 5

    71,163        151        0.85        74,914        121        0.65   

U.S.

    48,827        126        1.04        48,614        110        0.91   

Non-U.S.

    22,336        25        0.45        26,300        11        0.17   

Long-term borrowings 5, 6

    175,216        891        2.05        186,335        856        1.84   

U.S.

    168,704        854        2.04        179,976        814        1.81   

Non-U.S.

    6,512        37        2.29        6,359        42        2.65   

Other interest-bearing liabilities 7

    212,260        (53     (0.10     202,167        223        0.44   

U.S.

    154,596        (238     (0.62     147,911        (95     (0.26

Non-U.S.

    57,664        185        1.29        54,256        318        2.35   

Total interest-bearing liabilities

    791,766        1,965        1.00        791,946        2,268        1.15   

Non-interest-bearing deposits

    250                        190                   

Other non-interest-bearing liabilities 2

    87,918                        83,657                   

Total liabilities

    879,934                        875,793                   

Shareholders’ equity

           

Preferred stock

    3,538                        3,100                   

Common stock

    68,099                        69,374                   

Total shareholders’ equity

    71,637                        72,474                   

Total liabilities and shareholders’ equity

    $951,571                        $948,267                   

Interest rate spread

                    0.47                     0.63

Net interest income and net yield on interest-earning assets

            $1,090        0.52                $1,413        0.68   

U.S.

            780        0.61                1,093        0.80   

Non-U.S.

            310        0.39                320        0.45   

Percentage of interest-earning assets and interest-bearing liabilities attributable to non-U.S. operations 8

           

Assets

                    38.04                     34.17

Liabilities

                    26.73                        26.75   

 

108   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

Statistical Disclosures

 

    Six Months Ended June  
    2012         2011  
in millions, except rates  

Average

balance

    Interest    

Average

rate

(annualized)

        

Average

balance

    Interest    

Average

rate

(annualized)

 

Assets

             

Deposits with banks

    $  48,562        $      73        0.30         $  35,780        $     56        0.32

U.S.

    44,670        59        0.27            30,089        44        0.29   

Non-U.S.

    3,892        14        0.72            5,691        12        0.43   

Securities borrowed, securities purchased under agreements to resell, at fair value, and federal funds sold

    348,230        25        0.01            349,388        402        0.23   

U.S.

    198,562        (224     (0.23         226,732        (68     (0.06

Non-U.S.

    149,668        249        0.33            122,656        470        0.77   

Financial instruments owned, at fair value 1, 2

    299,592        5,010        3.36            289,123        5,463        3.81   

U.S.

    184,462        3,317        3.62            185,681        3,929        4.27   

Non-U.S.

    115,130        1,693        2.96            103,442        1,534        2.99   

Other interest-earning assets 3

    134,431        780        1.17            141,017        867        1.24   

U.S.

    88,224        486        1.11            97,514        459        0.95   

Non-U.S.

    46,207        294        1.28            43,503        408        1.89   

Total interest-earning assets

    830,815        5,888        1.43            815,308        6,788        1.68   

Cash and due from banks

    6,909                            4,177                   

Other non-interest-earning assets 2

    108,992                            113,718                   

Total assets

    $946,716                            $933,203                   

Liabilities

             

Interest-bearing deposits

    $  51,105        $   186        0.73         $  38,672        $   140        0.73

U.S.

    43,463        166        0.77            32,244        124        0.78   

Non-U.S.

    7,642        20        0.53            6,428        16        0.50   

Securities loaned and securities sold under agreements to repurchase, at fair value

    177,457        427        0.48            173,696        437        0.51   

U.S.

    120,095        180        0.30            112,112        153        0.28   

Non-U.S.

    57,362        247        0.87            61,584        284        0.93   

Financial instruments sold, but not yet purchased 1, 2

    95,364        1,189        2.51            102,841        1,259        2.47   

U.S.

    41,394        354        1.72            53,799        501        1.88   

Non-U.S.

    53,970        835        3.11            49,042        758        3.12   

Commercial paper

    1,180        2        0.27            1,408        2        0.22   

U.S.

    165        1        0.62            73               0.19   

Non-U.S.

    1,015        1        0.22            1,335        2        0.23   

Other borrowings 4, 5

    72,622        318        0.88            72,414        249        0.69   

U.S.

    49,229        262        1.07            47,016        230        0.99   

Non-U.S.

    23,393        56        0.48            25,398        19        0.15   

Long-term borrowings 5, 6

    178,728        1,900        2.14            185,922        1,642        1.78   

U.S.

    171,855        1,801        2.11            179,529        1,548        1.74   

Non-U.S.

    6,873        99        2.90            6,393        94        2.97   

Other interest-bearing liabilities 7

    208,213        (205     (0.20         198,277        288        0.29   

U.S.

    152,666        (489     (0.64         145,602        (149     (0.21

Non-U.S.

    55,547        284        1.03            52,675        437        1.67   

Total interest-bearing liabilities

    784,669        3,817        0.98            773,230        4,017        1.05   

Non-interest-bearing deposits

    217                            155                   

Other non-interest-bearing liabilities 2

    90,660                            85,299                   

Total liabilities

    875,546                            858,684                   

Shareholders’ equity

             

Preferred stock

    3,350                            4,753                   

Common stock

    67,820                            69,766                   

Total shareholders’ equity

    71,170                            74,519                   

Total liabilities and shareholders’ equity

    $946,716                            $933,203                   

Interest rate spread

                    0.45                         0.63

Net interest income and net yield on interest-earning assets

            $2,071        0.50                    $2,771        0.69   

U.S.

            1,363        0.53                    1,957        0.73   

Non-U.S.

            708        0.45                    814        0.60   

Percentage of interest-earning assets and interest-bearing liabilities attributable to non-U.S. operations 8

             

Assets

                    37.90                         33.77

Liabilities

                    26.23                            26.23   

 

  Goldman Sachs June 2012 Form 10-Q   109


Table of Contents

Statistical Disclosures

 

1.

Consists of cash financial instruments, including equity securities and convertible debentures.

 

2.

Derivative instruments and commodities are included in other non-interest-earning assets and other non-interest-bearing liabilities.

 

3.

Primarily consists of cash and securities segregated for regulatory and other purposes and certain receivables from customers and counterparties.

 

4.

Consists of short-term other secured financings and unsecured short-term borrowings, excluding commercial paper.

 

5.

Interest rates include the effects of interest rate swaps accounted for as hedges.

 

6.

Consists of long-term secured financings and unsecured long-term borrowings.

 

7.

Primarily consists of certain payables to customers and counterparties.

 

8.

Assets, liabilities and interest are attributed to U.S. and non-U.S. based on the location of the legal entity in which the assets and liabilities are held.

Ratios

The table below presents selected financial ratios.

 

    

Three Months

Ended June

       

Six Months

Ended June

 
      2012        2011            2012        2011   

Annualized net earnings to average assets

    0.4     0.5         0.6     0.8

Annualized return on average common shareholders’ equity 1

    5.4        6.1            8.8        8.0  4   

Annualized return on average total shareholders’ equity 2

    5.4        6.0            8.6        10.3   

Total average equity to average assets

    7.5        7.6            7.5        8.0   

Dividend payout ratio 3

    25.8        18.9            14.2        20.6   

 

1.

Based on annualized net earnings applicable to common shareholders divided by average monthly common shareholders’ equity.

 

2.

Based on annualized net earnings divided by average monthly total shareholders’ equity.

 

3.

Dividends declared per common share as a percentage of diluted earnings per common share.

 

4.

The $1.64 billion Series G Preferred Stock dividend was not annualized in the calculation of annualized net earnings applicable to common shareholders since it has no impact on other quarters in the year.

 

110   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

Statistical Disclosures

 

Cross-border Outstandings

Cross-border outstandings are based on the Federal Financial Institutions Examination Council’s (FFIEC) regulatory guidelines for reporting cross-border information and represent the amounts that the firm may not be able to obtain from a foreign country due to country-specific events, including unfavorable economic and political conditions, economic and social instability, and changes in government policies.

Credit exposure represents the potential for loss due to the default or deterioration in credit quality of a counterparty or an issuer of securities or other instruments the firm holds and is measured based on the potential loss in an event of non-payment by a counterparty. Credit exposure is reduced through the effect of risk mitigants, such as netting agreements with counterparties that permit the firm to offset receivables and payables with such counterparties or obtaining collateral from counterparties. The tables below do not include all the effects of such risk mitigants and do not represent the firm’s credit exposure.

Claims in the tables below include cash, receivables, securities purchased under agreements to resell, securities borrowed and cash financial instruments, but exclude derivative instruments and commitments. Securities purchased under agreements to resell and securities borrowed are presented gross, without reduction for related securities collateral held, based on the domicile of the counterparty. Margin loans (included in receivables) are presented based on the amount of collateral advanced by the counterparty.

The tables below present cross-border outstandings for each country in which cross-border outstandings exceed 0.75% of consolidated assets in accordance with the FFIEC guidelines.

 

 

    As of June 2012  
in millions   Banks     Governments      Other     Total  

Country

        

France

    $33,743  1      $    3,219         $  5,464        $42,426   

Cayman Islands

    8                31,282        31,290   

Germany

    6,648        15,383         8,527        30,558   

Japan

    19,713        12         9,737        29,462   

United Kingdom

    2,065        2,755         5,889        10,709   

Switzerland

    4,033        92         5,854        9,979   

Canada

    340        1,197         6,727        8,264   

Italy

    830        6,265         917        8,012   

Ireland

    1,118        85         6,069        7,272  2 
    As of December 2011  
in millions   Banks     Governments      Other     Total  

Country

        

France

    $33,916  1      $    2,859         $  3,776        $40,551   

Cayman Islands

                   33,742        33,742   

Japan

    18,745        31         6,457        25,233   

Germany

    5,458        16,089         3,162        24,709   

United Kingdom

    2,111        3,349         5,243        10,703   

Italy

    6,143        3,054         841        10,038  3 

Ireland

    1,148        63         8,801  2      10,012   

China

    6,722        38         2,908        9,668   

Switzerland

    3,836        40         5,112        8,988   

Canada

    676        1,019         6,841        8,536   

Australia

    1,597        470         5,209        7,276   

 

1.

Primarily comprised of secured lending transactions with a clearing house which are secured by collateral.

 

2.

Primarily comprised of interests in and receivables from funds domiciled in Ireland, but whose underlying investments are primarily located outside of Ireland, and secured lending transactions.

 

3.

Primarily comprised of secured lending transactions which are primarily secured by German government obligations.

 

  Goldman Sachs June 2012 Form 10-Q   111


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

INDEX

 

      Page No.
Introduction    113
Executive Overview    113
Business Environment    116
Critical Accounting Policies    117
Use of Estimates    121
Results of Operations    122
Balance Sheet and Funding Sources    136
Equity Capital    143
Off-Balance-Sheet Arrangements and Contractual Obligations    148
Overview and Structure of Risk Management    151
Liquidity Risk Management    156
Market Risk Management    163
Credit Risk Management    168
Operational Risk Management    175
Recent Accounting Developments    176
Certain Risk Factors That May Affect Our Businesses    177
Cautionary Statement Pursuant to the U.S. Private Securities Litigation Reform Act of 1995    178

 

112   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Introduction

The Goldman Sachs Group, Inc. (Group Inc.) is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in all major financial centers around the world.

We report our activities in four business segments: Investment Banking, Institutional Client Services, Investing & Lending and Investment Management. See “Results of Operations” below for further information about our business segments.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2011. References to “our Annual Report on Form 10-K” are to our Annual Report on Form 10-K for the year ended December 31, 2011.

When we use the terms “Goldman Sachs,” “the firm,” “we,” “us” and “our,” we mean Group Inc., a Delaware corporation, and its consolidated subsidiaries.

References to “this Form 10-Q” are to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2012. All references to June 2012 and June 2011 refer to our periods ended, or the dates, as the context requires, June 30, 2012 and June 30, 2011, respectively. All references to March 2012 and December 2011 refer to the dates March 31, 2012 and December 31, 2011, respectively. Any reference to a future year refers to a year ending on December 31 of that year. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.

Executive Overview

Three Months Ended June 2012 versus June 2011. The firm generated net earnings of $962 million for the second quarter of 2012, compared with $1.09 billion for the second quarter of 2011. Our diluted earnings per common share were $1.78 for the second quarter of 2012, compared with $1.85 for the second quarter of 2011. Annualized return on average common shareholders’ equity (ROE) 1 was 5.4% for the second quarter of 2012, compared with 6.1% for the second quarter of 2011.

Book value per common share was $137.00 and tangible book value per common share 2 was $126.12 as of June 2012, both approximately 2% higher compared with the end of the first quarter of 2012. Our Tier 1 capital ratio under Basel 1 was 15.0% and our Tier 1 common ratio under Basel 1 3 was 13.1% as of June 2012, both up slightly from the end of the first quarter of 2012. During the quarter, the firm repurchased 14.3 million shares of its common stock for a total cost of $1.50 billion.

The firm generated net revenues of $6.63 billion for the second quarter of 2012, compared with $7.28 billion for the second quarter of 2011. These results reflected significantly lower net revenues in Investing & Lending, as well as lower net revenues in Investment Banking compared with the second quarter of 2011. These decreases were partially offset by higher net revenues in Institutional Client Services and Investment Management compared with the second quarter of 2011.

In the context of difficult economic and financial conditions, the firm continues to focus on improving operating efficiencies and reducing operating expenses. We are currently targeting approximately $500 million in additional annual run rate compensation and non-compensation reductions that we expect to complete by year-end.

An overview of net revenues for each of our business segments is provided below.

 

 

1.

See “Results of Operations — Financial Overview” below for further information about our calculation of annualized ROE.

 

2.

Tangible book value per common share is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies. See “Equity Capital — Other Capital Metrics” below for further information about our calculation of tangible book value per common share.

 

3.

Tier 1 common ratio is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies. See “Equity Capital — Consolidated Regulatory Capital Ratios” below for further information about our Tier 1 common ratio.

 

  Goldman Sachs June 2012 Form 10-Q   113

 


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Investment Banking

Net revenues in Investment Banking decreased compared with the second quarter of 2011, reflecting significantly lower net revenues in Financial Advisory, as well as lower net revenues in our Underwriting business. The decrease in Financial Advisory reflected a decline in industry-wide completed mergers and acquisitions. Net revenues in equity underwriting were significantly lower compared with the second quarter of 2011, principally due to a decline in industry-wide activity. Net revenues in debt underwriting were higher compared with the second quarter of 2011, reflecting higher net revenues from investment-grade and commercial mortgage-related activity, partially offset by lower net revenues from leveraged finance activity.

Institutional Client Services

Net revenues in Institutional Client Services increased compared with the second quarter of 2011, reflecting significantly higher net revenues in Fixed Income, Currency and Commodities Client Execution, partially offset by lower net revenues in Equities.

The increase in Fixed Income, Currency and Commodities Client Execution compared with the second quarter of 2011 reflected higher net revenues in mortgages and commodities compared with difficult market-making conditions during the second quarter of 2011. During the second quarter of 2012, Fixed Income, Currency and Commodities Client Execution operated in a challenging environment reflecting broad market concerns and uncertainty, which resulted in generally wider credit spreads and lower activity levels compared with the first quarter of 2012.

The decrease in Equities compared with the second quarter of 2011 was primarily due to lower net revenues in equities client execution, reflecting significantly lower net revenues in derivatives. In addition, commissions and fees were lower compared with the second quarter of 2011, generally consistent with broader market activity. Securities services net revenues were lower compared with the second quarter of 2011, reflecting the impact of slightly lower average customer balances. During the second quarter of 2012, Equities operated in an environment characterized by a decrease in global equity prices and higher volatility levels compared with the first quarter of 2012.

Investing & Lending

Net revenues in Investing & Lending were $203 million for the second quarter of 2012, compared with $1.04 billion for the second quarter of 2011. During the second quarter of 2012, Investing & Lending net revenues were negatively impacted by a decrease in global equity prices and generally wider credit spreads. Results for the second quarter of 2012 included a loss of $194 million from our investment in the ordinary shares of Industrial and Commercial Bank of China Limited (ICBC) and net losses of $112 million from other investments in equities, reflecting losses in public equities, largely offset by gains in private equities. In addition, Investing & Lending included net interest income and net gains of $222 million from debt securities and loans, and other net revenues of $287 million, principally related to our consolidated investment entities.

Investment Management

Net revenues in Investment Management increased compared with the second quarter of 2011 due to significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC, partially offset by lower management and other fees, and lower transaction revenues. During the quarter, assets under management increased $12 billion to $836 billion. The increase in assets under management included net inflows of $16 billion 1, primarily in fixed income and money market assets, partially offset by net market depreciation of $4 billion, primarily in equity assets.

Six Months Ended June 2012 versus June 2011. The firm generated net earnings of $3.07 billion for the first half of 2012, compared with $3.82 billion for the first half of 2011. Our diluted earnings per common share were $5.72 for the first half of 2012, compared with $3.40 2 for the first half of 2011. Annualized ROE 3 was 8.8% for the first half of 2012, compared with 8.0% 2 for the first half of 2011.

The firm generated net revenues of $16.58 billion for the first half of 2012, compared with $19.18 billion for the first half of 2011. These results reflected significantly lower net revenues in Investing & Lending, as well as lower net revenues in each of our other business segments compared with the first half of 2011. An overview of net revenues for each of our business segments is provided below.

 

 

1.

Includes $17 billion of fixed income asset inflows in connection with our acquisition of Dwight Asset Management Company LLC (Dwight Asset Management).

 

2.

Excluding the impact of the preferred dividend of $1.64 billion in the first quarter of 2011 related to the redemption of our Series G Preferred Stock (calculated as the difference between the carrying value and the redemption value of the preferred stock), diluted earnings per common share were $6.25 and annualized ROE was 10.2% for the first half of 2011. We believe that presenting our results for the first half of 2011 excluding this dividend is meaningful, as it increases the comparability of period-to-period results. Diluted earnings per common share and annualized ROE excluding this dividend are non-GAAP measures and may not be comparable to similar non-GAAP measures used by other companies. See “Results of Operations — Financial Overview” below for further information about our calculation of diluted earnings per common share and annualized ROE excluding the impact of this dividend.

 

3.

See “Results of Operations — Financial Overview” below for further information about our calculation of annualized ROE.

 

114   Goldman Sachs June 2012 Form 10-Q  

 


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Investment Banking

Net revenues in Investment Banking decreased compared with the first half of 2011, primarily reflecting lower net revenues in our Underwriting business. Net revenues in equity underwriting were significantly lower compared with the first half of 2011, primarily reflecting a decline in industry-wide activity. Net revenues in debt underwriting were essentially unchanged compared with the first half of 2011. In addition, net revenues in Financial Advisory were slightly lower compared with the first half of 2011.

Institutional Client Services

Net revenues in Institutional Client Services decreased compared with the first half of 2011, reflecting lower net revenues in both Fixed Income, Currency and Commodities Client Execution, and Equities.

The decrease in Fixed Income, Currency and Commodities Client Execution compared with the first half of 2011 reflected lower net revenues in credit products, currencies and commodities, partially offset by higher net revenues in interest rate products and mortgages. Although the first quarter of 2012 was generally characterized by tighter credit spreads and improved activity levels, the environment became more challenging during the second quarter of 2012, as broad market concerns and uncertainties resurfaced, which led to generally wider credit spreads and lower activity levels compared with the first quarter of 2012.

The decrease in Equities compared with the first half of 2011 was primarily due to lower commissions and fees, generally consistent with broader market activity. Equities client execution net revenues were slightly lower compared with the first half of 2011, reflecting lower net revenues in derivatives. In addition, securities services net revenues decreased slightly compared with the first half of 2011. During the first half of 2012, Equities operated in an environment generally characterized by higher volatility levels towards the end of the period and an increase in global equity prices, although equity prices decreased during the second quarter.

Investing & Lending

Net revenues in Investing & Lending were $2.11 billion for the first half of 2012, compared with $3.75 billion for the first half of 2011. Results for the first half of 2012 included a loss of $25 million from our investment in the ordinary shares of ICBC and net gains of $779 million from other investments in equities, reflecting gains in private equities. In addition, Investing & Lending included net gains and net interest income of $807 million from debt securities and loans, primarily reflecting the impact of generally tighter credit spreads, particularly during the first quarter of 2012, and other net revenues of $553 million, principally related to our consolidated investment entities.

Investment Management

Net revenues in Investment Management decreased slightly compared with the first half of 2011 due to lower management and other fees, and lower transaction revenues, partially offset by significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC. During the first half of 2012, assets under management increased $8 billion to $836 billion. The increase in assets under management included net market appreciation of $18 billion in fixed income and equity assets, partially offset by net outflows of $10 billion 1. Net outflows included outflows in money market, equity and alternative investment assets, partially offset by inflows in fixed income assets.

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, economic conditions generally and other factors. For a further discussion of the factors that may affect our future operating results, see “Certain Risk Factors That May Affect Our Businesses” below, as well as “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K.

 

 

1.

Includes $17 billion of fixed income asset inflows in connection with our acquisition of Dwight Asset Management.

  Goldman Sachs June 2012 Form 10-Q   115

 


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Business Environment

 

Global

During the second quarter of 2012, global economic conditions weakened, as real gross domestic product (GDP) appeared to decline in Europe, and real GDP in the United States and Japan appeared to grow at a slower pace. In addition, the global economy was further impacted by slowing economic conditions in China. After positive developments during the first quarter of 2012, concerns regarding European sovereign debt risk heightened as a result of political uncertainty in Greece and concerns about the fiscal outlook in Spain and Italy. These conditions contributed to generally wider credit spreads, lower global equity prices and higher volatility levels, which weighed on investment banking activity, particularly in equity and equity-related underwriting activity levels. In addition, the price of crude oil declined during the quarter. In response to these weakened macroeconomic conditions, some major central banks moved to further ease monetary policy.

United States

In the United States, real GDP growth decelerated during the quarter. Growth in fixed investment, industrial production and consumer spending slowed and net exports declined. Measures of business and consumer confidence deteriorated. Unemployment levels declined slightly, although the rate of unemployment remained elevated. Measures of inflation declined, reflecting the impact of lower energy prices. Housing market activity continued to improve, although the level of activity remained low. The U.S. Federal Reserve maintained its federal funds rate at a target of zero to 0.25% and extended through the end of the year its program to lengthen the maturity of the U.S. Treasury debt it holds. The 10-year Treasury note yield ended the quarter at 1.67%, 56 basis points lower than the end of the first quarter of 2012. In equity markets, the NASDAQ Composite Index decreased by 5%, and the S&P 500 Index and the Dow Jones Industrial Average each decreased by 3%.

Europe

In the Euro area, real GDP growth appeared to decline during the quarter, reflecting the impact that the ongoing sovereign debt crisis has had on the region’s economic growth. Measures of business confidence deteriorated and measures of inflation declined. The European Central Bank maintained its main refinancing operations rate at 1.00% and continued supporting liquidity in the Eurosystem. The Euro depreciated by 5% against the U.S. dollar. In the United Kingdom, real GDP declined during the quarter, for the third consecutive quarter. The Bank of England maintained its official bank rate at 0.50% and the British pound depreciated by 2% against the U.S. dollar. Long-term government bond yields in the U.K. and the Euro area generally declined during the quarter, although long-term government bond yields in Greece, Spain and Italy increased. The Euro Stoxx 50 Index, the DAX Index, the CAC 40 Index, and the FTSE 100 Index decreased by 9%, 8%, 7%, and 3%, respectively.

Asia

In Japan, real GDP appeared to increase during the quarter, although at a slower pace than in the first quarter of 2012, as growth in domestic demand moderated. The Bank of Japan left its target overnight call rate unchanged at a range of zero to 0.10% and continued to expand its asset purchase program. The yield on 10-year Japanese government bonds decreased, while the Japanese yen appreciated against the U.S. dollar by 4%. The Nikkei 225 Index ended the quarter 11% lower. In China, real GDP growth increased modestly during the quarter, but remained lower compared with the solid pace of growth in previous years. Measures of inflation continued to decline. The People’s Bank of China reduced the reserve requirement ratio by 50 basis points and lowered the benchmark lending and deposit rates. The Chinese yuan depreciated slightly against the U.S. dollar, while the Shanghai Composite Index decreased by 2%. In addition, equity markets in Hong Kong and South Korea decreased during the quarter. In India, real GDP growth appeared to decelerate during the quarter, as domestic demand continued to moderate. In addition, measures of wholesale inflation remained at an elevated level. The Indian rupee depreciated against the U.S. dollar and equity markets ended the second quarter essentially unchanged.

 

 

116   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Critical Accounting Policies

Fair Value

Fair Value Hierarchy. Financial instruments owned, at fair value and Financial instruments sold, but not yet purchased, at fair value (i.e., inventory), as well as certain other financial assets and financial liabilities, are reflected in our condensed consolidated statements of financial condition at fair value (i.e., marked-to-market), with related gains or losses generally recognized in our condensed consolidated statements of earnings. The use of fair value to measure financial instruments is fundamental to our risk management practices and is our most critical accounting policy.

The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the hierarchy under U.S. generally accepted accounting principles (U.S. GAAP) gives (i) the highest priority to unadjusted quoted prices in active markets for identical, unrestricted assets or liabilities (level 1 inputs), (ii) the next priority to inputs other than level 1 inputs that are observable, either directly or indirectly (level 2 inputs), and (iii) the lowest priority to inputs that cannot be observed in market activity (level 3 inputs). Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to their fair value measurement.

The fair values for substantially all of our financial assets and financial liabilities are based on observable prices and inputs and are classified in levels 1 and 2 of the hierarchy. Certain level 2 and level 3 financial assets and financial liabilities may require appropriate valuation adjustments that a market participant would require to arrive at fair value for factors such as counterparty and the firm’s credit quality, funding risk, transfer restrictions, liquidity and bid/offer spreads. Valuation adjustments are generally based on market evidence.

Instruments categorized within level 3 of the fair value hierarchy, which represent approximately 5% of the firm’s total assets, require one or more significant inputs that are not observable. Absent evidence to the contrary, instruments classified within level 3 of the fair value hierarchy are initially valued at transaction price, which is considered to be the best initial estimate of fair value. Subsequent to the transaction date, we use other methodologies to determine fair value, which vary based on the type of instrument. Estimating the fair value of level 3 financial instruments requires judgments to be made. These judgments include:

 

Ÿ  

determining the appropriate valuation methodology and/or model for each type of level 3 financial instrument;

 

Ÿ  

determining model inputs based on an evaluation of all relevant empirical market data, including prices evidenced by market transactions, interest rates, credit spreads, volatilities and correlations; and

 

Ÿ  

determining appropriate valuation adjustments related to illiquidity or counterparty credit quality.

Regardless of the methodology, valuation inputs and assumptions are only changed when corroborated by substantive evidence.

Controls Over Valuation of Financial Instruments. Market makers and investment professionals in our revenue-producing units are responsible for pricing our financial instruments. Our control infrastructure is independent of the revenue-producing units and is fundamental to ensuring that all of our financial instruments are appropriately valued at market-clearing levels. In the event that there is a difference of opinion in situations where estimating the fair value of financial instruments requires judgment (e.g., calibration to market comparables or trade comparison, as described below), the final valuation decision is made by senior managers in control and support functions that are independent of the revenue-producing units (independent control and support functions). This independent price verification is critical to ensuring that our financial instruments are properly valued.

 

 

  Goldman Sachs June 2012 Form 10-Q   117


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Price Verification. The objective of price verification is to have an informed and independent opinion with regard to the valuation of financial instruments under review. Instruments that have one or more significant inputs which cannot be corroborated by external market data are classified within level 3 of the fair value hierarchy. Price verification strategies utilized by our independent control and support functions include:

 

Ÿ  

Trade Comparison. Analysis of trade data (both internal and external where available) is used to determine the most relevant pricing inputs and valuations.

 

Ÿ  

External Price Comparison. Valuations and prices are compared to pricing data obtained from third parties (e.g., broker or dealers, MarkIt, Bloomberg, IDC, TRACE). Data obtained from various sources is compared to ensure consistency and validity. When broker or dealer quotations or third-party pricing vendors are used for valuation or price verification, greater priority is generally given to executable quotations.

 

Ÿ  

Calibration to Market Comparables. Market-based transactions are used to corroborate the valuation of positions with similar characteristics, risks and components.

 

Ÿ  

Relative Value Analyses. Market-based transactions are analyzed to determine the similarity, measured in terms of risk, liquidity and return, of one instrument relative to another or, for a given instrument, of one maturity relative to another.

 

Ÿ  

Collateral Analyses. Margin disputes on derivatives are examined and investigated to determine the impact, if any, on our valuations.

 

Ÿ  

Execution of Trades. Where appropriate, trading desks are instructed to execute trades in order to provide evidence of market-clearing levels.

 

Ÿ  

Backtesting. Valuations are corroborated by comparison to values realized upon sales.

See Notes 5 through 8 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about fair value measurements.

Review of Net Revenues. Independent control and support functions ensure adherence to our pricing policy through a combination of daily procedures, including the explanation and attribution of net revenues based on the underlying factors. Through this process we independently validate net revenues, identify and resolve potential fair value or trade booking issues on a timely basis and ensure that risks are being properly categorized and quantified.

Review of Valuation Models. Quantitative professionals within our Market Risk Management department (Market Risk Management) perform an independent model approval process. This process incorporates a review of a diverse set of model and trade parameters across a broad range of values (including extreme and/or improbable conditions) in order to critically evaluate:

 

Ÿ  

the model’s suitability for valuation and risk management of a particular instrument type;

 

Ÿ  

the model’s accuracy in reflecting the characteristics of the related product and its significant risks;

 

Ÿ  

the suitability and properties of the numerical algorithms incorporated in the model;

 

Ÿ  

the model’s consistency with models for similar products; and

 

Ÿ  

the model’s sensitivity to input parameters and assumptions.

New or changed models are reviewed and approved. Models are evaluated and re-approved annually to assess the impact of any changes in the product or market and any market developments in pricing theories.

 

 

118   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Level 3 Financial Assets at Fair Value. The table below presents financial assets measured at fair value and the amount of such assets that are classified within level 3 of the fair value hierarchy.

Total level 3 financial assets were $46.51 billion, $48.02 billion and $47.94 billion as of June 2012, March 2012 and December 2011, respectively.

See Notes 5 through 8 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about changes in level 3 financial assets and fair value measurements.

 

 

    As of June 2012          As of March 2012         As of December 2011  
in millions  

Total at

Fair Value

   

Level 3

Total

        

Total at

Fair Value

   

Level 3

Total

        

Total at

Fair Value

   

Level 3

Total

 

Commercial paper, certificates of deposit, time deposits and other money market instruments

    $  10,011        $         7            $  10,553        $         8            $  13,440        $       —   

U.S. government and federal agency obligations

    94,949                   90,488                   87,040          

Non-U.S. government and agency obligations

    63,890        8            60,812        105            49,205        148   

Mortgage and other asset-backed loans and securities:

               

Loans and securities backed by commercial real estate

    7,199        3,166            6,724        3,156            6,699        3,346   

Loans and securities backed by residential real estate

    8,467        1,632            8,815        1,610            7,592        1,709   

Bank loans and bridge loans

    20,770        10,461            18,988        11,051            19,745        11,285   

Corporate debt securities

    21,534        2,367            24,370        2,512            22,131        2,480   

State and municipal obligations

    3,493        547            3,407        612            3,089        599   

Other debt obligations

    4,639        1,757            4,702        1,549            4,362        1,451   

Equities and convertible debentures

    74,606        14,420            75,927        14,874            65,113        13,667   

Commodities

    6,330                   9,462                   5,762          

Total cash instruments

    315,888        34,365            314,248        35,477            284,178        34,685   

Derivatives

    71,308        10,501            71,258        11,151            80,028        11,900   

Financial instruments owned, at fair value

    387,196        44,866            385,506        46,628            364,206        46,585   

Securities segregated for regulatory and other purposes

    37,279                   33,679                   42,014          

Securities purchased under agreements to resell

    167,344        1,023            181,050        956            187,789        557   

Securities borrowed

    51,897                   57,062                   47,621          

Receivables from customers and counterparties

    7,444        616            8,328        431            9,682        795   

Total

    $651,160        $46,505            $665,625        $48,015            $651,312        $47,937   

 

  Goldman Sachs June 2012 Form 10-Q   119


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Goodwill and Identifiable Intangible Assets

Goodwill. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date. Goodwill is assessed annually for impairment, or more frequently if events occur or circumstances change that indicate an impairment may exist, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the results of the qualitative assessment are not conclusive, a quantitative goodwill impairment test is performed by comparing the estimated fair value of each reporting unit with its estimated net book value. We derive the fair value based on valuation techniques we believe market participants would use (i.e., observable price-to-earnings multiples and price-to-book multiples). We derive the net book value by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. Estimating the fair value of our reporting units requires management to make judgments. Critical inputs include (i) projected earnings, (ii) estimated long-term growth rates and (iii) cost of equity.

During the second half of 2011, consistent with the decline in stock prices in the broader financial services sector, our stock price declined and throughout most of this period, our market capitalization was below book value. Accordingly, we performed a quantitative impairment test during the fourth quarter of 2011 and determined that goodwill was not impaired. The estimated fair value of our reporting units in which we hold substantially all of our goodwill significantly exceeded the estimated carrying values. We believe that it is appropriate to consider market capitalization, among other factors, as an indicator of fair value over a reasonable period of time.

If the current economic market conditions persist, and there is a prolonged period of weakness in the business environment and financial markets, our earnings may be adversely affected, which could result in an impairment of goodwill in the future. In addition, significant changes to other critical inputs of the goodwill impairment test (e.g., cost of equity) could cause the estimated fair value of our reporting units to decline, which could result in an impairment of goodwill in the future.

See Note 13 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for the carrying value of our goodwill.

Identifiable Intangible Assets. We amortize our identifiable intangible assets (i) over their estimated lives, (ii) based on economic usage or (iii) in proportion to estimated gross profits or premium revenues. Identifiable intangible assets are tested for impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable.

An impairment loss, generally 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. See Note 13 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for the carrying value and estimated remaining lives of our identifiable intangible assets by major asset class and impairments of our identifiable intangible assets.

A prolonged period of market weakness could adversely impact our businesses and impair the value of our identifiable intangible assets. In addition, certain events could indicate a potential impairment of our identifiable intangible assets, including (i) decreases in revenues from commodity-related customer contracts and relationships, (ii) decreases in cash receipts from television broadcast royalties, (iii) an adverse action or assessment by a regulator or (iv) adverse actual experience on the contracts in our variable annuity and life insurance business. Management judgment is required to evaluate whether indications of potential impairment have occurred, and to test intangibles for impairment if required.

 

 

120   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Use of Estimates

 

The use of generally accepted accounting principles requires management to make certain estimates and assumptions. In addition to the estimates we make in connection with fair value measurements, the accounting for goodwill and identifiable intangible assets, and discretionary compensation accruals, the use of estimates and assumptions is also important in determining provisions for losses that may arise from litigation, regulatory proceedings and tax audits.

A substantial portion of our compensation and benefits represents discretionary compensation, which is finalized at year-end. We believe the most appropriate way to allocate estimated annual discretionary compensation 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, the structure of our share-based compensation programs and the external environment. See “Results of Operations — Financial Overview — Operating Expenses” below for information regarding our ratio of compensation and benefits to net revenues.

We estimate and provide for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be reasonably estimated. In accounting for income taxes, we estimate and provide for potential liabilities that may arise out of tax audits to the extent that uncertain tax positions fail to meet the recognition standard under FASB Accounting Standards Codification 740. See Note 24 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about accounting for income taxes.

Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total estimated 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. See Notes 18 and 27 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information on certain judicial, regulatory and legal proceedings.

 

 

  Goldman Sachs June 2012 Form 10-Q   121


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

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. See “Certain Risk Factors That May Affect Our Businesses” below and “Risk Factors” in Part I, Item 1A of our Annual Report on

Form 10-K for a further discussion of the impact of economic and market conditions on our results of operations.

Financial Overview

The table below presents an overview of our financial results.

 

 

    Three Months
Ended June
        Six Months
Ended June
 
$ in millions, except per share amounts   2012     2011          2012     2011  

Net revenues

    $6,627        $7,281            $16,576        $19,175   

Pre-tax earnings

    1,415        1,612            4,596        5,652   

Net earnings

    962        1,087            3,071        3,822   

Net earnings applicable to common shareholders

    927        1,052            3,001        1,960   

Diluted earnings per common share

    1.78        1.85            5.72        3.40  2 

Annualized return on average common shareholders’ equity 1

    5.4     6.1         8.8     8.0 2 

 

1.

Annualized ROE is computed by dividing annualized net earnings applicable to common shareholders by average monthly common shareholders’ equity. The impact of the $1.64 billion Series G Preferred Stock dividend in the first quarter of 2011 was not annualized in the calculation of annualized net earnings applicable to common shareholders for the six months ended June 2011 as this amount had no impact on other quarters in the year. The table below presents our average common shareholders’ equity.

 

    Average for the  
    Three Months
Ended June
        Six Months
Ended June
 
in millions   2012     2011          2012     2011  

Total shareholders’ equity

    $71,637        $72,474            $71,170        $74,519   

Preferred stock

    (3,538     (3,100         (3,350     (4,753

Common shareholders’ equity

    $68,099        $69,374            $67,820        $69,766   

 

2.

Excluding the impact of the preferred dividend of $1.64 billion in the first quarter of 2011 related to the redemption of our Series G Preferred Stock (calculated as the difference between the carrying value and the redemption value of the preferred stock), diluted earnings per common share were $6.25 and annualized ROE was 10.2% for the first half of 2011. We believe that presenting our results for the first half of 2011 excluding this dividend is meaningful, as it increases the comparability of period-to-period results. Diluted earnings per common share and annualized ROE excluding this dividend are non-GAAP measures and may not be comparable to similar non-GAAP measures used by other companies. The tables below present the calculation of net earnings applicable to common shareholders, diluted earnings per common share and average common shareholders’ equity excluding the impact of this dividend.

 

in millions, except per share amount  

Six Months Ended

June 2011

 

Net earnings applicable to common shareholders

    $1,960   

Impact of the Series G Preferred Stock dividend

    1,643   

Net earnings applicable to common shareholders, excluding the impact of the Series G Preferred Stock dividend

    3,603   

Divided by: average diluted common shares outstanding

    576.4   

Diluted earnings per common share, excluding the impact of the Series G Preferred Stock dividend

    $  6.25   

 

in millions   Average for the
Six Months Ended
June 2011
 

Total shareholders’ equity

    $74,519   

Preferred stock

    (4,753

Common shareholders’ equity

    69,766   

Impact of the Series G Preferred Stock dividend

    939   

Common shareholders’ equity, excluding the impact of the Series G Preferred Stock dividend

    $70,705   

 

122   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Net Revenues

Three Months Ended June 2012 versus June 2011. Net revenues on the condensed consolidated statements of earnings were $6.63 billion for the second quarter of 2012, 9% lower than the second quarter of 2011, reflecting significantly lower other principal transactions revenues and net interest income, as well as lower investment banking revenues and commissions and fees. These decreases were partially offset by significantly higher market-making revenues, as well as higher investment management revenues compared with the second quarter of 2011.

Six Months Ended June 2012 versus June 2011. Net revenues on the condensed consolidated statements of earnings were $16.58 billion for the first half of 2012, 14% lower than the first half of 2011, reflecting significantly lower other principal transactions revenues and net interest income, as well as lower investment banking revenues, commissions and fees and market-making revenues. Investment management revenues were essentially unchanged compared with the first half of 2011.

Non-interest Revenues

Investment banking

During the second quarter of 2012, investment banking revenues reflected an operating environment generally characterized by heightened macroeconomic concerns, including concerns about European sovereign debt risk and the slowing economic conditions in the United States and China. These concerns contributed to a decline in global equity prices, an increase in volatility levels and generally wider credit spreads compared with the first quarter of 2012. These factors weighed on investment banking activity, particularly in equity and equity-related underwriting activity levels. If macroeconomic concerns continue and equity prices decline further, resulting in lower levels of client activity, investment banking revenues would likely continue to be negatively impacted.

Three Months Ended June 2012 versus June 2011. Investment banking revenues on the condensed consolidated statements of earnings were $1.21 billion for the second quarter of 2012, 17% lower than the second quarter of 2011, reflecting significantly lower revenues in financial advisory, as well as lower revenues in our underwriting business. The decrease in financial advisory reflected a decline in industry-wide completed mergers and acquisitions. Revenues in equity underwriting were significantly lower compared with the second quarter of 2011, principally due to a decline in industry-wide activity. Revenues in debt underwriting were higher compared with the second quarter of 2011, reflecting higher revenues from investment-grade and commercial mortgage-related activity, partially offset by lower revenues from leveraged finance activity.

Six Months Ended June 2012 versus June 2011. Investment banking revenues on the condensed consolidated statements of earnings were $2.37 billion for the first half of 2012, 13% lower than the first half of 2011, primarily reflecting lower revenues in our underwriting business. Revenues in equity underwriting were significantly lower compared with the first half of 2011, primarily reflecting a decline in industry-wide activity. Revenues in debt underwriting were essentially unchanged compared with the first half of 2011. In addition, revenues in financial advisory were slightly lower compared with the first half of 2011.

Investment management

During the second quarter of 2012, investment management revenues reflected an operating environment generally characterized by decreased asset prices, particularly in equities, and a shift in investor assets away from asset classes with potentially higher risk and returns to asset classes with potentially lower risk and returns. If asset prices decline or investors continue to change their mix of assets to lower risk asset classes or withdraw their assets, investment management revenues would likely be negatively impacted. In addition, continued uncertainty regarding the global economic outlook could result in downward pressure on assets under management.

Three Months Ended June 2012 versus June 2011. Investment management revenues on the condensed consolidated statements of earnings were $1.27 billion for the second quarter of 2012, 7% higher than the second quarter of 2011, due to significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC, partially offset by lower management and other fees, and lower transaction revenues.

Six Months Ended June 2012 versus June 2011. Investment management revenues on the condensed consolidated statements of earnings were $2.37 billion for the first half of 2012, essentially unchanged compared with the first half of 2011, as significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC, were offset by lower management and other fees, and lower transaction revenues.

 

 

  Goldman Sachs June 2012 Form 10-Q   123


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Commissions and fees

Broad market concerns and uncertainties, including concerns about European sovereign debt risk and the slowing economic conditions in the United States and China, heightened during the second quarter of 2012. These concerns and uncertainties resulted in a decrease in global equity prices and higher volatility levels compared with the first quarter of 2012. The macroeconomic challenges during the quarter contributed to generally lower transaction volumes and fees. If macroeconomic concerns continue and equity prices decline further, resulting in lower market volumes, commissions and fees would likely continue to be negatively impacted.

Three Months Ended June 2012 versus June 2011. Commissions and fees on the condensed consolidated statements of earnings were $799 million for the second quarter of 2012, 11% lower than the second quarter of 2011, generally consistent with broader market activity.

Six Months Ended June 2012 versus June 2011. Commissions and fees on the condensed consolidated statements of earnings were $1.66 billion for the first half of 2012, 13% lower than the first half of 2011, generally consistent with broader market activity.

Market making

During the second quarter of 2012, market-making revenues reflected a challenging operating environment, as broad market concerns and uncertainties resurfaced, with the sovereign debt situation in Europe remaining the primary concern. The outlook for the global economy was further impacted by concerns about slowing economic conditions in the United States and China as a result of weak economic data during the quarter. These conditions resulted in generally wider credit spreads, lower global equity prices, higher volatility levels and lower activity levels in most businesses, compared with the first quarter of 2012, and negatively impacted revenues during the quarter. In addition, other broad market concerns persisted, such as continued uncertainty over financial regulatory reform. If these concerns and uncertainties continue over the long term, market-making revenues would likely continue to be negatively impacted.

Three Months Ended June 2012 versus June 2011. Market-making revenues on the condensed consolidated statement of earnings were $2.10 billion for the second quarter of 2012, 21% higher than the second quarter of 2011, reflecting higher revenues in mortgages and commodities compared with difficult market-making conditions during the second quarter of 2011, partially offset by lower revenues in most of our other major market-making activities, particularly in equity derivatives. During the second quarter of 2012, market-making revenues reflected a challenging operating environment characterized by broad market concerns and uncertainty, which resulted in generally wider credit spreads, lower global equity prices, higher volatility levels and lower activity levels compared with the first quarter of 2012.

Six Months Ended June 2012 versus June 2011. Market-making revenues on the condensed consolidated statement of earnings were $6.00 billion for the first half of 2012, 3% lower than the first half of 2011, primarily reflecting lower revenues in credit products, equity derivatives, currencies and commodities, partially offset by higher revenues in interest rate products and mortgages. Although the first quarter of 2012 was generally characterized by tighter credit spreads, higher global equity prices, lower volatility levels and improved activity levels, the environment became more challenging during the second quarter of 2012, as broad market concerns and uncertainties resurfaced, which led to generally wider credit spreads, lower global equity prices, higher volatility levels and lower activity levels compared with the first quarter of 2012.

 

 

124   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Other principal transactions

During the second quarter of 2012, other principal transactions revenues reflected an operating environment characterized by a decrease in global equity prices and generally wider credit spreads, as broad market concerns and uncertainties resurfaced, with the sovereign debt situation in Europe remaining the primary concern. The outlook for the global economy was further impacted by concerns about slowing economic conditions in the United States and China as a result of weak economic data during the quarter. In addition, other broad market concerns persisted, such as continued uncertainty over financial regulatory reform. If equity prices continue to decline and credit spreads continue to widen, other principal transactions revenues would likely continue to be negatively impacted.

Three Months Ended June 2012 versus June 2011. Other principal transactions revenues on the condensed consolidated statements of earnings were $169 million for the second quarter of 2012, compared with $602 million for the second quarter of 2011. Results for the second quarter of 2012 included a loss from our investment in the ordinary shares of ICBC and net losses from other investments in equities, reflecting losses in public equities, largely offset by gains in private equities. In addition, other principal transactions revenues included net gains from debt securities and loans, and revenues related to our consolidated investment entities. In the second quarter of 2011, other principal transactions revenues primarily included net gains from private equities and revenues from our consolidated investment entities, partially offset by net losses from our investment in the ordinary shares of ICBC and other public equities.

Six Months Ended June 2012 versus June 2011. Other principal transactions revenues on the condensed consolidated statements of earnings were $2.11 billion for the first half of 2012, compared with $3.21 billion for the first half of 2011. Results for the first half of 2012 included a loss from our investment in the ordinary shares of ICBC and net gains from other investments in equities, reflecting gains in private equities. In addition, other principal transactions revenues included net gains from debt securities and loans, and revenues related to our consolidated investment entities. In the first half of 2011, other principal transactions revenues primarily included net gains from private equities, net gains from debt securities and loans, and revenues from our consolidated investment entities.

Net Interest Income

Three Months Ended June 2012 versus June 2011. Net interest income on the condensed consolidated statements of earnings was $1.09 billion for the second quarter of 2012, 23% lower than the second quarter of 2011. The decrease compared with the second quarter of 2011 was primarily due to lower average yields on financial instruments owned, at fair value and collateralized agreements.

Six Months Ended June 2012 versus June 2011. Net interest income on the condensed consolidated statements of earnings was $2.07 billion for the first half of 2012, 25% lower than the first half of 2011. The decrease compared with the first half of 2011 was primarily due to lower average yields on financial instruments owned, at fair value and collateralized agreements, as well as higher interest expense related to our long-term borrowings.

Operating Expenses

Our operating expenses are primarily influenced by compensation, headcount and levels of business activity. Compensation and benefits includes salaries, estimated year-end discretionary compensation, amortization of equity awards and other items such as benefits. Discretionary compensation is significantly impacted by, among other factors, the level of net revenues, prevailing labor markets, business mix, the structure of our share-based compensation programs and the external environment.

In the context of more difficult economic and financial conditions, the firm launched an initiative during the second quarter of 2011 to identify areas where we can operate more efficiently and reduce our operating expenses. We have met our 2011 targeted annual run rate compensation and non-compensation reduction of approximately $1.4 billion. We are currently targeting approximately $500 million in additional annual run rate compensation and non-compensation reductions that we expect to complete by year-end.

 

 

  Goldman Sachs June 2012 Form 10-Q   125


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The table below presents our operating expenses and total staff.

 

    Three Months
Ended June
        Six Months
Ended June
 
$ in millions     2012        2011            2012        2011   

 

Compensation and benefits

    $  2,915        $  3,204            $  7,293        $  8,437   

Brokerage, clearing, exchange and distribution fees

    544        615            1,111        1,235   

 

Market development

    129        183            246        362   

 

Communications and technology

    202        210            398        408   

 

Depreciation and amortization

    409        372            842        962   

 

Occupancy

    214        252            426        519   

 

Professional fees

    213        263            447        496   

 

Insurance reserves 1

    121        117            278        205   

 

Other expenses

    465        453            939        899   

 

Total non-compensation expenses

    2,297        2,465            4,687        5,086   

 

Total operating expenses

    $  5,212        $  5,669            $11,980        $13,523   

 

Total staff at period-end 2

    32,300        35,500                       

 

1.

Revenues related to our insurance activities are included in “Market making” on the condensed consolidated statements of earnings.

 

2.

Includes employees, consultants and temporary staff.

 

Three Months Ended June 2012 versus June 2011. Operating expenses were $5.21 billion for the second quarter of 2012, 8% lower than the second quarter of 2011. The accrual for compensation and benefits expenses was $2.92 billion for the second quarter of 2012, a 9% decline compared with the second quarter of 2011. Total staff remained essentially unchanged during the second quarter of 2012.

Non-compensation expenses were $2.30 billion, 7% lower than the second quarter of 2011. The decrease compared with the second quarter of 2011 primarily reflected decreased levels of business activity and the impact of expense reduction initiatives, partially offset by higher impairment charges related to consolidated investment entities during the second quarter of 2012. The second quarter of 2012 included net provisions for litigation and regulatory proceedings of $67 million.

Six Months Ended June 2012 versus June 2011. Operating expenses were $11.98 billion for the first half of 2012, 11% lower than the first half of 2011. The accrual for compensation and benefits expenses was $7.29 billion for the first half of 2012, a 14% decline compared with the first half of 2011. The ratio of compensation and benefits to net revenues for the first half of 2012 was 44.0%, consistent with the first half of 2011. Total staff decreased 3% during the first half of 2012.

Non-compensation expenses were $4.69 billion, 8% lower than the first half of 2011. The decrease compared with the first half of 2011 primarily reflected decreased levels of business activity, the impact of expense reduction initiatives and lower impairment charges during the first half of 2012.

These decreases were partially offset by increased reserves related to our insurance business. The first half of 2012 included net provisions for litigation and regulatory proceedings of $126 million.

Provision for Taxes

The effective income tax rate for the first half of 2012 was 33.2%, down slightly from 33.7% for the first quarter of 2012 and up from 28.0% for 2011. The increase in the effective income tax rate from 28.0% to 33.2% was primarily due to the earnings mix and a decrease in the impact of permanent benefits.

Effective January 1, 2012, the rules related to the deferral of U.S. tax on certain non-repatriated active financing income expired. This change did not have a material effect on our financial condition, results of operations or cash flows as of or for the three and six months ended June 2012 and we do not expect this change to have a material effect on our financial condition, results of operations or cash flows for the remainder of 2012. This change may have a material impact on our effective tax rate for 2013 if the expired provisions are not re-enacted.

During March 2012, the United Kingdom government announced a budget proposal that would reduce the corporate income tax rate effective April 1, 2012. This budget proposal was enacted into law during the third quarter of 2012. We do not expect this change to have a material impact on our financial condition, results of operations or cash flows for the remainder of 2012.

 

 

126   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Segment Operating Results

The table below presents the net revenues, operating expenses and pre-tax earnings of our segments.

 

        Three Months
Ended June
        Six Months
Ended June
 
in millions        2012     2011          2012     2011  

Investment Banking

 

Net revenues

    $1,203        $1,448          $  2,357        $  2,717   
   

Operating expenses

    869        981            1,735        1,904   
   

Pre-tax earnings

    $   334        $   467            $     622        $     813   

Institutional Client Services

 

Net revenues

    $3,889        $3,515          $  9,598        $10,162   
   

Operating expenses

    2,947        3,040            6,830        7,624   
   

Pre-tax earnings

    $   942        $   475            $  2,768        $  2,538   

Investing & Lending

 

Net revenues

    $   203        $1,044          $  2,114        $  3,749   
   

Operating expenses

    256        547            1,214        1,778   
   

Pre-tax earnings/(loss)

    $    (53     $   497            $     900        $  1,971   

Investment Management

 

Net revenues

    $1,332        $1,274          $  2,507        $  2,547   
   

Operating expenses

    1,070        1,056            2,060        2,123   
   

Pre-tax earnings

    $   262        $   218            $     447        $     424   

Total

 

Net revenues

    $6,627        $7,281          $16,576        $19,175   
   

Operating expenses

    5,212        5,669            11,980        13,523   
   

Pre-tax earnings

    $1,415        $1,612            $  4,596        $  5,652   

 

Total operating expenses in the table above include the following expenses that have not been allocated to our segments:

 

Ÿ  

net provisions for a number of litigation and regulatory proceedings of $67 million and $45 million for the three months ended June 2012 and June 2011, respectively, and $126 million and $69 million for the six months ended June 2012 and June 2011, respectively;

 

Ÿ  

charitable contributions of $12 million and $25 million for the six months ended June 2012 and June 2011, respectively; and

 

Ÿ  

real estate-related exit costs of $3 million for both the three and six months ended June 2012.

Net revenues in our segments include allocations of interest income and interest expense to specific securities, commodities and other positions in relation to the cash generated by, or funding requirements of, such underlying positions. See Note 25 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our business segments.

The cost drivers of Goldman Sachs taken as a whole —compensation, headcount and levels of business activity — are broadly similar in each of our business segments. Compensation and benefits expenses within our segments reflect, among other factors, the overall performance of Goldman Sachs as well as the performance of individual businesses. Consequently, pre-tax margins in one segment of our business may be significantly affected by the performance of our other business segments. A discussion of segment operating results follows.

 

 

  Goldman Sachs June 2012 Form 10-Q   127


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Investment Banking

Our Investment Banking segment is comprised of:

Financial Advisory. Includes advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, risk management, restructurings and spin-offs, and derivative transactions directly related to these client advisory assignments.

Underwriting. Includes public offerings and private placements of a wide range of securities, loans and other financial instruments, and derivative transactions directly related to these client underwriting activities.

The table below presents the operating results of our Investment Banking segment.

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions   2012     2011          2012     2011  

Financial Advisory

    $  469        $    637            $   958        $    994   

Equity underwriting

    239        378            494        804   

Debt underwriting

    495        433            905        919   

Total Underwriting

    734        811            1,399        1,723   

Total net revenues

    1,203        1,448            2,357        2,717   

Operating expenses

    869        981            1,735        1,904   

Pre-tax earnings

    $  334        $    467            $   622        $    813   

The table below presents our financial advisory and underwriting transaction volumes.1

 

    Three Months
Ended June
        Six Months
Ended June
 
in billions   2012     2011          2012     2011  

Announced mergers and acquisitions

    $178        $183            $305        $354   

Completed mergers and acquisitions

    160        190            242        355   

Equity and equity-related offerings 2

    11        17            24        42   

Debt offerings 3

    41        60            109        133   

 

1.

Source: Thomson Reuters. Announced and completed mergers and acquisitions volumes are based on full credit to each of the advisors in a transaction. Equity and equity-related offerings and debt offerings are based on full credit for single book managers and equal credit for joint book managers. Transaction volumes may not be indicative of net revenues in a given period. In addition, transaction volumes for prior periods may vary from amounts previously reported due to the subsequent withdrawal or a change in the value of a transaction.

 

2.

Includes Rule 144A and public common stock offerings, convertible offerings and rights offerings.

 

3.

Includes non-convertible preferred stock, mortgage-backed securities, asset-backed securities and taxable municipal debt. Includes publicly registered and Rule 144A issues. Excludes leveraged loans.

Three Months Ended June 2012 versus June 2011. Net revenues in Investment Banking were $1.20 billion, 17% lower than the second quarter of 2011.

Net revenues in Financial Advisory were $469 million, 26% lower than the second quarter of 2011, reflecting a decline in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business were $734 million, 9% lower than the second quarter of 2011. Net revenues in equity underwriting were significantly lower compared with the second quarter of 2011, principally due to a decline in industry-wide activity. Net revenues in debt underwriting were higher compared with the second quarter of 2011, reflecting higher net revenues from investment-grade and commercial mortgage-related activity, partially offset by lower net revenues from leveraged finance activity.

During the second quarter of 2012, Investment Banking operated in an environment generally characterized by heightened macroeconomic concerns, including concerns about European sovereign debt risk and the slowing economic conditions in the United States and China. These concerns contributed to a decline in global equity prices, an increase in volatility levels and generally wider credit spreads compared with the first quarter of 2012. These factors weighed on investment banking activity, particularly in equity and equity-related underwriting activity levels. If macroeconomic concerns continue and equity prices decline further, resulting in lower levels of client activity, net revenues in Investment Banking would likely continue to be negatively impacted.

Our investment banking transaction backlog increased compared with the end of the first quarter of 2012. The increase compared with the end of the first quarter of 2012 was due to an increase in potential debt underwriting transactions, primarily reflecting an increase in client mandates to underwrite leveraged finance transactions, as well as higher estimated net revenues from potential advisory transactions. These increases were partially offset by a decrease in potential equity underwriting transactions compared with the end of the first quarter of 2012, reflecting a decrease in client mandates to underwrite initial public offerings.

 

 

128   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Our investment banking transaction backlog represents an estimate of our future net revenues from investment banking transactions where we believe that future revenue realization is more likely than not. We believe changes in our investment banking transaction backlog may be a useful indicator of client activity levels which, over the long term, impact our net revenues. However, the timeframe for completion and corresponding revenue recognition of transactions in our backlog varies based on the nature of the assignment, as certain transactions may remain in our backlog for longer periods of time and others may enter and leave within the same reporting period. In addition, our transaction backlog is subject to certain limitations, such as assumptions about the likelihood that individual client transactions will occur in the future. Transactions may be cancelled or modified, and transactions not included in the estimate may also occur.

Operating expenses were $869 million for the second quarter of 2012, 11% lower than the second quarter of 2011, primarily due to decreased compensation and benefits expenses. Pre-tax earnings were $334 million in the second quarter of 2012, 28% lower than the second quarter of 2011.

Six Months Ended June 2012 versus June 2011. Net revenues in Investment Banking were $2.36 billion, 13% lower than the first half of 2011.

Net revenues in Financial Advisory were $958 million, 4% lower than the first half of 2011. Net revenues in our Underwriting business were $1.40 billion, 19% lower than the first half of 2011. Net revenues in equity underwriting were significantly lower compared with the first half of 2011, primarily reflecting a decline in industry-wide activity. Net revenues in debt underwriting were essentially unchanged compared with the first half of 2011.

During the first half of 2012, Investment Banking operated in an environment generally characterized by heightened macroeconomic concerns, including concerns about European sovereign debt risk and the slowing economic conditions in the United States and China, despite positive developments during the first quarter of 2012. These concerns weighed on investment banking activity, particularly in equity and equity-related underwriting activity levels. If macroeconomic concerns continue and equity prices decline, resulting in lower levels of client activity, net revenues in Investment Banking would likely continue to be negatively impacted.

Our investment banking transaction backlog increased compared with the end of 2011. The increase compared with the end of 2011 was due to an increase in potential debt underwriting transactions, primarily reflecting an increase in client mandates to underwrite leveraged finance transactions, as well as an increase in potential advisory transactions. These increases were partially offset by a decrease in potential equity underwriting transactions compared with the end of 2011, reflecting a decrease in client mandates to underwrite initial public offerings.

Operating expenses were $1.74 billion for the first half of 2012, 9% lower than the first half of 2011, primarily due to decreased compensation and benefits expenses. Pre-tax earnings were $622 million in the first half of 2012, 23% lower than the first half of 2011.

Institutional Client Services

Our Institutional Client Services segment is comprised of:

Fixed Income, Currency and Commodities Client Execution. Includes client execution activities related to making markets in interest rate products, credit products, mortgages, currencies and commodities.

We generate market-making revenues in these activities, in three ways:

 

Ÿ  

In large, highly liquid markets (such as markets for U.S. Treasury bills, large capitalization S&P 500 stocks or certain mortgage pass-through certificates), we execute a high volume of transactions for our clients for modest spreads and fees.

 

Ÿ  

In less liquid markets (such as mid-cap corporate bonds, growth market currencies and certain non-agency mortgage-backed securities), we execute transactions for our clients for spreads and fees that are generally somewhat larger.

 

Ÿ  

We also structure and execute transactions involving customized or tailor-made products that address our clients’ risk exposures, investment objectives or other complex needs (such as a jet fuel hedge for an airline).

 

 

  Goldman Sachs June 2012 Form 10-Q   129


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Given the focus on the mortgage market, our mortgage activities are further described below.

Our activities in mortgages include commercial mortgage-related securities, loans and derivatives, residential mortgage-related securities, loans and derivatives (including U.S. government agency-issued collateralized mortgage obligations, other prime, subprime and Alt-A securities and loans), and other asset-backed securities, loans and derivatives.

We buy, hold and sell long and short mortgage positions, primarily for market making for our clients. Our inventory therefore changes based on client demands and is generally held for short-term periods.

See Notes 18 and 27 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information about exposure to mortgage repurchase requests, mortgage rescissions and mortgage-related litigation.

Equities. Includes client execution activities related to making markets in equity products, as well as commissions and fees from executing and clearing institutional client transactions on major stock, options and futures exchanges worldwide. Equities also includes our securities services business, which provides financing, securities lending and other prime brokerage services to institutional clients, including hedge funds, mutual funds, pension funds and foundations, and generates revenues primarily in the form of interest rate spreads or fees, and revenues related to our insurance activities.

The table below presents the operating results of our Institutional Client Services segment.

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions     2012        2011            2012        2011   

Fixed Income, Currency and Commodities Client Execution

    $2,194        $1,599            $5,652        $  5,924   

Equities client execution

    510        623            1,560        1,602   

Commissions and fees

    776        861            1,610        1,832   

Securities services

    409        432            776        804   

Total Equities

    1,695        1,916            3,946        4,238   

Total net revenues

    3,889        3,515            9,598        10,162   

Operating expenses

    2,947        3,040            6,830        7,624   

Pre-tax earnings

    $   942        $   475            $2,768        $  2,538   

Three Months Ended June 2012 versus June 2011. Net revenues in Institutional Client Services were $3.89 billion, 11% higher than the second quarter of 2011.

Net revenues in Fixed Income, Currency and Commodities Client Execution were $2.19 billion, 37% higher than the second quarter of 2011, reflecting higher net revenues in mortgages and commodities compared with difficult market-making conditions during the second quarter of 2011. During the second quarter of 2012, Fixed Income, Currency and Commodities Client Execution operated in a challenging environment reflecting broad market concerns and uncertainty, which resulted in generally wider credit spreads and lower activity levels compared with the first quarter of 2012.

Net revenues in Equities were $1.70 billion, 12% lower than the second quarter of 2011, primarily due to lower net revenues in equities client execution, reflecting significantly lower net revenues in derivatives. In addition, commissions and fees were lower compared with the second quarter of 2011, generally consistent with broader market activity. Securities services net revenues were lower compared with the second quarter of 2011, reflecting the impact of slightly lower average customer balances. During the second quarter of 2012, Equities operated in an environment characterized by a decrease in global equity prices and higher volatility levels compared with the first quarter of 2012.

The net gain attributable to the impact of changes in our own credit spreads on borrowings for which the fair value option was elected was $6 million for the second quarter of 2012 compared with $85 million for the second quarter of 2011.

 

 

130   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

During the second quarter of 2012, Institutional Client Services operated in a challenging environment, as broad market concerns and uncertainties resurfaced, with the sovereign debt situation in Europe remaining the primary concern. The outlook for the global economy was further impacted by concerns about slowing economic conditions in the United States and China as a result of weak economic data during the quarter. These conditions resulted in generally wider credit spreads, lower global equity prices, higher volatility levels and lower activity levels in most businesses, compared with the first quarter of 2012, and negatively impacted net revenues during the quarter. In addition, other broad market concerns persisted, such as continued uncertainty over financial regulatory reform. If these concerns and uncertainties continue over the long term, net revenues in Fixed Income, Currency and Commodities Client Execution and Equities would likely continue to be negatively impacted.

Operating expenses were $2.95 billion for the second quarter of 2012, 3% lower than the second quarter of 2011, primarily due to decreased levels of business activity. Pre-tax earnings were $942 million in the second quarter of 2012, compared with $475 million in the second quarter of 2011.

Six Months Ended June 2012 versus June 2011. Net revenues in Institutional Client Services were $9.60 billion, 6% lower than the first half of 2011.

Net revenues in Fixed Income, Currency and Commodities Client Execution were $5.65 billion, 5% lower than the first half of 2011, reflecting lower net revenues in credit products, currencies and commodities, partially offset by higher net revenues in interest rate products and mortgages. Although the first quarter of 2012 was generally characterized by tighter credit spreads and improved activity levels, the environment became more challenging during the second quarter of 2012, as broad market concerns and uncertainties resurfaced, which led to generally wider credit spreads and lower activity levels compared with the first quarter of 2012.

Net revenues in Equities were $3.95 billion, 7% lower than the first half of 2011, primarily due to lower commissions and fees, generally consistent with broader market activity. Equities client execution net revenues were slightly lower compared with the first half of 2011, reflecting lower net revenues in derivatives. In addition, securities services net revenues decreased slightly compared with the first half of 2011. During the first half of 2012, Equities operated in an environment generally characterized by higher volatility levels towards the end of the period and an increase in global equity prices, although equity prices decreased during the second quarter.

The net loss attributable to the impact of changes in our own credit spreads on borrowings for which the fair value option was elected was $218 million for the first half of 2012, compared with a net gain of $126 million for the first half of 2011.

Institutional Client Services operated in an environment generally characterized by broad market concerns and uncertainties. Positive developments during the first quarter of 2012 helped to improve market conditions, including actions undertaken by the European Central Bank and other central banks to address funding risks for European financial institutions, the progress in resolving Greece’s debt situation, as well as encouraging U.S. economic data. However, during the second quarter of 2012, concerns surrounding the stability of the global economy and its future prospects resurfaced, with the sovereign debt situation in Europe remaining the primary concern. The outlook for the global economy was further impacted during the second quarter of 2012 by concerns about slowing economic conditions in the United States and China as a result of weak economic data, which led to generally wider credit spreads, lower global equity prices, higher volatility levels and lower activity levels in most businesses. In addition, other broad market concerns persisted, such as continued uncertainty over financial regulatory reform. If these concerns and uncertainties continue over the long term, net revenues in Fixed Income, Currency and Commodities Client Execution and Equities would likely continue to be negatively impacted.

Operating expenses were $6.83 billion for the first half of 2012, 10% lower than the first half of 2011, primarily due to decreased compensation and benefits expenses, the impact of impairment charges during the first half of 2011, principally related to Litton Loan Servicing LP, and decreased levels of business activity. These decreases were partially offset by increased reserves related to our insurance business. Pre-tax earnings were $2.77 billion in the first half of 2012, 9% higher than the first half of 2011.

 

 

  Goldman Sachs June 2012 Form 10-Q   131


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Investing & Lending

Investing & Lending includes our investing activities and the origination of loans to provide financing to clients. These investments and loans are typically longer-term in nature. We make investments, directly and indirectly through funds that we manage, in debt securities, loans, public and private equity securities, real estate, consolidated investment entities and power generation facilities.

The table below presents the operating results of our Investing & Lending segment.

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions     2012        2011            2012        2011   

ICBC

    $(194     $  (176         $    (25     $   140   

Equity securities (excluding ICBC)

    (112     686            779        1,740   

Debt securities and loans

    222        200            807        1,224   

Other

    287        334            553        645   

Total net revenues

    203        1,044            2,114        3,749   

Operating expenses

    256        547            1,214        1,778   

Pre-tax earnings/(loss)

    $  (53     $   497            $   900        $1,971   

Three Months Ended June 2012 versus June 2011. Net revenues in Investing & Lending were $203 million for the second quarter of 2012, compared with $1.04 billion for the second quarter of 2011. During the second quarter of 2012, Investing & Lending net revenues were negatively impacted by a decrease in global equity prices and generally wider credit spreads. Results for the second quarter of 2012 included a loss of $194 million from our investment in the ordinary shares of ICBC and net losses of $112 million from other investments in equities, reflecting losses in public equities, largely offset by gains in private equities. In addition, Investing & Lending included net interest income and net gains of $222 million from debt securities and loans, and other net revenues of $287 million, principally related to our consolidated investment entities.

Results for the second quarter of 2011 included a loss of $176 million from our investment in the ordinary shares of ICBC, net gains of $686 million from other investments in equities and net revenues of $200 million from debt securities and loans, primarily reflecting net interest income on loans, primarily mezzanine and senior corporate loans. The net gains from other investments in equities were primarily driven by gains from private equities, partially

offset by losses from public equities. In addition, Investing & Lending included other net revenues of $334 million, principally related to our consolidated investment entities.

Operating expenses were $256 million for the second quarter of 2012, 53% lower than the second quarter of 2011, primarily due to decreased compensation and benefits expenses. Pre-tax loss was $53 million in the second quarter of 2012, compared with pre-tax earnings of $497 million in the second quarter of 2011.

Six Months Ended June 2012 versus June 2011. Net revenues in Investing & Lending were $2.11 billion for the first half of 2012, compared with $3.75 billion for the first half of 2011. Results for the first half of 2012 included a loss of $25 million from our investment in the ordinary shares of ICBC and net gains of $779 million from other investments in equities, reflecting gains in private equities. In addition, Investing & Lending included net gains and net interest income of $807 million from debt securities and loans, primarily reflecting the impact of generally tighter credit spreads, particularly during the first quarter of 2012, and other net revenues of $553 million, principally related to our consolidated investment entities.

Results for the first half of 2011 included a gain of $140 million from our investment in the ordinary shares of ICBC, net gains of $1.74 billion from other investments in equities and net gains and net interest of $1.22 billion from debt securities and loans, primarily mezzanine and senior corporate loans. The net gains from other investments in equities were primarily driven by gains from private equities. Net revenues from debt securities and loans reflected the impact of generally favorable credit markets, which provided favorable conditions for borrowers to refinance, primarily during the first quarter of 2011. In addition, Investing & Lending included other net revenues of $645 million, principally related to our consolidated investment entities.

Operating expenses were $1.21 billion for the first half of 2012, 32% lower than the first half of 2011, primarily due to decreased compensation and benefits expenses, partially offset by higher impairment charges related to our consolidated investment entities. Pre-tax earnings were $900 million in the first half of 2012, 54% lower than the first half of 2011.

 

 

132   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Investment Management

Investment Management provides investment management services and offers investment products (primarily through separately managed accounts and commingled vehicles, such as mutual funds and private investment funds) across all major asset classes to a diverse set of institutional and individual clients. Investment Management also offers wealth advisory services, including portfolio management and financial counseling, and brokerage and other transaction services to high-net-worth individuals and families.

Assets under management typically generate fees as a percentage of net asset value, which vary by asset class and are affected by investment performance as well as asset inflows and redemptions. In certain circumstances, we are also entitled to receive incentive fees based on a percentage of a fund’s return or when the return exceeds a specified benchmark or other performance targets. Incentive fees are recognized when all material contingencies are resolved.

The table below presents the operating results of our Investment Management segment.

 

    Three Months
Ended June
        Six Months
Ended June
 
in millions     2012        2011            2012        2011   

Management and other fees

    $1,019        $1,080            $2,022        $2,128   

Incentive fees

    217        63            275        137   

Transaction revenues

    96        131            210        282   

Total net revenues

    1,332        1,274            2,507        2,547   

Operating expenses

    1,070        1,056            2,060        2,123   

Pre-tax earnings

    $   262        $   218            $   447        $   424   

Assets under management include client assets where we earn a fee for managing assets on a discretionary basis. This includes net assets in our mutual funds, hedge funds and private equity funds (including real estate funds), and separately managed accounts for institutional and individual investors. Assets under management do not include the self-directed assets of our clients, including brokerage accounts, or interest-bearing deposits held through our bank depository institution subsidiaries.

The tables below present our assets under management by asset class and a summary of the changes in our assets under management.

 

    As of  
    June 30,         December 31,  
in billions     2012        2011            2011        2010   

Alternative investments 1

    $137        $148            $142        $148   

Equity

    127        148            126        144   

Fixed income

    363        352            340        340   

Total non-money market assets

    627        648            608        632   

Money markets

    209        196            220        208   

Total assets under management

    $836        $844            $828        $840   

 

1.

Primarily includes hedge funds, private equity, real estate, currencies, commodities and asset allocation strategies.

 

    Three Months
Ended June 30,
        Six Months
Ended June 30,
 
in billions     2012        2011            2012        2011   

Balance, beginning of period

    $824        $840            $828        $840   

Net inflows/(outflows)

         

Alternative investments

    (1     (3         (5     (3

Equity

    (2     (2         (7     (2

Fixed income

    12        7            13        2   

Total non-money market net inflows/(outflows)

    9        2            1        (3

Money markets

    7        (5         (11     (12

Total net inflows/(outflows)

    16  1      (3         (10 1      (15

Net market appreciation/(depreciation)

    (4     7            18        19   

Balance, end of period

    $836        $844            $836        $844   

 

1.

Includes $17 billion of fixed income asset inflows in connection with our acquisition of Dwight Asset Management.

Three Months Ended June 2012 versus June 2011. Net revenues in Investment Management were $1.33 billion, 5% higher than the second quarter of 2011. The increase in net revenues compared with the second quarter of 2011 was due to significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC, partially offset by lower management and other fees, and lower transaction revenues. During the quarter, assets under management increased $12 billion to $836 billion. The increase in assets under management included net inflows of $16 billion (including $17 billion of fixed income asset inflows in connection with our acquisition of Dwight Asset Management), primarily in fixed income and money market assets, partially offset by net market depreciation of $4 billion, primarily in equity assets.

 

 

  Goldman Sachs June 2012 Form 10-Q   133


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

During the second quarter of 2012, Investment Management operated in an environment generally characterized by decreased asset prices, particularly in equities, and a shift in investor assets away from asset classes with potentially higher risk and returns to asset classes with potentially lower risk and returns. If asset prices decline or investors continue to change their mix of assets to lower risk asset classes or withdraw their assets, net revenues in Investment Management would likely be negatively impacted. In addition, continued uncertainty regarding the global economic outlook could result in downward pressure on assets under management.

Operating expenses were $1.07 billion for the second quarter of 2012, essentially unchanged compared with the second quarter of 2011. Pre-tax earnings were $262 million in the second quarter of 2012, 20% higher than the second quarter of 2011.

Six Months Ended June 2012 versus June 2011. Net revenues in Investment Management were $2.51 billion, slightly lower than the first half of 2011 due to lower management and other fees, and lower transaction revenues, partially offset by significantly higher incentive fees, primarily related to the sale of our funds’ remaining investment in the ordinary shares of ICBC. During the first half of 2012, assets under management increased $8 billion to $836 billion. The increase in assets under management included net market appreciation of $18 billion in fixed income and equity assets, partially offset by net outflows of $10 billion. Net outflows included outflows in money market, equity and alternative investment assets, partially offset by inflows in fixed income assets.

During the first quarter of 2012, Investment Management operated in an environment generally characterized by improved asset prices, resulting in appreciation in the value of client assets and a shift in investor assets away from money markets, consistent with industry trends. However, during the second quarter of 2012, heightened uncertainty regarding the global economic outlook resulted in a decline in asset prices, particularly in equities. These conditions contributed to investors shifting assets away from asset classes with potentially higher risk and returns to asset classes with potentially lower risk and returns. If asset prices decline or investors continue to change their mix of assets to lower risk asset classes or withdraw their assets, net revenues in Investment Management would likely be negatively impacted. In addition, continued uncertainty regarding the global economic outlook could result in downward pressure on assets under management.

Operating expenses were $2.06 billion for the first half of 2012, 3% lower than the first half of 2011, due to decreased compensation and benefits expenses. Pre-tax earnings were $447 million in the first half of 2012, 5% higher than the first half of 2011.

 

Geographic Data

See Note 25 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for a summary of our total net revenues and pre-tax earnings by geographic region.

Regulatory Developments

The U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), enacted in July 2010, significantly altered the financial regulatory regime within which we operate. The implications of the Dodd-Frank Act for our businesses will depend to a large extent on the rules that will be adopted by the Board of Governors of the Federal Reserve System (Federal Reserve Board), the Federal Deposit Insurance Corporation (FDIC), the SEC, the U.S. Commodity Futures Trading Commission (CFTC) and other agencies to implement the legislation, as well as the development of market practices and structures under the regime established by the legislation and the implementing rules. Similar reforms are being considered by other regulators and policy makers worldwide and these reforms may affect our businesses. We expect that the principal areas of impact from regulatory reform for us will be:

 

Ÿ  

the Dodd-Frank prohibition on “proprietary trading” and the limitation on the sponsorship of, and investment in, hedge funds and private equity funds by banking entities, including bank holding companies, referred to as the “Volcker Rule”;

 

Ÿ  

increased regulation of and restrictions on over-the-counter (OTC) derivatives markets and transactions; and

 

Ÿ  

increased regulatory capital requirements.

In October 2011, the proposed rules to implement the Volcker Rule were issued and included an extensive request for comments on the proposal. The proposed rules are highly complex and many aspects of the Volcker Rule remain unclear. The full impact of the rule will depend upon the detailed scope of the prohibitions, permitted activities, exceptions and exclusions, and the full impact on the firm will not be known with certainty until the rules are finalized.

While many aspects of the Volcker Rule remain unclear, we evaluated the prohibition on “proprietary trading” and determined that businesses that engage in “bright line” proprietary trading are most likely to be prohibited. In 2011 and 2010, we liquidated substantially all of our Principal Strategies and global macro proprietary trading positions.

 

 

134   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

In addition, we evaluated the limitations on sponsorship of, and investments in, hedge funds and private equity funds. The firm earns management fees and incentive fees for investment management services from private equity and hedge funds, which are included in our Investment Management segment. The firm also makes investments in funds and the gains and losses from such investments are included in our Investing & Lending segment; these gains and losses will be impacted by the Volcker Rule. The Volcker Rule limitation on investments in hedge funds and private equity funds requires the firm to reduce its investment in each private equity and hedge fund to 3% or less of net asset value, and to reduce the firm’s aggregate investment in all such funds to 3% or less of the firm’s Tier 1 capital. Over the period from 1999 through the second quarter of 2012, the firm’s aggregate net revenues from its investments in hedge funds and private equity funds were not material to the firm’s aggregate total net revenues over the same period. We continue to manage our existing private equity funds taking into account the transition periods under the Volcker Rule. With respect to our hedge funds, we currently plan to comply with the Volcker Rule by redeeming certain of our interests in the funds. We currently expect to redeem up to approximately 10% of certain hedge funds’ total redeemable units per quarter over ten consecutive quarters, beginning March 2012 and ending June 2014. We redeemed approximately $250 million and $500 million of these interests in hedge funds during the three and six months ended June 2012, respectively. In addition, we have limited the firm’s initial investment to 3% for certain new funds.

As required by the Dodd-Frank Act, the Federal Reserve Board and FDIC have jointly issued a rule requiring each bank holding company with over $50 billion in assets and each designated systemically important financial institution to provide to regulators an annual plan for its rapid and orderly resolution in the event of material financial distress or failure (resolution plan). Our resolution plan must, among other things, ensure that Goldman Sachs Bank USA (GS Bank USA) is adequately protected from risks arising from our other entities. The regulators’ joint rule sets specific standards for the resolution plans, including requiring a detailed resolution strategy and analyses of the company’s material entities, organizational structure, interconnections and interdependencies, and management information systems, among other elements. We submitted our first resolution plan to the regulators on June 29, 2012. GS Bank USA also submitted a plan for its rapid and orderly resolution in the event of material financial distress or failure on June 29, 2012, as required by the FDIC.

In September 2011, the SEC proposed rules to implement the Dodd-Frank Act’s prohibition against securitization participants’ engaging in any transaction that would involve or result in any material conflict of interest with an investor in a securitization transaction. The proposed rules would except bona fide market-making activities and risk-mitigating hedging activities in connection with securitization activities from the general prohibition.

In December 2011, the Federal Reserve Board proposed regulations designed to strengthen the regulation and supervision of large bank holding companies and systemically important nonbank financial firms. These proposals address risk-based capital and leverage requirements, liquidity requirements, stress tests, single counterparty limits and early remediation requirements that are designed to address financial weakness at an early stage. Although many of the proposals mirror initiatives to which bank holding companies are already subject, their full impact on the firm will not be known with certainty until the rules are finalized.

The Dodd-Frank Act also contains provisions that include (i) requiring the registration of all swap dealers, major swap participants, security-based swap dealers, and/or major security-based swap participants, and the clearing and execution of more liquid “swaps” through regulated facilities (subject to limited exceptions) and both public and regulatory reporting of trade information, (ii) placing new requirements on swap dealers and security-based swap dealers to comply with new business conduct standards, covering their relationships with counterparties and their internal management of risks and information associated with swaps and securities based swaps, and (iii) establishing mandatory margin requirements for trades that are not cleared through a central counterparty. Although it has not yet finalized its capital regulations, the CFTC has finalized many other rules and has laid out implementation deadlines in the second half of 2012, while the SEC has not yet finalized certain of its rules or the implementation deadlines for its rules.

The Dodd-Frank Act also establishes a Bureau of Consumer Financial Protection having broad authority to regulate providers of credit, payment and other consumer financial products and services, and this Bureau has oversight over certain of our products and services.

See Note 20 to the condensed consolidated financial statements in Part I, Item I of this Form 10-Q for additional information about regulatory developments as they relate to our regulatory capital ratios.

See “Business — Regulation” in Part I, Item 1 of our Annual Report on Form 10-K for more information.

 

 

  Goldman Sachs June 2012 Form 10-Q   135


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Balance Sheet and Funding Sources

Balance Sheet Management

One of our most important risk management disciplines is our ability to manage the size and composition of our balance sheet. While our asset base changes due to client activity, market fluctuations and business opportunities, the size and composition of our balance sheet reflect (i) our overall risk tolerance, (ii) our ability to access stable funding sources and (iii) the amount of equity capital we hold.

Although our balance sheet fluctuates on a day-to-day basis, our total assets and adjusted assets at quarterly and year-end dates are generally not materially different from those occurring within our reporting periods.

In order to ensure appropriate risk management, we seek to maintain a liquid balance sheet and have processes in place to dynamically manage our assets and liabilities which include:

 

Ÿ  

quarterly planning;

 

Ÿ  

business-specific limits;

 

Ÿ  

monitoring of key metrics; and

 

Ÿ  

scenario analyses.

Quarterly Planning. We prepare a quarterly balance sheet plan that combines our projected total assets and composition of assets with our expected funding sources and capital levels for the upcoming quarter. The objectives of this quarterly planning process are:

 

Ÿ  

to develop our near-term balance sheet projections, taking into account the general state of the financial markets and expected client-driven and firm-driven activity levels;

 

Ÿ  

to ensure that our projected assets are supported by an adequate amount and tenor of funding and that our projected capital and liquidity metrics are within management guidelines; and

 

Ÿ  

to allow business risk managers and managers from our independent control and support functions to objectively evaluate balance sheet limit requests from business managers in the context of the firm’s overall balance sheet constraints. These constraints include the firm’s liability profile and equity capital levels, maturities and plans for new debt and equity issuances, share repurchases, deposit trends and secured funding transactions.

To prepare our quarterly balance sheet plan, business risk managers and managers from our independent control and support functions meet with business managers to review current and prior period metrics and discuss expectations for the upcoming quarter. The specific metrics reviewed include asset and liability size and composition, aged inventory, limit utilization, risk and performance measures, and capital usage.

Our consolidated quarterly plan, including our balance sheet plans by business, funding and capital projections, and projected capital and liquidity metrics, is reviewed by the Firmwide Finance Committee. See “Overview and Structure of Risk Management.”

 

 

136   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Business-Specific Limits. The Firmwide Finance Committee sets asset and liability limits for each business and aged inventory limits for certain financial instruments as a disincentive to hold inventory over longer periods of time. These limits are set at levels which are close to actual operating levels in order to ensure prompt escalation and discussion among business managers and managers in our independent control and support functions on a routine basis. The Firmwide Finance Committee reviews and approves balance sheet limits on a quarterly basis and may also approve changes in limits on an ad hoc basis in response to changing business needs or market conditions.

Monitoring of Key Metrics. We monitor key balance sheet metrics daily both by business and on a consolidated basis, including asset and liability size and composition, aged inventory, limit utilization, risk measures and capital usage. We allocate assets to businesses and review and analyze movements resulting from new business activity as well as market fluctuations.

Scenario Analyses. We conduct scenario analyses to determine how we would manage the size and composition of our balance sheet and maintain appropriate funding, liquidity and capital positions in a variety of situations:

 

Ÿ  

These scenarios cover short-term and long-term time horizons using various macro-economic and firm-specific assumptions. We use these analyses to assist us in developing longer-term funding plans, including the level of unsecured debt issuances, the size of our secured funding program and the amount and composition of our equity capital. We also consider any potential future constraints, such as limits on our ability to grow our asset base in the absence of appropriate funding.

 

Ÿ  

Through our Internal Capital Adequacy Assessment Process (ICAAP) and our resolution and recovery planning, we further analyze how we would manage our balance sheet and risks through the duration of a severe crisis and we develop plans to access funding, generate liquidity, and/or redeploy or issue equity capital, as appropriate.

Balance Sheet Allocation

In addition to preparing our condensed consolidated statements of financial condition in accordance with U.S. GAAP, we prepare a balance sheet that generally allocates assets to our businesses, which is a non-GAAP presentation and may not be comparable to similar non-GAAP presentations used by other companies. We believe that presenting our assets on this basis is meaningful because it is consistent with the way management views and manages risks associated with the firm’s assets and better enables investors to assess the liquidity of the firm’s assets. The table below presents a summary of this balance sheet allocation.

 

    As of  
in millions    

 

June

2012

  

  

      

 

December

2011

  

  

Excess liquidity (Global Core Excess)

    $174,584           $171,581   

Other cash

    7,393           7,888   

Excess liquidity and cash

    181,977           179,469   

Secured client financing

    255,528           283,707   

Inventory

    298,922           273,640   

Secured financing agreements

    94,977           71,103   

Receivables

    40,670           35,769   

Institutional Client Services

    434,569           380,512   

ICBC

    1,717           4,713   

Equity (excluding ICBC)

    21,023           23,041   

Debt

    23,154           23,311   

Receivables and other

    6,506           5,320   

Investing & Lending

    52,400           56,385   

Total inventory and related assets

    486,969           436,897   

Other assets

    24,164           23,152   

Total assets

    $948,638           $923,225   
 

 

  Goldman Sachs June 2012 Form 10-Q   137


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The following is a description of the captions in the table above.

Excess Liquidity and Cash. We maintain substantial excess liquidity to meet a broad range of potential cash outflows and collateral needs in the event of a stressed environment. See “Liquidity Risk Management” below for details on the composition and sizing of our excess liquidity pool or “Global Core Excess” (GCE). In addition to our excess liquidity, we maintain other operating cash balances, primarily for use in specific currencies, entities, or jurisdictions where we do not have immediate access to parent company liquidity.

Secured Client Financing. We provide collateralized financing for client positions, including margin loans secured by client collateral, securities borrowed, and resale agreements primarily collateralized by government obligations. As a result of client activities, we are required to segregate cash and securities to satisfy regulatory requirements. Our secured client financing arrangements, which are generally short-term, are accounted for at fair value or at amounts that approximate fair value, and include daily margin requirements to mitigate counterparty credit risk.

Institutional Client Services. In Institutional Client Services, we maintain inventory positions to facilitate market-making in fixed income, equity, currency and commodity products. Additionally, as part of client market-making activities, we enter into resale or securities borrowing arrangements to obtain securities which we can use to cover transactions in which we or our clients have sold securities that have not yet been purchased. The receivables in Institutional Client Services primarily relate to securities transactions.

Investing & Lending. In Investing & Lending, we make investments and originate loans to provide financing to clients. These investments and loans are typically longer-term in nature. We make investments, directly and indirectly through funds that we manage, in debt securities, loans, public and private equity securities, real estate and other investments.

Other Assets. Other assets are generally less liquid, non-financial assets, including property, leasehold improvements and equipment, goodwill and identifiable intangible assets, income tax-related receivables, equity-method investments and miscellaneous receivables.

 

 

138   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The tables below present the reconciliation of this balance sheet allocation to our U.S. GAAP balance sheet. In the tables below, total assets for Institutional Client Services and Investing & Lending represent the inventory and related assets. These amounts differ from total assets by

business segment disclosed in Note 25 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q because total assets disclosed in Note 25 include allocations of our excess liquidity and cash, secured client financing and other assets.

 

 

    As of June 2012  
in millions   Excess  
Liquidity  
and Cash 1
     Secured
Client
Financing
     Institutional
Client
Services
    

Investing &

Lending

     Other
Assets
     Total
Assets
 

Cash and cash equivalents

    $  58,913           $          —         $          —         $       —         $        —         $  58,913   

Cash and securities segregated for regulatory and other purposes

    —           56,685                                 56,685   

Securities purchased under agreements to resell and federal funds sold

    54,128           80,458         32,668         90                 167,344   

Securities borrowed

    27,746           77,461         62,309                         167,516   

Receivables from brokers, dealers and clearing organizations

    —           4,557         14,455         134                 19,146   

Receivables from customers and counterparties

    —           36,367         26,215         5,092                 67,674   

Financial instruments owned, at fair value

    41,190                   298,922         47,084                 387,196   

Other assets

    —                                   24,164         24,164   

Total assets

    $181,977           $255,528         $434,569         $52,400         $24,164         $948,638   
    As of December 2011  
in millions   Excess  
Liquidity  
and Cash 1
     Secured
Client
Financing
     Institutional
Client
Services
    

Investing &

Lending

     Other
Assets
    

Total

Assets

 

Cash and cash equivalents

    $  56,008           $          —         $          —         $        —         $        —         $  56,008   

Cash and securities segregated for regulatory and other purposes

    —           64,264                                 64,264   

Securities purchased under agreements to resell and federal funds sold

    70,220           98,445         18,671         453                 187,789   

Securities borrowed

    14,919           85,990         52,432                         153,341   

Receivables from brokers, dealers and clearing organizations

    —           3,252         10,612         340                 14,204   

Receivables from customers and counterparties

    —           31,756         25,157         3,348                 60,261   

Financial instruments owned, at fair value

    38,322                   273,640         52,244                 364,206   

Other assets

    —                                   23,152         23,152   

Total assets

    $179,469           $283,707         $380,512         $56,385         $23,152         $923,225   

 

1.

Includes unencumbered cash, U.S. government and federal agency obligations (including highly liquid U.S. federal agency mortgage-backed obligations), and German, French, Japanese and United Kingdom government obligations.

 

  Goldman Sachs June 2012 Form 10-Q   139


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Less Liquid Inventory Composition

We seek to maintain a liquid balance sheet comprised of assets that can be readily sold or funded on a secured basis. However, we do hold certain financial instruments that may be more difficult to sell, or fund on a secured basis, especially during times of market stress. We focus on funding these assets with liabilities that have longer-term contractual maturities to reduce the need to refinance in periods of market stress. The table below presents our aggregate holdings in these categories of financial instruments.

 

    As of  
in millions  

June

2012

      

December

2011

 

Bank loans and bridge loans 1

    $20,770           $19,745   

Private equity investments and restricted public equity securities 2

    16,275           15,463   

Mortgage and other asset-backed loans and securities

    15,666           14,291   

High-yield and other debt obligations

    12,004           11,118   

Emerging market debt securities

    5,770           4,624   

Emerging market equity securities

    4,351           3,922   

Other investments in funds 3

    3,034           3,394   

ICBC ordinary shares 4

    1,717           4,713   

 

1.

Includes funded commitments and inventory held in connection with our origination, investing and market-making activities.

 

2.

Includes interests in funds that we manage. Such amounts exclude assets for which the firm does not bear economic exposure of $2.38 billion as of both June 2012 and December 2011, including assets related to consolidated investment funds and consolidated variable interest entities (VIEs).

 

3.

Includes interests in other investment funds that we manage. We redeemed approximately $250 million and $500 million of these interests in hedge funds during the three and six months ended June 2012, respectively. See “Results of Operations — Regulatory Developments” for more information about our plans to redeem certain of our interests in hedge funds to comply with the Volcker Rule.

 

4.

Includes interests of $2.60 billion as of December 2011, held by investment funds managed by Goldman Sachs. These investment funds no longer have an interest in the ordinary shares of ICBC.

See Notes 4 through 6 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about the financial instruments we hold.

Balance Sheet Analysis and Metrics

As of June 2012, total assets on our condensed consolidated statements of financial condition were $948.64 billion, an increase of $25.41 billion from December 2011. This increase was primarily due to an increase in financial instruments owned, at fair value of $22.99 billion, primarily due to increases in U.S. government and federal agency obligations, non-U.S. government and agency obligations and equities and convertible debentures, partially offset by a decrease in derivatives.

As of June 2012, total liabilities on our condensed consolidated statements of financial condition were $875.78 billion, an increase of $22.94 billion from December 2011. This increase reflects (i) an increase in payables to customers and counterparties of $14.89 billion, primarily due to client activity and (ii) an increase in deposits of $11.21 billion, primarily due to increases in client activity.

As of June 2012 and December 2011, our total securities sold under agreements to repurchase, accounted for as collateralized financings, were $160.44 billion and $164.50 billion, respectively, which were 5% lower and 7% higher, respectively, than the daily average amount of repurchase agreements over the respective quarters. As of June 2012, the decrease in our repurchase agreements relative to the daily average during the quarter was due to a decrease in firm financing and client activity at the end of the quarter. The level of our repurchase agreements fluctuates between and within periods, primarily due to providing clients with access to highly liquid collateral, such as U.S. government and federal agency, and investment-grade sovereign obligations through collateralized financing activities.

 

 

140   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The table below presents information on our assets, unsecured long-term borrowings, shareholders’ equity and leverage ratios.

 

    As of  
$ in millions  

June

2012

    

December

2011

 

Total assets

    $948,638         $923,225   

Adjusted assets

    $654,799         $604,391   

Unsecured long-term borrowings

    $166,993         $173,545   

Total shareholders’ equity

    $  72,855         $  70,379   

Leverage ratio

    13.0      13.1

Adjusted leverage ratio

    9.0      8.6

Debt to equity ratio

    2.3      2.5

Adjusted assets. Adjusted assets equals total assets less (i) low-risk collateralized assets generally associated with our secured client financing transactions, federal funds sold and excess liquidity (which includes financial instruments sold, but not yet purchased, at fair value, less derivative liabilities) and (ii) cash and securities we segregate for regulatory and other purposes. Adjusted assets is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies.

The table below presents the reconciliation of total assets to adjusted assets.

 

    As of  
in millions  

June

2012

    

December

2011

 

Total assets

    $ 948,638         $ 923,225   

Deduct:

 

Securities borrowed

    (167,516      (153,341
   

Securities purchased under agreements to resell and federal funds sold

    (167,344      (187,789

Add:

 

Financial instruments sold, but not yet purchased, at fair value

    149,948         145,013   
   

Less derivative liabilities

    (52,242      (58,453
   

Subtotal

    (237,154      (254,570

Deduct:

 

Cash and securities segregated for regulatory and other purposes

    (56,685      (64,264

Adjusted assets

    $ 654,799         $ 604,391   

Leverage ratio. The leverage ratio equals total assets divided by total shareholders’ equity and measures the proportion of equity and debt the firm is using to finance assets. This ratio is different from the Tier 1 leverage ratio included in “Equity Capital — Consolidated Regulatory Capital Ratios” below, and further described in Note 20 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

Adjusted leverage ratio. The adjusted leverage ratio equals adjusted assets divided by total shareholders’ equity. We believe that the adjusted leverage ratio is a more meaningful measure of our capital adequacy than the leverage ratio because it excludes certain low-risk collateralized assets that are generally supported with little or no capital. The adjusted leverage ratio is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies.

Our adjusted leverage ratio increased to 9.0x as of June 2012 from 8.6x as of December 2011 as our adjusted assets increased.

Debt to equity ratio. The debt to equity ratio equals unsecured long-term borrowings divided by total shareholders’ equity.

Funding Sources

Our primary sources of funding are secured financings, unsecured long-term and short-term borrowings, and deposits. We seek to maintain broad and diversified funding sources globally.

We raise funding through a number of different products, including:

 

Ÿ  

collateralized financings, such as repurchase agreements, securities loaned and other secured financings;

 

Ÿ  

long-term unsecured debt (including structured notes) through syndicated U.S. registered offerings, U.S. registered and 144A medium-term note programs, offshore medium-term note offerings and other debt offerings;

 

Ÿ  

demand and savings deposits through deposit sweep programs and time deposits through internal and third-party broker-dealers; and

 

Ÿ  

short-term unsecured debt through U.S. and non-U.S. commercial paper and promissory note issuances and other methods.

We generally distribute our funding products through our own sales force and third-party distributors, to a large, diverse creditor base in a variety of markets in the Americas, Europe and Asia. We believe that our relationships with our creditors are critical to our liquidity. Our creditors include banks, governments, securities lenders, pension funds, insurance companies, mutual funds and individuals. We have imposed various internal guidelines to monitor creditor concentration across our funding programs.

 

 

  Goldman Sachs June 2012 Form 10-Q   141


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Secured Funding. We fund a significant amount of our inventory on a secured basis. Secured funding is less sensitive to changes in our credit quality than unsecured funding due to the nature of the collateral we post to our lenders. However, because the terms or availability of secured funding, particularly short-dated funding, can deteriorate rapidly in a difficult environment, we generally do not rely on short-dated secured funding unless it is collateralized with highly liquid securities such as government obligations.

Substantially all of our other secured funding is executed for tenors of one month or greater. Additionally, we monitor counterparty concentration and hold a portion of our GCE for refinancing risk associated with our secured funding transactions. We seek longer terms for secured funding collateralized by lower-quality assets because these funding transactions may pose greater refinancing risk. In addition, we maintain secured funding capacity that is in excess of our existing requirements. This capacity is available to finance additional eligible inventory or to replace other secured liabilities.

The weighted average maturity of our secured funding, excluding funding collateralized by highly liquid securities eligible for inclusion in our GCE, exceeded 100 days as of June 2012.

A majority of our secured funding for securities not eligible for inclusion in the GCE is executed through term repurchase agreements and securities lending contracts. We also raise financing through other types of collateralized financings, such as secured loans and notes.

GS Bank USA has access to funding through the Federal Reserve Bank discount window. While we do not rely on this funding in our liquidity planning and stress testing, we maintain policies and procedures necessary to access this funding and test discount window borrowing procedures.

Unsecured Long-Term Borrowings. We issue unsecured long-term borrowings as a source of funding for inventory and other assets and to finance a portion of our GCE. We issue in different tenors, currencies, and products to maximize the diversification of our investor base. The table below presents our quarterly unsecured long-term borrowings maturity profile through the second quarter of 2018 as of June 2012.

 

 

LOGO

 

142   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The weighted average maturity of our unsecured long-term borrowings as of June 2012 was approximately eight years. To mitigate refinancing risk, we seek to limit the principal amount of debt maturing on any one day or during any week or year. We enter into interest rate swaps to convert a substantial portion of our long-term borrowings into floating-rate obligations in order to manage our exposure to interest rates. See Note 16 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our unsecured long-term borrowings.

Temporary Liquidity Guarantee Program (TLGP). The remaining portion of our senior unsecured short-term debt guaranteed by the FDIC under the TLGP matured during the second quarter of 2012. As of June 2012, no borrowings guaranteed by the FDIC under the TLGP were outstanding and the program had expired for new issuances.

Deposits. As of June 2012, our bank depository institution subsidiaries had $57.32 billion in customer deposits, including $19.57 billion of certificates of deposit and other time deposits with a weighted average maturity of three years, and $37.75 billion of other deposits, substantially all of which were from private bank deposits and deposit sweep programs sourced through our own sales force and third-party distributors. We utilize deposits to finance activities in our bank subsidiaries and to support potential outflows, such as draws on unfunded commitments.

Unsecured Short-Term Borrowings. A significant portion of our short-term borrowings were originally long-term debt that is scheduled to mature within one year of the reporting date. We use short-term borrowings to finance liquid assets and for other cash management purposes. We primarily issue commercial paper, promissory notes, and other hybrid instruments.

As of June 2012, our unsecured short-term borrowings, including the current portion of unsecured long-term borrowings, were $45.69 billion. See Note 15 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our unsecured short-term borrowings.

Equity Capital

Capital adequacy is of critical importance to us. Our objective is to be conservatively capitalized in terms of the amount and composition of our equity base. Accordingly, we have in place a comprehensive capital management policy that serves as a guide to determine the amount and composition of equity capital we maintain.

The level and composition of our equity capital are determined by multiple factors including our current and future consolidated regulatory capital requirements, our ICAAP and results of stress tests, and may also be influenced by other factors such as rating agency guidelines, subsidiary capital requirements, the business environment, conditions in the financial markets and assessments of potential future losses due to adverse changes in our business and market environments. In addition, we maintain a capital plan which projects sources and uses of capital given a range of business environments, and a contingency capital plan which provides a framework for analyzing and responding to an actual or perceived capital shortfall.

As part of the Federal Reserve Board’s annual Comprehensive Capital Analysis and Review, U.S. bank holding companies with total consolidated assets of $50 billion or greater, are required to submit annual capital plans for review by the Federal Reserve Board. The capital plans should demonstrate the ability of a bank holding company to maintain its capital ratios above minimum regulatory capital requirements and above a Tier 1 common ratio of 5% on a pro forma basis inclusive of proposed capital actions under expected and stressed scenarios. The purpose of the Federal Reserve Board’s review is to ensure that these institutions have robust, forward-looking capital planning processes that account for their unique risks and that permit continued operations during times of economic and financial stress. As part of the capital plan review, the Federal Reserve Board evaluates an institution’s plan to make capital distributions, such as increasing dividend payments or repurchasing or redeeming stock, across a range of macro-economic and firm-specific assumptions. The Federal Reserve has informed us that it does not object to our proposed capital actions through the first quarter of 2013, including the repurchase of outstanding common stock and an increase in the quarterly common stock dividend.

 

 

  Goldman Sachs June 2012 Form 10-Q   143


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Our consolidated regulatory capital requirements are determined by the Federal Reserve Board, as described below. Our ICAAP incorporates an internal risk-based capital assessment designed to identify and measure material risks associated with our business activities, including market risk, credit risk and operational risk, in a manner that is closely aligned with our risk management practices. Our internal risk-based capital assessment is supplemented with the results of stress tests.

As of June 2012, our total shareholders’ equity was $72.86 billion (consisting of common shareholders’ equity of $68.01 billion and preferred stock of $4.85 billion). As of December 2011, our total shareholders’ equity was $70.38 billion (consisting of common shareholders’ equity of $67.28 billion and preferred stock of $3.10 billion). In addition, $3.25 billion of our junior subordinated debt issued to trusts qualifies as equity capital for regulatory and certain rating agency purposes. See “— Consolidated Regulatory Capital Ratios” below for information regarding the impact of regulatory developments.

Consolidated Regulatory Capital

The Federal Reserve Board is the primary regulator of Group Inc., a bank holding company and a financial holding company under the U.S. Bank Holding Company Act of 1956. As a bank holding company, we are subject to consolidated regulatory capital requirements that are computed in accordance with the Federal Reserve Board’s generally applicable risk-based capital requirements (which are based on the ‘Basel 1’ Capital Accord of the Basel Committee on Banking Supervision (Basel Committee)). These capital requirements are expressed as capital ratios that compare measures of capital to risk-weighted assets (RWAs). See Note 20 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information regarding the firm’s RWAs. The firm’s capital levels are also subject to qualitative judgments by its regulators about components, risk weightings and other factors.

Federal Reserve Board regulations require bank holding companies to maintain a minimum Tier 1 capital ratio of 4% and a minimum total capital ratio of 8%. The required minimum Tier 1 capital ratio and total capital ratio in order to be considered a “well-capitalized” bank holding company under the Federal Reserve Board guidelines are 6% and 10%, respectively. Bank holding companies may be expected to maintain ratios well above the minimum levels, depending on their particular condition, risk profile and growth plans. The minimum Tier 1 leverage ratio is 3% for bank holding companies that have received the highest supervisory rating under Federal Reserve Board guidelines or that have implemented the Federal Reserve Board’s risk-based capital measure for market risk. Other bank holding companies must have a minimum Tier 1 leverage ratio of 4%.

 

 

144   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Consolidated Regulatory Capital Ratios

The table below presents information about our regulatory capital ratios.

 

    As of  
$ in millions    

 

June

2012

  

  

   

 

December

2011

  

  

Common shareholders’ equity

    $  68,005        $  67,279   

Less: Goodwill

    (3,779     (3,802

Less: Disallowable intangible assets

    (1,621     (1,666

Less: Other deductions 1

    (6,261     (6,649

Tier 1 Common Capital

    56,344        55,162   

Preferred stock

    4,850        3,100   

Junior subordinated debt issued to trusts 2

    3,250        5,000   

Tier 1 Capital

    64,444        63,262   

Qualifying subordinated debt 3

    13,221        13,828   

Other adjustments

    83        53   

Tier 2 Capital

    $  13,304        $  13,881   

Total Capital

    $  77,748        $  77,143   

Risk-Weighted Assets 4

    $428,589        $457,027   

Tier 1 Capital Ratio

    15.0     13.8

Total Capital Ratio

    18.1     16.9

Tier 1 Leverage Ratio 4

    7.0     7.0

Tier 1 Common Ratio 5

    13.1     12.1

 

1.

Principally includes equity investments in non-financial companies and the cumulative change in the fair value of our unsecured borrowings attributable to the impact of changes in our own credit spreads, disallowed deferred tax assets, and investments in certain nonconsolidated entities.

 

2.

See Note 16 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information about the junior subordinated debt issued to trusts.

 

3.

Substantially all of our subordinated debt qualifies as Tier 2 capital for Basel 1 purposes.

 

4.

See Note 20 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information about the firm’s RWAs and Tier 1 leverage ratio.

 

5.

The Tier 1 common ratio equals Tier 1 common capital divided by RWAs. We believe that the Tier 1 common ratio is meaningful because it is one of the measures that we and investors use to assess capital adequacy and, while not currently a formal regulatory capital ratio, this measure is of increasing importance to regulators. The Tier 1 common ratio is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies.

Our Tier 1 capital ratio increased to 15.0% as of June 2012 from 13.8% as of December 2011 primarily reflecting an increase in shareholders’ equity and a decrease in RWAs.

See Note 20 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information about our regulatory capital ratios and the related regulatory requirements, including pending and proposed regulatory changes.

Internal Capital Adequacy Assessment Process

We perform an ICAAP with the objective of ensuring that the firm is appropriately capitalized relative to the risks in our business.

As part of our ICAAP, we perform an internal risk-based capital assessment. This assessment incorporates market risk, credit risk and operational risk. Market risk is calculated by using Value-at-Risk (VaR) calculations supplemented by risk-based add-ons which include risks related to rare events (tail risks). Credit risk utilizes assumptions about our counterparties’ probability of default, the size of our losses in the event of a default and the maturity of our counterparties’ contractual obligations to us. Operational risk is calculated based on scenarios incorporating multiple types of operational failures. Backtesting is used to gauge the effectiveness of models at capturing and measuring relevant risks.

We evaluate capital adequacy based on the result of our internal risk-based capital assessment, supplemented with the results of stress tests which measure the firm’s performance under various market conditions. Our goal is to hold sufficient capital, under our internal risk-based capital framework, to ensure we remain adequately capitalized after experiencing a severe stress event. Our assessment of capital adequacy is viewed in tandem with our assessment of liquidity adequacy and integrated into the overall risk management structure, governance and policy framework of the firm.

We attribute capital usage to each of our businesses based upon our internal risk-based capital and regulatory frameworks and manage the levels of usage based upon the balance sheet and risk limits established.

 

 

  Goldman Sachs June 2012 Form 10-Q   145


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Rating Agency Guidelines

The credit rating agencies assign credit ratings to the obligations of Group Inc., which directly issues or guarantees substantially all of the firm’s senior unsecured obligations. Goldman, Sachs & Co. (GS&Co.) and Goldman Sachs International (GSI) have been assigned long- and short-term issuer ratings by certain credit rating agencies. GS Bank USA has also been assigned long-term issuer ratings as well as ratings on its long-term and short-term bank deposits. In addition, credit rating agencies have assigned ratings to debt obligations of certain other subsidiaries of Group Inc.

The level and composition of our equity capital are among the many factors considered in determining our credit ratings. Each agency has its own definition of eligible capital and methodology for evaluating capital adequacy, and assessments are generally based on a combination of factors rather than a single calculation. See “Liquidity Risk Management — Credit Ratings” for further information about credit ratings of Group Inc., GS&Co., GSI and GS Bank USA.

Subsidiary Capital Requirements

Many of our subsidiaries, including GS Bank USA and our broker-dealer subsidiaries, are subject to separate regulation and capital requirements of the jurisdictions in which they operate. For purposes of assessing the adequacy of its capital, GS Bank USA has established an ICAAP which is similar to that used by Group Inc. GS Bank USA’s capital levels and prompt corrective action classification are subject to qualitative judgments by its regulators about components, risk weightings and other factors.

We expect that the capital requirements of several of our subsidiaries will be impacted in the future by the various developments arising from the Basel Committee, the Dodd-Frank Act, and other governmental entities and regulators.

See Note 20 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information about GS Bank USA’s capital ratios under Basel 1 as implemented by the Federal Reserve Board, and for further information about the capital requirements of our other regulated subsidiaries and the potential impact of regulatory reform.

Subsidiaries not subject to separate regulatory capital requirements may hold capital to satisfy local tax and legal guidelines, rating agency requirements (for entities with assigned credit ratings) or internal policies, including policies concerning the minimum amount of capital a subsidiary should hold based on its underlying level of risk. In certain instances, Group Inc. may be limited in its ability to access capital held at certain subsidiaries as a result of regulatory, tax or other constraints. As of June 2012 and December 2011, Group Inc.’s equity investment in subsidiaries was $70.13 billion and $67.70 billion, respectively, compared with its total shareholders’ equity of $72.86 billion and $70.38 billion, respectively.

Group Inc. has guaranteed the payment obligations of GS&Co., GS Bank USA, Goldman Sachs Bank (Europe) plc and Goldman Sachs Execution & Clearing, L.P. (GSEC) subject to certain exceptions. In November 2008, Group Inc. contributed subsidiaries into GS Bank USA, and Group Inc. agreed to guarantee certain losses, including credit-related losses, relating to assets held by the contributed entities. In connection with this guarantee, Group Inc. also agreed to pledge to GS Bank USA certain collateral, including interests in subsidiaries and other illiquid assets.

Our capital invested in non-U.S. subsidiaries is generally exposed to foreign exchange risk, substantially all of which is managed through a combination of derivatives and non-U.S. denominated debt.

Contingency Capital Plan

Our contingency capital plan provides a framework for analyzing and responding to a perceived or actual capital deficiency, including, but not limited to, identification of drivers of a capital deficiency, as well as mitigants and potential actions. It outlines the appropriate communication procedures to follow during a crisis period, including internal dissemination of information as well as ensuring timely communication with external stakeholders.

 

 

146   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Equity Capital Management

Our objective is to maintain a sufficient level and optimal composition of equity capital. We principally manage our capital through issuances and repurchases of our common stock. We may also, from time to time, issue or repurchase our preferred stock, junior subordinated debt issued to trusts and other subordinated debt or other forms of capital as business conditions warrant and subject to any regulatory approvals. We manage our capital requirements principally by setting limits on balance sheet assets and/or limits on risk, in each case both at the consolidated and business levels. We attribute capital usage to each of our businesses based upon our internal risk-based capital and regulatory frameworks and manage the levels of usage based upon the balance sheet and risk limits established.

Preferred Stock. In March 2011, we provided notice to Berkshire Hathaway that we would redeem in full the 50,000 shares of our Series G Preferred Stock held by Berkshire Hathaway for the stated redemption price of $5.50 billion ($110,000 per share), plus accrued and unpaid dividends. In connection with this notice, we recognized a preferred dividend of $1.64 billion (calculated as the difference between the carrying value and the redemption value of the preferred stock), which was recorded as a reduction to earnings applicable to common shareholders for the first quarter of 2011. The redemption also resulted in the acceleration of $24 million of preferred dividends related to the period from April 1, 2011 to the redemption date, which was included in our results during the three months ended March 2011. The Series G Preferred Stock was redeemed on April 18, 2011. Berkshire Hathaway continues to hold a five-year warrant, issued in October 2008, to purchase up to 43.5 million shares of common stock at an exercise price of $115.00 per share.

Share Repurchase Program. We seek to use our share repurchase program to help maintain the appropriate level of common equity and to substantially offset increases in share count over time resulting from employee share-based compensation. The repurchase program is effected primarily through regular open-market purchases, the amounts and timing of which are determined primarily by our current and projected capital positions (i.e., comparisons of our desired level and composition of capital to our actual level and composition of capital) and the issuance of shares resulting from employee share-based compensation, but which may also be influenced by general market conditions and the prevailing price and trading volumes of our common stock.

As of June 2012, under the share repurchase program approved by the Board, we can repurchase up to 46.0 million additional shares of common stock; however, any such repurchases are subject to the approval of the Federal Reserve Board. See “Unregistered Sales of Equity Securities and Use of Proceeds” in Part II, Item 2 and Note 19 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for additional information on our repurchase program.

See Notes 16 and 19 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our preferred stock, junior subordinated debt issued to trusts and other subordinated debt.

 

 

  Goldman Sachs June 2012 Form 10-Q   147


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Other Capital Metrics

The table below presents information on our shareholders’ equity and book value per common share.

 

    As of  
$ in millions, except per share amounts    

 

June

2012

  

  

    

 

December

2011

  

  

Total shareholders’ equity

    $72,855         $70,379   

Common shareholders’ equity

    68,005         67,279   

Tangible common shareholders’ equity

    62,605         61,811   

Book value per common share

    137.00         130.31   

Tangible book value per common share

    126.12         119.72   

Tangible common shareholders’ equity. Tangible common shareholders’ equity equals total shareholders’ equity less preferred stock, goodwill and identifiable intangible assets. We believe that tangible common shareholders’ equity is meaningful because it is a measure that we and investors use to assess capital adequacy. Tangible common shareholders’ equity is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies.

The table below presents the reconciliation of total shareholders’ equity to tangible common shareholders’ equity.

 

    As of  
in millions    

 

June

2012

  

  

   

 

December

2011

  

  

Total shareholders’ equity

    $72,855        $70,379   

Deduct: Preferred stock

    (4,850     (3,100

Common shareholders’ equity

    68,005        67,279   

Deduct: Goodwill and identifiable intangible assets

    (5,400     (5,468

Tangible common shareholders’ equity

    $62,605        $61,811   

Book value and tangible book value per common share. Book value and tangible book value per common share are based on common shares outstanding, including restricted stock units granted to employees with no future service requirements, of 496.4 million and 516.3 million as of June 2012 and December 2011, respectively. We believe that tangible book value per common share (tangible common shareholders’ equity divided by common shares outstanding) is meaningful because it is a measure that we and investors use to assess capital adequacy. Tangible book value per common share is a non-GAAP measure and may not be comparable to similar non-GAAP measures used by other companies.

Off-Balance-Sheet Arrangements and Contractual Obligations

Off-Balance-Sheet Arrangements

We have various types of off-balance-sheet arrangements that we enter into in the ordinary course of business. Our involvement in these arrangements can take many different forms, including:

 

Ÿ  

purchasing or retaining residual and other interests in special purpose entities such as mortgage-backed and other asset-backed securitization vehicles;

 

Ÿ  

holding senior and subordinated debt, interests in limited and general partnerships, and preferred and common stock in other nonconsolidated vehicles;

 

Ÿ  

entering into interest rate, foreign currency, equity, commodity and credit derivatives, including total return swaps;

 

Ÿ  

entering into operating leases; and

 

Ÿ  

providing guarantees, indemnifications, loan commitments, letters of credit and representations and warranties.

We enter into these arrangements for a variety of business purposes, including securitizations. The securitization vehicles that purchase mortgages, corporate bonds, and other types of financial assets are critical to the functioning of several significant investor markets, including the mortgage-backed and other asset-backed securities markets, since they offer investors access to specific cash flows and risks created through the securitization process.

We also enter into these arrangements to underwrite client securitization transactions; provide secondary market liquidity; make investments in performing and nonperforming debt, equity, real estate and other assets; provide investors with credit-linked and asset-repackaged notes; and receive or provide letters of credit to satisfy margin requirements and to facilitate the clearance and settlement process.

Our financial interests in, and derivative transactions with, such nonconsolidated entities are generally accounted for at fair value, in the same manner as our other financial instruments, except in cases where we apply the equity method of accounting.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The table below presents where a discussion of our various off-balance-sheet arrangements may be found in Part I, Items 1 and 2 of this Form 10-Q. In addition, see Note 3 to

the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for a discussion of our consolidation policies.

 

 

Type of Off-Balance-Sheet Arrangement    Disclosure in Form 10-Q

Variable interests and other obligations, including contingent obligations, arising from variable interests in nonconsolidated VIEs

  

See Note 11 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

Leases, letters of credit, and lending and other commitments

  

See below and Note 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

Guarantees

  

See below and Note 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

Derivatives

  

See Notes 4, 5, 7 and 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

 

  Goldman Sachs June 2012 Form 10-Q   149


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Contractual Obligations

We have certain contractual obligations which require us to make future cash payments. These contractual obligations include our unsecured long-term borrowings, secured long-term financings, time deposits, contractual interest payments and insurance agreements, all of which are included in our condensed consolidated statements of financial condition. Our obligations to make future cash

payments also include certain off-balance-sheet contractual obligations such as purchase obligations, minimum rental payments under noncancelable leases and commitments and guarantees.

The table below presents our contractual obligations, commitments and guarantees as of June 2012.

 

 

in millions    Remainder
of 2012
     2013-2014      2015-2016     

2017-

Thereafter

     Total  

Amounts related to on-balance-sheet obligations

              

Time deposits 1

     $          —         $    5,782         $  3,372         $  5,193         $  14,347   

Secured long-term financings 2

             5,807         1,692         1,846         9,345   

Unsecured long-term borrowings 3

             29,458         40,211         97,324         166,993   

Contractual interest payments 4

     3,377         13,390         10,656         36,345         63,768   

Insurance liabilities 5

     652         2,201         1,708         18,763         23,324   

Subordinated liabilities issued by consolidated VIEs

     6         33         37         911         987   

Amounts related to off-balance-sheet arrangements

              

Commitments to extend credit

     5,046         17,307         38,215         13,830         74,398   

Contingent and forward starting resale and securities borrowing agreements

     64,579         314                         64,893   

Forward starting repurchase and secured lending agreements

     8,785                                 8,785   

Underwriting commitments

     36                                 36   

Letters of credit

     487         282         5         5         779   

Investment commitments

     983         4,155         141         2,530         7,809   

Other commitments

     3,817         149         64         9         4,039   

Minimum rental payments

     223         818         665         1,531         3,237   

Derivative guarantees

     391,536         329,049         65,849         63,693         850,127   

Securities lending indemnifications

     30,192                                 30,192   

Other financial guarantees

     296         757         1,224         1,092         3,369   

 

1.

Excludes $5.23 billion of time deposits maturing within one year.

 

2.

The aggregate contractual principal amount of secured long-term financings for which the fair value option was elected, primarily consisting of transfers of financial assets accounted for as financings rather than sales and certain other nonrecourse financings, exceeded their related fair value by $214 million.

 

3.

Includes $10.76 billion related to interest rate hedges on certain unsecured long-term borrowings. In addition, the aggregate contractual principal amount of unsecured long-term borrowings (principal and non-principal protected) for which the fair value option was elected exceeded the related fair value by $236 million.

 

4.

Represents estimated future interest payments related to unsecured long-term borrowings, secured long-term financings and time deposits based on applicable interest rates as of June 2012. Includes stated coupons, if any, on structured notes.

 

5.

Represents estimated undiscounted payments related to future benefits and unpaid claims arising from policies associated with our insurance activities, excluding separate accounts and estimated recoveries under reinsurance contracts.

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

In the table above:

 

Ÿ  

Obligations maturing within one year of our financial statement date or redeemable within one year of our financial statement date at the option of the holder are excluded and are treated as short-term obligations.

 

Ÿ  

Obligations that are repayable prior to maturity at our option are reflected at their contractual maturity dates and obligations that are redeemable prior to maturity at the option of the holders are reflected at the dates such options become exercisable.

 

Ÿ  

Amounts included in the table do not necessarily reflect the actual future cash flow requirements for these arrangements because commitments and guarantees represent notional amounts and may expire unused or be reduced or cancelled at the counterparty’s request.

 

Ÿ  

Due to the uncertainty of the timing and amounts that will ultimately be paid, our liability for unrecognized tax benefits has been excluded. See Note 24 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our unrecognized tax benefits.

See Notes 15 and 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our short-term borrowings, and commitments and guarantees.

As of June 2012, our unsecured long-term borrowings were $166.99 billion, with maturities extending to 2061, and consisted principally of senior borrowings. See Note 16 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about our unsecured long-term borrowings.

As of June 2012, our future minimum rental payments net of minimum sublease rentals under noncancelable leases were $3.24 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 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about 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. During the three and six months ended June 2012, total occupancy expenses for space held in excess of our current requirements were not material. In addition, during both the three and six months ended June 2012, we incurred exit costs of $3 million related to our office space. We may incur exit costs in the future 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.

Overview and Structure of Risk Management

Overview

We believe that effective risk management is of primary importance to the success of the firm. Accordingly, we have comprehensive risk management processes through which we monitor, evaluate and manage the risks we assume in conducting our activities. These include market, credit, liquidity, operational, legal, regulatory and reputational risk exposures. Our risk management framework is built around three core components: governance, processes and people.

Governance. Risk management governance starts with our Board, which plays an important role in reviewing and approving risk management policies and practices, both directly and through its Risk Committee, which consists of all of our independent directors. The Board also receives periodic updates on firmwide risks from our independent control and support functions. Next, at the most senior levels of the firm, our leaders are experienced risk managers, with a sophisticated and detailed understanding of the risks we take. Our senior managers lead and participate in risk-oriented committees, as do the leaders of our independent control and support functions — including those in internal audit, compliance, controllers, credit risk management, human capital management, legal, market risk management, operations, operational risk management, tax, technology and treasury.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The firm’s governance structure provides the protocol and responsibility for decision-making on risk management issues and ensures implementation of those decisions. We make extensive use of risk-related committees that meet regularly and serve as an important means to facilitate and foster ongoing discussions to identify, manage and mitigate risks.

We maintain strong communication about risk and we have a culture of collaboration in decision-making among the revenue-producing units, independent control and support functions, committees and senior management. While we believe that the first line of defense in managing risk rests with the managers in our revenue-producing units, we dedicate extensive resources to independent control and support functions in order to ensure a strong oversight structure and an appropriate segregation of duties.

Processes. We maintain various processes and procedures that are critical components of our risk management. First and foremost is our daily discipline of marking substantially all of the firm’s inventory to current market levels. Goldman Sachs carries its inventory at fair value, with changes in valuation reflected immediately in our risk management systems and in net revenues. We do so because we believe this discipline is one of the most effective tools for assessing and managing risk and that it provides transparent and realistic insight into our financial exposures.

We also apply a rigorous framework of limits to control risk across multiple transactions, products, businesses and markets. This includes setting credit and market risk limits at a variety of levels and monitoring these limits on a daily basis. Limits are typically set at levels that will be periodically exceeded, rather than at levels which reflect our maximum risk appetite. This fosters an ongoing dialogue on risk among revenue-producing units, independent control and support functions, committees and senior management, as well as rapid escalation of risk-related matters. See “Market Risk Management” and “Credit Risk Management” for further information on our risk limits.

Active management of our positions is another important process. Proactive mitigation of our market and credit exposures minimizes the risk that we will be required to take outsized actions during periods of stress.

We also focus on the rigor and effectiveness of the firm’s risk systems. The goal of our risk management technology is to get the right information to the right people at the right time, which requires systems that are comprehensive, reliable and timely. We devote significant time and resources to our risk management technology to ensure that it consistently provides us with complete, accurate and timely information.

People. Even the best technology serves only as a tool for helping to make informed decisions in real time about the risks we are taking. Ultimately, effective risk management requires our people to interpret our risk data on an ongoing and timely basis and adjust risk positions accordingly. In both our revenue-producing units and our independent control and support functions, the experience of our professionals, and their understanding of the nuances and limitations of each risk measure, guide the firm in assessing exposures and maintaining them within prudent levels.

Structure

Ultimate oversight of risk is the responsibility of the firm’s Board. The Board oversees risk both directly and through its Risk Committee. Within the firm, a series of committees with specific risk management mandates have oversight or decision-making responsibilities for risk management activities. Committee membership generally consists of senior managers from both our revenue-producing units and our independent control and support functions. We have established procedures for these committees to ensure that appropriate information barriers are in place. Our primary risk committees, most of which also have additional sub-committees or working groups, are described below. In addition to these committees, we have other risk-oriented committees which provide oversight for different businesses, activities, products, regions and legal entities.

Membership of the firm’s risk committees is reviewed regularly and updated to reflect changes in the responsibilities of the committee members. Accordingly, the length of time that members serve on the respective committees varies as determined by the committee chairs and based on the responsibilities of the members within the firm.

In addition, independent control and support functions, which report to the chief financial officer, general counsel, chief administrative officer, or in the case of Internal Audit, to the Audit Committee of the Board, are responsible for day-to-day oversight of risk, as discussed in greater detail in the following sections.

 

 

152   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The chart below presents an overview of our risk management governance structure, highlighting the

oversight of our Board, our key risk-related committees and the independence of our control and support functions.

 

 

LOGO

 

Management Committee. The Management Committee oversees the global activities of the firm, including all of the firm’s independent control and support functions. It provides this oversight directly and through authority delegated to committees it has established. This committee is comprised of the most senior leaders of the firm, and is chaired by the firm’s chief executive officer. The Management Committee has established various committees with delegated authority and the chairperson of the Management Committee appoints the chairpersons of these committees. Most members of the Management Committee are also members of other firmwide, divisional and regional committees. The following are the committees that are principally involved in firmwide risk management.

Firmwide Client and Business Standards Committee. The Firmwide Client and Business Standards Committee assesses and makes determinations regarding business standards and practices, reputational risk management, client relationships and client service, is chaired by the firm’s president and chief operating officer, and reports to the Management Committee. This committee also has responsibility for overseeing the implementation of the recommendations of the Business Standards Committee. This committee has established the following two risk-related committees that report to it:

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Ÿ  

Firmwide New Activity Committee. The Firmwide New Activity Committee is responsible for reviewing new activities and establishing a process to identify and review previously approved activities that are significant and that have changed in complexity and/or structure or present different reputational and suitability concerns over time to consider whether these activities remain appropriate. This committee is co-chaired by the firm’s head of operations/chief operating officer for Europe, Middle East and Africa and the chief administrative officer of our Investment Management Division who are appointed by the Firmwide Client and Business Standards Committee chairperson.

 

Ÿ  

Firmwide Suitability Committee. The Firmwide Suitability Committee is responsible for setting standards and policies for product, transaction and client suitability and providing a forum for consistency across divisions, regions and products on suitability assessments. This committee also reviews suitability matters escalated from other firm committees. This committee is co-chaired by the firm’s international general counsel and the co-head of our Investment Management Division who are appointed by the Firmwide Client and Business Standards Committee chairperson.

Firmwide Risk Committee. The Firmwide Risk Committee is responsible for the ongoing monitoring and control of the firm’s global financial risks. Through both direct and delegated authority, the Firmwide Risk Committee approves firmwide, product, divisional and business-level limits for both market and credit risks, approves sovereign credit risk limits and reviews results of stress tests and scenario analyses. This committee is co-chaired by the firm’s chief financial officer and a senior managing director from the firm’s executive office, and reports to the Management Committee. The following four committees report to the Firmwide Risk Committee. The chairperson of the Securities Division Risk Committee is appointed by the chairperson of the Firmwide Risk

Committee; the chairpersons of the Credit Policy and Operational Risk Committees are appointed by the firm’s chief risk officer; and the chairperson of the Firmwide Finance Committee is appointed by the Firmwide Risk Committee:

 

Ÿ  

Securities Division Risk Committee. The Securities Division Risk Committee sets market risk limits, subject to overall firmwide risk limits, for our Fixed Income, Currency and Commodities Client Execution and Equities Client Execution businesses based on a number of risk measures, including VaR, stress tests, scenario analyses, and inventory levels. This committee is chaired by the chief risk officer of our Securities Division.

 

Ÿ  

Credit Policy Committee. The Credit Policy Committee establishes and reviews broad credit policies and parameters that are implemented by our Credit Risk Management department (Credit Risk Management). This committee is chaired by the firm’s chief credit officer.

 

Ÿ  

Operational Risk Committee. The Operational Risk Committee provides oversight of the ongoing development and implementation of our operational risk policies, framework and methodologies, and monitors the effectiveness of operational risk management. This committee is chaired by a managing director in Credit Risk Management.

 

Ÿ  

Firmwide Finance Committee. The Firmwide Finance Committee has oversight of firmwide liquidity, the size and composition of our balance sheet and capital base, and our credit ratings. This committee regularly reviews our liquidity, balance sheet, funding position and capitalization, and makes adjustments in light of current events, risks and exposures, and regulatory requirements. This committee is also responsible for reviewing and approving balance sheet limits and the size of our GCE. This committee is co-chaired by the firm’s chief financial officer and the firm’s global treasurer.

 

 

154   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The following committees report jointly to the Firmwide Risk Committee and the Firmwide Client and Business Standards Committee:

 

Ÿ  

Firmwide Commitments Committee. The Firmwide Commitments Committee reviews the firm’s underwriting and distribution activities with respect to equity and equity-related product offerings, and sets and maintains policies and procedures designed to ensure that legal, reputational, regulatory and business standards are maintained on a global basis. In addition to reviewing specific transactions, this committee periodically conducts general strategic reviews of sectors and products and establishes policies in connection with transaction practices. This committee is co-chaired by the firm’s senior strategy officer and the head of Mergers & Acquisitions for Europe, Middle East, Africa and Asia Pacific for Investment Banking who are appointed by the Firmwide Client and Business Standards Committee chairperson.

 

Ÿ  

Firmwide Capital Committee. The Firmwide Capital Committee provides approval and oversight of debt-related transactions, including principal commitments of the firm’s capital. This committee aims to ensure that business and reputational standards for underwritings and capital commitments are maintained on a global basis. This committee is co-chaired by the firm’s global treasurer and the head of credit finance for Europe, Middle East and Africa who are appointed by the Firmwide Risk Committee chairpersons.

Investment Management Division Risk Committee. The Investment Management Division Risk Committee is responsible for the ongoing monitoring and control of global market, counterparty credit and liquidity risks associated with the activities of our investment management businesses. The head of Investment Management Division risk management is the chair of this committee. The Investment Management Division Risk Committee reports to the firm’s chief risk officer.

Conflicts Management

Conflicts of interest and the firm’s approach to dealing with them are fundamental to our client relationships, our reputation and our long-term success. The term “conflict of interest” does not have a universally accepted meaning, and conflicts can arise in many forms within a business or between businesses. The responsibility for identifying potential conflicts, as well as complying with the firm’s policies and procedures, is shared by the entire firm.

We have a multilayered approach to resolving conflicts and addressing reputational risk. The firm’s senior management oversees policies related to conflicts resolution. The firm’s senior management, the Business Selection and Conflicts Resolution Group, the Legal Department and Compliance Division, the Firmwide Client and Business Standards Committee and other internal committees all play roles in the formulation of policies, standards and principles and assist in making judgments regarding the appropriate resolution of particular conflicts. Resolving potential conflicts necessarily depends on the facts and circumstances of a particular situation and the application of experienced and informed judgment.

At the transaction level, various people and groups have roles. As a general matter, prior to businesses accepting mandates, or making new loans or investments, the Business Selection and Conflicts Resolution Group reviews the potential transaction. It reviews all financing and advisory assignments in Investment Banking and investing, lending and other activities of the firm. Various transaction oversight committees, such as the Firmwide Capital, Commitments and Suitability Committees and other committees across the firm, also review new underwritings, loans, investments and structured products. These committees work with internal and external lawyers and the Compliance Division to evaluate and address any actual or potential conflicts.

We regularly assess our policies and procedures that address conflicts of interest in an effort to conduct our business in accordance with the highest ethical standards and in compliance with all applicable laws, rules, and regulations.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Liquidity Risk Management

 

Liquidity is of critical importance to financial institutions. Most of the recent failures of financial institutions have occurred in large part due to insufficient liquidity. Accordingly, the firm has in place a comprehensive and conservative set of liquidity and funding policies to address both firm-specific and broader industry or market liquidity events. Our principal objective is to be able to fund the firm and to enable our core businesses to continue to serve clients and generate revenues, even under adverse circumstances.

We manage liquidity risk according to the following principles:

Excess Liquidity. We maintain substantial excess liquidity to meet a broad range of potential cash outflows and collateral needs in a stressed environment.

Asset-Liability Management. We assess anticipated holding periods for our assets and their expected liquidity in a stressed environment. We manage the maturities and diversity of our funding across markets, products and counterparties, and seek to maintain liabilities of appropriate tenor relative to our asset base.

Contingency Funding Plan. We maintain a contingency funding plan to provide a framework for analyzing and responding to a liquidity crisis situation or periods of market stress. This framework sets forth the plan of action to fund normal business activity in emergency and stress situations. These principles are discussed in more detail below.

Excess Liquidity

Our most important liquidity policy is to pre-fund our estimated potential cash needs during a liquidity crisis and hold this excess liquidity in the form of unencumbered, highly liquid securities and cash. We believe that the securities held in our global core excess would be readily convertible to cash in a matter of days, through liquidation, by entering into repurchase agreements or from maturities of reverse repurchase agreements, and that this cash would allow us to meet immediate obligations without needing to sell other assets or depend on additional funding from credit-sensitive markets.

As of June 2012 and December 2011, the fair value of the securities and certain overnight cash deposits included in our GCE totaled $174.58 billion and $171.58 billion, respectively. Based on the results of our internal liquidity risk model, discussed below, as well as our consideration of other factors including, but not limited to, a qualitative assessment of the condition of the financial markets and the firm, we believe our liquidity position as of June 2012 was appropriate.

The table below presents the fair value of the securities and certain overnight cash deposits that are included in our GCE.

 

    Average for the  
in millions  

Three Months Ended

June 2012

     Year Ended
December 2011
 

U.S. dollar-denominated

    $125,486         $125,668   

Non-U.S. dollar-denominated

    48,233         40,291   

Total

    $173,719         $165,959   
 

 

156   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The U.S. dollar-denominated excess is composed of (i) unencumbered U.S. government and federal agency obligations (including highly liquid U.S. federal agency mortgage-backed obligations), all of which are eligible as collateral in Federal Reserve open market operations and (ii) certain overnight U.S. dollar cash deposits. The non-U.S. dollar-denominated excess is composed of only unencumbered German, French, Japanese and United Kingdom government obligations and certain overnight cash deposits in highly liquid currencies. We strictly limit our excess liquidity to this narrowly defined list of securities and cash because they are highly liquid, even in a difficult funding environment. We do not include other potential sources of excess liquidity, such as less liquid unencumbered securities or committed credit facilities, in our GCE.

The table below presents the fair value of our GCE by asset class.

 

    Average for the  
in millions  

Three Months Ended

June 2012

    Year Ended
December 2011
 

Overnight cash deposits

    $  48,116        $  34,622   

U.S. government obligations

    76,565        88,528   

U.S. federal agency obligations, including highly liquid U.S. federal agency mortgage-backed obligations

    2,538        5,018   

German, French, Japanese and United Kingdom government obligations

    46,500        37,791   

Total

    $173,719        $165,959   

The GCE is held at Group Inc. and our major broker-dealer and bank subsidiaries, as presented in the table below.

 

    Average for the  
in millions  

Three Months Ended

June 2012

    Year Ended
December 2011
 

Group Inc.

    $  43,198        $  49,548   

Major broker-dealer subsidiaries

    78,654        75,086   

Major bank subsidiaries

    51,867        41,325   

Total

    $173,719        $165,959   

Our GCE reflects the following principles:

 

Ÿ  

The first days or weeks of a liquidity crisis are the most critical to a company’s survival.

 

Ÿ  

Focus must be maintained on all potential cash and collateral outflows, not just disruptions to financing flows. Our businesses are diverse, and our liquidity needs are determined by many factors, including market movements, collateral requirements and client commitments, all of which can change dramatically in a difficult funding environment.

Ÿ  

During a liquidity crisis, credit-sensitive funding, including unsecured debt and some types of secured financing agreements, may be unavailable, and the terms (e.g., interest rates, collateral provisions and tenor) or availability of other types of secured financing may change.

 

Ÿ  

As a result of our policy to pre-fund liquidity that we estimate may be needed in a crisis, we hold more unencumbered securities and have larger 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 total assets and our funding costs.

We believe that our GCE provides us with a resilient source of funds that would be available in advance of potential cash and collateral outflows and gives us significant flexibility in managing through a difficult funding environment.

In order to determine the appropriate size of our GCE, we use an internal liquidity model, referred to as the Modeled Liquidity Outflow, which captures and quantifies the firm’s liquidity risks. We also consider other factors including, but not limited to, an assessment of our potential intraday liquidity needs and a qualitative assessment of the condition of the financial markets and the firm.

We distribute our GCE across entities, asset types, and clearing agents to provide us with sufficient operating liquidity to ensure timely settlement in all major markets, even in a difficult funding environment.

We maintain our GCE to enable us to meet current and potential liquidity requirements of our parent company, Group Inc., and our major broker-dealer and bank subsidiaries. The Modeled Liquidity Outflow incorporates a consolidated requirement as well as a standalone requirement for each of our major broker-dealer and bank subsidiaries. Liquidity held directly in each of these subsidiaries is intended for use only by that subsidiary to meet its liquidity requirements and is assumed not to be available to Group Inc. unless (i) legally provided for and (ii) there are no additional regulatory, tax or other restrictions. We hold a portion of our GCE directly at Group Inc. to support consolidated requirements not accounted for in the major subsidiaries. In addition to the GCE, we maintain operating cash balances in several of our other operating entities, primarily for use in specific currencies, entities, or jurisdictions where we do not have immediate access to parent company liquidity.

 

 

  Goldman Sachs June 2012 Form 10-Q   157


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

In addition to our GCE, we have a significant amount of other unencumbered cash and financial instruments, including other government obligations, high-grade money market securities, corporate obligations, marginable equities, loans and cash deposits not included in our GCE. The fair value of these assets averaged $84.60 billion and $83.32 billion for the three months ended June 2012 and year ended December 2011, respectively. We do not consider these assets liquid enough to be eligible for our GCE liquidity pool and therefore conservatively do not assume we will generate liquidity from these assets in our Modeled Liquidity Outflow.

Modeled Liquidity Outflow. Our Modeled Liquidity Outflow is based on a scenario that includes both a market-wide stress and a firm-specific stress, characterized by some or all of the following qualitative elements:

 

Ÿ  

Global recession, default by a medium-sized sovereign, low consumer and corporate confidence, and general financial instability.

 

Ÿ  

Severely challenged market environment with material declines in equity markets and widening of credit spreads.

 

Ÿ  

Damaging follow-on impacts to financial institutions leading to the failure of a large bank.

 

Ÿ  

A firm-specific crisis potentially triggered by material losses, reputational damage, litigation, executive departure, and/or a ratings downgrade.

The following are the critical modeling parameters of the Modeled Liquidity Outflow:

 

Ÿ  

Liquidity needs over a 30-day scenario.

 

Ÿ  

A two-notch downgrade of the firm’s long-term senior unsecured credit ratings.

 

Ÿ  

A combination of contractual outflows, such as upcoming maturities of unsecured debt, and contingent outflows (e.g., actions though not contractually required, we may deem necessary in a crisis). We assume that most contingent outflows will occur within the initial days and weeks of a crisis.

 

Ÿ  

No issuance of equity or unsecured debt.

 

Ÿ  

No support from government funding facilities. Although we have access to various central bank funding programs, we do not assume reliance on them as a source of funding in a liquidity crisis.

Ÿ  

No diversification benefit across liquidity risks. We assume that liquidity risks are additive.

 

Ÿ  

Maintenance of our normal business levels. We do not assume asset liquidation, other than the GCE.

The Modeled Liquidity Outflow is calculated and reported to senior management on a daily basis. We regularly refine our model to reflect changes in market or economic conditions and the firm’s business mix.

The potential contractual and contingent cash and collateral outflows covered in our Modeled Liquidity Outflow include:

Unsecured Funding

Ÿ  

Contractual: All upcoming maturities of unsecured long-term debt, commercial paper, promissory notes and other unsecured funding products. We assume that we will be unable to issue new unsecured debt or rollover any maturing debt.

 

Ÿ  

Contingent: Repurchases of our outstanding long-term debt, commercial paper and hybrid financial instruments in the ordinary course of business as a market maker.

Deposits

Ÿ  

Contractual: All upcoming maturities of term deposits. We assume that we will be unable to raise new term deposits or rollover any maturing term deposits.

 

Ÿ  

Contingent: Withdrawals of bank deposits that have no contractual maturity. The withdrawal assumptions reflect, among other factors, the type of deposit, whether the deposit is insured or uninsured, and the firm’s relationship with the depositor.

Secured Funding

Ÿ  

Contractual: A portion of upcoming contractual maturities of secured funding due to either the inability to refinance or the ability to refinance only at wider haircuts (i.e., on terms which require us to post additional collateral). Our assumptions reflect, among other factors, the quality of the underlying collateral and counterparty concentration.

 

Ÿ  

Contingent: A decline in value of financial assets pledged as collateral for financing transactions, which would necessitate additional collateral postings under those transactions.

 

 

158   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

OTC Derivatives

Ÿ  

Contingent: Collateral postings to counterparties due to adverse changes in the value of our OTC derivatives.

 

Ÿ  

Contingent: Other outflows of cash or collateral related to OTC derivatives, including the impact of trade terminations, collateral substitutions, collateral disputes, collateral calls or termination payments required by a two-notch downgrade in our credit ratings, and collateral that has not been called by counterparties, but is available to them.

Exchange-Traded Derivatives

Ÿ  

Contingent: Variation margin postings required due to adverse changes in the value of our outstanding exchange-traded derivatives.

 

Ÿ  

Contingent: An increase in initial margin and guaranty fund requirements by derivative clearing houses.

Customer Cash and Securities

Ÿ  

Contingent: Liquidity outflows associated with our prime brokerage business, including withdrawals of customer credit balances, and a reduction in customer short positions, which serve as a funding source for long positions.

Unfunded Commitments

Ÿ  

Contingent: Draws on our unfunded commitments. Draw assumptions reflect, among other things, the type of commitment and counterparty.

Other

Ÿ  

Other upcoming large cash outflows, such as tax payments.

Asset-Liability Management

Our liquidity risk management policies are designed to ensure we have a sufficient amount of financing, even when funding markets experience persistent stress. We seek to maintain a long-dated and diversified funding profile, taking into consideration the characteristics and liquidity profile of our assets.

Our approach to asset-liability management includes:

 

Ÿ  

Conservatively managing the overall characteristics of our funding book, with a focus on maintaining long-term, diversified sources of funding in excess of our current requirements. See “Balance Sheet and Funding Sources — Funding Sources” for additional details.

 

Ÿ  

Actively managing and monitoring our asset base, with particular focus on the liquidity, holding period and our ability to fund assets on a secured basis. This enables us to determine the most appropriate funding products and tenors. Less liquid assets are more difficult to fund and therefore require funding of longer tenor. See “Balance Sheet and Funding Sources — Balance Sheet Management” for more detail on our balance sheet management process.

 

Ÿ  

Raising secured and unsecured financing that has a long tenor relative to the liquidity profile of our assets. This reduces the risk that our liabilities will come due in advance of our ability to generate liquidity from the sale of our assets. Because we maintain a highly liquid balance sheet, the holding period of certain of our assets may be materially shorter than their contractual maturity dates.

Our goal is to ensure that the firm maintains sufficient liquidity to fund its assets and meet its contractual and contingent obligations in normal times as well as during periods of market stress. Through our dynamic balance sheet management process, (see “Balance Sheet and Funding Sources — Balance Sheet Management”), we use actual and projected asset balances to determine secured and unsecured funding requirements. Funding plans are reviewed and approved by the Firmwide Finance Committee on a quarterly basis. In addition, senior managers in our independent control and support functions regularly analyze, and the Firmwide Finance Committee reviews, our consolidated total capital position (unsecured long-term borrowings plus total shareholders’ equity) so that we maintain a level of long-term funding that is sufficient to meet our long-term financing requirements. In a liquidity crisis, we would first use our GCE in order to avoid reliance on asset sales (other than our GCE). However, we recognize that orderly asset sales may be prudent or necessary in a severe or persistent liquidity crisis.

 

 

  Goldman Sachs June 2012 Form 10-Q   159


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Subsidiary Funding Policies. The majority of our unsecured funding is raised by Group Inc. which lends the necessary funds to its subsidiaries, some of which are regulated, to meet their asset financing, liquidity and capital requirements. In addition, Group Inc. provides its regulated subsidiaries with the necessary capital to meet their regulatory requirements. The benefits of this approach to subsidiary funding are enhanced control and greater flexibility to meet the funding requirements of our subsidiaries. Funding is also raised at the subsidiary level through a variety of products, including secured funding, unsecured borrowings and deposits.

Our intercompany funding policies assume that, unless legally provided for, a subsidiary’s funds or securities are not freely available to its parent company or other subsidiaries. In particular, many of our subsidiaries are subject to laws that authorize regulatory bodies to block or reduce 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 its obligations. Accordingly, we assume that the capital provided to our regulated subsidiaries is not available to Group Inc. or other subsidiaries and any other financing provided to our regulated subsidiaries is not available until the maturity of such financing.

Group Inc. has provided substantial amounts of equity and subordinated indebtedness, directly or indirectly, to its regulated subsidiaries. For example, as of June 2012, Group Inc. had $29.05 billion of equity and subordinated indebtedness invested in GS&Co., its principal U.S. registered broker-dealer; $29.10 billion invested in GSI, a regulated U.K. broker-dealer; $2.63 billion invested in GSEC, a U.S. registered broker-dealer; $4.15 billion invested in Goldman Sachs Japan Co., Ltd., a regulated Japanese broker-dealer; and $19.92 billion invested in GS Bank USA, a regulated New York State-chartered bank. Group Inc. also provided, directly or indirectly, $81.71 billion of unsubordinated loans and $5.99 billion of collateral to these entities, substantially all of which was to GS&Co. and GSI, as of June 2012. In addition, as of June 2012, Group Inc. had significant amounts of capital invested in and loans to its other regulated subsidiaries.

Contingency Funding Plan

The Goldman Sachs contingency funding plan sets out the plan of action we would use to fund business activity in crisis situations and periods of market stress. The contingency funding plan outlines a list of potential risk factors, key reports and metrics that are reviewed on an ongoing basis to assist in assessing the severity of, and managing through, a liquidity crisis and/or market dislocation. The contingency funding plan also describes in detail the firm’s potential responses if our assessments indicate that the firm has entered a liquidity crisis, which include pre-funding for what we estimate will be our potential cash and collateral needs as well as utilizing secondary sources of liquidity. Mitigants and action items to address specific risks which may arise are also described and assigned to individuals responsible for execution.

The contingency funding plan identifies key groups of individuals to foster effective coordination, control and distribution of information, all of which are critical in the management of a crisis or period of market stress. The contingency funding plan also details the responsibilities of these groups and individuals, which include making and disseminating key decisions, coordinating all contingency activities throughout the duration of the crisis or period of market stress, implementing liquidity maintenance activities and managing internal and external communication.

 

 

160   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Credit Ratings

The table below presents the unsecured credit ratings and outlook of Group Inc.

 

    As of June 2012  
    

Short-Term

Debt

   

Long-Term

Debt

   

Subordinated

Debt

    Trust
Preferred 1
   

Preferred

Stock

   

Ratings

Outlook

 

DBRS, Inc.

    R-1 (middle     A (high     A        A        BBB  3      Stable   

Fitch, Inc.

    F1        A  2      A-        BBB-        BB+  4      Stable   

Moody’s Investors Service (Moody’s)

    P-2        A3  2      Baa1        Baa3        Ba2  3      Negative  5 

Standard & Poor’s Ratings Services (S&P)

    A-2        A-  2      BBB+        BB+        BB+  3      Negative   

Rating and Investment Information, Inc.

    a-1        A+        A        N/A        N/A        Negative   

 

1.

Trust preferred securities issued by Goldman Sachs Capital I.

 

2.

Includes the senior guaranteed trust securities issued by Murray Street Investment Trust I.

 

3.

Includes Group Inc.’s non-cumulative preferred stock and the APEX issued by Goldman Sachs Capital II and Goldman Sachs Capital III.

 

4.

Includes Group Inc.’s non-cumulative preferred stock and the APEX issued by Goldman Sachs Capital II. The APEX issued by Goldman Sachs Capital III has been assigned a rating of BBB-.

 

5.

The ratings outlook for trust preferred and preferred stock is stable.

The table below presents the unsecured credit ratings of GS Bank USA, GS&Co. and GSI.

 

    As of June 2012  
    

Short-Term

Debt

    

Long-Term

Debt

    

Short-Term

Bank Deposits

    

Long-Term

Bank Deposits

 

Fitch, Inc.

          

GS Bank USA

    F1         A         F1         A+   

GS&Co.

    F1         A         N/A         N/A   

Moody’s

          

GS Bank USA

    P-1         A2         P-1         A2   

S&P

          

GS Bank USA

    A-1         A         N/A         N/A   

GS&Co.

    A-1         A         N/A         N/A   

GSI

    A-1         A         N/A         N/A   

 

During the second quarter of 2012, as part of a global review of financial institutions, Moody’s lowered Group Inc.’s ratings on short-term debt (from P-1 to P-2), long-term debt (from A1 to A3), subordinated debt (from A2 to Baa1), trust preferred (from A3 to Baa3) and preferred stock (from Baa2 to Ba2). This ratings action aligns our Moody’s rating with our S&P rating. The additional collateral or termination payments that were called by counterparties as a result of Moody’s lowering Group Inc.’s ratings were not material. In addition, Rating and Investment Information, Inc. lowered Group Inc.’s ratings on short-term debt (from a-1+ to a-1), long-term debt (from AA- to A+), and subordinated debt (from A+ to A).

We rely on the short-term and long-term debt capital markets to fund a significant portion of our day-to-day operations and the cost and availability of debt financing is influenced by our credit ratings. Credit ratings are also important when we are competing in certain markets, such as OTC derivatives, and when we seek to engage in longer-term transactions. See “Certain Risk Factors That May Affect Our Businesses” below and “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for a discussion of the risks associated with a reduction in our credit ratings.

 

 

  Goldman Sachs June 2012 Form 10-Q   161


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

We believe our credit ratings are primarily based on the credit rating agencies’ assessment of:

 

Ÿ  

our liquidity, market, credit and operational risk management practices;

 

Ÿ  

the level and variability of our earnings;

 

Ÿ  

our capital base;

 

Ÿ  

our franchise, reputation and management;

 

Ÿ  

our corporate governance; and

 

Ÿ  

the external operating environment, including the assumed level of government support.

Certain of the firm’s derivatives have been transacted under bilateral agreements with counterparties who may require us to post collateral or terminate the transactions based on changes in our credit ratings. We assess the impact of these bilateral agreements by determining the collateral or termination payments that would occur assuming downgrade by all rating agencies. A downgrade by any one rating agency, depending on the agency’s relative ratings of the firm at the time of the downgrade, may have an impact which is comparable to the impact of a downgrade by all rating agencies. We allocate a portion of our GCE to ensure we would be able to make the additional collateral or termination payments that may be required in the event of a two-notch reduction in our long-term credit ratings, as well as collateral that has not been called by counterparties, but is available to them. The table below presents the additional collateral or termination payments that could have been called at the reporting date by counterparties in the event of a one-notch and two-notch downgrade in our credit ratings.

 

    As of  
in millions  

June

2012

    

December

2011

 

Additional collateral or termination payments for a one-notch downgrade

    $1,344         $1,303   

Additional collateral or termination payments for a two-notch downgrade

    2,456         2,183   

The Basel Committee on Banking Supervision’s international framework for liquidity risk measurement, standards and monitoring calls for imposition of a liquidity coverage ratio, designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets based on expected cash outflows under an acute liquidity stress scenario, and a net stable funding ratio, designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. The liquidity coverage ratio is not expected to be introduced as a requirement until January 1, 2015, and the net stable funding ratio is not expected to be introduced as a requirement until January 1, 2018. While the principles behind the new framework are broadly consistent with our current liquidity management framework, it is possible that the implementation of these standards could impact our liquidity and funding requirements and practices.

Cash Flows

As a global financial institution, our cash flows are complex and bear little relation to our net earnings and net assets. Consequently, we believe that traditional cash flow analysis is less meaningful in evaluating our liquidity position than the excess liquidity and asset-liability management policies described above. Cash flow analysis may, however, be helpful in highlighting certain macro trends and strategic initiatives in our businesses.

Six Months Ended June 2012. Our cash and cash equivalents increased by $2.91 billion to $58.91 billion at the end of the second quarter of 2012. We generated $8.91 billion in net cash from operating activities. We used net cash of $6.00 billion for investing and financing activities, primarily for net repayments of secured and unsecured borrowings, partially offset by a net increase in bank deposits.

Six Months Ended June 2011. Our cash and cash equivalents increased by $5.65 billion to $45.43 billion at the end of the second quarter of 2011. We generated $13.10 billion in net cash from operating and investing activities. We used net cash of $7.45 billion for financing activities, primarily for the repurchases of our Series G Preferred Stock and common stock, and the payment of dividends, partially offset by net issuances of unsecured and secured borrowings.

 

 

162   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Market Risk Management

 

Overview

Market risk is the risk of loss in the value of our inventory due to changes in market prices. We hold inventory primarily for market making for our clients and for our investing and lending activities. Our inventory therefore changes based on client demands and our investment opportunities. Our inventory is accounted for at fair value and therefore fluctuates on a daily basis. Categories of market risk include the following:

 

Ÿ  

Interest rate risk: results from exposures to changes in the level, slope and curvature of yield curves, the volatilities of interest rates, mortgage prepayment speeds and credit spreads.

 

Ÿ  

Equity price risk: results from exposures to changes in prices and volatilities of individual equities, baskets of equities and equity indices.

 

Ÿ  

Currency rate risk: results from exposures to changes in spot prices, forward prices and volatilities of currency rates.

 

Ÿ  

Commodity price risk: results from exposures to changes in spot prices, forward prices and volatilities of commodities, such as electricity, natural gas, crude oil, petroleum products, and precious and base metals.

Market Risk Management Process

We manage our market risk by diversifying exposures, controlling position sizes and establishing economic hedges in related securities or derivatives. This includes:

 

Ÿ  

accurate and timely exposure information incorporating multiple risk metrics;

 

Ÿ  

a dynamic limit setting framework; and

 

Ÿ  

constant communication among revenue-producing units, risk managers and senior management.

Market Risk Management, which is independent of the revenue-producing units and reports to the firm’s chief risk officer, has primary responsibility for assessing, monitoring and managing market risk at the firm. We monitor and control risks through strong firmwide oversight and independent control and support functions across the firm’s global businesses.

Managers in revenue-producing units are accountable for managing risk within prescribed limits. These managers have in-depth knowledge of their positions, markets and the instruments available to hedge their exposures.

Managers in revenue-producing units and Market Risk Management discuss market information, positions and estimated risk and loss scenarios on an ongoing basis.

Risk Measures

Market Risk Management produces risk measures and monitors them against market risk limits set by our firm’s risk committees. These measures reflect an extensive range of scenarios and the results are aggregated at trading desk, business and firmwide levels.

We use a variety of risk measures to estimate the size of potential losses for both moderate and more extreme market moves over both short-term and long-term time horizons. Risk measures used for shorter-term periods include VaR and sensitivity metrics. For longer-term horizons, our primary risk measures are stress tests. Our risk reports detail key risks, drivers and changes for each desk and business, and are distributed daily to senior management of both our revenue-producing units and our independent control and support functions.

Systems

We have made a significant investment in technology to monitor market risk including:

 

Ÿ  

an independent calculation of VaR and stress measures;

 

Ÿ  

risk measures calculated at individual position levels;

 

Ÿ  

attribution of risk measures to individual risk factors of each position;

 

Ÿ  

the ability to report many different views of the risk measures (e.g., by desk, business, product type or legal entity); and

 

Ÿ  

the ability to produce ad hoc analyses in a timely manner.

 

 

  Goldman Sachs June 2012 Form 10-Q   163


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Value-at-Risk

VaR is the potential loss in value of inventory positions due to adverse market movements over a defined time horizon with a specified confidence level. We typically employ a one-day time horizon with a 95% confidence level. The VaR model captures risks including interest rates, equity prices, currency rates and commodity prices. As such, VaR facilitates comparison across portfolios of different risk characteristics. VaR also captures the diversification of aggregated risk at the firmwide level.

We are aware of the inherent limitations to VaR and therefore use a variety of risk measures in our market risk management process. Inherent limitations to VaR include:

 

Ÿ  

VaR does not estimate potential losses over longer time horizons where moves may be extreme.

 

Ÿ  

VaR does not take account of the relative liquidity of different risk positions.

 

Ÿ  

Previous moves in market risk factors may not produce accurate predictions of all future market moves.

When calculating VaR, we use historical simulations with full valuation of approximately 70,000 market factors. The historical data used in our VaR calculation is weighted to give greater importance to more recent observations and reflect current asset volatilities. This improves the accuracy of our estimates of potential loss. As a result, even if our inventory positions were unchanged, our VaR would increase with increasing market volatility and vice versa.

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.

We evaluate the accuracy of our VaR model through daily backtesting (i.e., comparing daily trading net revenues to the VaR measure calculated as of the prior business day) at the firmwide level and for each of our businesses and major regulated subsidiaries. Our VaR model is regularly reviewed and enhanced in order to incorporate changes in the composition of inventory positions, as well as variations in market conditions.

Our VaR measure does not include:

 

Ÿ  

positions that are best measured and monitored using sensitivity measures; and

 

Ÿ  

the impact of changes in counterparty and our own credit spreads on derivatives, as well as changes in our own credit spreads on unsecured borrowings for which the fair value option was elected.

Stress Testing

We use stress testing to examine risks of specific portfolios as well as the potential impact of significant risk exposures across the firm. We use a variety of scenarios to calculate the potential loss from a wide range of market moves on the firm’s portfolios. These scenarios include the default of single corporate or sovereign entities, the impact of a move in a single risk factor across all positions (e.g., equity prices or credit spreads) or a combination of two or more risk factors. For example, for sovereign stress testing we calculate potential direct exposure associated with our sovereign inventory as well as the corresponding debt, equity and currency exposures associated with our non-sovereign inventory that may be impacted by the sovereign distress.

Unlike VaR measures, which have an implied probability because they are calculated at a specified confidence level, there is generally no implied probability that our stress test scenarios will occur. Instead, stress tests are used to model both moderate and more extreme moves in underlying market factors. When estimating potential loss, we generally assume that our positions cannot be reduced or hedged (although experience demonstrates that we are generally able to do so).

Stress test scenarios are conducted on a regular basis as part of the firm’s routine risk management process and on an ad hoc basis in response to market events or concerns. Stress testing is an important part of the firm’s risk management process because it allows us to highlight potential loss concentrations, undertake risk/reward analysis, and assess and mitigate our risk positions.

 

 

164   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Limits

We use risk limits at various levels in the firm (including firmwide, product and business) to govern risk appetite by controlling the size of our exposures to market risk. Limits are reviewed frequently and amended on a permanent or temporary basis to reflect changing market conditions, business conditions or tolerance for risk.

The Firmwide Risk Committee sets market risk limits at firmwide and product levels and our Securities Division Risk Committee sets sub-limits for market-making and investing activities at a business level. The purpose of the firmwide limits is to assist senior management in controlling the firm’s overall risk profile. Sub-limits set the desired maximum amount of exposure that may be managed by any particular business on a day-to-day basis without additional levels of senior management approval, effectively leaving day-to-day trading decisions to individual desk managers and traders. Accordingly, sub-limits are a management tool designed to ensure appropriate escalation rather than to establish maximum risk tolerance. Sub-limits also distribute risk among various businesses in a manner that is consistent with their level of activity and client demand, taking into account the relative performance of each area.

Our market risk limits are monitored daily by Market Risk Management, which is responsible for identifying and escalating, on a timely basis, instances where limits have been exceeded. The business-level limits that are set by the Securities Division Risk Committee are subject to the same scrutiny and limit escalation policy as the firmwide limits.

When a risk limit has been exceeded (e.g., due to changes in market conditions, such as increased volatilities or changes in correlations), it is reported to the appropriate risk committee and a discussion takes place with the relevant desk managers, after which either the risk position is reduced or the risk limit is temporarily or permanently increased.

Metrics

We analyze VaR at the firmwide level and a variety of more detailed levels, including by risk category, business, and region. The tables below present, by risk category, average daily VaR and period-end VaR, as well as the high and low VaR for the period. Diversification effect in the tables below represents the difference between total VaR and the sum of the VaRs for the four risk categories. This effect arises because the four market risk categories are not perfectly correlated.

Average Daily VaR

 

in millions

 

Risk Categories

  Three Months
Ended June
        Six Months
Ended June
 
  2012     2011          2012     2011  

Interest rates

    $ 83        $  76            $ 87        $  81   

Equity prices

    23        35            26        42   

Currency rates

    16        21            16        23   

Commodity prices

    20        39            23        38   

Diversification effect

    (50     (70         (58     (77

Total

    $ 92        $101            $ 94        $107   

Our average daily VaR decreased to $92 million for the second quarter of 2012 from $101 million for the second quarter of 2011, primarily reflecting decreases in the commodity prices and equity prices categories, principally due to reduced exposures. These decreases were partially offset by a decrease in the diversification benefit across risk categories.

Our average daily VaR decreased to $94 million for the first half of 2012 from $107 million for the first half of 2011, reflecting decreases in the equity prices, commodity prices and currency rates categories, principally due to reduced exposures. These decreases were partially offset by a decrease in the diversification benefit across risk categories.

Quarter-End VaR and High and Low VaR

 

              Three Months Ended

in millions

 

Risk Categories

  As of        

June 2012

  June
2012
    March
2012
         High   Low

Interest rates

    $ 79        $ 83          $  90   $76

Equity prices

    17        29          49   14

Currency rates

    15        15          21   11

Commodity prices

    19        22          25   15

Diversification effect

    (45     (54      

Total

    $ 85        $ 95          $102   $83

Our daily VaR decreased to $85 million as of June 2012 from $95 million as of March 2012, reflecting a decrease in the equity prices category, principally due to reduced exposures, and a decrease in the interest rates and commodity prices categories, principally due to lower levels of volatility. These decreases were partially offset by a decrease in the diversification benefit across risk categories.

During the second quarter of 2012, the firmwide VaR risk limit was not exceeded, raised or reduced.

 

 

  Goldman Sachs June 2012 Form 10-Q   165


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The chart below reflects the VaR over the last four quarters.

 

LOGO

 

The chart below presents the frequency distribution of our daily trading net revenues for substantially all inventory

positions included in VaR for the quarter ended June 2012.

 

 

LOGO

 

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 second quarter of 2012.

During periods in which the firm has significantly more positive net revenue days than net revenue loss days, we expect to have fewer VaR exceptions because, under

normal conditions, our business model generally produces positive net revenues. In periods in which our franchise revenues are adversely affected, we generally have more loss days, resulting in more VaR exceptions. In addition, VaR backtesting is performed against total daily market-making revenues, including bid/offer net revenues, which are more likely than not to be positive by their nature.

 

 

166   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Sensitivity Measures

Certain portfolios and individual positions are not included in VaR because VaR is not the most appropriate risk measure. The market risk of these positions is determined by estimating the potential reduction in net revenues of a 10% decline in the underlying asset value.

The table below presents market risk for positions that are not included in VaR. These measures do not reflect diversification benefits across asset categories and therefore have not been aggregated.

 

Asset Categories

 

  10% Sensitivity  
  Amount as of  
in millions    

 

June

2012

  

  

   

 

March

2012

  

  

ICBC 1

    $   162        $   230   

Equity (excluding ICBC) 2

    2,413        2,496   

Debt 3

    1,522        1,456   

 

1.

Excludes third-party interests held by investment funds managed by Goldman Sachs. As of June 2012, these investment funds no longer have an interest in the ordinary shares of ICBC.

 

2.

Relates to private and restricted public equity securities, including interests in firm-sponsored funds that invest in corporate equities and real estate and interests in firm-sponsored hedge funds.

 

3.

Primarily relates to interests in our firm-sponsored funds that invest in corporate mezzanine and senior debt instruments. Also includes loans backed by commercial and residential real estate, corporate bank loans and other corporate debt, including acquired portfolios of distressed loans.

VaR excludes the impact of changes in counterparty and our own credit spreads on derivatives as well as changes in our own credit spreads on unsecured borrowings for which the fair value option was elected. The estimated sensitivity to a one basis point increase in credit spreads (counterparty and our own) on derivatives was a $3 million gain (including hedges) as of June 2012. In addition, the estimated sensitivity to a one basis point increase in our own credit spreads on unsecured borrowings for which the fair value option was elected was a $7 million gain (including hedges) as of June 2012. However, the actual net impact of a change in our own credit spreads is also affected by the liquidity, duration and convexity (as the sensitivity is not linear to changes in yields) of those unsecured borrowings for which the fair value option was elected, as well as the relative performance of any hedges undertaken.

The firm engages in insurance activities where we reinsure and purchase portfolios of insurance risk and pension liabilities. The risks associated with these activities include, but are not limited to: equity price, interest rate, reinvestment and mortality risk. The firm mitigates risks associated with insurance activities through the use of reinsurance and hedging. Certain of the assets associated with the firm’s insurance activities are included in VaR. In addition to the positions included in VaR, we held $6.96 billion of securities accounted for as available-for-sale as of June 2012, substantially all of which support the firm’s insurance subsidiaries. As of June 2012, our available-for-sale securities primarily consisted of $2.95 billion of corporate debt securities with an average yield of 4%, the majority of which will mature after five years, $2.08 billion of mortgage and other asset-backed loans and securities with an average yield of 7%, the majority of which will mature after ten years, and $1.01 billion of U.S. government and federal agency obligations with an average yield of 2%, the majority of which will mature after five years. As of March 2012, we held $4.69 billion of securities accounted for as available-for-sale, primarily consisting of $1.62 billion of corporate debt securities with an average yield of 5%, the majority of which will mature after five years, $1.69 billion of mortgage and other asset-backed loans and securities with an average yield of 9%, the majority of which will mature after ten years, and $642 million of U.S. government and federal agency obligations with an average yield of 3%, the majority of which will mature after ten years.

In addition, as of June 2012 and March 2012, we had commitments and held loans for which we have obtained credit loss protection from Sumitomo Mitsui Financial Group, Inc. See Note 18 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for further information about such lending commitments.

Additionally, we make investments accounted for under the equity method and we also make direct investments in real estate, both of which are included in “Other assets” in the condensed consolidated statements of financial condition. Direct investments in real estate are accounted for at cost less accumulated depreciation. See Note 12 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information on “Other assets.”

 

 

  Goldman Sachs June 2012 Form 10-Q   167


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Credit Risk Management

 

Overview

Credit risk represents the potential for loss due to the default or deterioration in credit quality of a counterparty (e.g., an OTC derivatives counterparty or a borrower) or an issuer of securities or other instruments we hold. Our exposure to credit risk comes mostly from client transactions in OTC derivatives and loans and lending commitments. Credit risk also comes from cash placed with banks, securities financing transactions (i.e., resale and repurchase agreements and securities borrowing and lending activities) and receivables from brokers, dealers, clearing organizations, customers and counterparties.

Credit Risk Management, which is independent of the revenue-producing units and reports to the firm’s chief risk officer, has primary responsibility for assessing, monitoring and managing credit risk at the firm. The Credit Policy Committee and the Firmwide Risk Committee establish and review credit policies and parameters. In addition, we hold other positions that give rise to credit risk (e.g., bonds held in our inventory and secondary bank loans). These credit risks are captured as a component of market risk measures, which are monitored and managed by Market Risk Management, consistent with other inventory positions.

Policies authorized by the Firmwide Risk Committee and the Credit Policy Committee prescribe the level of formal approval required for the firm to assume credit exposure to a counterparty across all product areas, taking into account any enforceable netting provisions, collateral or other credit risk mitigants.

Credit Risk Management Process

Effective management of credit risk requires accurate and timely information, a high level of communication and knowledge of customers, countries, industries and products. Our process for managing credit risk includes:

 

Ÿ  

approving transactions and setting and communicating credit exposure limits;

 

Ÿ  

monitoring compliance with established credit exposure limits;

 

Ÿ  

assessing the likelihood that a counterparty will default on its payment obligations;

 

Ÿ  

measuring the firm’s current and potential credit exposure and losses resulting from counterparty default;

Ÿ  

reporting of credit exposures to senior management, the Board and regulators;

 

Ÿ  

use of credit risk mitigants, including collateral and hedging; and

 

Ÿ  

communication and collaboration with other independent control and support functions such as operations, legal and compliance.

As part of the risk assessment process, Credit Risk Management performs credit reviews which include initial and ongoing analyses of our counterparties. A credit review is an independent judgment about the capacity and willingness of a counterparty to meet its financial obligations. For substantially all of our credit exposures, the core of our process is an annual counterparty review. A counterparty review is a written analysis of a counterparty’s business profile and financial strength resulting in an internal credit rating which represents the probability of default on financial obligations to the firm. The determination of internal credit ratings incorporates assumptions with respect to the counterparty’s future business performance, the nature and outlook for the counterparty’s industry, and the economic environment. Senior personnel within Credit Risk Management, with expertise in specific industries, inspect and approve credit reviews and internal credit ratings.

Our global credit risk management systems capture credit exposure to individual counterparties and on an aggregate basis to counterparties and their subsidiaries (economic groups). These systems also provide management with comprehensive information on our aggregate credit risk by product, internal credit rating, industry, country and region.

Risk Measures and Limits

We measure our credit risk based on the potential loss in an event of non-payment by a counterparty. For derivatives and securities financing transactions, the primary measure is potential exposure, which is our estimate of the future exposure that could arise over the life of a transaction based on market movements within a specified confidence level. Potential exposure takes into account netting and collateral arrangements. For loans and lending commitments, the primary measure is a function of the notional amount of the position. We also monitor credit risk in terms of current exposure, which is the amount presently owed to the firm after taking into account applicable netting and collateral.

 

 

168   Goldman Sachs June 2012 Form 10-Q  


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

We use credit limits at various levels (counterparty, economic group, industry, country) to control the size of our credit exposures. Limits for counterparties and economic groups are reviewed regularly and revised to reflect changing appetites for a given counterparty or group of counterparties. Limits for industries and countries are based on the firm’s risk tolerance and are designed to allow for regular monitoring, review, escalation and management of credit risk concentrations.

Stress Tests/Scenario Analysis

We use regular stress tests to calculate the credit exposures, including potential concentrations that would result from applying shocks to counterparty credit ratings or credit risk factors (e.g., currency rates, interest rates, equity prices). These shocks include a wide range of moderate and more extreme market movements. Some of our stress tests include shocks to multiple risk factors, consistent with the occurrence of a severe market or economic event. In the case of sovereign default, we estimate the direct impact of the default on our sovereign credit exposures, changes to our credit exposures arising from potential market moves in response to the default, and the impact of the credit market deterioration on corporate borrowers and counterparties that may result from the sovereign default. Unlike potential exposure, which is calculated within a specified confidence level, with a stress test there is generally no assumed probability of these events occurring.

We run stress tests on a regular basis as part of our routine risk management processes and conduct tailored stress tests on an ad hoc basis in response to market developments. Stress tests are regularly conducted jointly with the firm’s market and liquidity risk functions.

Risk Mitigants

To reduce our credit exposures on derivatives and securities financing transactions, we may enter into netting agreements with counterparties that permit us to offset receivables and payables with such counterparties. We may also reduce credit risk with counterparties by entering into agreements that enable us to obtain collateral from them on an upfront or contingent basis and/or to terminate transactions if the counterparty’s credit rating falls below a specified level.

For loans and lending commitments, we typically employ a variety of potential risk mitigants, depending on the credit quality of the borrower and other characteristics of the transaction. Risk mitigants include: collateral provisions, guarantees, covenants, structural seniority of the bank loan claims and, for certain lending commitments, provisions in the legal documentation that allow the firm to adjust loan amounts, pricing, structure and other terms as market conditions change. The type and structure of risk mitigants employed can significantly influence the degree of credit risk involved in a loan.

When we do not have sufficient visibility into a counterparty’s financial strength or when we believe a counterparty requires support from its parent company, we may obtain third-party guarantees of the counterparty’s obligations. We may also mitigate our credit risk using credit derivatives or participation agreements.

Credit Exposures

The firm’s credit exposures are described further below.

Cash and Cash Equivalents. Cash and cash equivalents include both interest-bearing and non-interest-bearing deposits. To mitigate the risk of credit loss, we place substantially all of our deposits with highly rated banks and central banks.

OTC Derivatives. Derivatives are reported on a net-by-counterparty basis (i.e., the net payable or receivable for derivative assets and liabilities for a given counterparty) when a legal right of setoff exists under an enforceable netting agreement.

Derivatives are accounted for at fair value net of cash collateral received or posted under credit support agreements. As credit risk is an essential component of fair value, the firm includes a credit valuation adjustment (CVA) in the fair value of derivatives to reflect counterparty credit risk, as described in Note 7 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q. CVA is a function of the present value of expected exposure, the probability of counterparty default and the assumed recovery upon default.

 

 

  Goldman Sachs June 2012 Form 10-Q   169


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

The tables below present the distribution of our exposure to OTC derivatives by tenor, based on expected duration for mortgage-related credit derivatives and generally on remaining contractual maturity for other derivatives, both before and after the effect of collateral and netting agreements. Receivable and payable balances for the same counterparty across tenor categories are netted under

enforceable netting agreements, and cash collateral received is netted under credit support agreements. Receivable and payable balances with the same counterparty in the same tenor category are netted within such tenor category. The categories shown reflect our internally determined public rating agency equivalents.

 

 

    As of June 2012  

in millions

 

Credit Rating Equivalent

  0 - 12
Months
     1 - 5
Years
    

5 Years

or Greater

     Total      Netting     Exposure      Exposure
Net of
Collateral
 

AAA/Aaa

    $     646         $  1,103         $    2,472         $    4,221         $       (856     $  3,365         $  2,992   

AA/Aa2

    3,762         8,919         20,655         33,336         (16,372     16,964         11,012   

A/A2

    14,784         30,630         45,329         90,743         (66,154     24,589         15,935   

BBB/Baa2

    5,971         15,226         28,402         49,599         (36,991     12,608         3,807   

BB/Ba2 or lower

    3,247         4,811         9,235         17,293         (9,600     7,693         4,957   

Unrated

    721         679         372         1,772         (17     1,755         1,299   

Total

    $29,131         $61,368         $106,465         $196,964         $(129,990     $66,974         $40,002   

 

    As of December 2011  

in millions

 

Credit Rating Equivalent

  0 - 12
Months
     1 - 5
Years
    

5 Years

or Greater

     Total      Netting     Exposure      Exposure
Net of
Collateral
 

AAA/Aaa

    $     727         $     786         $    2,297         $    3,810         $       (729     $  3,081         $  2,770   

AA/Aa2

    4,661         10,198         28,094         42,953         (22,972     19,981         12,954   

A/A2

    17,704         36,553         50,787         105,044         (73,873     31,171         17,109   

BBB/Baa2

    7,376         14,222         25,612         47,210         (36,214     10,996         6,895   

BB/Ba2 or lower

    2,896         4,497         6,597         13,990         (6,729     7,261         4,527   

Unrated

    752         664         391         1,807         (149     1,658         1,064   

Total

    $34,116         $66,920         $113,778         $214,814         $(140,666     $74,148         $45,319   

 

170   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Lending Activities. We manage the firm’s traditional credit origination activities, including funded loans and lending commitments (both fair value and held for investment loans and lending commitments), using the credit risk process, measures and limits described above. Other lending positions, including secondary trading positions, are risk-managed as a component of market risk.

Other Credit Exposures. The firm is exposed to credit risk from its receivables from brokers, dealers and clearing organizations and customers and counterparties. Receivables from brokers, dealers and clearing organizations are primarily comprised of initial margin placed with clearing organizations and receivables related to sales of securities which have traded, but not yet settled. These receivables have minimal credit risk due to the low probability of clearing organization default and the short-term nature of receivables related to securities settlements. Receivables from customers and counterparties are generally comprised of collateralized receivables related to customer securities transactions and have minimal credit risk due to both the value of the collateral received and the short-term nature of these receivables.

Credit Exposures

As of June 2012, our credit exposures increased as compared with December 2011, primarily reflecting an increase in loans and lending commitments, partially offset by a decrease in OTC derivative exposures. The percentage of our credit exposure arising from non-investment-grade counterparties (based on our internally determined public rating agency equivalents) was essentially unchanged from December 2011. Counterparty defaults rose slightly during the six months ended June 2012; however, the associated credit losses were lower as compared with the same prior year period.

The tables below present the firm’s credit exposures related to cash, OTC derivatives, and loans and lending commitments associated with traditional credit origination activities broken down by industry, region and internal credit rating.

 

 

  Goldman Sachs June 2012 Form 10-Q   171


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Credit Exposure by Industry

 

    Cash          OTC Derivatives          Loans and Lending
Commitments 1
 
    As of          As of          As of  
in millions  

June

2012

    

December

2011

         

June

2012

    

December

2011

         

June

2012

    

December

2011

 

Asset Managers & Funds

    $       51         $       64             $10,410         $10,582             $  1,653         $  1,290   

Banks, Brokers & Other Financial Institutions

    13,439         12,535             21,054         25,041             4,878         3,591   

Consumer Products, Non-Durables & Retail

            11             1,194         1,031             14,424         12,685   

Government & Central Banks

    45,417         43,389             14,396         16,642             1,754         1,828   

Healthcare & Education

                        3,700         2,962             8,980         7,158   

Insurance

                        2,776         2,828             3,340         2,891   

Natural Resources & Utilities

                        4,431         4,803             15,837         14,795   

Real Estate

                        320         327             2,577         2,695   

Technology, Media, Telecommunications & Services

            2             1,803         2,124             14,167         12,646   

Transportation

                        1,417         1,104             5,552         5,753   

Other

    6         7             5,473         6,704             5,533         5,759   

Total 2

    $58,913         $56,008             $66,974         $74,148             $78,695         $71,091   

Credit Exposure by Region

 

    Cash          OTC Derivatives          Loans and Lending
Commitments 1
 
    As of          As of          As of  
in millions  

June

2012

    

December

2011

         

June

2012

    

December

2011

         

June

2012

    

December

2011

 

Americas

    $51,582         $48,543             $33,276         $36,591             $56,410         $52,755   

EMEA 3

    1,771         1,800             26,229         29,549             20,874         16,989   

Asia

    5,560         5,665             7,469         8,008             1,411         1,347   

Total 2

    $58,913         $56,008             $66,974         $74,148             $78,695         $71,091   

Credit Exposure by Credit Quality

 

    Cash          OTC Derivatives          Loans and Lending
Commitments 1
 
    As of          As of          As of  

in millions

Credit Rating Equivalent

 

June

2012

    

December

2011

         

June

2012

    

December

2011

         

June

2012

    

December

2011

 

AAA/Aaa

    $43,179         $40,559             $  3,365         $  3,081             $  2,062         $  2,192   

AA/Aa2

    7,536         7,463             16,964         19,981             7,865         7,026   

A/A2

    6,867         6,464             24,589         31,171             21,206         21,055   

BBB/Baa2

    397         195             12,608         10,996             27,314         22,937   

BB/Ba2 or lower

    841         1,209             7,693         7,261             20,248         17,820   

Unrated

    93         118             1,755         1,658                     61   

Total 2

    $58,913         $56,008             $66,974         $74,148             $78,695         $71,091   

 

1.

Includes approximately $10 billion of loans as of both June 2012 and December 2011, and approximately $69 billion and $61 billion of lending commitments as of June 2012 and December 2011, respectively. Excludes approximately $11 billion and $10 billion of loans as of June 2012 and December 2011, respectively, and lending commitments with a total notional value of approximately $5 billion as of both June 2012 and December 2011, that are risk managed as part of market risk using VaR and sensitivity measures.

 

2.

The firm bears credit risk related to resale agreements and securities borrowed only to the extent that cash advanced to the counterparty exceeds the value of the collateral received. The firm also has credit exposure on repurchase agreements and securities loaned to the extent that the value of securities pledged or delivered to the counterparty for these transactions exceeds the amount of cash or collateral received. We had approximately $43 billion and $41 billion as of June 2012 and December 2011, respectively, in credit exposure related to securities financing transactions reflecting enforceable netting agreements.

 

3.

EMEA (Europe, Middle East and Africa).

 

172   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Selected Country Exposures

During 2011 and continuing into 2012, there have been concerns about European sovereign debt risk and its impact on the European banking system and a number of European member states have been experiencing significant credit deterioration. The most pronounced market concerns relate to Greece, Ireland, Italy, Portugal and Spain. The tables below present our credit exposure (both gross and net of hedges) to all sovereigns, financial institutions and corporate counterparties or borrowers in these countries. Credit exposure represents the potential for loss due to the default or deterioration in credit quality of a counterparty or borrower. In addition, the tables include the market

exposure of our long and short inventory for which the issuer or underlier is located in these countries. Market exposure represents the potential for loss in value of our inventory due to changes in market prices. There is no overlap between the credit and market exposures in the tables below.

The country of risk is determined by the location of the counterparty, issuer or underlier’s assets, where they generate revenue, the country in which they are headquartered, and/or the government whose policies affect their ability to repay their obligations.

 

 

    As of June 2012  
    Credit Exposure         Market Exposure  
in millions   Loans     OTC
Derivatives
    Other     Gross
Funded
    Hedges    

Total Net
Funded
Credit

Exposure

   

Unfunded

Credit
Exposure

    Total
Credit
Exposure
         Debt     Equities
and
Other
    Credit
Derivatives
    Total
Market
Exposure
 

Greece

                         

Sovereign

    $     —        $     11        $  —        $     11        $       —        $     11        $   —        $     11            $     30        $   —        $       —        $   30   

Non-Sovereign

    22        23               45               45               45            57        (1     7        63   

Total Greece

    22        34               56               56               56            87        (1     7        93   

Ireland

                         

Sovereign

           1        106        107               107               107            17               (386     (369

Non-Sovereign

           215        59        274        (22     252               252            627        7        120        754   

Total Ireland

           216        165        381        (22     359               359            644        7        (266     385   

Italy

                         

Sovereign

           1,404        59        1,463        (1,391     72               72            191        45        (279     (43

Non-Sovereign

    179        405        65        649        (34     615        400        1,015            322        (130     (1,126     (934

Total Italy

    179        1,809        124        2,112        (1,425     687        400        1,087            513        (85     (1,405     (977

Portugal

                         

Sovereign

           110        42        152               152               152            26               (197     (171

Non-Sovereign

           27               27               27               27            149               (185     (36

Total Portugal

           137        42        179               179               179            175               (382     (207

Spain

                         

Sovereign

           84        1        85               85               85            (26     5        (873     (894

Non-Sovereign

    950        88        60        1,098        (56     1,042        543        1,585            861        189        (427     623   

Total Spain

    950        172        61        1,183        (56     1,127        543        1,670            835        194        (1,300     (271

Subtotal

    $1,151  1      $2,368  2      $392        $3,911        $(1,503 3      $2,408        $943        $3,351            $2,254        $115        $(3,346 3      $(977

 

1.

Principally consists of collateralized loans.

 

2.

Includes the benefit of $6.9 billion of cash and U.S. Treasury securities collateral and excludes non-U.S. government and agency obligations and corporate securities collateral of $279 million.

 

3.

Includes written and purchased credit derivative notionals reduced by the fair values of such credit derivatives.

 

  Goldman Sachs June 2012 Form 10-Q   173


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

    As of December 2011  
    Credit Exposure         Market Exposure  
in millions   Loans     OTC
Derivatives
    Other     Gross
Funded
    Hedges    

Total

Net Funded
Credit

Exposure

   

Unfunded

Credit
Exposure

    Total
Credit
Exposure
         Debt     Equities
and
Other
    Credit
Derivatives
    Total
Market
Exposure
 

Greece

                         

Sovereign

    $  —        $      —        $   —        $     —        $       —        $      —        $   —        $      —            $   329        $   —        $     (22     $ 307   

Non-Sovereign

    20        53               73               73               73            32        11        18        61   

Total Greece

    20        53               73               73               73            361        11        (4     368   

Ireland

                         

Sovereign

           1        256        257               257               257            411               (352     59   

Non-Sovereign

           542        66        608        (8     600        57        657            412        85        115        612   

Total Ireland

           543        322        865        (8     857        57        914            823        85        (237     671   

Italy

                         

Sovereign

           1,666        3        1,669        (1,410     259               259            210               200        410   

Non-Sovereign

    126        457               583        (25     558        408        966            190        297        (896     (409

Total Italy

    126        2,123        3        2,252        (1,435     817        408        1,225            400        297        (696     1   

Portugal

                         

Sovereign

           151               151               151               151            (98            23        (75

Non-Sovereign

           53        2        55               55               55            230        13        (179     64   

Total Portugal

           204        2        206               206               206            132        13        (156     (11

Spain

                         

Sovereign

           88               88               88               88            151               (550     (399

Non-Sovereign

    153        254        11        418        (141     277        146        423            345        239        (629     (45

Total Spain

    153        342        11        506        (141     365        146        511            496        239        (1,179     (444

Subtotal

    $299        $3,265  1      $338        $3,902        $(1,584     $2,318        $611        $2,929            $2,212        $645        $(2,272 2      $ 585   

 

1.

Includes the benefit of $6.5 billion of cash and U.S. Treasury securities collateral and excludes non-U.S. government and agency obligations and corporate securities collateral of $341 million.

 

2.

Includes written and purchased credit derivative notionals reduced by the fair values of such credit derivatives.

 

We economically hedge our exposure to written credit derivatives by entering into offsetting purchased credit derivatives with identical underlyings. Where possible, we endeavor to match the tenor and credit default terms of such hedges to that of our written credit derivatives. Substantially all purchased credit derivatives included above are bought from investment-grade counterparties domiciled outside of these countries and are collateralized with cash or U.S. Treasury securities. The gross purchased and written credit derivative notionals across the above countries for single-name and index credit default swaps (included in Hedges and Credit Derivatives in the tables above) were $165.2 billion and $154.4 billion, respectively, as of June 2012, and $177.8 billion and $167.3 billion, respectively, as of December 2011. Including netting under legally enforceable netting agreements, within each and across all of the countries above, the purchased and written credit derivative notionals for single-name and index credit default swaps were $25.4 billion and $14.6 billion, respectively, as of June 2012, and $28.2 billion and $17.7 billion, respectively, as of December 2011. These notionals are not representative of our exposure because they exclude available netting under legally enforceable

netting agreements on other derivatives outside of these countries and collateral received or posted under credit support agreements.

In credit exposure above, ‘Other’ principally consists of deposits, secured lending transactions and other secured receivables. As of June 2012 and December 2011, $4.6 billion and $7.0 billion, respectively, of secured lending transactions and other secured receivables were fully collateralized.

For information about the nature of or payout under trigger events related to written and purchased credit protection contracts see Note 7 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q.

We evaluate and monitor the effects of indirect exposure from these countries. See “Liquidity Risk Management — Modeled Liquidity Outflow,” “Market Risk Management — Stress Testing” and “Credit Risk Management — Stress Tests/Scenario Analysis” for further discussion.

Credit events which occurred subsequent to June 2012 related to these countries did not have a material effect on our financial condition, results of operations, liquidity or capital resources.

 

 

174   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Operational Risk Management

 

Overview

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Our exposure to operational risk arises from routine processing errors as well as extraordinary incidents, such as major systems failures. Potential types of loss events related to internal and external operational risk include:

 

Ÿ  

clients, products and business practices;

 

Ÿ  

execution, delivery and process management;

 

Ÿ  

business disruption and system failures;

 

Ÿ  

employment practices and workplace safety;

 

Ÿ  

damage to physical assets;

 

Ÿ  

internal fraud; and

 

Ÿ  

external fraud.

The firm maintains a comprehensive control framework designed to provide a well-controlled environment to minimize operational risks. The Firmwide Operational Risk Committee, along with the support of regional or entity-specific working groups or committees, provides oversight of the ongoing development and implementation of our operational risk policies and framework. Our Operational Risk Management department (Operational Risk Management) is a risk management function independent of our revenue-producing units, reports to the firm’s chief risk officer, and is responsible for developing and implementing policies, methodologies and a formalized framework for operational risk management with the goal of minimizing our exposure to operational risk.

Operational Risk Management Process

Managing operational risk requires timely and accurate information as well as a strong control culture. We seek to manage our operational risk through:

 

Ÿ  

the training, supervision and development of our people;

 

Ÿ  

the active participation of senior management in identifying and mitigating key operational risks across the firm;

 

Ÿ  

independent control and support functions that monitor operational risk on a daily basis and have instituted extensive policies and procedures and implemented controls designed to prevent the occurrence of operational risk events;

 

Ÿ  

proactive communication between our revenue-producing units and our independent control and support functions; and

 

Ÿ  

a network of systems throughout the firm to facilitate the collection of data used to analyze and assess our operational risk exposure.

We combine top-down and bottom-up approaches to manage and measure operational risk. From a top-down perspective, the firm’s senior management assesses firmwide and business level operational risk profiles. From a bottom-up perspective, revenue-producing units and independent control and support functions are responsible for risk management on a day-to-day basis, including identifying, mitigating, and escalating operational risks to senior management.

Our operational risk framework is in part designed to comply with the operational risk measurement rules under Basel 2 and has evolved based on the changing needs of our businesses and regulatory guidance. Our framework includes the following practices:

 

Ÿ  

Risk identification and reporting;

 

Ÿ  

Risk measurement; and

 

Ÿ  

Risk monitoring.

Internal Audit performs a review of our operational risk framework, including our key controls, processes and applications, on an annual basis to ensure the effectiveness of our framework.

 

 

  Goldman Sachs June 2012 Form 10-Q   175


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Risk Identification and Reporting

The core of our operational risk management framework is risk identification and reporting. We have a comprehensive data collection process, including firmwide policies and procedures, for operational risk events.

We have established policies that require managers in our revenue-producing units and our independent control and support functions to escalate operational risk events. When operational risk events are identified, our policies require that the events be documented and analyzed to determine whether changes are required in the firm’s systems and/or processes to further mitigate the risk of future events.

In addition, our firmwide systems capture internal operational risk event data, key metrics such as transaction volumes, and statistical information such as performance trends. We use an internally-developed operational risk management application to aggregate and organize this information. Managers from both revenue-producing units and independent control and support functions analyze the information to evaluate operational risk exposures and identify businesses, activities or products with heightened levels of operational risk. We also provide operational risk reports to senior management, risk committees and the Board periodically.

Risk Measurement

We measure the firm’s operational risk exposure over a twelve-month time horizon using both statistical modeling and scenario analyses, which involve qualitative assessments of the potential frequency and extent of potential operational risk losses, for each of the firm’s businesses. Operational risk measurement incorporates qualitative and quantitative assessments of factors including:

 

Ÿ  

internal and external operational risk event data;

 

Ÿ  

assessments of the firm’s internal controls;

 

Ÿ  

evaluations of the complexity of the firm’s business activities;

 

Ÿ  

the degree of and potential for automation in the firm’s processes;

 

Ÿ  

new product information;

 

Ÿ  

the legal and regulatory environment;

 

Ÿ  

changes in the markets for the firm’s products and services, including the diversity and sophistication of the firm’s customers and counterparties; and

 

Ÿ  

the liquidity of the capital markets and the reliability of the infrastructure that supports the capital markets.

The results from these scenario analyses are used to monitor changes in operational risk and to determine business lines that may have heightened exposure to operational risk. These analyses ultimately are used to determine the appropriate level of operational risk capital to hold.

Risk Monitoring

We evaluate changes in the operational risk profile of the firm and its businesses, including changes in business mix or jurisdictions in which the firm operates, by monitoring these factors at a firmwide, entity and business level. The firm has both detective and preventive internal controls, which are designed to reduce the frequency and severity of operational risk losses and the probability of operational risk events. We monitor the results of assessments and independent internal audits of these internal controls.

Recent Accounting Developments

See Note 3 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information about Recent Accounting Developments.

 

 

176   Goldman Sachs June 2012 Form 10-Q  


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Certain Risk Factors That May Affect Our Businesses

 

 

We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal, regulatory and reputational risks. For a discussion of how management seeks to manage some of these risks, see “Overview and Structure of Risk Management.” A summary of the more important factors that could affect our businesses follows. For a further discussion of these and other important factors that could affect our businesses, financial condition, results of operations, cash flows and liquidity, see “Risk Factors” in Part I, Item 1A of our Annual Report on
Form 10-K.

 

Ÿ  

Our businesses have been and may continue to be adversely affected by conditions in the global financial markets and economic conditions generally.

 

Ÿ  

Our businesses have been and may be adversely affected by declining asset values. This is particularly true for those businesses in which we have net “long” positions, receive fees based on the value of assets managed, or receive or post collateral.

 

Ÿ  

Our businesses have been and may be adversely affected by disruptions in the credit markets, including reduced access to credit and higher costs of obtaining credit.

 

Ÿ  

Our market-making activities have been and may be affected by changes in the levels of market volatility.

 

Ÿ  

Our investment banking, client execution and investment management businesses have been adversely affected and may continue to be adversely affected by market uncertainty or lack of confidence among investors and CEOs due to general declines in economic activity and other unfavorable economic, geopolitical or market conditions.

 

Ÿ  

Our investment management business may be affected by the poor investment performance of our investment products.

 

Ÿ  

We may incur losses as a result of ineffective risk management processes and strategies.

 

Ÿ  

Our liquidity, profitability and businesses may be adversely affected by an inability to access the debt capital markets or to sell assets or by a reduction in our credit ratings or by an increase in our credit spreads.

 

Ÿ  

Conflicts of interest are increasing and a failure to appropriately identify and address conflicts of interest could adversely affect our businesses.

 

Ÿ  

Group Inc. is a holding company and is dependent for liquidity on payments from its subsidiaries, many of which are subject to restrictions.

Ÿ  

Our businesses, profitability and liquidity may be adversely affected by deterioration in the credit quality of, or defaults by, third parties who owe us money, securities or other assets or whose securities or obligations we hold.

 

Ÿ  

Concentration of risk increases the potential for significant losses in our market-making, underwriting, investing and lending activities.

 

Ÿ  

The financial services industry is highly competitive.

 

Ÿ  

We face enhanced risks as new business initiatives lead us to transact with a broader array of clients and counterparties and expose us to new asset classes and new markets.

 

Ÿ  

Derivative transactions and delayed settlements may expose us to unexpected risk and potential losses.

 

Ÿ  

Our businesses may be adversely affected if we are unable to hire and retain qualified employees.

 

Ÿ  

Our businesses and those of our clients are subject to extensive and pervasive regulation around the world.

 

Ÿ  

We may be adversely affected by increased governmental and regulatory scrutiny or negative publicity.

 

Ÿ  

A failure in our operational systems or infrastructure, or those of third parties, could impair our liquidity, disrupt our businesses, result in the disclosure of confidential information, damage our reputation and cause losses.

 

Ÿ  

Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause us significant reputational harm, which in turn could seriously harm our business prospects.

 

Ÿ  

The growth of electronic trading and the introduction of new trading technology may adversely affect our business and may increase competition.

 

Ÿ  

Our commodities activities, particularly our power generation interests and our physical commodities activities, subject us to extensive regulation, potential catastrophic events and environmental, reputational and other risks that may expose us to significant liabilities and costs.

 

Ÿ  

In conducting our businesses around the world, we are subject to political, economic, legal, operational and other risks that are inherent in operating in many countries.

 

Ÿ  

We may incur losses as a result of unforeseen or catastrophic events, including the emergence of a pandemic, terrorist attacks or natural disasters.

 

 

  Goldman Sachs June 2012 Form 10-Q   177


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Management’s Discussion and Analysis

 

Cautionary Statement Pursuant to the U.S. Private Securities Litigation Reform Act of 1995

 

 

We have included or incorporated by reference in this Form 10-Q, and from time to time our management may make, statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts, but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside our control. It is possible that our actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these forward-looking statements. For a discussion of some of the risks and important factors that could affect our future results and financial condition, see “Certain Risk Factors That May Affect Our Businesses” above, as well as “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K.

Statements about our investment banking transaction backlog also may constitute forward-looking statements. Such statements are subject to the risk that the terms of these transactions may be modified or that they may not be completed at all; therefore, the net revenues, if any, that we actually 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 or continued weakness in general economic conditions, outbreak of hostilities, 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 inability to obtain adequate financing, an adverse development with respect to a party to the transaction or a failure to obtain a required regulatory approval. For a discussion of other important factors that could adversely affect our investment banking transactions, see “Certain Risk Factors That May Affect Our Businesses” above, as well as “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K.

 

 

178   Goldman Sachs June 2012 Form 10-Q  


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Item 3.    Quantitative and Qualitative Disclosures About Market Risk

Quantitative and qualitative disclosures about market risk are set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk Management” in Part I, Item 2 above.

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 (Exchange Act)). 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 Exchange Act) occurred during our most recent quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. OTHER INFORMATION

Item 1.    Legal Proceedings

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our businesses. Many of these proceedings are at preliminary stages, and many of these cases seek an indeterminate amount of damages. However, we believe, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on our financial condition, but may be material to our operating results for any particular period, depending, in part, upon the operating results for such period. Given the range of litigation and investigations presently under way, our litigation expenses can be expected to remain high. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Use of Estimates” in Part I, Item 2 of this Form 10-Q. See Note 27 to the condensed consolidated financial statements in Part I, Item 1 of this Form 10-Q for information on certain judicial, regulatory and legal proceedings.

 

 

  Goldman Sachs June 2012 Form 10-Q   179


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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. (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 June 30, 2012.

 

 

Period   

Total Number

of Shares
Purchased

    

Average Price

Paid per
Share

    

Total Number of Shares   
Purchased as Part of   
Publicly Announced   

Plans or Programs 1

    

Maximum Number of   
Shares That May Yet Be   
Purchased Under the   

Plans or Programs 1

 

Month #1

(April 1, 2012 to April 30, 2012)

     3,765,588         $113.77         3,765,588            56,504,786      

Month #2

(May 1, 2012 to May 31, 2012)

     8,749,698         103.30         8,749,698            47,755,088      

Month #3

(June 1, 2012 to June 30, 2012)

     1,796,100         93.43         1,796,100            45,958,988      

Total

     14,311,386                  14,311,386               

 

1.

On March 21, 2000, we announced that the Board of Directors of Group Inc. (Board) had approved a repurchase program, pursuant to which up to 15 million shares of our common stock may be repurchased. This repurchase program was increased by an aggregate of 325 million shares by resolutions of our Board adopted on June 18, 2001, March 18, 2002, November 20, 2002, January 30, 2004, January 25, 2005, September 16, 2005, September 11, 2006, December 17, 2007 and July 18, 2011. We use our share repurchase program to help maintain the appropriate level of common equity and to substantially offset increases in share count over time resulting from employee share-based compensation. The repurchase program is effected primarily through regular open-market purchases, the amounts and timing of which are determined primarily by the firm’s current and projected capital position (i.e., comparisons of our desired level and composition of capital to our actual level and composition of capital) and its issuance of shares resulting from employee share-based compensation, but which may also be influenced by general market conditions and the prevailing price and trading volumes of our common stock. The repurchase program has no set expiration or termination date. Any repurchase of our common stock requires approval by the Federal Reserve Board.

 

180   Goldman Sachs June 2012 Form 10-Q  


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Item 6.    Exhibits

Exhibits

 

10.1  

Description of Compensation Arrangements with Executive Officer.

12.1  

Statement re: Computation of Ratios of Earnings to Fixed Charges and Ratios of Earnings to Combined Fixed Charges and Preferred Stock Dividends.

15.1  

Letter re: Unaudited Interim Financial Information.

31.1  

Rule 13a-14(a) Certifications.

32.1  

Section 1350 Certifications.*

101  

Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Condensed Consolidated Statements of Earnings for the three and six months ended June 30, 2012 and June 30, 2011, (ii) the Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2012 and June 30, 2011, (iii) the Condensed Consolidated Statements of Financial Condition as of June 30, 2012 and December 31, 2011, (iv) the Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2012 and year ended December 31, 2011, (v) the Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and June 30, 2011, and (vi) the notes to the Condensed Consolidated Financial Statements.

 

*    This information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

 

  Goldman Sachs June 2012 Form 10-Q   181


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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 Officer

Date: August 8, 2012

 

182   Goldman Sachs June 2012 Form 10-Q