The Goldman Sachs Group, Inc.
Q3 2007 Earnings Call Transcript

Published: 20 Sep 2007

[Samuel Robinson:]

Good morning. This is Samuel Robinson from Goldman Sachs Welcome to our third quarter earnings conference call. Today's call may include forward-looking statements. This statements represents the firm's belief regarding future events that by their nature are uncertain and outside of the firm's control. The firm's actual results and financial condition may differ -- possibly materially -- from what is indicated in those forward-looking statements. For a discussion of some of the risks and factors that could affect the firm's future results, please see the description of risk factors in our current annual report on Form 10-K for our fiscal year ended November, 2006. I would also direct to you read the forward-looking disclaimer in our quarterly earnings release, particularly as it relates to our investment banking transaction backlog. And, you should also read the information on the calculation of non-GAAP financial measures that is posted on the Investor Relations portion of our website, gs.com. This audio cast is copyrighted material of the Goldman Sachs Group Inc. and may not be duplicated, reproduced, or rebroadcast without our consent. Let me now ask David Viniar, our Chief Financial Officer, to review the firm's third quarter results.

[David Viniar:]

Thanks, Samuel. Good morning and I would like to thank all of you for listening. I will give a brief review of our results, and then we'll be happy to take your questions. I am pleased to report a very strong quarter for Goldman Sachs. Third quarter net revenues were $12.3 billion, our second-highest result ever. Net earnings were $2.9 billion and earning per diluted share were $6.13. For the quarter, return on tangible equity was 36.6% and return on common equity was 31.6%. Before I address each business in detail, I'd like to make a few comments about our overall performance in the third quarter. First, although there has rightly been a great deal of focus on the challenges all markets participants faced during August, it is important to remember that for many of our businesses, the environment was very favorable. Second, for some of our clients and businesses, the heightened volatility in volumes later in the quarter resulted in a higher level of activity. Third, as you have heard me say many times before, we benefit from our client franchise and our broad business and geographic diversity. There were many examples of this in the third quarter, but I would make particular mention of our international businesses. Finally, we're able to remain focused and nimble in constantly changing conditions. This combination of factors allowed us to produce very strong results. Let me now review each of our major businesses. Investment banking produced record net revenues of $2.1 billion in the quarter. Third quarter advisory revenues were a record $1.4 billion, nearly double last quarter's performance. These results, which were 64% better than our previous record, reflect contributions from a significant number of deals that closed during the quarter. These included

[Operator:]

Your first question comes from Guy Moszkowski - Merrill Lynch.

[Guy Moszkowski:]

You alluded to $1.7 billion of leverage finance writedowns before fee impact, is that right?

[David Viniar:]

That's correct. That is after the impact.

[Guy Moszkowski:]

That is what I meant by after fees. I was wondering if you could give us the impact the gross impact before the fees?

[David Viniar:]

It would be about $2.4 billion.

[Guy Moszkowski:]

Thanks. That's helpful.

[David Viniar:]

No problem.

[Guy Moszkowski:]

There has been mention at several of the other firms that have reported this week benefits of the mark on structured liabilities from your own spread widening. Can you talk a little bit about the impact that would have had on Goldman on the fixed income and then separately, the equities business?

[David Viniar:]

The total impact for us, Guy, is pretty immaterial in the context of our quarter. It was a little bit under $300 million in total, and I actually don't have the exact breakdown because it depends on which business unit the structure notes are issued from. Some portion that far would be in the various businesses within FIC and some portion within equities, but the total is less than $300 million.

[Guy Moszkowski:]

You mentioned the backlog being down somewhat versus the prior quarter. Is that mostly because of deals that completed or was a large part of that because deals were either pulled or probability adjusted downward?

[David Viniar:]

Well, it is both. Part of it was because of deals being completed. On the debt underwriting side, which was the biggest part of the decline, a substantial portion was because the fees that were expected to be earned on some of the leveraged finance commitments are now not expected to be earned.

[Guy Moszkowski:]

Finally, just a question on your thoughts on the outlook for some of the higher margin structured fixed income products over the next few quarters.

[David Viniar:]

Guy, it is always hard to predict what the next quarter or two will bring. I am always more comfortable predicting what I think is going to happen over the medium to long term. I think it is pretty clear there is going to be lower CDO activity in the next quarter than there was a year ago. I don't think any of those businesses are gone. I think that there is going to be some shakeout and I think and they will be slower over the next couple of quarters, and then we'll see.

[Operator:]

Your next question comes from Susan Katzke - Credit Suisse.

[Susan Katzke:]

I was wondering David, with some of the larger LBO financings coming to market post Labor Day, are you willing to discuss at all the validation of the marks that you took on those commitments at the end of the August?

[David Viniar:]

Sure. We haven't sold that much since the end of the quarter, but we have had reasonable sized sales of the some of the positions, and everything that we have sold so far has been either at or slightly above our marks.

[Susan Katzke:]

Second on the comp ratio, I was a little surprised that it stuck at the 48% level. Can you just walk us back once again through your policy or philosophy on comp accruals vis-a-vis the competitive environment? Clearly with Goldman's revenue this is year you have the wherewithal to out pay any of your peers. How much does that factor in?

[David Viniar:]

The competition for talent remains there. We are in a competitive environment. We compete not just with securities firms, we compete with hedge funds and private equity firms and all other types of financial firms. When we look and we do our calculation, as you know, we are accrued at 48% because as we sit here today that's our best estimate of what we think we might have to pay. Of course you know the great majority of our compensation is bonuses. That is calculated and done at the end of each year, so ultimately our compensation expense will be ultimately what we pay but we have no better information than 48% today.

[Operator:]

Your next question will come from the line of Glen Schorr - UBS.

[Glen Schorr:]

First of all, Samuel did an awesome job.

[David Viniar:]

Samuel thanks you.

[Glen Schorr:]

Where does the quant investment show up?

[David Viniar:]

It is in equities.

[Glen Schorr:]

In equities, so that will get a mark-to-market on a quarterly basis. Now, did I read right somewhere in the press you're up 16% since you made the investment?

[David Viniar:]

16% from when we invested until the end of the quarter.

[Glen Schorr:]

Until the end of the quarter. Great. Like I said, it will run through equities up and down each quarter.

[David Viniar:]

Correct.

[Glen Schorr:]

In asset management, the $19 billion in in-flows the long-term money side, qualitatively, driven via the new funds that you've been talking about or old funds, a combination?

[David Viniar:]

It depends on which sector. In alternative investments the inflows, a lot of that was in new funds we raised. In equities and fixed income it would largely be inflows into the current mutual funds or fixed income funds or other funds we have.

[Glen Schorr:]

In the press release or in the news, CoGentrics, we know the cost but I don't think I saw the sale price anywhere. Is that disclosed?

[David Viniar:]

I don't believe so.

[Operator:]

Your next question comes from Roger Freeman - Lehman Brothers.

[Roger Freeman:]

With respect to your position on credit, you have been open in the past about saying your stance was one of bearishness. Where would you place yourself today?

[David Viniar:]

That was on mortgages.

[Roger Freeman:]

I meant on mortgages.

[David Viniar:]

I think what I would say is we are a lot closer to the bottom than where we were at the end of the second quarter. There is still I think some things that have to be worked through the market, and we haven't seen the end of that, but we're a lot closer to the bottom.

[Roger Freeman:]

In terms of the GO and Global Alpha Funds, can you tell us where they ended for the month of August and relative to where they bottomed? You're up 16% since you made the investment in GO.

[David Viniar:]

GO ended the quarter, I believe it was down a little bit over 20% for the quarter and Alpha was down about 30% for the quarter.

[Roger Freeman:]

When you made the investment in GO, obviously that was a vote of confidence in the fund. At the time, you had some redemption notice periods coming up. Can you speak to whether there were any significant redemption requests?

[David Viniar:]

In Alpha the redemption requests are a little bit over $1.6 billion and in the other funds given where the funds are, probably not very material to the funds.

[Roger Freeman:]

Can you walk through the loan commitments from the end of the second quarter to the end of the third quarter and what fell away and what got funded, what got resized?

[David Viniar:]

I will give you the numbers, but then I also want to make a comment. The numbers were we had about $51 billion of commitments at the end of the second quarter. There was approximately $28 billion that went away either because the deals closed, syndicated, the deals went away, and then there were $19 billion of new commitments which left us with a total of $42 billion at the end of the third quarter. Now, the only comment I want to make is there has been some talk about the fact that that's actually relevant because things you might have committed to in the third quarter might have had better terms than in the second quarter. But remember, because we mark everything to market based on where we are today, at the end of the third quarter it is the same. Whenever we commit to them, it doesn't really matter. They're all marked to what their current value is and where we can exit them today.

[Roger Freeman:]

Can you talk to any changes in level 2/level 3 assets and particularly any shift between 2 and 3?

[David Viniar:]

Let me make some comments there as best I can, because it is very technical. Our level 3 assets at the end of the second quarter were roughly 6% of our balance sheet. We expect them to increase; again we're still working through these numbers, but we expect them to increase to around 7% at the end of the third quarter. The great bulk of that increase is going to be from leverage loans. One of the things I want to clarify is what's in these categories. Again, there is some confusion. Remember, level 1 assets are limited to actively traded, generally quoted instruments like listed equities on the New York Stock Exchange that you pick up the newspaper and find the quote. Virtually all derivatives by definition can't be level 1. Exchange-traded options can be, but interest rate swaps which trade in very, very liquid markets where someone can easily get prices on it by definition are not Level 1 securities, are Level 2 securities. Most of our mortgage inventory, for example, because we have reasonable external pricing is level 2. Level 3, although it does include some derivatives, and it includes derivatives where at least one input is unobservable, it also included a lot of assets that people understand quite well, so leverage loans are in level 3. Real estate which is valued using discount cash flow and has been for 100 years, is in level 3, and corporate principal investments are in level 3. If you took those three categories of assets for us, it would make up the majority of our level 3 assets, so I just want to clarify that a little bit.

[Operator:]

Your next question will come from the line of Meredith Whitney with CIBC.

[Meredith Whitney:]

Good morning. Three questions, please. It was a very efficient call. Thanks.

[David Viniar:]

You're welcome.

[Meredith Whitney:]

The level of conviction you have with your marks, can you talk about that in terms of historical context and regression analysis you've done in different environments where you've taken similar marks and where that has ended up being relative to market value?

[David Viniar:]

Again, there has been a lot of confusion about this. Marking our assets to market is in some ways the life blood of what we do. We mark all of our assets to market, our traders mark our assets. We have a controllers' department that has around 1,000 people that is responsible for verifying the prices of all of the marks of all of the assets at Goldman Sachs, and we do that not just in market turmoil. We do it every day, and we can't manage our risk if we don't know the value of our assets, and so our whole risk management process is predicated on being able to value the assets that you have, so we do it; we do it carefully. It is reviewed by very, very senior people. It is then reviewed by our auditors, and as I said, we have ongoing discussion with the SEC as our main regulators about the methodology for marking and for verifying our prices -- and not just this quarter, but we have forever and we continue to. One of the things that we do in addition to marking and using all of the evidence that we have, most of which is actual market trades, is we back test. So we look at assets that we sell compared to where they were marked. Obviously that couldn't change what you did, but informs us of whether or not we've been doing it accurately over time. Over time what we find is never say all, but substantially all of the sales that we see are at or slightly above where we have assets marked.

[Meredith Whitney:]

That's very helpful. Thanks. Getting back to one of Glen's question was CoGentrics, can you give us an “ish” type of context which is, is it horizon-ish like or Linden Power like in gain, or will we even notice it?

[David Viniar:]

How about if I tell you it is profitable- “ish”.

[Meredith Whitney:]

Funny-“ish” enough.

[David Viniar:]

That's as close as we're going to get.

[Meredith Whitney:]

My last question is on distressed opportunities within the mortgage space and outside the mortgage space with larger debt markets, obviously issues are trading at significant discounts to where they're cash flowing. Can you give a sense of the timing? This is more of a market question, a timing of when a lot of funds that have been raised to invest in these distressed assets will really start to move so we will see stabilization of these markets?

[David Viniar:]

That's a very good question, Meredith, because clearly there are distressed assets out there. There are also assets that I would say are not distressed assets that are trading at distressed prices, so there are a lot of people looking on some of these assets like the leverage loans, one of the things that's going on is there are a lot of distressed buyers out there, but the holders don't believe they are distressed assets because they're very good assets. That's one of the reasons there is a supply/demand imbalance because people have not yet come to an agreement on what price the sellers will sell at, where the buyers will actually buy. I think it is getting closer, and I think we're getting to the point where at least in my view the buyers are becoming more realistic about price and therefore I think you will see some of the that log jam be broken, but I think it is going to happen over the next couple months.

[Operator:]

Your next question will come from the line of Mike Mayo with Deutsche Bank.

[Mike Mayo:]

If you can fix my math here, you took $2.4 billion of writedowns gross of fees on those leveraged loans, and should we use a denominator of the $42 billion period end, which implies a 6% markdown?

[David Viniar:]

Let's just do the math first. The writedowns were on the commitments. It was also on funded loans which we had about $10 billion at the end of the quarter but also some that we had sold already, so you can't completely do that math but I will tell you the bulk of the writedowns were on unfunded commitments; not all, but the bulk. The only thing I will tell you, Mike, is that that math, all it will do is give you a mathematical answer to what the numerator over the denominator tells you. It won't tell you much else. As I mentioned, we mark every single position individually. They all have different characteristics. Some will be marked at 98, some at 96 and some 94 and some at 90 and at 88 and 86, and every one is completely different and so I think doing the mathematical calculation might be interesting, but it won't tell you very much.

[Mike Mayo:]

Are we in the ballpark if we say the average writedown per dollar of leveraged loan is 5% to 6%?

[David Viniar:]

The mathematical calculation is correct. Yes, you would be correct. That is a true statement if you said the averages, you just take the numerator over the dominator but I will tell you, it will not inform very much if you think we wrote everything down by 5%. There are some that we did and some we wrote down by less and some we wrote down by more. Mathematically you're correct.

[Mike Mayo:]

Separately on international, how did non-U.S. do this quarter versus the second quarter?

[David Viniar:]

Our international businesses were about 53% of our revenues during the quarter. I will give you two comments there. One, just a note of caution that that number could easily bounce around within a few percent here or there. It includes lots of transactions that are cross border transactions where you have a non-U.S. buyer and a U.S. seller or vice versa, a non-U.S. company issuing equities in the U.S.; we have global trading books. So as I said, the number could bounce around. It is certainly does indicate the where the business is going which is that the non-U.S. businesses are growing faster than the businesses within the U.S., so I think it does inform you by its direction more than by its precision.

[Mike Mayo:]

In your opening comments you stressed, I think you said something like especially international, was strong but the proportion is kind of similar?

[David Viniar:]

Because it continues to grow. The percentage of revenues outside the U.S. continues to grow. For example, the $ 1.7 billion of losses in leveraged loans were substantially in the United States.

[Mike Mayo:]

Any one region you want to highlight? China is kind of a long-term story, but that market has done well. Is there any way to capitalize more aggressively there than you're already doing?

[David Viniar:]

I think we are very, very focused on China. We think we have a terrific team there. We think we have a terrific franchise in China. We think we were there ahead of most of our competitors and we continue to be extremely focused and it is certainly one of -- if not the -- biggest focus in the firm and highest growth areas we have.

[Mike Mayo:]

Last question, in mortgages you have been under represented and that helped you and also being short on mortgages obviously helped you. How do you think about the mortgage businesses? Is now the right time to expand in that business more aggressively? Also can you size what kind of gain you might have made by shorting mortgages?

[David Viniar:]

Mortgages is an important business for Goldman Sachs. It always has been, but in the context of all of our other businesses, it is certainly smaller than some of our competitors. We think that there are going to be opportunities in the mortgage business. There is certainly going to be opportunities to buy distressed assets. Timing is going to be very important, and it is something we are certainly looking at right now. We'll continue to look at it and consider it over time. Sorry, but one thing we don't do is disclose individual business units and so I can't tell you the actual profits of the shorts.

[Mike Mayo:]

Was this one desk or is this a whole unit or a whole asset class up to the CEO?

[David Viniar:]

It was across the capital structure of mortgages.

[Operator:]

At this time, I will turn the call back over to Mr. Robinson.

[Samuel Robinson:]

Thanks very much for joining our call. Please call Investor Relations with any further questions.