10-Q 1 y40224e10vq.htm FORM 10-Q 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 August 31, 2007
 
or
     
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
     
    For the transition period                    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.)
     
85 Broad Street, New York, NY
  10004
(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  o  No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  x    Accelerated filer  o    Non-accelerated filer  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     o  Yes  x  No
 
APPLICABLE ONLY TO CORPORATE ISSUERS
 
As of September 28, 2007 there were 397,674,804 shares of the registrant’s common stock outstanding.
 


 

 
THE GOLDMAN SACHS GROUP, INC.
 
QUARTERLY REPORT ON FORM 10-Q FOR THE FISCAL QUARTER ENDED AUGUST 31, 2007
 
INDEX
 
             
    Page
Form 10-Q Item Number:
 
No.
 
     
           
     
      2
      3
      4
      5
      6
      7
      53
           
    54
           
    104
           
    104
           
PART II:      
           
    105
           
    106
           
    107
       
  108
 EX-12.1: STATEMENT RE: COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES AND TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS
 EX-15.1: LETTER RE: UNAUDITED INTERIM FINANCIAL INFORMATION
 EX-31.1: RULE 13A-14(A) CERTIFICATIONS
 EX-32.1: SECTION 1350 CERTIFICATIONS


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PART I: FINANCIAL INFORMATION
 
Item 1:   Financial Statements (Unaudited)
 
THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(UNAUDITED)
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions, except per share amounts)  
 
Revenues
                               
Investment banking
  $ 2,145     $ 1,285     $ 5,581     $ 4,276  
Trading and principal investments
    7,576       4,368       22,891       17,976  
Asset management and securities services
    1,272       975       3,512       3,545  
Interest income
    12,810       9,351       34,450       25,430  
                                 
Total revenues
    23,803       15,979       66,434       51,227  
                                 
Interest expense
    11,469       8,395       31,188       22,969  
                                 
Revenues, net of interest expense
    12,334       7,584       35,246       28,258  
                                 
Operating expenses
                               
Compensation and benefits
    5,920       3,530       16,918       13,952  
                                 
Brokerage, clearing, exchange and distribution fees
    795       523       1,984       1,414  
Market development
    148       117       424       338  
Communications and technology
    169       141       481       396  
Depreciation and amortization
    145       126       417       378  
Amortization of identifiable intangible assets
    53       50       154       128  
Occupancy
    218       221       632       613  
Professional fees
    188       135       510       367  
Cost of power generation
    88       101       253       308  
Other expenses
    351       278       924       789  
                                 
Total non-compensation expenses
    2,155       1,692       5,779       4,731  
                                 
Total operating expenses
    8,075       5,222       22,697       18,683  
                                 
                                 
Pre-tax earnings
    4,259       2,362       12,549       9,575  
Provision for taxes
    1,405       768       4,165       3,190  
                                 
Net earnings
    2,854       1,594       8,384       6,385  
Preferred stock dividends
    48       39       143       91  
                                 
Net earnings applicable to common shareholders
  $ 2,806     $ 1,555     $ 8,241     $ 6,294  
                                 
Earnings per common share
                               
Basic
  $ 6.54     $ 3.46     $ 18.89     $ 13.92  
Diluted
    6.13       3.26       17.75       13.12  
                                 
Dividends declared and paid per common share
  $ 0.35     $ 0.35     $ 1.05     $ 0.95  
                                 
Average common shares outstanding
                               
Basic
    429.0       449.4       436.2       452.1  
Diluted
    457.4       477.4       464.3       479.7  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(UNAUDITED)
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions, except share and per share amounts)  
Assets
               
Cash and cash equivalents
  $ 12,655     $ 6,293  
Cash and securities segregated for regulatory and other purposes (includes $71,968
and $20,723 at fair value as of August 2007 and November 2006, respectively)
    97,677       80,990  
Receivables from brokers, dealers and clearing organizations
    19,093       13,223  
Receivables from customers and counterparties (includes $3,851 at fair value as of
August 2007)
    116,487       79,790  
Collateralized agreements:
               
Securities borrowed (includes $85,015 at fair value as of August 2007)
    267,200       219,342  
Financial instruments purchased under agreements to resell (includes $80,494 at fair value as of August 2007)
    80,494       82,126  
                 
Financial instruments owned, at fair value
    379,980       298,563  
Financial instruments owned and pledged as collateral, at fair value
    48,176       35,998  
                 
Total financial instruments owned, at fair value
    428,156       334,561  
Other assets
    24,016       21,876  
                 
Total assets
  $ 1,045,778     $ 838,201  
                 
                 
Liabilities and shareholders’ equity
               
Unsecured short-term borrowings, including the current portion of unsecured long-term borrowings (includes $47,235 and $10,220 at fair value as of August 2007 and
November 2006, respectively)
  $ 66,283     $ 47,904  
Bank deposits
    14,086       10,697  
Payables to brokers, dealers and clearing organizations
    10,085       6,293  
Payables to customers and counterparties
    266,327       206,884  
Collateralized financings:
               
Securities loaned (includes $3,640 at fair value as of August 2007)
    23,759       22,208  
Financial instruments sold under agreements to repurchase (includes $160,253 at fair value as of August 2007)
    160,253       147,492  
Other secured financings (includes $39,615 and $3,300 at fair value as of August 2007 and November 2006, respectively)
    74,786       50,424  
Financial instruments sold, but not yet purchased, at fair value
    196,106       155,805  
Other liabilities and accrued expenses
    43,903       31,866  
Unsecured long-term borrowings (includes $14,471 and $7,250 at fair value as of
August 2007 and November 2006, respectively)
    151,072       122,842  
                 
Total liabilities
    1,006,660       802,415  
                 
Commitments, contingencies and guarantees
               
                 
Shareholders’ equity
               
Preferred stock, par value $0.01 per share; 150,000,000 shares authorized, 124,000 shares issued and outstanding as of both August 2007 and November 2006, with liquidation preference of $25,000 per share
    3,100       3,100  
Common stock, par value $0.01 per share; 4,000,000,000 shares authorized, 614,121,075 and 599,697,200 shares issued as of August 2007 and November 2006, respectively, and 397,550,889 and 412,666,084 shares outstanding as of August 2007 and November 2006, respectively
    6       6  
Restricted stock units and employee stock options
    6,489       6,290  
Nonvoting common stock, par value $0.01 per share; 200,000,000 shares authorized, no shares issued and outstanding
           
Additional paid-in capital
    21,358       19,731  
Retained earnings
    35,634       27,868  
Accumulated other comprehensive income
    30       21  
Common stock held in treasury, at cost, par value $0.01 per share; 216,570,186 and 187,031,116 shares as of August 2007 and November 2006, respectively
    (27,499 )     (21,230 )
                 
Total shareholders’ equity
    39,118       35,786  
                 
Total liabilities and shareholders’ equity
  $ 1,045,778     $ 838,201  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(UNAUDITED)
 
                 
    Period Ended  
    August
    November
 
   
2007
   
2006
 
    (in millions, except
 
    per share amounts)  
 
Preferred stock
               
Balance, beginning of year
  $ 3,100     $ 1,750  
Issued
          1,350  
                 
Balance, end of period
    3,100       3,100  
Common stock, par value $0.01 per share
               
Balance, beginning of year
    6       6  
Issued
           
                 
Balance, end of period
    6       6  
Restricted stock units and employee stock options
               
Balance, beginning of year
    6,290       3,415  
Issuance and amortization of restricted stock units and employee stock options
    1,567       3,787  
Delivery of common stock underlying restricted stock units
    (1,288 )     (781 )
Forfeiture of restricted stock units and employee stock options
    (73 )     (129 )
Exercise of employee stock options
    (7 )     (2 )
                 
Balance, end of period
    6,489       6,290  
Additional paid-in capital
               
Balance, beginning of year
    19,731       17,159  
Issuance of common stock, including proceeds from exercise of employee stock options
    1,840       2,432  
Cancellation of restricted stock units in satisfaction of withholding tax requirements
    (929 )     (375 )
Stock purchase contract fee related to automatic preferred enhanced capital securities
    (20 )      
Preferred stock issuance costs
          (1 )
Excess net tax benefit related to share-based compensation
    737       653  
Cash settlement of share-based compensation
    (1 )     (137 )
                 
Balance, end of period
    21,358       19,731  
Retained earnings
               
Balance, beginning of year, as previously reported
    27,868       19,085  
Cumulative effect of adjustment from adoption of SFAS No. 157, net of tax
    51        
Cumulative effect of adjustment from adoption of SFAS No. 159, net of tax
    (45 )      
                 
Balance, beginning of year, after cumulative effect of adjustments
    27,874       19,085  
Net earnings
    8,384       9,537  
Dividends and dividend equivalents declared on common stock and restricted stock units
    (481 )     (615 )
Dividends declared on preferred stock
    (143 )     (139 )
                 
Balance, end of period
    35,634       27,868  
Accumulated other comprehensive income/(loss)
               
Balance, beginning of year
    21        
Currency translation adjustment, net of tax
    30       45  
Minimum pension liability adjustment, net of tax
          (27 )
Net gains/(losses) on cash flow hedges, net of tax
    (2 )     (7 )
Net unrealized gains/(losses) on available-for-sale securities, net of tax
    (11 )     10  
Reclassification to retained earnings from adoption of SFAS No. 159, net of tax
    (8 )      
                 
Balance, end of period
    30       21  
Common stock held in treasury, at cost
               
Balance, beginning of year
    (21,230 )     (13,413 )
Repurchased
    (6,272 )     (7,817 )
Reissued
    3        
                 
Balance, end of period
    (27,499 )     (21,230 )
                 
Total shareholders’ equity
  $ 39,118     $ 35,786  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
                 
    Nine Months
 
    Ended August  
   
2007
   
2006
 
    (in millions)  
Cash flows from operating activities
               
Net earnings
  $ 8,384     $ 6,385  
Non-cash items included in net earnings
               
Depreciation and amortization
    636       547  
Amortization of identifiable intangible assets
    200       182  
Share-based compensation
    1,038       921  
Changes in operating assets and liabilities
               
Cash and securities segregated for regulatory and other purposes
    (16,767 )     (16,364 )
Net receivables from brokers, dealers and clearing organizations
    (2,076 )     (3,009 )
Net payables to customers and counterparties
    22,721       14,059  
Securities borrowed, net of securities loaned
    (46,307 )     (15,312 )
Financial instruments sold under agreements to repurchase, net of financial instruments purchased under agreements to resell
    14,393       (20,233 )
Financial instruments owned, at fair value
    (92,725 )     (31,535 )
Financial instruments sold, but not yet purchased, at fair value
    39,345       7,136  
Other, net
    6,929       7,833  
                 
Net cash used for operating activities
    (64,229 )     (49,390 )
Cash flows from investing activities
               
Purchase of property, leasehold improvements and equipment
    (1,483 )     (1,785 )
Proceeds from sales of property, leasehold improvements and equipment
    55       175  
Business acquisitions, net of cash acquired
    (1,385 )     (780 )
Proceeds from sales of investments
    2,783       1,197  
Purchase of available-for-sale securities
    (675 )     (6,363 )
Proceeds from sales of available-for-sale securities
    628       4,193  
                 
Net cash used for investing activities
    (77 )     (3,363 )
Cash flows from financing activities
               
Unsecured short-term borrowings, net
    12,548       1,331  
Other secured financings (short-term), net
    9,355       10,146  
Proceeds from issuance of other secured financings (long-term)
    21,391       9,042  
Repayment of other secured financings (long-term), including the current portion
    (6,372 )     (5,652 )
Proceeds from issuance of unsecured long-term borrowings
    43,945       38,560  
Repayment of unsecured long-term borrowings, including the current portion
    (11,785 )     (10,080 )
Derivative contracts with a financing element, net
    3,887       3,195  
Bank deposits, net
    3,389       7,950  
Common stock repurchased
    (6,269 )     (4,165 )
Dividends and dividend equivalents paid on common stock, preferred stock and restricted stock units
    (624 )     (543 )
Proceeds from issuance of common stock
    530       1,200  
Proceeds from issuance of preferred stock, net of issuance costs
          1,349  
Excess tax benefit related to share-based compensation
    674       349  
Cash settlement of share-based compensation
    (1 )     (127 )
                 
Net cash provided by financing activities
    70,668       52,555  
                 
Net increase/(decrease) in cash and cash equivalents
    6,362       (198 )
                 
Cash and cash equivalents, beginning of year
    6,293       10,261  
                 
Cash and cash equivalents, end of period
  $ 12,655     $ 10,063  
                 
 
SUPPLEMENTAL DISCLOSURES:
 
Cash payments for interest, net of capitalized interest, were $30.47 billion and $22.56 billion during the nine months ended
August 2007 and August 2006, respectively.
 
Cash payments for income taxes, net of refunds, were $4.45 billion and $2.85 billion during the nine months ended August 2007 and August 2006, respectively.
 
Non-cash activities:
The firm assumed $137 million and $352 million of debt in connection with business acquisitions during the nine months ended August 2007 and August 2006, respectively. For the nine months ended August 2007, the firm issued $17 million of common stock in connection with business acquisitions.
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions)  
 
Net earnings
  $ 2,854     $ 1,594     $ 8,384     $ 6,385  
Currency translation adjustment, net of tax
    10       3       30       30  
Net gains/(losses) on cash flow hedges, net of tax
          (10 )     (2 )     (12 )
Net unrealized gains/(losses) on available-for-sale securities, net of tax
    (3 )     9       (11 )     (5 )
                                 
Comprehensive income
  $ 2,861     $ 1,596     $ 8,401     $ 6,398  
                                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
Note 1.   Description of Business
 
The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, together with its consolidated subsidiaries (collectively, the firm), is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
 
The firm’s activities are divided into three segments:
 
  •  Investment Banking.  The firm provides a broad range of investment banking services to a diverse group of corporations, financial institutions, investment funds, governments and individuals.
 
  •  Trading and Principal Investments.  The firm facilitates client transactions with a diverse group of corporations, financial institutions, investment funds, governments and individuals and takes proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on these products. In addition, the firm engages in specialist and market-making activities on equities and options exchanges and clears client transactions on major stock, options and futures exchanges worldwide. In connection with the firm’s merchant banking and other investing activities, the firm makes principal investments directly and through funds that the firm raises and manages.
 
  •  Asset Management and Securities Services.  The firm provides investment advisory and financial planning services and offers investment products (primarily through separate accounts and funds) across all major asset classes to a diverse group of institutions and individuals worldwide and provides prime brokerage services, financing services and securities lending services to institutional clients, including hedge funds, mutual funds, pension funds and foundations, and to high-net-worth individuals worldwide.
 
Note 2.   Significant Accounting Policies
 
Basis of Presentation
 
These condensed consolidated financial statements include the accounts of Group Inc. and all other entities in which the firm has a controlling financial interest. All material intercompany transactions and balances have been eliminated.
 
The firm determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity, a variable interest entity (VIE) or a qualifying special-purpose entity (QSPE) under generally accepted accounting principles.
 
  •  Voting Interest Entities.  Voting interest entities are entities in which (i) the total equity investment at risk is sufficient to enable the entity to finance its activities independently and (ii) the equity holders have the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities are consolidated in accordance with Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” as amended. ARB No. 51 states that the usual condition for a controlling financial interest in an entity is ownership of a majority voting interest. Accordingly, the firm consolidates voting interest entities in which it has a majority voting interest.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
  •  Variable Interest Entities.  VIEs are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in a VIE is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. In accordance with Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 46-R, “Consolidation of Variable Interest Entities,” the firm consolidates VIEs for which it is the primary beneficiary.
 
The firm determines whether it is the primary beneficiary of a VIE by first performing a qualitative analysis of the VIE that includes a review of, among other factors, its capital structure, contractual terms, which interests create or absorb variability, related party relationships and the design of the VIE. Where qualitative analysis is not conclusive, the firm performs a quantitative analysis. For purposes of allocating a VIE’s expected losses and expected residual returns to its variable interest holders, the firm utilizes the “top down” method. Under that method, the firm calculates its share of the VIE’s expected losses and expected residual returns using the specific cash flows that would be allocated to it, based on contractual arrangements and/or the firm’s position in the capital structure of the VIE, under various probability-weighted scenarios.
 
  •  QSPEs.  QSPEs are passive entities that are commonly used in mortgage and other securitization transactions. Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” sets forth the criteria an entity must satisfy to be a QSPE. These criteria include the types of assets a QSPE may hold, limits on asset sales, the use of derivatives and financial guarantees, and the level of discretion a servicer may exercise in attempting to collect receivables. These criteria may require management to make judgments about complex matters, including whether a derivative is considered passive and the degree of discretion a servicer may exercise. In accordance with SFAS No. 140 and FIN No. 46-R, the firm does not consolidate QSPEs.
 
  •  Equity-Method Investments.  When the firm does not have a controlling financial interest in an entity but exerts significant influence over the entity’s operating and financial policies (generally defined as owning a voting interest of 20% to 50%) and has an investment in common stock or in-substance common stock, the firm accounts for its investment in accordance with the equity method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” For investments acquired subsequent to the adoption of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” the firm generally has elected to apply the fair value option in accounting for such investments.
See “— Recent Accounting Developments” for a discussion of the firm’s adoption of SFAS No. 159.
 
  •  Other.  If the firm does not consolidate an entity or apply the equity method of accounting, the firm accounts for its investment at fair value. The firm also has formed numerous nonconsolidated investment funds with third-party investors that are typically organized as limited partnerships. The firm acts as general partner for these funds and does not hold a majority of the economic interests in any fund. The firm has generally provided the third-party investors with rights to terminate the funds or to remove the firm as the general partner. These fund investments are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
These condensed consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements incorporated by reference in the firm’s Annual Report on Form 10-K for the fiscal year ended November 24, 2006. The condensed consolidated financial information as of November 24, 2006 has been derived from audited consolidated financial statements not included herein.
 
These unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. These adjustments are of a normal, recurring nature. Interim period operating results may not be indicative of the operating results for a full year.
 
Unless specifically stated otherwise, all references to August 2007 and August 2006 refer to the firm’s fiscal periods ended, or the dates, as the context requires, August 31, 2007 and August 25, 2006, respectively. All references to November 2006, unless specifically stated otherwise, refer to the firm’s fiscal year ended, or the date, as the context requires, November 24, 2006. All references to 2007, unless specifically stated otherwise, refer to the firm’s fiscal year ending, or the date, as the context requires, November 30, 2007. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.
 
Use of Estimates
 
These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles that require management to make certain estimates and assumptions. The most important of these estimates and assumptions relate to fair value measurements, the accounting for goodwill and identifiable intangible assets and the provision for potential losses that may arise from litigation and regulatory proceedings and tax audits. Although these and other estimates and assumptions are based on the best available information, actual results could be materially different from these estimates.
 
Revenue Recognition
 
Investment Banking.  Underwriting revenues and fees from mergers and acquisitions and other financial advisory assignments are recognized in the condensed consolidated statements of earnings when the services related to the underlying transaction are completed under the terms of the engagement. Expenses associated with such transactions are deferred until the related revenue is recognized or the engagement is otherwise concluded. Underwriting revenues are presented net of related expenses. Expenses associated with financial advisory transactions are recorded as non-compensation expenses, net of client reimbursements.
 
Financial Instruments.  “Total financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” are reflected in the condensed consolidated statements of financial condition on a trade-date basis. Related unrealized gains or losses are generally recognized in “Trading and principal investments” in the condensed consolidated statements of earnings. 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 (the exit price). Instruments that the firm owns (long positions) are marked to bid prices, and instruments that the firm has sold, but not yet purchased (short positions), are marked to offer prices. Fair value measurements are not adjusted for transaction costs.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
The firm adopted SFAS No. 157, “Fair Value Measurements,” as of the beginning of 2007. SFAS No. 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:
 
Basis of Fair Value Measurement
 
  Level 1   Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
 
  Level 2   Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly;
 
  Level 3   Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.
 
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. See “— Recent Accounting Developments” for a discussion of the impact of adopting SFAS No. 157.
 
In determining fair value, the firm separates its “Financial instruments owned, at fair value” and its “Financial instruments sold, but not yet purchased, at fair value” into two categories: cash instruments and derivative contracts.
 
  •  Cash Instruments.  The firm’s cash instruments are generally classified within level 1 or level 2 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include most U.S. government and agency securities, many other sovereign government obligations, active listed equities and most money market securities. Such instruments are generally classified within level 1 of the fair value hierarchy. The firm does not adjust the quoted price for such instruments, even in situations where the firm holds a large position and a sale could reasonably impact the quoted price.
 
The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, most mortgage products, certain corporate bank and bridge loans, certain loan commitments, less liquid listed equities, state, municipal and provincial obligations, and most physical commodities. Such instruments are generally classified within level 2 of the fair value hierarchy.
 
Certain cash instruments are classified within level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. Such instruments include certain corporate bank and bridge loans, certain loan commitments, less liquid mortgage whole loans, distressed debt instruments, private equity and real estate fund investments. The transaction price is used as the best estimate of fair value at inception. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so that the model value at inception equals the transaction price. The valuation is adjusted only when changes to inputs and assumptions are corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets, and changes in financial ratios or cash flows.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
For positions that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
 
  •  Derivative Contracts.  Derivative contracts can be exchange-traded or over-the-counter (OTC). Exchange-traded derivatives typically fall within level 1 or level 2 of the fair value hierarchy depending on whether they are deemed to be active or not. The firm generally values exchange-traded derivatives within portfolios using models which calibrate to market clearing levels and eliminate timing differences between the closing price of the exchange-traded derivatives and their underlying cash instruments. In such cases, exchange-traded derivatives are classified within level 2 of the fair value hierarchy.
 
OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. The firm generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be verified and model selection does not involve significant management judgment. Such instruments are typically classified within level 2 of the fair value hierarchy.
 
Certain OTC derivatives trade in less liquid markets with limited pricing information, and the determination of fair value for these derivatives is inherently more difficult. Such instruments are classified within level 3 of the fair value hierarchy. Where the firm does not have corroborating market evidence to support significant model inputs and cannot verify the model to market transactions, transaction price is used as the best estimate of fair value at inception. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so that the model value at inception equals the transaction price. The valuations of these less liquid OTC derivatives are typically based on level 1 and/or level 2 inputs that can be observed in the market, as well as unobservable level 3 inputs. Subsequent to initial recognition, the firm updates the level 1 and level 2 inputs to reflect observable market changes, with resulting gains and losses reflected within level 3. Level 3 inputs are only 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 to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value.
 
When appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Collateralized Agreements and Financings.  Collateralized agreements consist of resale agreements and securities borrowed. Collateralized financings consist of repurchase agreements, securities loaned and other secured financings. Interest on collateralized agreements and collateralized financings is recognized in “Interest income” or “Interest expense,” respectively, over the life of the transaction.
 
  •  Resale and Repurchase Agreements.  Financial instruments purchased under agreements to resell and financial instruments sold under agreements to repurchase, principally U.S. government, federal agency and investment-grade sovereign obligations, represent collateralized financing transactions. The firm receives financial instruments purchased under agreements to resell, makes delivery of financial instruments sold under agreements to repurchase, monitors the market value of these financial instruments on a daily basis and delivers or obtains additional collateral as appropriate. Resale and repurchase agreements are carried in the condensed consolidated statements of financial condition at fair value as allowed by SFAS No. 159. Prior to the adoption of SFAS No. 159, these transactions were recorded at contractual amounts plus accrued interest. Resale and repurchase agreements are generally valued based on inputs with reasonable levels of price transparency and are classified within level 2 of the fair value hierarchy. Resale and repurchase agreements are presented on a net-by-counterparty basis when the requirements of FIN No. 41, “Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements,” or FIN No. 39, “Offsetting of Amounts Related to Certain Contracts,” are satisfied.
 
  •  Securities Borrowed and Loaned.  Securities borrowed and loaned are generally collateralized by cash, securities or letters of credit. The firm receives securities borrowed, makes delivery of securities loaned, monitors the market value of securities borrowed and loaned, and delivers or obtains additional collateral as appropriate. Securities borrowed and loaned within Securities Services, relating to both customer activities and, to a lesser extent, certain firm financing activities, are recorded based on the amount of cash collateral advanced or received plus accrued interest. As these arrangements are generally transacted on-demand, they exhibit little, if any, sensitivity to changes in interest rates. Securities borrowed and loaned within Trading and Principal Investments, which are related to the firm’s matched book and certain firm financing activities, are recorded at fair value as allowed by SFAS No. 159. Prior to the adoption of SFAS No. 159, these transactions were recorded based on the amount of cash collateral advanced or received plus accrued interest. These securities borrowed and loaned transactions are generally valued based on inputs with reasonable levels of price transparency and are classified within level 2 of the fair value hierarchy.
 
  •  Other Secured Financings.  In addition to repurchase agreements and securities loaned, the firm funds assets through the use of other secured financing arrangements and pledges financial instruments and other assets as collateral in these transactions. SFAS No. 159 has been adopted for those financings for which the use of fair value would eliminate non-economic volatility in earnings from using different measurement attributes (i.e., assets recorded at fair value with related nonrecourse financings recorded based on the amount of cash received plus accrued interest), primarily transfers accounted for as financings rather than sales under SFAS No. 140 and debt raised through the firm’s William Street program. These other secured financing transactions are generally valued based on inputs with reasonable levels of price transparency and are classified within level 2 of the fair value hierarchy. Other secured financings that are not recorded at fair value are recorded based on the amount of cash received plus accrued interest. See Note 3 for further information regarding other secured financings.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Hybrid Financial Instruments.  Hybrid financial instruments are instruments that contain bifurcatable embedded derivatives under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” 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, it 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 hedge accounting relationships. If the firm does not elect to bifurcate, the entire hybrid financial instrument is accounted for at fair value under SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” The primary reasons for electing the fair value option for hybrid financial instruments are mitigating volatility in earnings from using different measurement attributes, simplification and cost-benefit considerations. See Notes 3, 4 and 5 for additional information about hybrid financial instruments.
 
Transfers of Financial Assets.  In general, transfers of financial assets are accounted for as sales under SFAS No. 140 when the firm has relinquished control over the transferred assets. For transfers accounted for as sales, any related gains or losses are recognized in net revenues. Transfers that are not accounted for as sales are accounted for as collateralized financings, with the related interest expense recognized in net revenues over the life of the transaction.
 
Power Generation.  Power generation revenues associated with the firm’s consolidated power generation facilities are included in “Trading and principal investments” in the condensed consolidated statements of earnings when power is delivered. These revenues were $112 million and $146 million for the three months ended August 2007 and August 2006, respectively, and $333 million and $436 million for the nine months ended August 2007 and August 2006, respectively. Direct employee costs associated with the firm’s consolidated power generation facilities of $24 million and $20 million for the three months ended August 2007 and August 2006, respectively, and $65 million and $55 million for the nine months ended August 2007 and August 2006, respectively, are included in “Compensation and benefits.” The other direct costs associated with these power generation facilities and related contractual assets are included in “Cost of power generation.”
 
Commissions.  Commission revenues from executing and clearing client transactions on stock, options and futures markets worldwide are recognized in “Trading and principal investments” in the condensed consolidated statements of earnings on a trade-date basis.
 
Insurance Activities.  Revenues from variable annuity and variable life insurance contracts, and from providing reinsurance of such contracts, generally consist of fees assessed on contract holder account balances for mortality charges, policy administration and surrender charges. These fees are recognized within “Trading and principal investments” in the condensed consolidated statements of earnings in the period that services are provided.
 
Interest credited to variable annuity and life insurance account balances and changes in reserves are recognized in “Other expenses” in the condensed consolidated statements of earnings.
 
Premiums earned for providing property catastrophe reinsurance are recognized within “Trading and principal investments” in the condensed consolidated statements of earnings over the coverage period, net of premiums ceded for the cost of reinsurance. Expenses for liabilities related to property catastrophe reinsurance claims, including estimates of claims that have been incurred but not reported, are recognized within “Other expenses” in the condensed consolidated statements of earnings.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Merchant Banking Overrides.  The firm is entitled to receive merchant banking overrides (i.e., an increased share of a fund’s income and gains) when the return on the funds’ investments exceeds certain threshold returns. Overrides are based on investment performance over the life of each merchant banking fund, and future investment underperformance may require amounts of override previously distributed to the firm to be returned to the funds. Accordingly, overrides are recognized in the condensed consolidated statements of earnings only when all material contingencies have been resolved. Overrides are included in “Trading and principal investments” in the condensed consolidated statements of earnings.
 
Asset Management.  Management fees are recognized over the period that the related service is provided based upon average net asset values. In certain circumstances, the firm is also entitled to receive incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are generally based on investment performance over a 12-month period and are subject to adjustment prior to the end of the measurement period. Accordingly, incentive fees are recognized in the condensed consolidated statements of earnings when the measurement period ends. Asset management fees and incentive fees are included in “Asset management and securities services” in the condensed consolidated statements of earnings.
 
Share-Based Compensation
 
In the first quarter of 2006, the firm adopted SFAS No. 123-R, “Share-Based Payment,” which is a revision to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123-R focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for share-based payments. Under SFAS No. 123-R, the cost of employee services received in exchange for an award of equity instruments is generally measured based on the grant-date fair value of the award. Under SFAS No. 123-R, 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 employee awards that require future service are amortized over the relevant service period. The firm adopted SFAS No. 123-R under the modified prospective adoption method. Under that method of adoption, the provisions of SFAS No. 123-R are generally applied only to share-based awards granted subsequent to adoption. Share-based awards held by employees that were retirement-eligible on the date of adoption of SFAS No. 123-R must continue to be amortized over the stated service period of the award (and accelerated if the employee actually retires). SFAS No. 123-R requires expected forfeitures to be included in determining share-based employee compensation expense.
 
The firm pays cash dividend equivalents on outstanding restricted stock units. Dividend equivalents paid on restricted stock units accounted for under SFAS No. 123 and SFAS No. 123-R are charged to retained earnings. SFAS No. 123-R requires dividend equivalents paid on restricted stock units expected to be forfeited to be included in compensation expense. Prior to the adoption of SFAS No. 123-R, dividend equivalents paid on restricted stock units that were later forfeited by employees were reclassified to compensation expense from retained earnings. The tax benefit related to dividend equivalents paid on restricted stock units is accounted for as a reduction of income tax expense (see “— Recent Accounting Developments” for a discussion of Emerging Issues Task Force (EITF) Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards”).
 
In certain cases, primarily related to the death of an employee or conflicted employment (as outlined in the applicable award agreements), the firm may cash settle share-based compensation awards. “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.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Goodwill
 
Goodwill is the cost of acquired companies in excess of the fair value of identifiable net assets at acquisition date. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is tested at least annually for impairment. An impairment loss is triggered if the estimated fair value of an operating segment is less than its estimated net book value. Such loss is calculated as the difference between the estimated fair value of goodwill and its carrying value.
 
Identifiable Intangible Assets
 
Identifiable intangible assets, which consist primarily of customer lists, above-market power contracts, specialist rights and the value of business acquired (VOBA) and deferred acquisition costs (DAC) in the firm’s insurance subsidiaries, are amortized over their estimated useful lives. Identifiable intangible assets are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.
 
Property, Leasehold Improvements and Equipment
 
Property, leasehold improvements and equipment, net of accumulated depreciation and amortization, are included in “Other assets” in the condensed consolidated statements of financial condition.
 
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 potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144. An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the expected undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.
 
The firm’s operating leases include space held in excess of current requirements. Rent expense relating to space held for growth is included in “Occupancy” in the condensed consolidated statements of earnings. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the firm records a liability, based on the remaining lease rentals reduced by any potential or existing sublease rentals, for leases where the firm has ceased using the space and management has concluded that the firm will not derive any future economic benefits. Costs to terminate a lease before the end of its term are recognized and measured at fair value upon termination.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(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 statement of financial condition, and revenues and expenses are translated at average rates of exchange for the year. 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. The firm seeks to reduce its net investment exposure to fluctuations in foreign exchange rates through the use of foreign currency forward contracts and foreign currency-denominated debt. For foreign currency forward contracts, hedge effectiveness is assessed based on changes in forward exchange rates; accordingly, forward points are reflected as a component of the currency translation adjustment in the condensed consolidated statements of comprehensive income. For foreign currency-denominated debt, hedge effectiveness is assessed based on changes in spot rates. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are included in the condensed consolidated statements of earnings.
 
Income Taxes
 
Deferred tax assets and liabilities are recognized for temporary differences between the financial reporting and tax bases of the firm’s assets and liabilities. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. The firm’s tax assets and liabilities are presented as a component of “Other assets” and “Other liabilities and accrued expenses,” respectively, in the condensed consolidated statements of financial condition. Tax provisions are computed in accordance with SFAS No. 109, “Accounting for Income Taxes.” Contingent liabilities related to income taxes are recorded when the criteria for loss recognition under SFAS No. 5, “Accounting for Contingencies,” as amended, have been met (see “— Recent Accounting Developments” below for a discussion of the impact of FIN No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109,” on SFAS No. 109).
 
Earnings Per Common Share (EPS)
 
Basic EPS is calculated by dividing net earnings applicable to common shareholders by the weighted average number of common shares outstanding. Common shares outstanding includes common stock and restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted EPS includes the determinants of basic EPS and, in addition, reflects the dilutive effect of the common stock deliverable pursuant to stock options and to restricted stock units for which future service is required as a condition to the delivery of the underlying common stock.
 
Cash and Cash Equivalents
 
The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business.
 
Recent Accounting Developments
 
FIN No. 48.  In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” FIN No. 48 requires that the firm determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets this recognition threshold, the position is measured to determine the


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
amount of benefit to be recognized in the financial statements. The firm will adopt the provisions of FIN No. 48 beginning in the first quarter of 2008. The firm does not expect that the adoption of FIN No. 48 will have a material effect on its financial condition, results of operations or cash flows.
 
SFAS No. 157.  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Under SFAS No. 157, fair value measurements are not adjusted for transaction costs.
 
SFAS No. 157 nullifies the guidance included in EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” that prohibited the recognition of a day one gain or loss on derivative contracts (and hybrid financial instruments measured at fair value under SFAS No. 155) where the firm was unable to verify all of the significant model inputs to observable market data and/or verify the model to market transactions. However, SFAS No. 157 requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model.
 
In addition, SFAS No. 157 prohibits the recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available for an identical asset or liability in an active market.
 
The provisions of SFAS No. 157 are to be applied prospectively, except changes in fair value measurements that result from the initial application of SFAS No. 157 to existing derivative financial instruments measured under EITF Issue No. 02-3, existing hybrid financial instruments measured at fair value and block discounts, all of which are to be recorded as an adjustment to beginning retained earnings in the year of adoption.
 
The firm adopted SFAS No. 157 as of the beginning of 2007. The transition adjustment to beginning retained earnings was a gain of $51 million, net of tax. For the first quarter of 2007, the effect of the nullification of EITF Issue No. 02-3 and the removal of liquidity discounts for actively traded positions was not material. In addition, under SFAS No. 157, gains on principal investments are recorded in the absence of substantial third-party transactions if market evidence is sufficient. In the first quarter of 2007, the firm recorded approximately $500 million of such gains as a result of adopting SFAS No. 157.
 
SFAS No. 158.  In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132-R.” SFAS No. 158 requires an entity to recognize in its statement of financial condition the funded status of its defined benefit pension and postretirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. SFAS No. 158 also requires an entity to recognize changes in the funded status of a defined benefit pension and postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost. SFAS No. 158 is effective as of the end of the fiscal year ending after December 15, 2006. The firm will adopt SFAS No. 158 as of the end of 2007. The firm does not expect that the adoption of SFAS No. 158 will have a material effect on its financial condition, results of operations or cash flows.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
SFAS No. 159.  In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which gives entities the option to measure eligible financial assets, financial liabilities and firm commitments at fair value (i.e., the fair value option), on an instrument-by-instrument basis, that are otherwise not accounted for at fair value under other accounting standards. The election to use the fair value option is available at specified election dates, such as when an entity first recognizes a financial asset or financial liability or upon entering into a firm commitment. Subsequent changes in fair value must be recorded in earnings. Additionally, SFAS No. 159 allows for a one-time election for existing positions upon adoption, with the transition adjustment recorded to beginning retained earnings.
 
The firm adopted SFAS No. 159 as of the beginning of 2007 and elected to apply the fair value option to the following financial assets and liabilities existing at the time of adoption:
 
  •  certain unsecured short-term borrowings, consisting of all promissory notes and commercial paper;
 
  •  certain other secured financings, primarily transfers accounted for as financings rather than sales under SFAS No. 140 and debt raised through the firm’s William Street program;
 
  •  certain unsecured long-term borrowings, including prepaid physical commodity transactions;
 
  •  resale and repurchase agreements;
 
  •  securities borrowed and loaned within Trading and Principal Investments;
 
  •  securities held by the firm’s bank subsidiary (previously accounted for as
available-for-sale); and
 
  •  receivables from customers and counterparties arising from transfers accounted for as secured loans rather than purchases under SFAS No. 140.
 
The primary reasons for electing the fair value option are mitigating volatility in earnings from using different measurement attributes, simplification and cost-benefit considerations. The transition adjustment to beginning retained earnings related to the adoption of SFAS No. 159 was a loss of $45 million, net of tax, substantially all of which related to applying the fair value option to prepaid physical commodity transactions.
 
Subsequent to the adoption of SFAS No. 159, the firm has elected to apply the fair value option to new positions within the above categories and generally to investments where the firm would otherwise apply the equity method of accounting. In certain cases, the firm may continue to apply the equity method of accounting to those investments which are strategic in nature or closely related to the firm’s principal business activities, where the firm has a significant degree of involvement in the cash flows or operations of the investee, and/or where cost-benefit considerations are less significant.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
SOP No. 07-1 and FIN No. 46-R-7.  In June 2007, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) No. 07-1, “Clarification of the Scope of the Audit and Accounting Guide ‘Audits of Investment Companies’ and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies.” SOP No. 07-1 clarifies when an entity may apply the provisions of the Audit and Accounting Guide for Investment Companies (the Guide). Investment companies that are within the scope of the Guide report investments at fair value; consolidation or use of the equity method for investments is generally not appropriate. SOP No. 07-1 also addresses the retention of specialized investment company accounting by a parent company in consolidation or by an equity method investor. SOP No. 07-1 is effective for fiscal years beginning on or after December 15, 2007 with early adoption encouraged. In May 2007, the FASB issued FSP FIN No. 46-R-7, “Application of FIN 46-R to Investment Companies,” which amends FIN No. 46-R to make permanent the temporary deferral of the application of FIN No. 46-R to entities within the scope of the revised Guide under SOP No. 07-1. FSP FIN No. 46-R-7 is effective upon adoption of SOP No. 07-1. The firm is evaluating the impact of adopting SOP No. 07-1 and FSP FIN No. 46-R-7 on its financial condition, results of operations and cash flows.
 
EITF Issue No. 06-11.  In June 2007, the EITF reached consensus on Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF Issue No. 06-11 requires that the tax benefit related to dividend equivalents paid on restricted stock units, which are expected to vest, be recorded as an increase to additional paid-in capital. The firm currently accounts for this tax benefit as a reduction to income tax expense. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007, and the firm expects to adopt the provisions of EITF Issue No. 06-11 beginning in the first quarter of 2009. The firm is currently evaluating the impact of adopting EITF Issue No. 06-11 on its financial condition, results of operations and cash flows.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Note 3.   Financial Instruments
 
Fair Value of Financial Instruments
 
The following table sets forth the firm’s financial instruments owned, at fair value, including those pledged as collateral, and financial instruments sold, but not yet purchased, at fair value:
 
                                 
    As of
    August 2007   November 2006
   
Assets
 
Liabilities
 
Assets
 
Liabilities
    (in millions)
 
Corporate and other debt obligations
                               
Mortgage whole loans and asset-backed securities
  $ 55,322  (1)(2)   $ 211     $ 41,017  (1)   $ 253  
Investment-grade corporate bonds
    21,026       4,711       17,485       4,745  
Bank loans
    41,243       3,439       28,196       1,154  
High-yield securities
    14,840       1,915       11,054       2,064  
Preferred stock
    6,235       312       7,927       118  
Other
    1,870       151       1,267       241  
                                 
      140,536       10,739       106,946       8,575  
Equities and convertible debentures
    113,215       42,330       75,355       30,323  
U.S. government, federal agency and sovereign obligations
    73,215       58,045       64,383       51,200  
Commercial paper, certificates of deposit, time deposits and other money market instruments
    9,227  (3)           14,723  (3)      
State, municipal and provincial obligations
    3,057       13       3,688        
Physical commodities
    1,881       284       1,923       211  
Derivative contracts
    87,025  (4)     84,695  (5)     67,543  (4)     65,496  (5)
                                 
Total
  $ 428,156     $ 196,106     $ 334,561     $ 155,805  
                                 
 
 
(1) In addition to holding long positions in mortgage whole loans and mortgage-backed securities, the firm seeks to actively manage its risks related to mortgage instruments through the use of derivative contracts. The firm uses credit default swaps on specific mortgage-backed securities and indices of mortgage-backed securities to adjust its exposure to mortgage instruments and to achieve a desired long or short risk position.
 
(2) Includes $10.56 billion of mortgage whole loans that were transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales under SFAS No. 140. The firm distributed to investors the securities that were issued by the securitization vehicles and therefore does not bear economic exposure to the underlying mortgage whole loans.
 
(3) Includes $6.06 billion and $6.93 billion as of August 2007 and November 2006, respectively, of money market instruments held by William Street Funding Corporation to support the William Street credit extension program (see Note 6 for further information regarding the William Street program).
 
(4) Net of cash received pursuant to credit support agreements of $37.04 billion and $24.06 billion as of August 2007 and November 2006, respectively.
 
(5) Net of cash paid pursuant to credit support agreements of $17.66 billion and $16.00 billion as of August 2007 and November 2006, respectively.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Fair Value Hierarchy
 
The following tables set forth by level within the fair value hierarchy “Financial instruments owned, at fair value”, “Financial instruments sold, but not yet purchased, at fair value” and financial assets and liabilities accounted for at fair value under SFAS No. 155 and SFAS No. 159 as of August 2007 (see Note 2 for further information on the fair value hierarchy). As required by SFAS No. 157, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
Total financial assets at fair value classified within level 3 were $72.05 billion or 7% of “Total assets” on the condensed consolidated statements of financial condition as of August 2007. This includes $21.12 billion of financial assets at fair value classified within level 3 for which the firm does not bear economic exposure. Excluding assets for which the firm does not bear economic exposure, level 3 assets were 5% of “Total assets” as of August 2007.
 
                                         
    Assets at Fair Value
 
    As of August 2007  
                      Netting and
       
   
Level 1
   
Level 2
   
Level 3
   
Collateral
   
Total
 
    (in millions)  
 
Corporate and other debt obligations
  $ 161     $ 99,405     $ 40,970  (6)   $     $ 140,536  
Equities and convertible debentures
    69,918       28,837       14,460             113,215  
U.S. government, federal agency and sovereign obligations
    45,946       26,782       487             73,215  
Commercial paper, certificates of deposit, time deposits and other money market instruments
    5,458       3,579       190             9,227  
State, municipal and provincial obligations
          3,013       44             3,057  
Physical commodities
          1,829       52             1,881  
                                         
Cash instruments
    121,483       163,445       56,203             341,131  
Derivative contracts
    271       113,283       15,845       (42,374 (7)     87,025  
                                         
Financial instruments owned, at fair value
    121,754       276,728       72,048       (42,374 )     428,156  
Securities segregated for regulatory and other purposes
    23,421  (4)     48,547  (5)                 71,968  
Receivables from customers and counterparties (1)
          3,851                   3,851  
Securities borrowed (2)
          85,015                   85,015  
Financial instruments purchased under agreements to resell, at fair value
          80,494                   80,494  
                                         
Collateralized agreements
          165,509                   165,509  
                                         
Total assets at fair value
  $ 145,175     $ 494,635     $ 72,048     $ (42,374 )   $ 669,484  
                                         
Level 3 assets for which the firm does not bear economic exposure (3)
                    (21,116 )                
                                         
Level 3 assets for which the firm bears economic exposure
                  $ 50,932                  
                                         
 
 
(1) Consists of transfers accounted for as secured loans rather than purchases under SFAS No. 140 and prepaid variable share forwards.
(2) Reflects securities borrowed within Trading and Principal Investments. Excludes securities borrowed within Securities Services, which are accounted for based on the amount of cash collateral advanced plus accrued interest.
(3) Consists of level 3 assets which are financed by nonrecourse debt, attributable to minority investors or attributable to employee interests in certain consolidated funds.
(4) Consists of U.S. Treasury securities and money market instruments as well as insurance separate account assets measured at fair value under AICPA SOP 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.”
(5) Consists of securities borrowed and resale agreements. The underlying securities have been segregated to satisfy certain regulatory requirements.
(6) Includes non-prime residential mortgage whole loans and mortgage-backed securities of $1.82 billion and funded leveraged loans arising from capital market transactions of $6.80 billion. The remainder of the $40.97 billion primarily consists of private corporate mezzanine loans and securities, other bank loans, including portfolios of corporate loans, and loans related to commercial real estate financing.
(7) Represents cash collateral and the impact of netting across the levels of the fair value hierarchy. Netting among positions classified within the same level is included in that level.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
                                         
    Liabilities at Fair Value
 
    As of August 2007  
                      Netting and
       
   
Level 1
   
Level 2
   
Level 3
   
Collateral
   
Total
 
    (in millions)  
 
Corporate and other debt obligations
  $ 186     $ 9,305     $ 1,248     $     $ 10,739  
Equities and convertible debentures
    41,053       1,275       2             42,330  
U.S. government, federal agency and sovereign obligations
    57,114       916       15             58,045  
Commercial paper, certificates of deposit, time deposits and other money market instruments
                             
State, municipal and provincial obligations
          13                   13  
Physical commodities
    284                         284  
                                         
Cash instruments
    98,637       11,509       1,265             111,411  
Derivative contracts
    253       90,816       16,878       (23,252 (5)     84,695  
                                         
Financial instruments sold, but not yet purchased, at fair value
    98,890       102,325       18,143       (23,252 )     196,106  
Securities loaned (1)
          3,640                   3,640  
Financial instruments sold under agreements to repurchase, at fair value
          160,253                   160,253  
Other secured financings (2)
          39,615                   39,615  
                                         
Collateralized financings
          203,508                   203,508  
Unsecured short-term borrowings (3)
          43,954       3,281             47,235  
Unsecured long-term borrowings (4)
          13,819       652             14,471  
                                         
Total liabilities at fair value
  $ 98,890     $ 363,606     $ 22,076     $ (23,252 )   $ 461,320  
                                         
 
 
(1) Reflects securities loaned within Trading and Principal Investments. Excludes securities loaned within Securities Services, which are accounted for based on the amount of cash collateral received plus accrued interest.
 
(2) Primarily includes transfers accounted for as financings rather than sales under SFAS No. 140 and debt raised through the firm’s William Street program.
 
(3) Consists of promissory notes, commercial paper and hybrid financial instruments.
 
(4) Primarily includes hybrid financial instruments and prepaid physical commodity transactions.
 
(5) Represents cash collateral and the impact of netting across the levels of the fair value hierarchy. Netting among positions classified within the same level is included in that level.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Level 3 Gains and Losses
 
The following tables set forth a summary of changes in the fair value of the firm’s level 3 financial assets and liabilities for the three and nine months ended August 2007.
 
Cash Instruments
 
As reflected in the table below, the net unrealized loss on level 3 cash instruments was $2.17 billion and $1.23 billion for the three and nine months ended August 2007, respectively, primarily consisting of unrealized losses on non-prime residential mortgage loans and securities as well as non-investment-grade loan commitments. Level 3 cash instruments are frequently hedged with instruments classified in level 1 and level 2, and accordingly, gains or losses that have been reported in level 3 are frequently offset by gains or losses attributable to instruments classified in level 1 or level 2 or by derivative contracts classified in level 3 of the fair value hierarchy.
 
Derivative Contracts
 
As reflected in the table below, the net unrealized gain on level 3 derivative contracts was $2.62 billion and $2.81 billion for the three and nine months ended August 2007, respectively.
 
The level 3 gains and losses on derivative contracts should be considered in the context of the following factors:
 
  •  A derivative contract with level 1 and/or level 2 inputs is classified as a level 3 financial instrument in its entirety if it has at least one significant level 3 input.
 
  •  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) is still classified as level 3.
 
  •  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 instruments classified in level 1 or level 2 or by cash instruments reported in level 3 of the fair value hierarchy.
 
The unrealized gains referenced above principally resulted from changes in level 2 inputs, as opposed to changes in level 3 inputs.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
                                         
    Level 3 Financial Assets and Liabilities
 
    Three Months Ended August 2007  
    Cash
    Cash
    Derivative
    Unsecured
    Unsecured
 
    Instruments
    Instruments
    Contracts
    Short-Term
    Long-Term
 
   
- Assets
   
- Liabilities
   
- Net
   
Borrowings
   
Borrowings
 
    (in millions)  
 
Balance, beginning of period
  $ 45,141     $ (849 )   $ 399     $ (5,507 )   $ (503 )
Realized gains/(losses)
    251  (1)     7  (2)     313  (2)     (41 ) (2)      
Unrealized gains/(losses) relating to instruments still held at the
reporting date
    (1,607 ) (1)     (558 ) (2)     2,624  (2)(3)     92  (2)     69  (2)
Purchases, issuances and settlements
    5,682       140       (1,180 )     (232 )     (250 )
Transfers in and/or out of level 3
    6,736       (5 )     (3,189 )     2,407       32  
                                         
Balance, end of period
  $ 56,203     $ (1,265 )   $ (1,033 )   $ (3,281 )   $ (652 )
                                         
 
                                         
    Level 3 Financial Assets and Liabilities
 
    Nine Months Ended August 2007  
    Cash
    Cash
    Derivative
    Unsecured
    Unsecured
 
    Instruments
    Instruments
    Contracts
    Short-Term
    Long-Term
 
   
- Assets
   
- Liabilities
   
- Net
   
Borrowings
   
Borrowings
 
    (in millions)  
 
Balance, beginning of year
  $ 29,905     $ (223 )   $ 580     $ (3,253 )   $ (135 )
Realized gains/(losses)
    1,363  (4)     14  (2)     1,135  (2)     (100 ) (2)     1  
Unrealized gains/(losses) relating to instruments still held at the reporting date
    (662 ) (4)     (569 ) (2)     2,812  (2)(3)     21  (2)     71  (2)
Purchases, issuances and settlements
    18,886       (489 )     (3,154 )     (985 )     (559 )
Transfers in and/or out of level 3
    6,711       2       (2,406 )     1,036       (30 )
                                         
Balance, end of period
  $ 56,203     $ (1,265 )   $ (1,033 )   $ (3,281 )   $ (652 )
                                         
 
 
(1) The aggregate of $(1.36) billion includes approximately $(1.93) billion and $572 million reported in “Trading and principal investments” and “Interest income,” respectively, in the condensed consolidated statements of earnings.
 
(2) Substantially all is reported in “Trading and principal investments” in the condensed consolidated statements of earnings.
 
(3) Principally resulted from changes in level 2 inputs.
 
(4) The aggregate of $701 million includes approximately $(789) million and $1.49 billion reported in “Trading and principal investments” and “Interest income,’’ respectively, in the condensed consolidated statements of earnings.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
As of August 2007, the changes in the fair value of receivables (including securities borrowed and resale agreements) for which the fair value option was elected that were attributable to changes in instrument-specific credit spreads were not material. During the three and nine months ended August 2007, the firm recognized gains of $270 million and $269 million, respectively, attributable to the observable impact of the market’s widening of the firm’s own credit spread on liabilities for which the fair value option was elected. The firm calculates the impact of its own credit spread on liabilities carried at fair value by discounting future cash flows at a rate which incorporates the firm’s observable credit spreads. As of August 2007, the difference between the fair value and the aggregate contractual principal amount of both long-term receivables and long-term debt instruments (principal and non-principal protected) for which the fair value option was elected was not material.
 
The following table sets forth the gains and (losses) included in earnings during the three and nine months ended August 2007 related to financial assets and liabilities for which the firm has elected to apply the fair value option under SFAS No. 155 and SFAS No. 159. The table does not reflect the impact to the firm’s earnings of adopting SFAS No. 159 because a significant amount of these gains and losses would have been recognized under previously issued generally accepted accounting principles. In addition, instruments for which the firm has elected the fair value option are economically hedged with instruments accounted for at fair value under other generally accepted accounting principles that are not reflected in the below table.
 
                 
    Three Months
    Nine Months
 
    Ended
    Ended
 
   
August 2007
   
August 2007
 
    (in millions)  
 
Financial instruments owned, at fair value (1)
  $ (33 )   $ 39  
Unsecured short-term borrowings
    (51 )     (403 )
Other secured financings (2)
    897       772  
Unsecured long-term borrowings
    (226 )     (957 )
Other (3)
    11       10  
                 
Total (4)
  $ 598     $ (539 )
                 
 
 
(1) Consists of investments where the firm would otherwise have applied the equity method of accounting as well as securities held in the firm’s bank subsidiary (previously accounted for as available-for-sale).
 
(2) Includes gains of $948 million related to financings recorded as a result of certain mortgage securitizations that are accounted for as secured financings rather than sales under SFAS No. 140. The firm distributed to investors the securities that were issued by the securitization vehicles and therefore does not bear economic exposure to the underlying mortgage whole loans. The loans are reflected within the firm’s “Financial instruments owned, at fair value” and the proceeds received from the transfer are reflected as a liability within “Other secured financings.” Changes in the fair value of the loans are equally offset by changes in the fair value of the secured financing.
 
(3) Consists of resale and repurchase agreements and securities borrowed and loaned within Trading and Principal Investments.
 
(4) Reported within “Trading and principal investments” within the condensed consolidated statements of earnings. The amounts exclude contractual interest, which is included in “Interest Income” and “Interest Expense,” for all instruments other than hybrid financial instruments.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Derivative Activities
 
Derivative contracts are instruments, such as futures, forwards, swaps or option contracts, that derive their value from underlying assets, indices, reference rates or a combination of these factors. Derivative instruments may be privately negotiated contracts, which are often referred to as OTC derivatives, or they may be listed and traded on an exchange. Derivatives may involve future commitments to purchase or sell financial instruments or commodities, or to exchange currency or interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, securities, commodities, currencies or indices.
 
Certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments, are not considered derivatives even though their values or contractually required cash flows are derived from the price of some other security or index. However, certain commodity-related contracts are included in the firm’s derivatives disclosure, as these contracts may be settled in cash or the assets to be delivered under the contract are readily convertible into cash.
 
The firm enters into derivative transactions to facilitate client transactions, to take proprietary positions and as a means of risk management. Risk exposures are managed through diversification, by controlling position sizes and by entering into offsetting positions. For example, the firm may manage the risk related to a portfolio of common stock by entering into an offsetting position in a related equity-index futures contract.
 
The firm applies hedge accounting under SFAS No. 133 to certain derivative contracts. The firm uses these derivatives to manage certain interest rate and currency exposures, including the firm’s net investment in non-U.S. operations. The firm designates certain interest rate swap contracts as fair value hedges. These interest rate swap contracts hedge changes in the relevant benchmark interest rate (e.g., London Interbank Offered Rate (LIBOR)), effectively converting a substantial portion of the firm’s unsecured long-term and certain unsecured short-term borrowings into floating rate obligations. See Note 2 for information regarding the firm’s policy on foreign currency forward contracts used to hedge its net investment in non-U.S. operations.
 
The firm applies a long-haul method to substantially all of its hedge accounting relationships to perform an ongoing assessment of the effectiveness of these relationships in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. The firm utilizes a dollar-offset method, which compares the change in the fair value of the hedging instrument to the change in the fair value of the hedged item, excluding the effect of the passage of time, to prospectively and retrospectively assess hedge effectiveness. The firm’s prospective dollar-offset assessment utilizes scenario analyses to test hedge effectiveness via simulations of numerous parallel and slope shifts of the relevant yield curve. Parallel shifts change the interest rate of all maturities by identical amounts. Slope shifts change the curvature of the yield curve. For both the prospective assessment, in response to each of the simulated yield curve shifts, and the retrospective assessment, a hedging relationship is deemed to be effective if the fair value of the hedging instrument and the hedged item change inversely within a range of 80% to 125%.
 
For fair value hedges, gains or losses on derivative transactions are recognized in “Interest expense” in the condensed consolidated statements of earnings. 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 related to hedge ineffectiveness for all hedges are generally included in “Interest expense.” These gains or losses and the component of gains or losses on derivative transactions excluded from the assessment of hedge effectiveness (e.g., the effect of the passage of time on fair value hedges of the firm’s borrowings) were not material to the firm’s results of operations for the three and nine months ended August 2007 or August 2006. Gains and losses on derivatives used for trading purposes are included in “Trading and principal investments” in the condensed consolidated statements of earnings.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
The fair value of the firm’s derivative contracts is reflected net of cash paid or received pursuant to credit support agreements and is reported on a net-by-counterparty basis in the firm’s condensed consolidated statements of financial condition when management believes a legal right of setoff exists under an enforceable netting agreement. The fair value of derivative financial instruments, computed in accordance with the firm’s netting policy, is set forth below:
 
                                 
    As of  
    August 2007     November 2006  
   
Assets
   
Liabilities
   
Assets
   
Liabilities
 
    (in millions)  
 
Forward settlement contracts
  $ 12,176     $ 13,671     $ 11,751     $ 14,335  
Swap agreements
    40,143       32,297       28,012       22,471  
Option contracts
    34,706       38,727       27,780       28,690  
                                 
Total
  $ 87,025     $ 84,695     $ 67,543     $ 65,496  
                                 
 
The fair value of derivatives accounted for as qualifying hedges under SFAS No. 133 consisted of $2.13 billion and $2.66 billion in assets as of August 2007 and November 2006, respectively, and $816 million and $551 million in liabilities as of August 2007 and November 2006, respectively.
 
The firm also has embedded derivatives that have been bifurcated from related borrowings under SFAS No. 133. Such derivatives, which are classified in unsecured short-term and unsecured long-term borrowings, had a carrying value of $754 million and $1.13 billion (excluding the debt host contract) as of August 2007 and November 2006, respectively. See Notes 4 and 5 for further information regarding the firm’s unsecured borrowings.
 
Securitization Activities
 
The firm securitizes commercial and residential mortgages, home equity and auto loans, government and corporate bonds and other types of financial assets. The firm acts as underwriter of the beneficial interests that are sold to investors. The firm derecognizes financial assets transferred in securitizations provided it has relinquished control over such assets. Transferred assets are accounted for at fair value prior to securitization. Net revenues related to these underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.
 
The firm may retain interests in securitized financial assets, primarily in the form of senior or subordinated securities, including residual interests. Retained interests are accounted for at fair value and are included in “Total financial instruments owned, at fair value” in the condensed consolidated statements of financial condition.
 
During the nine months ended August 2007, the firm securitized $69.75 billion of financial assets ($22.85 billion of residential mortgages, $15.61 billion of commercial mortgages and $31.29 billion of other financial assets, primarily in connection with collateralized debt and loan obligations (CDOs and CLOs)), including $23.94 billion in the firm’s third quarter ($2.86 billion of residential mortgages, $14.25 billion of commercial mortgages and $6.83 billion of other financial assets, primarily in connection with CLOs and CDOs). During the nine months ended August 2006, the firm securitized $78.77 billion of financial assets ($55.20 billion of residential mortgages, $6.99 billion of commercial mortgages and $16.58 billion of other financial assets, primarily in connection with CDOs and CLOs), including $29.12 billion in the firm’s third quarter ($18.63 billion of residential mortgages, $3.09 billion of commercial mortgages and $7.40 billion of other financial assets, primarily in connection with CLOs and CDOs). Cash flows received on retained interests were approximately $183 million and $548 million for the three and nine months ended
August 2007, respectively, and $191 million and $613 million for the three and nine months ended August 2006, respectively.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
As of August 2007 and November 2006, the firm held $4.70 billion and $7.08 billion of retained interests, respectively, including $2.90 billion and $5.18 billion, respectively, held in QSPEs.
 
The following table sets forth the weighted average key economic assumptions used in measuring the fair value of the firm’s retained interests and the sensitivity of this fair value to immediate adverse changes of 10% and 20% in those assumptions:
 
                                                 
    As of August 2007     As of November 2006  
    Type of Retained Interests     Type of Retained Interests  
    Mortgage-
    CDOs and
    Corporate
    Mortgage-
    CDOs and
    Corporate
 
   
Backed
   
CLOs
   
Debt (1)
   
Backed
   
CLOs
   
Debt (1)
 
    ($ in millions)  
 
Fair value of retained interests
  $ 2,922     $ 1,773     $     $ 4,013     $ 1,973     $ 1,097  
Weighted average life (years)
    6.6       5.0             6.0       7.0       2.2  
Constant prepayment rate
    15.8 %     18.5 %     N/A       21.2 %     24.5 %     N/A  
Impact of 10% adverse change
  $ (66 )   $ (27 )   $     $ (121 )   $ (2 )   $  
Impact of 20% adverse change
    (116 )     (55 )           (221 )     (6 )      
Anticipated credit losses (2)
    4.5 %     N/A       N/A       2.0 %     N/A       N/A  
Impact of 10% adverse change (3)
  $ (57 )   $     $     $ (81 )   $     $  
Impact of 20% adverse change (3)
    (88 )                 (155 )            
Discount rate
    11.2 %     14.5 %     N/A %     9.4 %     6.9 %     3.9 %
Impact of 10% adverse change
  $ (102 )   $ (68 )   $     $ (136 )   $ (38 )   $ (9 )
Impact of 20% adverse change
    (196 )     (130 )           (266 )     (74 )     (17 )
 
 
(1) Includes retained interests in bonds and other types of financial assets that are not subject to prepayment risk.
 
(2) Anticipated credit losses are computed only on positions for which expected credit loss is a key assumption in the determination of fair value or positions for which expected credit loss is not reflected within the discount rate.
 
(3) The impacts of adverse change take into account credit mitigants incorporated in the retained interests, including over-collateralization and subordination provisions.
 
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 is calculated independently of changes in any other assumption. In practice, simultaneous changes in assumptions might magnify or counteract the sensitivities disclosed above.
 
In addition to the retained interests described above, the firm also held interests in residential mortgage QSPEs purchased in connection with secondary market-making activities. These purchased interests approximated $7 billion and $8 billion as of August 2007 and November 2006, respectively.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Variable Interest Entities (VIEs)
 
The firm, in the ordinary course of business, retains interests in VIEs in connection with its securitization activities. The firm also purchases and sells variable interests in VIEs, which primarily issue mortgage-backed and other asset-backed securities, CDOs and CLOs, in connection with its market-making activities and makes investments in and loans to VIEs that hold performing and nonperforming debt, equity, real estate, power-related and other assets. In addition, the firm utilizes VIEs to provide investors with principal-protected notes, credit-linked notes and asset-repackaged notes designed to meet their objectives.
 
VIEs generally purchase assets by issuing debt and equity instruments. In certain instances, the firm provides guarantees to VIEs or holders of variable interests in VIEs. In such cases, the maximum exposure to loss included in the tables set forth below is the notional amount of such guarantees. Such amounts do not represent anticipated losses in connection with these guarantees.
 
The firm’s variable interests in VIEs include senior and subordinated debt; loan commitments; limited and general partnership interests; preferred and common stock; interest rate, foreign currency, equity, commodity and credit derivatives; guarantees; and residual interests in mortgage-backed and asset-backed securitization vehicles, CDOs and CLOs. The firm’s exposure to the obligations of VIEs is generally limited to its interests in these entities.
 
The following tables set forth total assets in nonconsolidated VIEs in which the firm holds significant variable interests and the firm’s maximum exposure to loss associated with these interests. The firm has aggregated nonconsolidated VIEs based on principal business activity, as reflected in the first column. The nature of the firm’s variable interests can take different forms, as described in the columns under maximum exposure to loss.
 
                                                   
    As of August 2007  
            Maximum Exposure to Loss in Nonconsolidated VIEs (1)  
            Purchased
    Commitments
                   
    VIE
      and Retained
    and
          Loans and
       
   
Assets
     
Interests
   
Guarantees
   
Derivatives
   
Investments
   
Total
 
            (in millions)  
CDOs and CLOs (2)
  $ 32,895       $ 1,729     $     $ 12,433     $     $ 14,162  
Real estate, credit-related and other investing (3)
    14,479               109       7       2,357       2,473  
Municipal bond securitizations
    1,508               1,508                   1,508  
Mortgage-backed and other asset-backed
    3,955         1,097                         1,097  
Power-related
    3,249         2       37             766       805  
Principal-protected notes (4)
    5,192                     5,079             5,079  
Asset repackagings and credit-linked notes
    4,262                     1,306             1,306  
                                                   
Total
  $ 65,540       $ 2,828     $ 1,654     $ 18,825     $ 3,123     $ 26,430  
                                                   


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
                                                   
    As of November 2006  
            Maximum Exposure to Loss in Nonconsolidated VIEs (1)  
            Purchased
    Commitments
                   
    VIE
      and Retained
    and
          Loans and
       
   
Assets
     
Interests
   
Guarantees
   
Derivatives
   
Investments
   
Total
 
            (in millions)  
CDOs and CLOs (2)
  $ 37,610       $ 2,406     $     $ 9,782     $     $ 12,188  
Real estate, credit-related
and other investing (3)
    16,300               113       8       2,088       2,209  
Municipal bond securitizations
    1,182               1,182                   1,182  
Mortgage-backed and other
asset-backed
    8,239         477             66             543  
Power-related
    3,422         10       73             597       680  
Principal-protected notes (4)
    4,363                     3,437             3,437  
Asset repackagings and
credit-linked notes
    1,360                     355             355  
                                                   
Total
  $ 72,476       $ 2,893     $ 1,368     $ 13,648     $ 2,685     $ 20,594  
                                                   
 
 
(1)  Such amounts do not represent the anticipated losses in connection with these transactions.
 
(2)  The firm’s purchased and retained interests in CDOs and CLOs primarily consist of securities that are ranked senior in the CDO and CLO capital structures. Derivatives related to CDOs and CLOs consist of total return swaps on securities that are ranked senior in the CDO and CLO capital structures and out-of-the-money written put options on investment-grade collateral held by VIEs.
 
(3)  The firm obtains interests in these VIEs in connection with making proprietary investments in real estate, distressed loans and other types of debt, mezzanine instruments and equities.
 
(4)  Derivatives related to principal-protected notes consist of out-of-the-money written put options that provide principal protection to clients invested in various fund products, with risk to the firm mitigated through portfolio rebalancing.
 
The following table sets forth the firm’s total assets and maximum exposure to loss associated with its significant variable interests in consolidated VIEs where the firm does not hold a majority voting interest. The firm has aggregated consolidated VIEs based on principal business activity, as reflected in the first column.
 
                                 
    As of August 2007     As of November 2006  
          Maximum
          Maximum
 
    VIE
    Exposure
    VIE
    Exposure
 
   
Assets (1)
   
to Loss (2)
   
Assets (1)
   
to Loss (2)
 
    (in millions)  
 
Real estate, credit-related and other investing
  $ 2,092     $ 672     $ 3,077     $ 1,368  
Municipal bond securitizations
    1,807       1,807       2,715       2,715  
CDOs, mortgage-backed and other asset-backed
    492       378       1,537       20  
Foreign exchange and commodities
    466       493       433       340  
Principal-protected notes
    1,134       1,111       894       774  
Asset repackagings and credit-linked notes
    211       1       388       36  
                                 
Total
  $ 6,202     $ 4,462     $ 9,044     $ 5,253  
                                 
 
 
  (1)  Consolidated VIE assets include assets financed on a nonrecourse basis.
 
  (2)  Such amounts do not represent the anticipated losses in connection with these transactions.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
  Collateralized Transactions
 
The firm receives financial instruments as collateral, primarily in connection with resale agreements, securities borrowed, derivative transactions and customer margin loans. Such financial instruments may include obligations of the U.S. government, federal agencies, sovereigns and corporations, as well as equities and convertibles.
 
In many cases, the firm is permitted to deliver or repledge these financial instruments in connection with entering into repurchase agreements, securities lending agreements and other secured financings, collateralizing derivative transactions and meeting firm or customer settlement requirements. As of
August 2007 and November 2006, the fair value of financial instruments received as collateral by the firm that it was permitted to deliver or repledge was $844.38 billion and $746.08 billion, respectively, of which the firm delivered or repledged $733.69 billion and $639.87 billion, respectively.
 
The firm also pledges assets that it owns to counterparties who may or may not have the right to deliver or repledge them. Financial instruments owned and pledged to counterparties that have the right to deliver or repledge are reported as “Financial instruments owned and pledged as collateral, at fair value” in the condensed consolidated statements of financial condition and were $48.18 billion and $36.00 billion as of August 2007 and November 2006, respectively. Financial instruments owned and pledged in connection with repurchase agreements, securities lending agreements and other secured financings to counterparties that did not have the right to sell or repledge are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition and were $162.75 billion and $134.31 billion as of August 2007 and November 2006, respectively. Other assets (primarily real estate, power generation facilities and related assets, and cash) owned and pledged in connection with other secured financings to counterparties that did not have the right to sell or repledge were $8.04 billion and $5.34 billion as of August 2007 and November 2006, respectively.
 
In addition to repurchase agreements and securities lending agreements, the firm obtains secured funding through the use of other arrangements. Other secured financings include arrangements that are nonrecourse, that is, only the subsidiary that executed the arrangement or a subsidiary guaranteeing the arrangement is obligated to repay the financing. Other secured financings consist of liabilities related to the firm’s William Street program, consolidated variable interest entities, collateralized central bank financings, transfers of financial assets that are accounted for as financings rather than sales under SFAS No. 140 (primarily pledged bank loans and mortgage whole loans), consolidated power generation facilities and other structured financing arrangements.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Other secured financings are set forth in the table below:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Other secured financings (short-term) (1)(2)
  $ 36,878     $ 24,290  
Other secured financings (long-term):
               
2008
    3,577       5,535  
2009
    774       877  
2010
    2,676       1,894  
2011
    6,099       5,105  
2012
    2,448       1,928  
2013-thereafter
    22,334       10,795  
                 
Total other secured financings (long-term) (3)(4)
    37,908       26,134  
                 
Total other secured financings (5)
  $ 74,786     $ 50,424  
                 
 
 
  (1)  As of August 2007, consists of U.S. dollar-denominated financings of $22.42 billion with a weighted average interest rate of 5.85% and non-U.S. dollar-denominated financings of $14.46 billion with a weighted average interest rate of 1.09%. As of November 2006, consists of U.S. dollar-denominated financings of $14.28 billion with a weighted average interest rate of 5.22% and non-U.S. dollar-denominated financings of $10.01 billion with a weighted average interest rate of 2.00%. The weighted average interest rates as of August 2007 and November 2006 excluded financial instruments accounted for at fair value under SFAS No. 155 or SFAS No. 159.
 
  (2)  Includes other secured financings maturing within one year of the financial statement date and other secured financings that are redeemable within one year of the financial statement date at the option of the holder.
 
  (3)  As of August 2007, consists of U.S. dollar-denominated financings of $23.22 billion with a weighted average interest rate of 5.80% and non-U.S. dollar-denominated financings of $14.69 billion with a weighted average interest rate of 4.36%. As of November 2006, consists of U.S. dollar-denominated financings of $16.97 billion with a weighted average interest rate of 5.61% and non-U.S. dollar-denominated financings of $9.16 billion with a weighted average interest rate of 3.81%.
 
  (4)  Secured long-term financings that are repayable prior to maturity at the option of the firm are reflected at their contractual maturity dates. Secured long-term financings that are redeemable prior to maturity at the option of the holder are reflected at the dates such options become exercisable.
 
  (5)  As of August 2007, $70.06 billion of these financings were collateralized by financial instruments and $4.73 billion by other assets (primarily real estate, power generation facilities and related assets, and cash). As of November 2006, $47.22 billion of these financings were collateralized by financial instruments and $3.20 billion by other assets. Other secured financings include $32.89 billion and $19.79 billion of nonrecourse obligations as of August 2007 and November 2006, respectively.
 
Note 4.   Unsecured Short-Term Borrowings
 
The firm obtains unsecured short-term borrowings primarily through the issuance of promissory notes, commercial paper and hybrid financial instruments. As of August 2007 and November 2006, these borrowings were $66.28 billion and $47.90 billion, respectively. Such amounts 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 SFAS No. 155 or SFAS No. 159. 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.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Unsecured short-term borrowings are set forth below:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Promissory notes
  $ 13,439     $ 13,811  
Commercial paper
    4,995       1,489  
Current portion of unsecured long-term borrowings
    19,740       14,115  
Hybrid financial instruments
    21,331       14,060  
Other short-term borrowings
    6,778       4,429  
                 
Total (1)
  $ 66,283     $ 47,904  
                 
 
 
(1) The weighted average interest rates for these borrowings were 5.20% and 5.13% as of August 2007 and November 2006, respectively. The weighted average interest rates, after giving effect to hedging activities, were 5.31% and 5.16% as of August 2007 and November 2006, respectively. The weighted average interest rates as of August 2007 and
November 2006 excluded financial instruments accounted for at fair value under SFAS No. 155 or SFAS No. 159.
 
Note 5.   Unsecured Long-Term Borrowings
 
The firm obtains unsecured long-term borrowings that consist principally of senior borrowings with maturities extending to 2043. As of August 2007 and November 2006, these borrowings were $151.07 billion and $122.84 billion, respectively.
 
Unsecured long-term borrowings are set forth below:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Fixed rate obligations (1)
               
U.S. dollar
  $ 47,818     $ 41,719  
Non-U.S. dollar
    24,985       22,854  
Floating rate obligations (2)
               
U.S. dollar
    47,540       38,342  
Non-U.S. dollar
    30,729       19,927  
                 
Total
  $ 151,072     $ 122,842  
                 
 
 
  (1)  As of both August 2007 and November 2006, interest rates on U.S. dollar fixed rate obligations ranged from 3.88% to 12.00%. As of August 2007 and November 2006, interest rates on non-U.S. dollar fixed rate obligations ranged from 0.67% to 8.88% and from 0.31% to 8.88%, 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.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Unsecured long-term borrowings by maturity date are set forth below:
 
                                                 
    As of  
    August 2007 (1)(2)     November 2006 (1)(2)  
    U.S.
    Non-U.S.
          U.S.
    Non-U.S.
       
   
Dollar
   
Dollar
   
Total
   
Dollar
   
Dollar
   
Total
 
    (in millions)  
 
2008
  $ 4,096     $ 1,883     $ 5,979     $ 14,848     $ 3,038     $ 17,886  
2009
    19,941       2,799       22,740       12,398       2,978       15,376  
2010
    8,034       5,248       13,282       5,034       4,945       9,979  
2011
    5,835       4,476       10,311       5,675       4,389       10,064  
2012
    9,896       3,271       13,167       4,500       2,098       6,598  
2013-thereafter
    47,555       38,038       85,593       37,606       25,333       62,939  
                                                 
Total
  $ 95,357     $ 55,715     $ 151,072     $ 80,061     $ 42,781     $ 122,842  
                                                 
 
 
  (1)  Unsecured long-term borrowings maturing within one year of the financial statement date and certain 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 in the condensed consolidated statements of financial condition.
 
  (2)  Unsecured long-term borrowings that are repayable prior to maturity at the option of the firm are reflected at their contractual maturity dates. Unsecured long-term borrowings that are redeemable prior to maturity at the option of the holder are reflected at the dates such options become exercisable.
 
The firm enters into derivative contracts, such as interest rate futures contracts, interest rate swap agreements, currency swap agreements, commodity contracts and equity-linked and indexed contracts, to effectively convert a substantial portion of its unsecured long-term borrowings into U.S. dollar-based floating rate obligations. Accordingly, the carrying value of unsecured long-term borrowings approximated fair value as of August 2007 and November 2006.
 
The effective weighted average interest rates for unsecured long-term borrowings are set forth below:
 
                                 
    As of  
    August 2007     November 2006  
   
Amount
   
Rate
   
Amount
   
Rate
 
    ($ in millions)  
 
Fixed rate obligations
  $ 4,254       6.05 %   $ 1,997       6.13 %
Floating rate obligations (1)(2)
    146,818       5.81       120,845       5.75  
                                 
Total
  $ 151,072       5.82     $ 122,842       5.75  
                                 
 
 
  (1)  Includes fixed rate obligations that have been converted into floating rate obligations through derivative contracts.
 
  (2)  The weighted average interest rates as of August 2007 and November 2006 excluded financial instruments accounted for at fair value under SFAS No. 155 or SFAS No. 159.
 
  Subordinated Borrowings
 
Unsecured long-term borrowings include subordinated borrowings with outstanding principal of $13.67 billion and $7.51 billion as of August 2007 and November 2006, respectively, as set forth below.
 
Subordinated Notes.  As of August 2007, the firm had $8.58 billion of subordinated notes outstanding with maturities ranging from 2008 to 2036. The effective weighted average interest rate on these subordinated notes was 5.94%, after giving effect to derivative contracts used to convert fixed


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
rate obligations into floating rate obligations. As of November 2006, the firm had $4.67 billion of subordinated notes outstanding with maturities ranging from 2007 to 2036 and with an effective weighted average interest rate of 6.24%. These notes are junior in right of payment to all of the firm’s senior indebtedness.
 
Junior Subordinated Debt Issued to a Trust in Connection with Trust Preferred Securities.  The firm issued $2.84 billion of junior subordinated debentures in its first quarter of 2004 to Goldman Sachs Capital I (the Trust), a Delaware statutory trust that, in turn, issued $2.75 billion of guaranteed preferred beneficial interests to third parties and $85 million of common beneficial interests to the firm and invested the proceeds from the sale in junior subordinated debentures issued by the firm. The Trust is a wholly owned finance subsidiary of the firm for regulatory and legal purposes but is not consolidated for accounting purposes.
 
The firm pays interest semiannually on these debentures at an annual rate of 6.345% and the debentures mature on February 15, 2034. The coupon rate and the payment dates applicable to the beneficial interests are the same as the interest rate and payment dates applicable to the debentures. The firm has the right, from time to time, to defer payment of interest on the debentures, and, therefore, cause payment on the Trust’s preferred beneficial interests to be deferred, in each case up to ten consecutive semiannual periods. During any such extension period, the firm will not be permitted to, among other things, pay dividends on or make certain repurchases of its common stock. The Trust is not permitted to pay any distributions on the common beneficial interests held by the firm unless all dividends payable on the preferred beneficial interests have been paid in full. These debentures are junior in right of payment to all of the firm’s senior indebtedness and all of the firm’s subordinated borrowings, other than the junior subordinated debt issued in connection with the Normal Automatic Preferred Enhanced Capital Securities (see discussion below).
 
Junior Subordinated Debt Issued to Trusts in Connection with Fixed-to-Floating and Floating Rate Normal Automatic Preferred Enhanced Capital Securities.  In the second quarter of 2007, the firm issued a total of $2.25 billion of remarketable junior subordinated notes to Goldman Sachs Capital II and Goldman Sachs Capital III (the Trusts), Delaware statutory trusts that, in turn, issued $2.25 billion of guaranteed perpetual Automatic Preferred Enhanced Capital Securities (APEX) to third parties and a de minimis amount of common securities to the firm. The firm also entered into contracts with the Trusts to sell $2.25 billion of perpetual non-cumulative preferred stock to be issued by the firm (the stock purchase contracts). The Trusts are wholly owned finance subsidiaries of the firm for regulatory and legal purposes but are not consolidated for accounting purposes.
 
The firm pays interest semiannually on $1.75 billion of junior subordinated notes issued to Goldman Sachs Capital II at a fixed annual rate of 5.59% and the notes mature on June 1, 2043. The firm pays interest quarterly on $500 million of junior subordinated notes issued to Goldman Sachs Capital III at a rate per annum equal to three-month LIBOR plus .57% and the notes mature on September 1, 2043. In addition, the firm makes contract payments at a rate of .20% per annum on the stock purchase contracts held by the Trusts. The firm has the right to defer payments on the junior subordinated notes and the stock purchase contracts, subject to limitations, and therefore cause payment on the APEX to be deferred. 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 junior subordinated notes are junior in right of payment to all of the firm’s senior indebtedness and all of the firm’s other subordinated borrowings.
 
The firm has accounted for the stock purchase contracts as equity instruments under EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” and, accordingly, recorded the cost of the stock purchase contracts as a


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
reduction to additional paid-in capital. See Note 7 for information on the preferred stock that the firm will issue in connection with the stock purchase contracts.
 
Note 6.   Commitments, Contingencies and Guarantees
 
  Commitments
 
Forward Starting Collateralized Agreements and Financings.  The firm had forward starting resale agreements and securities borrowing agreements of $29.94 billion and $18.29 billion as of August 2007 and November 2006, respectively. The firm had forward starting repurchase agreements and securities lending agreements of $27.17 billion and $17.15 billion as of August 2007 and November 2006, respectively.
 
Commitments to Extend Credit.  In connection with its lending activities, the firm had outstanding commitments to extend credit of $135.53 billion and $100.48 billion as of August 2007 and November 2006, respectively. The firm’s commitments to extend credit are agreements to lend to counterparties that have fixed termination dates and are contingent on the satisfaction of all conditions to borrowing set forth in the contract. Since these commitments may expire unused or be reduced or cancelled at the counterparty’s request, the total commitment amount does not necessarily reflect the actual future cash flow requirements. The firm accounts for these commitments at fair value. To the extent that the firm recognizes losses on these commitments, such losses are recorded within the firm’s Trading and Principal Investments segment net of any related underwriting fees.
 
The following table summarizes the firm’s commitments to extend credit as of August 2007 and November 2006:
 
                 
    As of  
    August
    November
 
    2007     2006  
    (in millions)  
 
Commercial lending commitments
               
Investment-grade
  $ 42,025     $ 7,604  
Non-investment-grade
    62,621       57,017  
William Street program
    22,799       18,831  
Warehouse financing
    8,081       17,026  
                 
Total commitments to extend credit
  $ 135,526     $ 100,478  
                 
 
  •  Commercial lending commitments.  The firm extends commercial lending commitments primarily in connection with contingent acquisition financing and other types of corporate lending as well as commercial real estate financing. The total commitment amount does not necessarily reflect the actual future cash flow requirements, as the firm often syndicates all or substantial portions of these commitments, the commitments may expire unused, or the commitments may be cancelled or reduced at the request of the counterparty. In addition, commitments that are extended for contingent acquisition financing are often short-term in nature, as borrowers often replace them with other funding sources. Included within the non-investment-grade amount as of August 2007 was $41.98 billion of exposure to leveraged lending capital market transactions, $8.45 billion related to commercial real estate transactions and $12.19 billion arising from other unfunded credit facilities. Included within the non-investment-grade amount as of November 2006 was $39.68 billion of exposure to leveraged lending capital market transactions, $12.11 billion related to commercial real estate transactions and $5.23 billion arising from other unfunded credit facilities.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
  •  William Street program.  Substantially all of the commitments provided under the William Street credit extension program are to investment-grade corporate borrowers. Commitments under the program are primarily extended by William Street Commitment Corporation (Commitment Corp.), a consolidated wholly owned subsidiary of Group Inc. whose assets and liabilities are legally separated from other assets and liabilities of the firm, and, to a lesser extent, by William Street Credit Corporation, another consolidated wholly owned subsidiary of Group Inc. A significant portion of the commitments extended by Commitment Corp. are supported by funding raised by William Street Funding Corporation (Funding Corp.), another consolidated wholly owned subsidiary of Group Inc. whose assets and liabilities are also legally separated from other assets and liabilities of the firm. The assets of Commitment Corp. and of Funding Corp. will not be available to their respective shareholders until the claims of their respective creditors have been paid. In addition, no affiliate of either Commitment Corp. or Funding Corp., except in limited cases as expressly agreed in writing, is responsible for any obligation of either entity. With respect to substantially all of the William Street commitments, Sumitomo Mitsui Financial Group, Inc. (SMFG) provides the firm with credit loss protection that is generally limited to 95% of the first loss the firm realizes on approved loan commitments, up to a maximum of $1.00 billion. In addition, subject to the satisfaction of certain conditions, upon the firm’s request, SMFG will provide protection for 70% of the second loss on such commitments, up to a maximum of $1.13 billion. The firm also uses other financial instruments to mitigate credit risks related to certain William Street commitments not covered by SMFG.
 
  •  Warehouse financing.  The firm provides financing for the warehousing of financial assets to be securitized. These financings are expected to be repaid from the proceeds of the related securitizations for which the firm may or may not act as underwriter. These arrangements are secured by the warehoused assets, primarily consisting of corporate bank loans and commercial mortgages as of August 2007 and residential mortgages and mortgage-backed securities, corporate bank loans and commercial mortgages as of November 2006.
 
Letters of Credit.  The firm provides letters of credit issued by various banks to counterparties in lieu of securities or cash to satisfy various collateral and margin deposit requirements. Letters of credit outstanding were $7.95 billion and $5.73 billion as of August 2007 and November 2006, respectively.
 
Investment Commitments.  In connection with its merchant banking and other investing activities, the firm invests in private equity, real estate and other assets directly and through funds that it raises and manages. In connection with these activities, the firm had commitments to invest up to $18.57 billion and $8.24 billion as of August 2007 and November 2006, respectively, including $11.49 billion and $4.41 billion, respectively, of commitments to invest in funds managed by the firm.
 
Construction-Related Commitments.  As of August 2007 and November 2006, the firm had construction-related commitments of $812 million and $1.63 billion, respectively, including outstanding commitments of $737 million and $500 million as of August 2007 and November 2006, respectively, related to the firm’s new world headquarters in New York City, which is expected to cost between $2.3 billion and $2.5 billion. The firm is partially financing this construction project with tax-exempt Liberty Bonds. The firm borrowed approximately $1.40 billion through the issuance of Liberty Bonds in 2005 and approximately $250 million through the issuance of Liberty Bonds in the third quarter of 2007.
 
Underwriting Commitments.  As of August 2007 and November 2006, the firm had commitments to purchase $920 million and $2.62 billion, respectively, of securities in connection with its underwriting activities.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Other.  The firm had other purchase commitments of $555 million and $393 million as of August 2007 and November 2006, respectively.
 
In September 2007, Cogentrix Energy, Inc. (Cogentrix), a wholly owned subsidiary of the firm, entered into an agreement to sell a majority of its ownership interest in 14 power generation facilities. The transaction is expected to close by the end of the calendar year, subject to the receipt of regulatory approvals and other closing conditions. Depending on the level of the firm’s net revenues in such period, the resulting gain may be material to the firm’s results of operations.
 
Leases.  The firm has contractual obligations under long-term noncancelable lease agreements, principally for office space, expiring on various dates through 2069. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other charges. Future minimum rental payments, net of minimum sublease rentals, and rent charged to operating expense are set forth below:
 
         
    (in millions)  
 
Minimum rental payments
       
Remainder of 2007
  $ 96  
2008
    435  
2009
    457  
2010
    353  
2011
    296  
2012-thereafter
    2,231  
         
Total
  $ 3,868  
         
 
Contingencies
 
The firm is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its businesses. Management believes, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on the firm’s financial condition, but may be material to the firm’s operating results for any particular period, depending, in part, upon the operating results for such period. Given the inherent difficulty of predicting the outcome of the firm’s litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, the firm cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred.
 
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 $10.93 billion and $8.04 billion of contract holder account balances as of August 2007 and November 2006, respectively, for such benefits. The weighted average attained age of these contract holders was 67 years and 70 years as of August 2007 and November 2006, respectively. The net amount at risk, representing guaranteed minimum death benefits in excess of contract holder account balances, was $1.10 billion and $1.27 billion as of August 2007 and November 2006, respectively. See Note 10 for more information on the firm’s insurance liabilities.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Guarantees
 
The firm enters into various derivative contracts that meet the definition of a guarantee under
FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” Such derivative contracts include credit default and total return swaps, written equity and commodity put options, written currency contracts and interest rate caps, floors and swaptions. FIN No. 45 does not require disclosures about derivative contracts if such contracts may be cash settled and the firm has no basis to conclude it is probable that the counterparties held, at inception, the underlying instruments related to the derivative contracts. The firm has concluded that these conditions have been met for certain large, internationally active commercial and investment bank end users and certain other users. Accordingly, the firm has not included such contracts in the tables below.
 
The firm, in its capacity as an agency lender, indemnifies most of its securities lending customers against losses incurred in the event that borrowers do not return securities and the collateral held is insufficient to cover the market value of the securities borrowed.
 
In the ordinary course of business, the firm provides other financial guarantees of the obligations of third parties (e.g., performance bonds, standby letters of credit and other guarantees to enable clients to complete transactions and merchant banking fund-related guarantees). These guarantees represent obligations to make payments to beneficiaries if the guaranteed party fails to fulfill its obligation under a contractual arrangement with that beneficiary.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
The following tables set forth certain information about the firm’s derivative contracts that meet the definition of a guarantee and certain other guarantees as of August 2007 and November 2006:
 
                                         
    As of August 2007  
    Maximum Payout/Notional Amount by Period of Expiration (1)  
    Remainder
    2008-
    2010-
    2012-
       
   
of 2007
   
2009
   
2011
   
Thereafter
   
Total
 
    (in millions)  
 
Derivatives (2)
  $ 243,279     $ 640,477     $ 483,649     $ 617,156     $ 1,984,561  
Securities lending indemnifications (3)
    24,874                         24,874  
Performance bonds (4)
    1,906                         1,906  
Other financial guarantees (5)
    106       1,592       264       91       2,053  
 
                                         
    As of November 2006  
    Maximum Payout/Notional Amount by Period of Expiration (1)  
          2008-
    2010-
    2012-
       
   
2007
   
2009
   
2011
   
Thereafter
   
Total
 
    (in millions)  
 
Derivatives (2)
  $ 379,256     $ 428,258     $ 460,088     $ 399,449     $ 1,667,051  
Securities lending indemnifications (3)
    19,023                         19,023  
Performance bonds
                             
Other financial guarantees (5)
    592       99       76       86       853  
 
 
  (1)  Such amounts do not represent the anticipated losses in connection with these contracts.
 
  (2)  The aggregate carrying value of these derivatives as of August 2007 was a liability of $22.36 billion. The aggregate carrying value of these derivatives as of November 2006 was an asset of $1.12 billion, consisting of contracts with an asset value of $11.06 billion and contracts with a liability value of $9.94 billion. The carrying value excludes the effect of a legal right of setoff that may exist under an enforceable netting agreement. These derivative contracts are risk managed together with derivative contracts that are not considered guarantees under FIN No. 45, and therefore, these amounts do not reflect the firm’s overall risk related to its derivative activities.
 
  (3)  Collateral held by the lenders in connection with securities lending indemnifications was $25.64 billion and $19.70 billion as of August 2007 and November 2006, respectively.
 
  (4)  Excludes collateral of $1.91 billion related to these obligations.
 
  (5)  The carrying value of these guarantees was a liability of $107 million and $15 million as of August 2007 and
November 2006, respectively.
 
The firm has established trusts, including Goldman Sachs Capital I, II and III, 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. (See Note 5 for information regarding the transactions involving Goldman Sachs Capital I, II and III.) The firm effectively provides for the full and unconditional guarantee of the securities issued by these entities, which are not consolidated for accounting purposes. Timely payment by the firm of amounts due to these entities under the borrowing, preferred stock and related contractual arrangements will be sufficient to cover payments due on the securities issued by these entities. Management feels 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 borrowing, preferred stock and related contractual arrangements and in connection with certain expenses incurred by these entities.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
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 also indemnifies some clients against potential losses incurred in the event specified third-party service providers, including sub-custodians and third-party brokers, improperly execute transactions. In addition, the firm is a member of payment, clearing and settlement networks as well as securities exchanges around the world that may require the firm to meet the obligations of such networks and exchanges in the event of member defaults. In connection with its prime brokerage and clearing businesses, the firm agrees to clear and settle on behalf of its clients the transactions entered into by them with other brokerage firms. The firm’s obligations in respect of such transactions are secured by the assets in the client’s account as well as any proceeds received from the transactions cleared and settled by the firm on behalf of the client. In connection with joint venture investments, the firm may issue loan guarantees under which it may be liable in the event of fraud, misappropriation, environmental liabilities and certain other matters involving the borrower. The firm is unable to develop an estimate of the maximum payout under these guarantees and indemnifications. However, management believes that it is unlikely the firm will have to make any material payments under these arrangements, and no liabilities related to these guarantees and indemnifications have been recognized in the condensed consolidated statements of financial condition as of August 2007 and November 2006.
 
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 liabilities related to these arrangements have been recognized in the condensed consolidated statements of financial condition as of August 2007 and November 2006.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Note 7.   Shareholders’ Equity
 
On September 19, 2007, the Board of Directors of Group Inc. (the Board) declared a dividend of $0.35 per common share with respect to the firm’s third quarter of 2007 to be paid on November 26, 2007 to common shareholders of record on October 29, 2007.
 
During the three and nine months ended August 2007, the firm repurchased 11.2 million and 29.6 million shares of its common stock at a total cost of $2.45 billion and $6.27 billion, respectively. The average price paid per share for repurchased shares was $219.35 and $212.03 for the three and nine months ended August 2007, respectively. In addition, to satisfy minimum statutory employee tax withholding requirements related to the delivery of common stock underlying restricted stock units, the firm cancelled 4.7 million of restricted stock units with a total value of $929 million in the first nine months of 2007.
 
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 and is influenced by the firm’s overall capital position (i.e., the comparison of the firm’s capital requirements to its available capital), general market conditions and the prevailing price and trading volumes of the firm’s common stock.
 
As of August 2007, the firm had 124,000 shares of perpetual non-cumulative preferred stock outstanding in four series as set forth in the following table:
 
                             
    Shares
  Shares
      Earliest
  Redemption Value
Series
 
Issued
 
Authorized
 
Dividend Rate
 
Redemption Date
 
(in millions)
 
A
  30,000     50,000     3 month LIBOR + 0.75%,
with floor of 3.75% per annum
  April 25, 2010   $ 750  
B
  32,000     50,000     6.20% per annum   October 31, 2010     800  
C
  8,000     25,000     3 month LIBOR + 0.75%,
with floor of 4% per annum
  October 31, 2010     200  
D
  54,000     60,000     3 month LIBOR + 0.67%,
with floor of 4% per annum
  May 24, 2011     1,350  
                             
    124,000     185,000             $ 3,100  
                             
 
Each share of preferred stock has a par value of $0.01, has a liquidation preference of $25,000, is represented by 1,000 depositary shares and is redeemable at the firm’s option at a redemption price equal to $25,000 plus declared and unpaid dividends. Dividends on each series of preferred stock, if declared, are payable quarterly in arrears. The firm’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event that the firm fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period. All series of preferred stock are pari passu and have a preference over the firm’s common stock upon liquidation.
 
In the second quarter of 2007, the Board authorized 17,500.1 shares of perpetual Non-Cumulative Preferred Stock, Series E and 5,000.1 shares of perpetual Non-Cumulative Preferred Stock, Series F in connection with the APEX issuance (see Note 5 for further information on the APEX issuance). Under the stock purchase contracts, the firm will issue on the relevant stock purchase dates (on or before
June 1, 2013 and September 1, 2013 for Series E and Series F preferred stock, respectively) one share of Series E and Series F preferred stock to Goldman Sachs Capital II and III, respectively, for each $100,000 principal amount of subordinated notes held by these trusts. When issued, each share of Series E and Series F preferred stock will have a par value of $0.01 and a liquidation preference of


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
$100,000 per share. Dividends on Series E preferred stock, if declared, will be payable semiannually at a fixed annual rate of 5.79% if the stock is issued prior to June 1, 2012 and quarterly thereafter, at a rate per annum equal to the greater of (i) three-month LIBOR plus .77% and (ii) 4%. Dividends on Series F preferred stock, if declared, will be payable quarterly at a rate per annum equal to three-month LIBOR plus .77% if the stock is issued prior to September 1, 2012 and quarterly thereafter, at a rate per annum equal to the greater of (i) three-month LIBOR plus .77% and (ii) 4%. The preferred stock may be redeemed at the option of the firm on the stock purchase dates or any day thereafter, subject to the approval of the Securities and Exchange Commission (SEC) and 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.
 
On September 19, 2007, the Board declared a dividend per preferred share of $404.41, $387.50, $404.41 and $399.13 for Series A, Series B, Series C and Series D preferred stock, respectively, to be paid on November 13, 2007 to preferred shareholders of record on October 29, 2007.
 
The following table sets forth the firm’s accumulated other comprehensive income by type:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Currency translation adjustment, net of tax
  $ 59     $ 29  
Minimum pension liability adjustment, net of tax
    (38 )     (38 )
Net gains on cash flow hedges, net of tax
          2  
Net unrealized gains on available-for-sale securities, net of tax
    9  (1)     28  
                 
Total accumulated other comprehensive income, net of tax
  $ 30     $ 21  
                 
 
 
  (1)  Consists of net unrealized losses of $6 million on available-for-sale securities held by the firm’s insurance subsidiaries and net unrealized gains of $15 million on available-for-sale securities held by investees accounted for under the equity method.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Note 8.   Earnings Per Common Share
 
The computations of basic and diluted earnings per common share are set forth below:
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions, except per share amounts)  
 
Numerator for basic and diluted EPS — net earnings applicable to common shareholders
  $ 2,806     $ 1,555     $ 8,241     $ 6,294  
                                 
Denominator for basic EPS — weighted average number of common shares
    429.0       449.4       436.2       452.1  
Effect of dilutive securities (1)
                               
Restricted stock units
    14.4       14.4       13.2       12.9  
Stock options
    14.0       13.6       14.9       14.7  
                                 
Dilutive potential common shares
    28.4       28.0       28.1       27.6  
                                 
Denominator for diluted EPS — weighted average number of common shares and dilutive potential common shares
    457.4       477.4       464.3       479.7  
                                 
Basic EPS
  $ 6.54     $ 3.46     $ 18.89     $ 13.92  
Diluted EPS
    6.13       3.26       17.75       13.12  
 
 
 
  (1)  There were no anti-dilutive securities during the three and nine months ended August 2007 or August 2006.
 
Note 9.   Goodwill and Identifiable Intangible Assets
 
Goodwill
 
The following table sets forth the carrying value of the firm’s goodwill by operating segment, which is included in “Other assets” in the condensed consolidated statements of financial condition:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Investment Banking
               
Financial Advisory
  $     $  
Underwriting
    125       125  
Trading and Principal Investments
               
FICC
    117       136  
Equities (1)
    2,381       2,381  
Principal Investments
          4  
Asset Management and Securities Services
               
Asset Management (2)
    421       421  
Securities Services
    117       117  
                 
Total
  $ 3,161     $ 3,184  
                 
 
 
  (1)  Primarily related to SLK LLC (SLK).
 
  (2)  Primarily related to The Ayco Company, L.P. (Ayco).


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Identifiable Intangible Assets
 
The following table sets forth the gross carrying amount, accumulated amortization and net carrying amount of the firm’s identifiable intangible assets:
 
                     
        As of  
        August
    November
 
       
2007
   
2006
 
        (in millions)  
 
Customer lists (1)
  Gross carrying amount   $ 1,064     $ 1,034  
    Accumulated amortization     (339 )     (297 )
 
   
                   
    Net carrying amount   $ 725     $ 737  
 
   
                   
Power contracts (2)
  Gross carrying amount   $ 687     $ 750  
    Accumulated amortization     (126 )     (83 )
                     
    Net carrying amount   $ 561     $ 667  
                     
New York Stock
  Gross carrying amount   $ 714     $ 714  
Exchange (NYSE)
  Accumulated amortization     (202 )     (172 )
 
   
                   
specialist rights
  Net carrying amount   $ 512     $ 542  
 
   
                   
Insurance-related
  Gross carrying amount   $ 435     $ 396  
assets (3)
  Accumulated amortization     (64 )     (34 )
                     
    Net carrying amount   $ 371     $ 362  
                     
Exchange-traded
  Gross carrying amount   $ 138     $ 138  
fund (ETF)
  Accumulated amortization     (37 )     (33 )
 
   
                   
specialist rights
  Net carrying amount   $ 101     $ 105  
 
   
                   
Other (4)
  Gross carrying amount   $ 321     $ 335  
    Accumulated amortization     (276 )     (246 )
                     
    Net carrying amount   $ 45     $ 89  
                     
Total
  Gross carrying amount   $ 3,359     $ 3,367  
    Accumulated amortization     (1,044 )     (865 )
 
   
                   
    Net carrying amount   $ 2,315     $ 2,502  
 
   
                   
 
 
  (1)  Primarily includes the firm’s clearance and execution and NASDAQ customer lists related to SLK and financial counseling customer lists related to Ayco.
 
  (2)  Primarily relates to above-market power contracts of consolidated power generation facilities related to Cogentrix Energy, Inc. and National Energy & Gas Transmission, Inc. (NEGT). Substantially all of these power contracts have been pledged to counterparties in connection with the firm’s secured financings. The weighted average remaining life of these power contracts is approximately 11 years.
 
  (3)  Consists of VOBA and DAC. VOBA represents the present value of estimated future gross profits of the variable annuity and variable life insurance business. DAC results from commissions paid by the firm to the primary insurer (ceding company) on life and annuity reinsurance agreements as compensation to place the business with the firm and to cover the ceding company’s acquisition expenses. VOBA and DAC are amortized over the estimated life of the underlying contracts based on estimated gross profits, and amortization is adjusted based on actual experience. The weighted average remaining amortization period for VOBA and DAC is seven years as of August 2007.
 
  (4)  Primarily includes marketing and technology-related assets.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Substantially all of the firm’s identifiable intangible assets are considered to have finite lives and are amortized over their estimated useful lives. The weighted average remaining life of the firm’s identifiable intangibles is approximately 12 years.
 
Amortization expense associated with identifiable intangible assets was $63 million and $69 million for the three months ended August 2007 and August 2006, respectively, and $200 million and $182 million for the nine months ended August 2007 and August 2006, respectively. Amortization expense associated with the firm’s consolidated power generation facilities is reported within “Cost of power generation” in the condensed consolidated statements of earnings.
 
The estimated future amortization for existing identifiable intangible assets through 2012 is set forth below:
 
         
    (in millions)
 
Remainder of 2007
  $ 66  
2008
    228  
2009
    214  
2010
    203  
2011
    194  
2012
    181  
 
Note 10.   Other Assets and Other Liabilities
 
Other Assets
 
Other assets are generally less liquid, nonfinancial assets. The following table sets forth the firm’s other assets by type:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Property, leasehold improvements and equipment (1)
  $ 8,419     $ 6,990  
Goodwill and identifiable intangible assets (2)
    5,476       5,686  
Income tax-related assets
    3,382       3,427  
Equity-method investments (3)
    2,531       2,764  
Miscellaneous receivables and other
    4,208       3,009  
                 
Total
  $ 24,016     $ 21,876  
                 
 
 
  (1)  Net of accumulated depreciation and amortization of $5.64 billion and $5.06 billion as of August 2007 and November 2006, respectively.
 
  (2)  See Note 9 for further information regarding the firm’s goodwill and identifiable intangible assets.
 
  (3)  Excludes investments of $1.68 billion accounted for at fair value under SFAS No. 159 as of August 2007, which are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
 
Other Liabilities
 
The following table sets forth the firm’s other liabilities and accrued expenses by type:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Insurance-related liabilities (1)
  $ 10,626     $ 11,471  
Compensation and benefits
    13,107       9,165  
Minority interest (2)
    8,907       2,069  
Employee interests in consolidated funds
    5,233       2,690  
Income tax-related liabilities
    1,541       2,639  
Accrued expenses and other payables
    4,489       3,832  
                 
Total
  $ 43,903     $ 31,866  
                 
 
 
(1) Insurance-related liabilities are set forth in the table below:
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
    (in millions)  
 
Separate account liabilities
  $ 7,243     $ 7,957  
Liabilities for future benefits and unpaid claims
    2,219       2,123  
Contract holder account balances
    919       1,134  
Reserves for guaranteed minimum death and income benefits
    245       257  
                 
Total insurance-related liabilities
  $ 10,626     $ 11,471  
                 
 
Separate account liabilities are offset by separate account assets, representing segregated contract holder funds under variable annuity and variable life insurance contracts. Separate account assets are included in “Cash and securities segregated for regulatory and other purposes” in the condensed consolidated statements of financial condition.
 
Liabilities for future benefits and unpaid claims include liabilities arising from reinsurance provided by the firm to other insurers. The firm had a receivable for $1.33 billion as of both August 2007 and November 2006, related to such reinsurance contracts, which is reported in “Receivables from customers and counterparties” in the condensed consolidated statements of financial condition. 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 $759 million and $786 million as of August 2007 and November 2006, respectively, related to such reinsurance contracts, which is reported in “Receivables from customers and counterparties” in the condensed consolidated statements of financial condition. Contracts to cede risks to reinsurers do not relieve the firm from its obligations to contract holders.
 
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 computed in accordance with AICPA SOP 03-1 and are based on total payments expected to be made less total fees expected to be assessed over the life of the contract.
 
(2) Includes $7.58 billion and $619 million related to consolidated investment funds as of August 2007 and November 2006, respectively.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Note 11.   Employee Benefit Plans
 
The firm sponsors various pension plans and certain other postretirement benefit plans, primarily healthcare and life insurance. The firm also provides certain benefits to former or inactive employees prior to retirement.
 
Defined Benefit Pension Plans and Postretirement Plans
 
Employees of certain non-U.S. subsidiaries participate in various defined benefit pension plans. These plans generally provide benefits based on years of credited service and a percentage of the employee’s eligible compensation. The firm also maintains a defined benefit pension plan for substantially all U.S. employees hired prior to November 1, 2003. As of November 2004, this plan has been closed to new participants and no further benefits will be accrued to existing participants. In addition, the firm has unfunded postretirement benefit plans that provide medical and life insurance for eligible retirees and their dependents covered under these programs.
 
The components of pension expense/(income) and postretirement expense are set forth below:
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
    2007     2006     2007     2006  
    (in millions)  
 
U.S. pension
                               
Service cost
  $     $     $     $  
Interest cost
    5       5       16       15  
Expected return on plan assets
    (8 )     (7 )     (24 )     (20 )
Net amortization
          2       1       5  
                                 
Total
  $ (3 )   $     $ (7 )   $  
                                 
Non-U.S. pension
                               
Service cost
  $ 18     $ 14     $ 55     $ 42  
Interest cost
    8       6       24       18  
Expected return on plan assets
    (8 )     (7 )     (25 )     (21 )
Net amortization
    2       3       7       8  
                                 
Total
  $ 20     $ 16     $ 61     $ 47  
                                 
Postretirement
                               
Service cost
  $ 7     $ 4     $ 16     $ 12  
Interest cost
    7       4       17       13  
Net amortization
    6       5       14       15  
                                 
Total
  $ 20     $ 13     $ 47     $ 40  
                                 
 
The firm expects to contribute a minimum of $34 million to its pension plans and $7 million to its postretirement plans in 2007.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Note 12.   Transactions with Affiliated Funds
 
The firm has formed numerous nonconsolidated investment funds with third-party investors. The firm generally acts as the investment manager for these funds and, as such, is entitled to receive management fees and, in certain cases, advisory fees, incentive fees or overrides from these funds. These fees amounted to $2.76 billion and $2.56 billion for the nine months ended August 2007 and August 2006, respectively. As of August 2007 and November 2006, the fees receivable from these funds were $627 million and $362 million, respectively. Additionally, the firm may invest alongside the third-party investors in certain funds. The aggregate carrying value of the firm’s interests in these funds was $9.84 billion and $3.94 billion as of August 2007 and November 2006, respectively. In the ordinary course of business, the firm may also engage in other activities with these funds, including, among others, securities lending, trade execution, trading, custody and acquisition financing. See Note 6 for the firm’s commitments related to these funds.
 
Note 13.   Regulation
 
The firm is regulated by the U.S. Securities and Exchange Commission as a Consolidated Supervised Entity (CSE). As such, it is subject to group-wide supervision and examination by the SEC and to minimum capital standards on a consolidated basis. As of August 2007 and November 2006, the firm was in compliance with the CSE capital standards.
 
The firm’s principal U.S. regulated subsidiaries include Goldman, Sachs & Co. (GS&Co.) and Goldman Sachs Execution & Clearing, L.P. (GSEC). GS&Co. and GSEC are registered U.S. broker-dealers and futures commission merchants subject to Rule 15c3-1 of the SEC and Rule 1.17 of the Commodity Futures Trading Commission, which specify uniform minimum net capital requirements, as defined, for their registrants, and also 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 August 2007 and November 2006, GS&Co. and GSEC had net capital in excess of their minimum capital requirements. In addition to its alternative minimum net capital requirements, GS&Co. is also required to hold tentative net capital in excess of $1 billion and net capital in excess of $500 million in accordance with the market and credit risk standards of Appendix E of Rule 15c3-1. GS&Co. is also required to notify the SEC in the event that its tentative net capital is less than $5 billion. As of August 2007 and November 2006, GS&Co. had tentative net capital and net capital in excess of both the minimum and the notification requirements.
 
Goldman Sachs Bank USA (GS Bank), a wholly owned industrial bank, is regulated by the Federal Deposit Insurance Corporation and the State of Utah Department of Financial Institutions and is subject to minimum capital requirements. As of August 2007, GS Bank was in compliance with all regulatory capital requirements. Substantially all of the firm’s bank deposits consist of U.S. dollar-denominated savings accounts at GS Bank. Savings accounts at GS Bank have no stated maturity and can be withdrawn upon short notice. The weighted average interest rates for bank deposits were 5.10% and 5.17% as of August 2007 and November 2006, respectively. The carrying value of bank deposits approximated fair value as of August 2007 and November 2006.
 
The firm has U.S. insurance subsidiaries that are subject to state insurance regulation 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 are regulated by the Bermuda Registrar of Companies. The firm’s insurance subsidiaries were in compliance with all regulatory capital requirements as of August 2007 and November 2006.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
The firm’s principal non-U.S. regulated subsidiaries include Goldman Sachs International (GSI) and Goldman Sachs Japan Co., Ltd. (GSJCL). GSI, the firm’s regulated U.K. broker-dealer, is subject to the capital requirements of the U.K.’s Financial Services Authority. GSJCL, the firm’s regulated Japanese broker-dealer, is subject to the capital requirements of Japan’s Financial Services Agency. As of August 2007 and November 2006, 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 August 2007 and November 2006, these subsidiaries were in compliance with their local capital adequacy requirements.
 
Note 14.   Business Segments
 
In reporting to management, the firm’s operating results are categorized into the following three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services.
 
Basis of Presentation
 
In reporting segments, certain of the firm’s business lines have been aggregated where they have similar economic characteristics and are similar in each of the following areas: (i) the nature of the services they provide, (ii) their methods of distribution, (iii) the types of clients they serve and (iv) the regulatory environments in which they operate.
 
The cost drivers of the firm taken as a whole — compensation, headcount and levels of business activity — are broadly similar in each of the firm’s business segments. Compensation and benefits expenses within the firm’s segments reflect, among other factors, the overall performance of the firm as well as the performance of individual business units. Consequently, pre-tax margins in one segment of the firm’s business may be significantly affected by the performance of the firm’s other business segments. The timing and magnitude of changes in the firm’s bonus accruals can have a significant effect on segment results in a given period.
 
The firm allocates revenues and expenses among the three segments. Due to the integrated nature of the business segments, estimates and judgments have been made in allocating certain revenue and expense items. 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.
 
The segment information presented in the table below is prepared according to the following methodologies:
 
  •  Revenues and expenses directly associated with each segment are included in determining pre-tax earnings.
 
  •  Net revenues in the firm’s 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. Net interest is included within segment net revenues as it is consistent with the way in which management assesses segment performance.
 
  •  Overhead expenses not directly allocable to specific segments are allocated ratably based on direct segment expenses.


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
Segment Operating Results
 
Management believes that the following information provides a reasonable representation of each segment’s contribution to consolidated pre-tax earnings and total assets:
 
                                     
        As of or for the
    As of or for the
 
        Three Months
    Nine Months
 
        Ended August     Ended August  
       
2007
   
2006
   
2007
   
2006
 
        (in millions)  
 
Investment
  Net revenues   $ 2,145     $ 1,288     $ 5,582     $ 4,285  
Banking
  Operating expenses     1,291       940       3,831       3,223  
 
       
                                   
    Pre-tax earnings   $ 854     $ 348     $ 1,751     $ 1,062  
 
       
                                   
    Segment assets   $ 5,051     $ 3,060     $ 5,051     $ 3,060  
 
       
                                   
                                     
Trading and
  Net revenues   $ 8,229     $ 4,841     $ 24,295     $ 18,928  
Principal
  Operating expenses     5,344       3,320       14,934       12,263  
                                     
Investments
  Pre-tax earnings   $ 2,885     $ 1,521     $ 9,361     $ 6,665  
                                     
    Segment assets   $ 712,236     $ 547,662     $ 712,236     $ 547,662  
                                     
                                     
Asset Management
  Net revenues   $ 1,960     $ 1,455     $ 5,369     $ 5,045  
and Securities
  Operating expenses     1,405       970       3,895       3,157  
 
       
                                   
Services
  Pre-tax earnings   $ 555     $ 485     $ 1,474     $ 1,888  
 
       
                                   
    Segment assets   $ 328,491     $ 247,587     $ 328,491     $ 247,587  
 
       
                                   
                                     
Total
  Net revenues (1)   $ 12,334     $ 7,584     $ 35,246     $ 28,258  
    Operating expenses (2)     8,075       5,222       22,697       18,683  
                                     
    Pre-tax earnings (3)   $ 4,259     $ 2,362     $ 12,549     $ 9,575  
                                     
    Total assets   $ 1,045,778     $ 798,309     $ 1,045,778     $ 798,309  
                                     
 
(1) Net revenues include net interest as set forth in the table below:
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions)  
 
Investment Banking
  $     $ 3     $ 1     $ 9  
Trading and Principal Investments
    653       473       1,404       952  
Asset Management and Securities Services
    688       480       1,857       1,500  
                                 
Total net interest
  $ 1,341     $ 956     $ 3,262     $ 2,461  
                                 
 
(2) Operating expenses include net provisions for a number of litigation and regulatory proceedings of $35 million and $(8) million for the three months ended August 2007 and August 2006, respectively, and $37 million and $40 million for the nine months ended August 2007 and August 2006, respectively, that have not been allocated to the firm’s segments.
 
(3) Pre-tax earnings include total depreciation and amortization as set forth in the table below:
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions)  
 
Investment Banking
  $ 32     $ 26     $ 99     $ 90  
Trading and Principal Investments
    208       192       608       526  
Asset Management and Securities Services
    43       33       129       113  
                                 
Total depreciation and amortization
  $ 283     $ 251     $ 836     $ 729  
                                 


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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
 
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. Accordingly, management believes that profitability by geographic region is not necessarily meaningful. In addition, as a significant portion of the firm’s activities require cross-border coordination in order to facilitate the needs of the firm’s clients, the methodology for allocating the firm’s profitability to geographic regions is dependent on the judgment of management.
 
Geographic results are generally allocated as follows:
 
  •  Investment Banking: location of the client and investment banking team.
 
  •  Fixed Income, Currency and Commodities, and Equities: location of the trading desk.
 
  •  Principal Investments: location of the investment.
 
  •  Asset Management: location of the sales team.
 
  •  Securities Services: location of the primary market for the underlying security.
 
The following table sets forth the total net revenues of the firm and its consolidated subsidiaries by geographic region allocated on the methodology described above:
 
                                 
    Three Months
    Nine Months
 
    Ended August     Ended August  
   
2007
   
2006
   
2007
   
2006
 
    (in millions)  
 
Net revenues
                               
Americas (1)
  $ 5,759     $ 4,483     $ 16,918     $ 15,815  
EMEA (2)
    3,449       1,957       11,081       7,495  
Asia
    3,126       1,144       7,247       4,948  
                                 
Total net revenues
  $ 12,334     $ 7,584     $ 35,246     $ 28,258  
                                 
 
 
  (1)  Substantially all relates to U.S. results.
 
  (2)  EMEA (Europe, Middle East and Africa).


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Report of Independent Registered Public Accounting Firm
 
To the Directors and Shareholders of
The Goldman Sachs Group, Inc.:
 
We have reviewed the accompanying condensed consolidated statement of financial condition of The Goldman Sachs Group, Inc. and its subsidiaries (the Company) as of August 31, 2007, the related condensed consolidated statements of earnings for the three and nine months ended August 31, 2007 and August 25, 2006, the condensed consolidated statement of changes in shareholders’ equity for the nine months ended August 31, 2007, the condensed consolidated statements of cash flows for the nine months ended August 31, 2007 and August 25, 2006, and the condensed consolidated statements of comprehensive income for the three and nine months ended August 31, 2007 and August 25, 2006. These condensed consolidated interim financial statements are the responsibility of the Company’s management.
 
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
 
Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
 
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition as of November 24, 2006 and the related consolidated statements of earnings, changes in shareholders’ equity, cash flows and comprehensive income for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of November 24, 2006 and the effectiveness of the Company’s internal control over financial reporting as of November 24, 2006; and in our report dated January 31, 2007, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of November 24, 2006, and the condensed consolidated statement of changes in shareholders’ equity for the year ended November 24, 2006, 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
October 5, 2007


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Item 2:   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
INDEX
 
         
    Page
   
No.
 
  55
       
  56
       
  58
       
  59
       
  59
       
  63
       
  65
       
  65
       
  66
       
  70
       
  77
       
  77
       
  82
       
  85
       
  90
       
  90
       
  93
       
  100
       
  103
       
  104


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Introduction
 
Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
 
Our activities are divided into three segments:
 
  •  Investment Banking.  We provide a broad range of investment banking services to a diverse group of corporations, financial institutions, investment funds, governments and individuals.
 
  •  Trading and Principal Investments.  We facilitate client transactions with a diverse group of corporations, financial institutions, investment funds, governments and individuals and take proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on these products. In addition, we engage in specialist and market-making activities on equities and options exchanges and clear client transactions on major stock, options and futures exchanges worldwide. In connection with our merchant banking and other investing activities, we make principal investments directly and through funds that we raise and manage.
 
  •  Asset Management and Securities Services.  We provide investment advisory and financial planning services and offer investment products (primarily through separate accounts and funds) across all major asset classes to a diverse group of institutions and individuals worldwide and provide prime brokerage services, financing services and securities lending services to institutional clients, including hedge funds, mutual funds, pension funds and foundations, and to high-net-worth individuals worldwide.
 
This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended November 24, 2006. References herein to the Annual Report on Form 10-K are to our Annual Report on Form 10-K for the fiscal year ended November 24, 2006.
 
Unless specifically stated otherwise, all references to August 2007 and August 2006 refer to our fiscal periods ended, or the dates, as the context requires, August 31, 2007 and August 25, 2006, respectively. All references to November 2006, unless specifically stated otherwise, refer to our fiscal year ended, or the date, as the context requires, November 24, 2006. All references to 2007, unless specifically stated otherwise, refer to our fiscal year ending, or the date, as the context requires, November 30, 2007.
 
When we use the terms “Goldman Sachs,” “we,” “us” and “our,” we mean The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, and its consolidated subsidiaries.


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Executive Overview
 
Three Months Ended August 2007 versus August 2006.  Our diluted earnings per common share were $6.13 for the third quarter of 2007 compared with $3.26 for the third quarter of 2006. Annualized return on average tangible common shareholders’ equity (1) was 36.6% and annualized return on average common shareholders’ equity was 31.6% for the third quarter of 2007.
 
Our results for the third quarter of 2007 reflected strong performance in each of our three segments. Net revenues in Trading and Principal Investments increased compared with the third quarter of 2006, reflecting significantly higher net revenues in both Fixed Income, Currency and Commodities (FICC) and Equities, partially offset by lower net revenues in Principal Investments. In FICC, net revenues were higher in each of its major businesses, particularly in currencies and interest rate products. Net revenues in mortgages were also significantly higher, despite continued deterioration in the market environment. Although we recognized significant losses on our non-prime mortgage loans and securities, these losses were more than offset by gains on short mortgage positions. Credit products included substantial gains from equity investments, including a gain of approximately $900 million related to the disposition of Horizon Wind Energy L.L.C. In addition, credit products included a loss of $1.71 billion ($1.48 billion, net of hedges) related to non-investment grade credit origination activities. Although the mortgage and corporate credit markets were characterized by significantly wider spreads and reduced levels of liquidity, FICC benefited from strong customer-driven activity and favorable market opportunities in certain businesses during the quarter. Net revenues in Equities were more than double the amount of net revenues in the third quarter of 2006. The increase reflected significantly higher net revenues in derivatives, reflecting strength across all regions, as well as in shares, due to higher commission volumes. During the quarter, Equities operated in an environment characterized by strong customer-driven activity and higher volatility.
 
Investment Banking produced record quarterly net revenues, driven by strong results in Financial Advisory. Net revenues in Financial Advisory were more than double the amount of net revenues in the third quarter of 2006, reflecting significantly higher client activity. Our investment banking transaction backlog decreased during the quarter, but was higher than at the end of 2006. (2)
 
Net revenues in Asset Management and Securities Services were also higher than the third quarter of 2006. Asset Management net revenues increased, reflecting higher management and other fees. During the quarter, assets under management increased $38 billion or 5% to a record $796 billion, with net inflows of $50 billion. Securities Services net revenues also increased, reflecting continued growth in our prime brokerage business.
 
Nine Months Ended August 2007 versus August 2006.  Our diluted earnings per common share were $17.75 for the nine months ended August 2007 compared with $13.12 for the same period last year. Annualized return on average tangible common shareholders’ equity (1) was 37.5% and annualized return on average common shareholders’ equity was 32.0% for the nine months ended August 2007.
 
Our results for the first nine months of 2007 reflected growth in each of our three segments, primarily driven by Trading and Principal Investments and Investment Banking. The increase in Trading and Principal Investments reflected higher net revenues in Equities, FICC and Principal Investments. The increase in Equities reflected significantly higher net revenues in principal strategies, shares and derivatives. During the first nine months of 2007, Equities operated in an environment characterized by strong customer-driven activity, higher volatility and generally higher equity prices. The increase in FICC reflected significantly higher net revenues in credit products, currencies, interest rate products and mortgages, partially offset by lower, but strong net revenues in commodities. During the first nine months of 2007, FICC operated in an environment generally characterized by strong customer-driven activity and favorable market opportunities. However, during the year, the subprime sector of the mortgage market experienced weakness and, during the third quarter, the broader credit markets were characterized by significantly wider spreads and reduced levels of liquidity. The increase in Principal Investments reflected significantly higher gains from corporate and, to a lesser extent, real estate principal investments.


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The increase in Investment Banking reflected strong client activity, primarily in Financial Advisory. Net revenues in Asset Management and Securities Services also increased. The results in Securities Services reflected continued strength in our prime brokerage business. Asset Management also produced strong results, but net revenues were essentially unchanged as higher asset management and other fees were offset by significantly lower incentive fees.
 
Though we generated particularly strong results in the first nine months of 2007, our business, by its nature, does not produce predictable earnings. Our results in any given period can be materially affected by conditions in global financial markets and economic conditions generally. For a further discussion of the factors that may affect our future operating results, see “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K.
 
 
 
(1)  Return on average tangible common shareholders’ equity (ROTE) is computed by dividing net earnings (or annualized net earnings for annualized ROTE) applicable to common shareholders by average monthly tangible common shareholders’ equity. See “— Results of Operations — Financial Overview” below for further information regarding our calculation of annualized ROTE.
 
(2)  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.


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Business Environment
 
The global economy continued to grow at a solid pace during our third quarter of fiscal 2007, although the pace appeared to moderate and conditions in the financial markets became more challenging in the latter part of the quarter. Business confidence increased slightly from already high levels at the beginning of our fiscal quarter, but declined towards the end of the quarter in the U.S. and Europe. Consumer confidence decreased from generally high levels during the quarter in most countries. The fixed income environment was characterized by significantly wider spreads and reduced levels of liquidity in the mortgage and corporate credit markets. In addition, after rising in the first half of our fiscal quarter, 10-year yields in the U.S., Europe and Japan declined sharply, ending the quarter lower. Many equity markets experienced high volatility during the quarter. Major markets in the U.S., Europe and Japan fell during the second half of our fiscal quarter and generally ended the quarter lower. However, equity markets in many larger emerging market countries showed resilience with a number of them posting gains for the quarter. In Investment Banking, corporate activity levels in mergers and acquisitions remained strong during the quarter. In addition, equity underwriting activity remained solid, but debt underwriting activity declined sharply, particularly in leveraged finance, during our fiscal quarter.
 
In the U.S., economic growth showed signs of strengthening at the beginning of our fiscal quarter, driven by higher net exports, but the pace of growth appeared to slow later in the quarter and the housing market continued to weaken. Business confidence declined and, in August, consumer confidence fell sharply, ending the quarter lower. The labor market showed signs of deterioration as unemployment levels increased slightly during the quarter and payroll data showed some signs of weakness. However, inflationary pressures appeared to be contained, as evidenced by measures of core inflation. In response to concerns over liquidity in the financial markets, the U.S. Federal Reserve reduced its discount rate by 50 basis points in August. The federal funds target rate remained unchanged during our fiscal quarter at 5.25%. Long-term bond yields declined, with the 10-year U.S. Treasury note yield ending our quarter down 32 basis points at 4.54%. In the equity markets, the S&P 500 Index and Dow Jones Industrial Average decreased by 3% and 1%, respectively, while the NASDAQ Composite Index ended the quarter 2% higher.
 
In the Eurozone countries, economic growth continued at a modest pace relative to the first quarter of our fiscal year. Surveys of business activity reflected a slight decrease, albeit from high levels. Unemployment levels declined and inflationary pressures remained contained as evidenced by core inflation measures. The European Central Bank (ECB) increased its main refinancing operations rate by 25 basis points during our fiscal quarter to 4.00%. The ECB also engaged in open market operations to a greater extent than usual in August, in response to liquidity concerns in the financial markets. In the U.K., the pace of economic growth appeared to remain solid during our third quarter. Inflationary pressures, which had been high in the early part of our fiscal year, showed signs of easing toward the end of the quarter. The Bank of England raised its official bank rate by 25 basis points to 5.75%. Equity markets in both the U.K. and continental Europe declined during our fiscal quarter and long-term bond yields ended the quarter slightly lower.
 
In Japan, real gross domestic product growth continued to decelerate during our fiscal quarter. Although household income rose moderately and unemployment levels decreased, measures of consumption and activity in the housing sector declined during the quarter. Consumer prices were essentially unchanged from our prior quarter. The Bank of Japan left its target overnight call rate unchanged at 0.50% during the quarter. The yield on 10-year Japanese government bonds rose during the first half of our fiscal quarter, but ended the quarter lower. The Nikkei 225 Index ended the quarter 5% lower.
 
In China, economic growth remained strong driven primarily by continued strength in net exports and signs of an improvement in consumption. The People’s Bank of China raised its one-year benchmark lending rate by 45 basis points during our fiscal quarter to 7.02% and also raised its reserve requirement ratio by 100 basis points. The Shanghai Composite Index posted another sharp increase, ending our fiscal quarter 25% higher. Elsewhere in Asia, equity markets generally ended the quarter higher.


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Critical Accounting Policies
 
Fair Value
 
The use of fair value to measure financial instruments, with related unrealized gains or losses generally recognized in “Trading and principal investments” in our condensed consolidated statements of earnings, is fundamental to our financial statements 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 (the exit price). Instruments that we own (long positions) are marked to bid prices, and instruments that we have sold, but not yet purchased (short positions) are marked to offer prices.
 
We adopted SFAS No. 157, “Fair Value Measurements,” as of the beginning of 2007. See Notes 2 and 3 to the condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for further information on SFAS No. 157.
 
In determining fair value, we separate our “Financial instruments, owned at fair value” and “Financial instruments sold, but not yet purchased, at fair value” into two categories: cash instruments and derivative contracts, as set forth in the following table:
 
Financial Instruments by Category
(in millions)
 
                                 
    As of August 2007   As of November 2006
        Financial
      Financial
    Financial
  Instruments Sold,
  Financial
  Instruments Sold,
    Instruments
  but not Yet
  Instruments
  but not Yet
    Owned, at
  Purchased, at
  Owned, at
  Purchased, at
    Fair Value   Fair Value   Fair Value   Fair Value
 
Cash trading instruments
  $ 304,823     $ 108,723     $ 247,031     $ 87,244  
SMFG (1)
    3,690       2,688  (6)     4,505       3,065  (6)
ICBC
    6,281  (2)           5,194  (2)      
Other principal investments
    9,232  (3)           4,263  (3)      
                                 
Principal investments
    19,203       2,688       13,962       3,065  
                                 
Cash instruments
    324,026       111,411       260,993       90,309  
Exchange-traded
    17,379       16,644       14,407       13,851  
Over-the-counter
    69,646       68,051       53,136       51,645  
                                 
Derivative contracts
    87,025  (4)     84,695  (7)     67,543  (4)     65,496  (7)
                                 
Total
  $ 411,051  (5)   $ 196,106     $ 328,536  (5)   $ 155,805  
                                 
 
 
(1) The fair value of our Japanese yen-denominated investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG) includes the effect of foreign exchange revaluation, for which we maintain an economic currency hedge.
 
(2) Includes interests of $3.97 billion and $3.28 billion as of August 2007 and November 2006, respectively, held by investment funds managed by Goldman Sachs. The fair value of our investment in the ordinary shares of Industrial and Commercial Bank of China Limited (ICBC), which trade on The Stock Exchange of Hong Kong, includes the effect of foreign exchange revaluation for which we maintain an economic currency hedge.


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(3) The following table sets forth the principal investments (in addition to our investments in SMFG and ICBC) included within the Principal Investments component of our Trading and Principal Investments segment:
 
                                                 
    As of August 2007   As of November 2006
   
Corporate
 
Real Estate
 
Total
 
Corporate
 
Real Estate
 
Total
    (in millions)   (in millions)
 
Private
  $ 5,627     $ 1,695     $ 7,322     $ 2,741     $ 555     $ 3,296  
Public
    1,863       47       1,910       934       33       967  
                                                 
Total
  $ 7,490     $ 1,742     $ 9,232     $ 3,675     $ 588     $ 4,263  
                                                 
 
(4) Net of cash received pursuant to credit support agreements of $37.04 billion and $24.06 billion as of August 2007 and November 2006, respectively.
 
 
(5) Excludes assets related to consolidated investment funds of $17.11 billion and $6.03 billion as of August 2007 and November 2006, respectively, for which Goldman Sachs does not bear economic exposure.
 
 
(6) Represents an economic hedge on the shares of common stock underlying our investment in the convertible preferred stock of SMFG.
 
 
(7) Net of cash paid pursuant to credit support agreements of $17.66 billion and $16.00 billion as of August 2007 and November 2006, respectively.
 
 
Cash Instruments.  Cash instruments include cash trading instruments, public principal investments and private principal investments.
 
  •  Cash Trading Instruments.  Our cash trading instruments are generally valued using quoted market prices in active markets, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include most U.S. government and agency securities, many other sovereign government obligations, active listed equities and most money market securities.
 
The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, most mortgage products, certain corporate bank and bridge loans, certain loan commitments, less liquid listed equities, state, municipal and provincial obligations, and most physical commodities.
 
Certain cash trading instruments trade infrequently and therefore have little or no price transparency. Such instruments include certain corporate bank and bridge loans, certain loan commitments, less liquid mortgage whole loans, distressed debt instruments, private equity and real estate fund investments. The transaction price is used as the best estimate of fair value at inception. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so that the model value at inception equals the transaction price. The valuation is adjusted only when changes to inputs and assumptions are corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets, and changes in financial ratios or cash flows.
 
For positions that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.


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  •  Public Principal Investments.  Our public principal investments held within the Principal Investments component of our Trading and Principal Investments segment tend to be large, concentrated holdings resulting from initial public offerings or other corporate transactions, and are valued based on quoted market prices. For positions that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
 
Our two most significant public principal investments are our investment in the convertible preferred stock of SMFG and our investment in the ordinary shares of ICBC.
 
Our investment in SMFG is valued using a model that is principally based on SMFG’s common stock price. As of August 2007, the conversion price of our SMFG convertible preferred stock into shares of SMFG common stock was ¥318,800. This price is subject to downward adjustment if the price of SMFG common stock at the time of conversion is less than the conversion price (subject to a floor of ¥105,100). As a result of downside protection on the conversion stock price, the relationship between changes in the fair value of our investment and changes in SMFG’s common stock price would be nonlinear for a significant decline in the SMFG common stock price. As of August 2007, we had hedged approximately 70% of the common stock underlying our investment in SMFG and there were no restrictions on our ability to hedge the remainder.
 
Our investment in ICBC is valued using the quoted market prices adjusted for transfer restrictions. The ordinary shares acquired from ICBC are subject to transfer restrictions that, among other things, prohibit any sale, disposition or other transfer until April 28, 2009. From April 28, 2009 to October 20, 2009, we may transfer up to 50% of the aggregate ordinary shares of ICBC that we owned as of October 20, 2006. We may transfer our remaining shares after October 20, 2009. A portion of our interest is held by investment funds managed by Goldman Sachs.
 
  •  Private Principal Investments.  Our private principal investments held within the Principal Investments component of our Trading and Principal Investments segment include investments in private equity, debt and real estate. By their nature, these investments have little or no price transparency. We value such instruments initially at transaction price and adjust the valuation when evidence is available to support such adjustments. Such evidence includes transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets, and changes in financial ratios or cash flows.
 
Derivative Contracts.  Derivative contracts can be exchange-traded or over-the-counter (OTC). We generally value exchange-traded derivatives within portfolios using models which calibrate to market clearing levels and eliminate timing differences between the closing price of the exchange-traded derivatives and their underlying cash instruments.
 
OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. We generally use similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be verified and model selection does not involve significant management judgment.


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Certain OTC derivatives trade in less liquid markets with limited pricing information, and the determination of fair value for these derivatives is inherently more difficult. Where we do not have corroborating market evidence to support significant model inputs and cannot verify the model to market transactions, transaction price is used as the best estimate of fair value at inception. Accordingly, when a pricing model is used to value such an instrument, the model is adjusted so that the model value at inception equals the transaction price. Subsequent to initial recognition, we only update valuation inputs when corroborated by evidence such as similar market transactions, third-party pricing services and/or broker or dealer quotations, or other evidence such as empirical market data. In circumstances where we cannot verify the model value to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value. See “— Derivatives” below for further information on our OTC derivatives.
 
When appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
 
Other Financial Assets and Financial Liabilities.  In addition to “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” we have elected to account for certain of our other financial assets and financial liabilities at fair value under SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140,” or SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” Such financial assets and financial liabilities include (i) certain unsecured short-term borrowings, consisting of all promissory notes and commercial paper and certain hybrid financial instruments; (ii) certain other secured financings (primarily transfers accounted for as financings rather than sales under SFAS No. 140 and debt raised through our William Street program); (iii) certain unsecured long-term borrowings, including prepaid physical commodity transactions; (iv) resale and repurchase agreements; (v) securities borrowed and securities loaned within Trading and Principal Investments, consisting of our matched book activities and certain firm financing activities; (vi) securities held by Goldman Sachs Bank USA (previously accounted for as available-for-sale); (vii) certain receivables from customers and counterparties (transfers accounted for as secured loans rather than purchases under SFAS No. 140); and (viii) in general, investments acquired after the adoption of SFAS No. 159 where we have significant influence over the investee and would otherwise apply the equity method of accounting. See “— Recent Accounting Developments” below for a discussion of the impact of adopting SFAS No. 159.
 
Controls Over Valuation of Financial Instruments.  A control infrastructure, independent of the trading and investing functions, is fundamental to ensuring that our financial instruments are appropriately valued and that fair value measurements are reliable. This is particularly important where prices or valuations that require inputs are less observable.
 
We employ an oversight structure that includes appropriate segregation of duties. Senior management, independent of the trading functions, is responsible for the oversight of control and valuation policies and for reporting the results of these policies to our Audit Committee. We seek to maintain the necessary resources to ensure that control functions are performed to the highest standards. We employ procedures for the approval of new transaction types and markets, price verification, review of daily profit and loss, and review of valuation models by personnel with appropriate technical knowledge of relevant products and markets. These procedures are performed by personnel independent of the revenue-producing units. For trading and principal investments where prices or valuations that require inputs are less observable, we employ, where possible, procedures that include comparisons with similar observable positions, analysis of actual to projected cash flows, comparisons with subsequent sales and discussions with senior business leaders. See “— Market Risk” below for a further discussion of how we manage the risks inherent in our trading and principal investing businesses.


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Goodwill and Identifiable Intangible Assets
 
As a result of our acquisitions, principally SLK LLC (SLK) in 2000, The Ayco Company, L.P. (Ayco) in 2003, Cogentrix Energy, Inc. (Cogentrix) in 2004, National Energy & Gas Transmission, Inc. (NEGT) in 2005 and our variable annuity and variable life insurance business in 2006, we have acquired goodwill and identifiable intangible assets. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date.
 
Goodwill.  We test the goodwill in each of our operating segments for impairment at least annually in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” by comparing the estimated fair value of each operating segment with its estimated net book value. We derive the fair value of each of our operating segments primarily based on price-earnings multiples. We derive the net book value of our operating segments by estimating the amount of shareholders’ equity required to support the activities of each operating segment. Our last annual impairment test was performed during our 2006 fourth quarter and no impairment was identified.
 
The following table sets forth the carrying value of our goodwill by operating segment:
 
Goodwill by Operating Segment
(in millions)
 
                 
    As of  
    August
    November
 
   
2007
   
2006
 
 
Investment Banking
               
Financial Advisory
  $     $  
Underwriting
    125       125  
Trading and Principal Investments
               
FICC
    117       136  
Equities (1)
    2,381       2,381  
Principal Investments
          4  
Asset Management and Securities Services
               
Asset Management (2)
    421       421  
Securities Services
    117       117  
                 
Total
  $ 3,161     $ 3,184