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The Goldman Sachs Group, Inc. (NYSE:GS)

F3Q09 Earnings Call

October 15, 2009 9:00 am ET

Executives

Dane Holmes - Director, Investor Relations

David Viniar – Chief Financial Officer

Analysts

Glenn Schorr - UBS

Guy Moszkowski - BAS-ML

Roger Freeman - Barclays Capital

Howard Chen - Credit Suisse

Michael Mayo - Calyon Securities

Chris Kotowski - Oppenheimer & Co.

Michael Carrier - Deutsche Bank

Meredith Whitney - Meredith Whitney Advisory Group

Robert Lee - KBW

Steve Stelmach - FBR Capital Markets

Douglas Sipkin - Pali Research

Kian Abouhossein - JP Morgan

Matt Burnell - Wells Fargo Securities

Michael Hecht - JMP Securities

Operator

Good morning. I would like to welcome everyone to the Goldman Sachs third quarter 2009 earnings conference call. (Operator Instructions) This call is being recorded today, Thursday, October 15, 2009. Mr. Holmes, you may begin your conference.

Dane Holmes

Good morning. This is Dane Holmes, Director of Investor Relations at Goldman Sachs. Welcome to our third quarter earnings conference call.

Today's call may include forward-looking statements. These statements represent 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 these 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 the fiscal year ended November 2008. I would also direct you to read the forward-looking disclaimers 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 Web site at www.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.

Our Chief Financial Officer, David Viniar, will now review the firm's results.

David Viniar

I would like to thank all of you for listening today. I will give an overview of our third quarter results and then take your questions.

I am pleased to report strong third quarter results for Goldman Sachs. Net revenues were $12.4 billion, net earnings were $3.2 billion, and earnings per diluted share were $5.25. Our annualized return on common equity was 21.4%.

Our results in the third quarter reflect a continued demand for expert advice and execution for our global client base. Throughout this financial crisis, we have maintained an unwavering focus on serving our clients. We believe in staying close to our clients during periods of market turmoil reinforces the strength of our franchise. Our client relationships have been critical to our recent performance and will remain a key driver of our future performance.

Our FICC [Fixed Income, Currency, and Commodities] business continues to be a strong performer and many of the favorable conditions that benefited the businesses during the first half of 2009 continued in the third quarter.

The competitive environment remained fragmented and available risk capital was limited. Consequently, we continued to experience elevated market share and attractive margin dynamics within several of our market-making businesses. The depth and diversity of our FICC business continued to be a key contributor to our performances here.

Third quarter results, for example, include a record performance in mortgages and our second-best quarterly performance in credit. Rates, currency, and commodities each posted one of their two best quarterly performances in either the first or second quarter.

During the third quarter the S&P, Dow Jones, and FTSE posted their strongest quarterly gains in over a decade, which helped drive solid results in equities and principal investments.

Many of the headwinds that we faced during the first six months of 2009 also continued in the third quarter. The investment banking and securities services operating environment remained difficult. Investment banking revenues continued to be hampered by an uncertain macroeconomic outlook and low CL confidence.

That being said, we saw higher levels of strategic dialogue and a significant increase in our backlog during the quarter. However, these revenues will only be recognized if and when these transactions close over coming quarters.

Results from the securities service business continued to decline, principally reflecting lower seasonal dividend-related activity. Similar to investment banking business, we began to see some positive trends developing, including the beginning of inflows to select hedge funds and a modest increase in leverage. Despite the challenging environment, we maintain market-leading positions in both of these businesses.

In light of the difficult macro environment, we continue to conservatively manage our risks, capital, and liquidity levels. Given our cautious outlook and the prospect for higher capital requirements in the near future, maintaining robust levels of risk-adjusted capital, for the time being, remains appropriate.

At the end of the third quarter we had a Tier 1 ratio into Basel I of 14.5%. We also maintained a robust liquidity flow with our global core access averaging $167.0 billion during the quarter. As I've mentioned previously, we have an established track record of dynamically managing our capital liquidity based on our assessment of the operating environment and potential opportunities. Our current levels of capital liquidity reflect both the potential for further market disruptions, as well as the opportunity to capitalize on distressed investments.

I will now review each of our businesses.

Investment banking produced net revenues of $899.0 million, down 38% from the second quarter. Third quarter advisory revenues were $325.0 million, down 12% from the second quarter.

Goldman Sachs is ranked first in announced M&A globally year-to-date and advised on a number of important transactions that were announced during the quarter. These include Baker Hughes' $5.0 billion acquisition of BJ Services, Perot Systems' $3.9 billion sale to Dell, and Proctor &Gambles' $3.1 billion sale of its pharmaceutical business to Warner Chilcott.

We were also advisor on a number of significant closed transactions, including Nuon's $8.5 billion Euro sale to Vattenfall, Canada Pension Plan Investment Board's $7.3 billion Australian acquisition of Macquarie Communications Group, and Cardinal Health's $5.2 billion spin-off of Care Fusion.

Third quarter underwriting net revenues were $574.0 million. Equity underwriting revenues were $363.0 million, down significantly on a sequential basis, as a number of second quarter capital raises in the financial institution sector were not repeated in the third quarter. Debt underwriting declined 37% to $211.0 million due to seasonally weaker new issue markets over the summer months.

During the third quarter we participated in many noteworthy underwriting transactions, including Mizuho's $5.9 billion follow-on offering, NewPage Corporation's $1.6 billion high-yield notes offering, and REO's $720.0 million IPO.

Let me now turn to trading and principal investments, which is comprised of FICC, equities, and principal investments.

Net revenues were $10.0 billion in the third quarter, reflecting strength across each of the businesses. FICC net revenues were $6.0 billion in the third quarter, representing a 12% decrease from the second quarter. Our FICC performance continued to reflect strong market share, although client activity levels were generally lower relative to a particularly strong first half of 2009.

While bid/ask spreads have begun to compress, particularly in more liquid vanilla products like rates and currencies, they remain wide by historical standards. Credit products net revenues declined from the record second quarter but remained robust as we continued to benefit from strong market share and higher asset prices drove solid customer activity levels.

Net revenues in interest rates and currencies were strong but lower sequentially due to lighter trading volumes and tighter spreads. Mortgages produced record results, driven by strength in the customer trading business, partially offset by approximately $120.0 million in write-downs within our commercial loan portfolio. Commodity net revenues were down from the second quarter, reflecting lower volatility and decreased customer activity.

Turning to equities, net revenues for the third quarter were $2.8 billion, down 13% sequentially. Equities trading net revenues were $1.8 billion, strong but down 14% versus the second quarter due to lower client activity levels across both cash trading and derivatives.

Similar to the second quarter, net revenues from our principal strategies business were positive but not a significant revenue driver. Equities commissions were down 9% sequentially, to $930.0 million due to seasonally lower customer activity.

Turning to risks, average daily Value at Risk [VaR] in the third quarter was $208.0 million, down 15% from the second quarter.

I will now review principal investments, which produced net revenues of $1.3 billion in the third quarter.

Our corporate principal investment portfolio generated net gains of $977.0 million, largely in corporate debt and public equity investments. Our investment in ICBC [Industrial and Commercial Bank of China Limited] generated net revenues of $344.0 million and our real estate principal investments generated losses of $66.0 million.

In asset management and securities services we reported third quarter net revenues of $1.4 billion, down 6% from the second quarter. Asset management produced net revenues of $974.0 million, which was up 6% from the second quarter. Assets under management grew 4% sequentially to $848.0 billion due to market appreciation.

Securities services produced net revenues of $472.0 million, down 23% from a seasonally strong second quarter. The third quarter also reflected fewer hard to borrow opportunities in the market.

Now, let me turn to expenses.

Compensation and benefits expense in the third quarter was $5.4 billion, or 43.3% of net revenues, reflecting a decline in our year-to-date accrual to 47% of net revenues. The lower compensation accrual reflects our record year-to-date revenues in 2009 as well as better visibility on expected compensation levels as we approach the end of the year.

As I have highlighted previously, this number included salaries, discretionary compensation, amortization of prior-year equity awards, and other items such as payroll taxes, severance costs, and benefits. As in every other year, we must accrue compensation based on our expectation of the full-year expense, but incentive compensation decisions are not made until year end and this compensation will openly reflect the firm's performance for the entire year.

Third quarter non-compensation expenses were $2.2 billion, 7% higher than the second quarter, largely driven by a $200.0 million charitable contribution to the Goldman Sachs Foundation.

Total staff at the end of the third quarter was approximately 31,700, up 2% from the second quarter.

Our effective tax rate was 32.2% year-to-date and 33.5% for the third quarter.

The last 18 months have been an extremely challenging period for the global financial services industry. There are many lessons to be taken from all that has transpired. During the most turbulent of times, we stayed focused on several critical objectives: support the efficient functioning of capital markets, which is critical to global economies; financially prepare the firm for a more difficult operating environment; provide unwavering service to our clients; and protect our franchise and thus shareholder value.

To accomplish these objectives, we made prices when markets were volatile and illiquid and extended credit when credit was scarce. We incurred the economic cost associated with proactively reducing our exposure to leveraged loans in real estate by nearly 60% and raising $11.0 billion in capital. And these were steps we took before we received TARP funds from the U.S. government. In just over a year we nearly doubled our liquidity balances to over $170.0 billion.

We didn't have any unique insights about how difficult things would become. We took these actions out of prudence and awareness that we didn't have all the answers. We took these actions because we knew that we had an important role to play in supporting global capital markets and economies, our clients, our more than 30,000 employees, and most importantly, our shareholders.

By staying focused on these objectives, we have gained several secondary benefits:

First and foremost, the most attractive aspects of our culture—collaboration, nimbleness, and commitment to excellence—have been strengthened. These cultural attributes remain critical to our ability to navigate the current environment.

Second, our global team of talented professionals remains intact and committed to our business model. This holds true whether you speak to a management committee member who's been with the firm for twenty-five years, or a recent undergraduate hire. Since people are our greatest asset, we recognize that ultimately our success will be driven by their collective effort.

Third, our franchise maintains its breadth, depth, and diversity, and our relative competitive position has been materially improved during this period.

And finally, the combination of robust, risk-adjusted capitalization and profitable results allows the firm to take advantage of opportunities as they arise, to continue to invest in growth businesses and technology, and to adapt to volatile markets.

In summary, while the market outlook remains uncertain, we believe that the firm is well positioned to continue to execute on its key strategies.

With that, I would like to thank you again for listening today and I'm now happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

I kind of remember back to a period of time when you one February said this is the best environment in my 25 years in the business. That's not this environment, yet the numbers you're putting up are pretty damn close to record levels, on a leverage ratio that's pretty low and capital ratios that are much bigger. I guess the question is, is as you keep doing all the things that you said you're doing, in terms of collaborating, being nimble, and servicing the heck out of your clients, what are you thinking as the rules change—the spread environment won't change what it is but it seems like you have leeway on the capital and the leverage front to deploy things. How does that trade-off work over the next year or two?

David Viniar

So first of all, I am much more confident saying that this is not the best environment that I've ever seen than I was saying that that was the best environment I've ever seen. As you know, the best environment for Goldman Sachs is very, very strong global economic growth and that's not what we're in right now.

But our market shares have improved and I think we're getting a bigger share of a smaller pie right now. We are certainly hopeful that over time the pie will increase—our share will probably decrease—but we think the pie increasing will hopefully make up for the share decreasing.

As far as capital and leverage, we are still in an uncertain economic environment and an uncertain regulatory environment. I would suspect that the regulatory environment will clear itself up over the next year or so and hopefully the economic environment will get better. We will either see more opportunities, which we'll us our capital, or we'll do other things to reduce what is now over-capitalization. But that won't happen anytime, materially, in the very near future, it will happen over the next 12 to 18 months.

Glenn Schorr - UBS

I saw the liquidity pool drop a drop, but it's still really big and like I commented on the capital and leverage ratios, do your comments mean that, look, we happen to be fortunate enough to be making a lot of money right now, we'll wait for the regulations to change before we do anything significant on the capital, liquidity, and leverage front?

David Viniar

I think that's the most likely scenario.

Glenn Schorr - UBS

And then is there a function of today's trading environment, especially on the FICC side, you know, you look at a quarter like this where revenues are still pretty awesome and VaR is down, 15% sequentially. Are you seeing just an extraordinary velocity of balance sheet, if you will, and just able to turn the inventory as quick as you've seen in a long time? Is that what's helping contribute.

David Viniar

Yes, basically all of the trading is kind of plain vanilla, very liquid products that come on and off the balance sheet very quickly. And you see it from the balance sheet size. The balance sheet size stayed the same. VaR was down and yet results were quite good.

Glenn Schorr - UBS

On securities services, actually sequentially the percentage drop is not all that different from the third to second quarters that we've seen in the past. However, down 50% year-over-year still has us scratching our heads a little bit. I know rates are really now, I hear your comment on no one is doing the hard to borrow, the market goes up every day. But do you think that down 50% year-to-date is about right or where there some share gains there throughout the year that maybe as competitors heal you give a little bit back there as well?

David Viniar

No, I actually think 50% year-over-year is about right, given what's going on in the world. Between hedge fund assets being down last year—last year I think hedge fund assets in total were down probably close to 50%, total hedge fund assets over the last year. We've started to see them—and then, as I mentioned, the hard to borrows, with people being very worried about shorting anything.

So you put those two things together and I'm not surprised at the year-over-year decline but we have started—and again, I don't want to overstate this—we have started to see the reversal of that trend as we went through the third quarter.

Operator

Your next question comes from Guy Moszkowski - BAS-ML.

Guy Moszkowski - BAS-ML

I wanted to ask you first of all if it would be possible for you to give us a little more color on the movement of the bid/offer spreads in key categories that you've identified, like credit, rates, FX, etc., over the course of the year. If you can't quantify, which I understand why you wouldn't, can you give us sort of an indexed view of where they might have begun the year and where some of those key categories are right now?

David Viniar

It's hard to be very definitive in quantifying it but I would tell you that probably as we went through the first quarter and probably half of the second quarter, spreads in virtually every product were as wide as we've ever seen them.

And I would tell you that now, certainly in the more liquid products like rates and currencies, we have seen those spreads decline a fair bit. Still higher than what I would consider normal; a lot higher than what we saw in 2006 and 2007, but it's hard to index, but a fair amount lower than we saw in the first half of this year.

You know, credit products and things like that, still tighter than we saw in the first half, but well wide of our normal environments. So they haven't tightened as much as some of the more liquid products but tightened a bit, but well over normal levels.

Guy Moszkowski - BAS-ML

And do you have a thought on the outlook for that? Given the comments you made about industry conditions still being quite fragmented and risk capital still being kind of scarce, would you expect that the tightening trend will continue or do you think it stalls out here for a while?

David Viniar

No, I think the tightening trend will continue. I think that if the world continues to be a better place, then the tightening trend will continue, people will get healthier, volumes will go up, more risk capital will come into the market. And again, this is a question of pie versus share of the pie—I would expect that the pie will continue to grow and I think our what is now a very elevated share of the pie will come down. I think we will keep some of the market share gains we got but not all of them.

Guy Moszkowski - BAS-ML

If I could just turn to compensation for a minute, can you give us a sense for what the impact on reported compensation for the year might be, of decisions that you might make to, for example, defer some comp over a period of time, or increase the percentage that would be in shares?

David Viniar

We don't know yet. These are the things that we're still working through and we won't make final decisions on these until the end of the year. So I would be premature in giving you anything there.

Guy Moszkowski - BAS-ML

So for now, as we try to model the full year comp, is the best approach really to look at prior years with revenue similar to what we're seeing this year and just look at the full-year comp ratio for those periods?

David Viniar

I can't give you any better way to do it.

Operator

Your next question comes from Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

I just wanted to follow-up on a couple of these issues. First, on FICC, maybe just touch on these dynamics a little more. So the bid/ask spreads have come in a fair amount, as you say. You're saying wider than normal. I guess you probably heard Jamie Diamond's comments yesterday, he kind of used an index of one before the prices, six, and now two. I don't know if you broadly agree with that. But let's assume that it's something that's come in a fair amount and sounds like over—really since the second quarter. But your FICC revenues are only down 15%. One of the things we've heard is that because [inaudible] has come down positioning has been a lot easier within FICC. So I'm wondering, as we now come in the fourth quarter, if this credit spread rally has run out of steam—maybe there's some more to go in high yield—are we going to see that impact? I mean, how much has been positioning, principal, however you want to call it, in all of that?

David Viniar

Very little. First, you know me well enough to know that I can't, and I'm not going to try and tell you what's going to happen in the fourth quarter. Because we'll see. But most of our revenues across trading, across FICC, really have been client-related or our clients want to do things. There just hasn't been that much positioning, there hasn't been that much write-ups of prior distressed assets. It has been what I'll call blocking and tackling, every day, day after day, dealing with our clients who want to do things, making markets, making prices, helping them hedge things, whether it's rates or energy prices or currencies or things like that. That's really been the great, great majority of our revenues.

Roger Freeman - Barclays Capital

It stands to reason though, somehow, that the dramatic spread compression we have seen over the course of this year has to benefit a business that is an inventory business. Is that not a fair assumption?

David Viniar

It benefits it a little on some assets but the velocity of our assets is so fast that we're not really holding assets and while it's in inventory, we have inventory, we have hedges against most of that inventory. So you've got some things on the balance sheet, you have some hedges off the balance sheet, but our net-net, the contraction in spread, the biggest help in the contraction in spreads, and therefore the increase in kind of risk asset prices, has been two things.

One, it leads to higher activity levels—and two, in our principal investment area. So most of the gains on holding risk assets have been in the principal investment area.

Roger Freeman - Barclays Capital

And I guess there's been some shift into the higher margin, higher—wider bid/ask products like mortgages. That's helpful. But it gets to sort of more macro on this subject, you kind of look at $6.3 billion in really adjusted revenues, I think taking out some of the charges, etc. A strong quarter before the credit crisis for you was really like $4.0 billion, maybe low-$4.0 billions. And so you still have this delta, and like you said, there is market share—as the market share maybe comes down, some of these other higher margin products grow in total. It feels like this still moves probably down on a run rate basis. I know seasonally it's going to be down in the fourth quarter but it's hard probably for you to respond, but this is still a very elevated number.

David Viniar

We are very pleased with the performance. You know I don't talk about run rate revenue or sustainability but people asked the same question after the second quarter going into the summer, and the third quarter performed pretty well. I can't tell you if the fourth quarter is going to be as robust. I don't know. But I am pretty confident that our performance will be as good as it can be in whatever the environment is that unfolds.

Roger Freeman - Barclays Capital

Just back on the comp, and I guess you said the best advice is look at prior years. Just one question around that.

David Viniar

What I said was I couldn't give you better advice.

Roger Freeman - Barclays Capital

Okay. But let's say 2006 and 2007, it seems to me that a lot of the strength there was generated from harvesting principal investment gains, private equity that you would argue maybe were generated by fewer people and you had more comp leverage off that. I'm just wondering is that really sort of fair? I mean, at this time you've got a wider range of the organization involved in generating these revenues. I guess I'm just wondering if that's a fair way to go.

David Viniar

I think that is a fair way to think about the firm. The revenues that we have now are being driven very much by our franchise, which takes the entire firm behind it to be successful and I think we have to be fair to those people. But we're also cognizant of what's going on in the world and the pressures we're under and so we're going to try and balance those things as we work through the end of the year and we'll make our decisions as we get to year end based on the overall performance of the firm and our people.

Operator

Your next question comes from Howard Chen - Credit Suisse.

Howard Chen - Credit Suisse

You have been under the belief that this distressed investing cycle is going to take a little bit longer to play out than the past ones. Just curious, can you touch on the firm's current appetite for putting capital to work on the distressed front? And how does the bid/ask evolve through the opportunities that are out there?

David Viniar

That's a good question. We would have thought that there would have been many more opportunities by now. We definitely have an appetite and have had an appetite and are willing to—and you know, it's been a business that we've been in for a long time—we're willing to be a purchaser of assets if we think the returns are worth it.

Now, in the environment where the returns on very, very liquid products have been so high, we're only going to invest in illiquid products if the returns are even higher. But there's been very little willingness of the holders of distressed assets to sell them at what we thought were reasonable prices. Just a difference in their views of price and our views.

I think those views have gotten a lot closer and I think that we are starting to see what I would call a—maybe it's a little more than a trickle, but not much more—of potential opportunities and so I'm hopeful that we'll find some. I don't think it's going to be a gigantic number but I'm hopeful that we'll find some opportunities over the next several quarters to use our capital to invest.

Howard Chen - Credit Suisse

So just stepping back from that, I guess by geography and by business, where are you seeing the best opportunities to deploy resources today?

David Viniar

I actually think it's going to be—if I give you geographies and businesses, when I'm done I will have gone through all of them. We're really seeing these opportunities in different ways, globally, and we're seeing them really across our trading businesses, we're starting to see a pick up in the investment banking backlog. We're starting to see more inflows in people, what I would call re-risking in the asset management business. So we're really starting to see opportunities across all of the businesses pick up.

Now, we've all seen it. Tomorrow I could tell you something different. But that's how it feels right now, how we're seeing it across the U.S., across Europe, across Asia, across developing markets and developed markets. It's really across the board.

Howard Chen - Credit Suisse

And then real estate assets have been written down pretty hard. You're write-downs on the trading portfolio and within REPIA [Real Estate Principal Investment Area] are at their lowest levels. I'm curious, are you seeing people here more willing to move assets or are folks still holding on to what they've got?

David Viniar

I think the real estate assets are probably still the least liquid and most distressed of the asset classes. As you said, we have written ours down pretty heavily and we don't have that much left. But I think we are still a bit away from breaking that logjam.

Howard Chen - Credit Suisse

And just a final numbers question, what impact did tightening of spreads have on the trading revenues this quarter and just where are the marks on the commercial estate stuff stand?

David Viniar

Do you mean our spreads?

Howard Chen - Credit Suisse

Yes, your own spreads, the DVA.

David Viniar

I think it's about $275.0 million in the quarter and something like 80% of that was in FICC and the rest was in equities. And the marks on commercial real estate I think were at about 50, average across our commercial real estate portfolio.

Operator

Your next question comes from Michael Mayo - Calyon Securities.

Michael Mayo - Calyon Securities

Just a follow-up to the other question. Is there any way to quantify the increase in the velocity of the assets in FICC trading?

David Viniar

The only way I would quantify it, the real answer is no. It's very hard to quantify. But you see, our balance sheet hasn't moved. Our balance sheet was 890 last quarter, 882, this quarter. Kind of the same. And it's been like that for a couple of quarters. And it's not like we're not doing anything. You see the fact that we're making as much money as we are in trading is because there's a lot of activity and yet the balance sheet is kind of staying the same and it's just assets going on and off the balance sheet constantly.

Michael Mayo - Calyon Securities

Whatever the decline in the margin is made up for in the velocity.

David Viniar

Yes.

Michael Mayo - Calyon Securities

And can you give us any sense for how much the margin might have gone down?

David Viniar

It's really hard for me to quantify. I don't like to kind of make up numbers and I it's just very hard for me to quantify. But it's down, in some of the more liquid products it's down a fair amount, but it's still significantly higher than we've seen in previous environments.

Michael Mayo - Calyon Securities

In terms of the backlog, can you give any color, mergers, equity underwriting, debt underwriting, and by region?

David Viniar

Yes. It's up in all of them. I would say really dominated by mergers and equity underwriting more than debt underwriting, but all of them are up. And I think it's really across all the regions.

Now, it will take longer for merger revenue to show up than equity underwriting revenue and equity underwriting revenue will show up if the markets stay okay. And if they don't, then some of that will go away. But I would say more in mergers and equity underwriting than fixed income, but pretty much across the board.

Michael Mayo - Calyon Securities

And revenues outside the U.S., what was the relative growth this quarter and what are you doing in Asia with the markets?

David Viniar

We were at a little over 50% in the U.S. and the rest outside the U.S. And you know we've been very focused on growing our Asian business, especially our China business, for a while and we continue to be. We were one of the first ones in there, we're one of the few that has a license to operate there. And it's probably the biggest near-term focus for the firm.

Operator

Your next question comes from Chris Kotowski - Oppenheimer & Co.

Chris Kotowski - Oppenheimer & Co.

Could you talk a little bit about the assets management business? I noticed there were modest outflows of the money market funds but it didn't go into any of the other alternatives. Any color there?

David Viniar

Yes, what I would say there, you know, like it is a big focus of ours and it continues to grow well and I think if you look at our statistics they are very consistent with the industry over the course of the quarter. But really what you saw is over the last year. I would say, within the asset management world, for us and for others. You saw tremendous de-risking. So people basically took their assets out of equities, alternative investments, other things, and put them into money markets.

And what you saw in the third quarter was the beginnings of re-risking. Now, not all of it came into our funds but people taking their money out of money market funds and starting to put it into more risky investments, starting with fixed income. Because I think the general view of the world was that the credit space was the best place to invest and I think maybe you'll start seeing some flows in some other areas over the next couple of quarters. If the world stays okay.

Chris Kotowski - Oppenheimer & Co.

On the principal investments I noticed that they're up about $1.3 billion in aggregate from the prior quarter. Is that marks or putting new money to work?

David Viniar

It's largely marks on all stuff. We made some new investments, more on the debt side than the equity side, but it was—the ICBC one you can see. That was just the ICBC stock price going up and in the corporate principal investments, it was really dominated by private investments in debt securities. So that was our mez fund, you know, senior loan fund, and some other investments. And investments in equities that whereas gone public. So it's just the equity markets going up. That was most of the earnings.

Chris Kotowski - Oppenheimer & Co.

And finally, any thought on the contributions to the foundation? Is that something that we should look for on a semi-ongoing basis and is there a target level at which you would like to get the foundation to? Or how should we think about that?

David Viniar

No target at this time. And we will make a fourth quarter decision in the fourth quarter.

Operator

Your next question comes from Michael Carrier - Deutsche Bank.

Michael Carrier - Deutsche Bank

One question on FICC. It has been talked about on the spreads and then you have mentioned your velocity. If you look relative to like 2006, 2007 levels we can kind of see what has happened on the spread side, but from the client activity side, based on the data the Fed puts out or you're talking to different fixed income desks, it seems like client activity is still relatively low. Like up a lot since the first quarter but should we expect as spreads come in, just client activity, the markets become more efficient, and trading volumes in general will start to increase, and so that will cause some of the offset?

David Viniar

That is what should happen. And I think you said it exactly right. In the scheme of what we saw in 2005, 2006, and 2007, client activity is still low. We have a pretty big share. And what will drive more client activity will be better economic growth and when there is better economic growth, clients do more things. And any time there is a merger transaction, there are hedging transactions, whether it's currencies or rates or commodities, or something that comes with it. Anytime there's an underwriting there is more stuff that comes with it. And as companies do more things, they are more active. And that happens when there is more economic growth.

And so that's why I said before that what we're hopeful of is that we know we're not going to keep all of the market share gains that we have—we think we'll keep some of them but not all of them—but that hopefully the market, of which we're getting a share, will get bigger as the world gets better.

Michael Carrier - Deutsche Bank

On the capital levels, there have been some adjustments put out by Basel II in terms of new requirements, and based on the U.S. getting there in 2010 and then implementation by 2012, it seems like for Goldman, you are always are managing the risk with your internal standards, and it tends to be more conservative than where the regulation is. In Basel II I think the internal models, you know, sometimes there is more weighting there and if the models are deemed very robust then you can actually have some benefits in terms of the amount of risk you need to put against these assets.

Based on anything that Basel II has put out, and I guess the most recent was back in July, when you look at it and look at where Basel II is headed, are there areas that you feel like you're already at, relative to the industry, based on Basel I? And then do you feel like relative to where your current capital level is, either you're fine—and I guess most importantly, like the regulators in Basel, are they talking to you? Because it seems like through all of this, especially when it comes to capital levels, you've done fairly well.

David Viniar

It's still too early to tell exactly where the capital regulations are going to come out. I think it's pretty clear that capital requirements will go up. For certainly some of the same assets people will need to hold higher capital levels.

We have dialogue with our regulators all the time about our internal models and what they mean. Our management of risk, I think as you said, we think we manage our risk very, very conservatively, and always have. But I think we are still in a wait-and-see mode. I think it's too early for us to really know exactly where this is all going to fall out.

Michael Carrier - Deutsche Bank

And on the innovation side, or where you see new opportunities, you had mentioned distressed assets and opportunities, it seems like through each downturn, whether it was stacked with principal investments or long-term capital and fixed income and commodities, it seems like there was always an opportunity besides just the stressed assets, so when you look at the current environment, there is a lot talked about, like the shadow banking system, and that going away. I don't think Goldman is going to become a big mortgage originator, but are there any opportunities out there that you see there's a void or a vacuum right now that potentially there is some significant upside for Goldman or for the industry?

David Viniar

We actually think that the biggest opportunity for us is just to continue to grow what we have, that our businesses are good businesses. We think there are opportunities to grow them around the world and that's really what we're focused on rather than trying to get into something new where we don't have expertise.

Operator

Your next question comes from Meredith Whitney - Meredith Whitney Advisory Group.

Meredith Whitney - Meredith Whitney Advisory Group

The government purchase program was supposed to end this quarter, or they've extended it to the next quarter, how much of that is a driver of velocity of flows? And how are you positioned when they exit, if they exit, for any type of principal risk and what do you think that impact is going to be in the larger market?

David Viniar

I think, as you know, and I think the Fed knows this, exiting their support of various markets is a very tricky thing. I think they're going to do it carefully. They're going to do it slowly and over time and I think they are signaling the market. I think they're doing a very good job of letting people know they're going to continue for a while but they're not going to continue forever.

As far as our positioning, I don't think it really matters at all. As you know, as I said, most of what's happened has been our velocity not the positioning, and I think that they're going to slowly extricate themselves from that as the markets get healthier and can pick up the slack.

Meredith Whitney - Meredith Whitney Advisory Group

But in terms of the flow volume, so you have been the greatest beneficiary of increased flow volumes. How are the flow volumes going to be influenced as they exit?

David Viniar

I think that they will try to time their exits for the market being healthy enough to pick up that flow. And so I think the flow will continue.

Meredith Whitney - Meredith Whitney Advisory Group

And who would you imagine would be the substitute buyers?

David Viniar

The various market participants. I think it will be the various financial institutions, funds. I think the whole variety of buyers. And there is a lot of cash out there to buy.

Meredith Whitney - Meredith Whitney Advisory Group

Of the principal revenues, almost a billion, how much of that was cash sales and how much were mark ups?

David Viniar

I would say that it was much more mark ups than sales. I don't have the exact number but it would be much more mark ups than sales.

Operator

Your next question comes from Robert Lee - KBW.

Robert Lee - KBW

Quick question on FAS 166, 167, can you update us on the anticipated impact next year and specifically, I'm just curious, a lot of asset managers are kind of concerned about the impact to them as it would require consolidation of a lot more investment products with the pharmacies. Do you see that having the same impact on you. Could you just give us a sense on where you see that headed?

David Viniar

Two things. First, from our balance sheet point of view we think it will have some, but a relatively immaterial, impact. The other thing to remember, that is probably the most important thing, for us, from a P&L point of view, whether something is on our balance sheet or not, if we have the financial commitment, if we have the financial risk, we mark it to market and run for our income statement. So it will have absolutely no effect on our income statement at all. And we think some, but a pretty immaterial, effect on our balance sheet.

Operator

Your next question comes from Steve Stelmach - FBR Capital Markets.

Steve Stelmach - FBR Capital Markets

Is it fair to infer from your answers that in a better economy you suspect that velocity will increase and that maybe the second and third quarters are not sort of the peak in your balance sheet for velocity?

David Viniar

I guess what I would say, and we're using terms here interchangeably so I want to be a little careful, I would expect in a better economy the amount of activity will increase. Whether assets come on or off our balance as fast, hard to say. In a better world we might do more investing than we're doing right now. So I can't say that velocity would necessarily increase. But I think the amount of activity from which we would get transactions of our clients would be higher.

Operator

Your next question comes from Douglas Sipkin - Pali Research.

Douglas Sipkin - Pali Research

The balance sheet, fairly constant the last couple of quarters, is that, for the most part, a conscious decision by you or is it really just a function of the way things shake out? And what would it take for you to sort of increase it a little bit? I know the leverage is still very low by some of the historical standards?

David Viniar

I think it is more the latter, that it's the way things shaken out. Because the opportunities we saw were largely in very, very liquid product that did not require any increase on our balance sheet. If there were opportunities to increase it a little bit right now, we would do that. I don't think we would want to increase it very dramatically right now because we are still conscious of the fact that knowing we're not out of the woods in the economic environment yet. But I think we would increase it a little bit but there just haven't been those opportunities.

Douglas Sipkin - Pali Research

Just hitting a little more on the bid/ask spread stuff, it just seems like a lot of your competitors are making bigger commitments now and I'm wondering, has all that not shown up yet and maybe will at sort of like January 1, 2010, with a lot of the hiring that's taking place and sort of the rejuvenated commitments to fixed income trading? I mean, with respect to corporate and MBS, it sound like we are still seeing very good profitability. What's the level of concern, post end of year, with a lot of fresh money maybe coming back to those products from competitors?

David Viniar

I'm not sure that there's a date on which it's going to change dramatically. I think that it's going to be a gradual shift over time, with more competitors entering the market. And remember, in order to do this and do it well, you need not just for firms to get healthier but to be confident in their risk management. And we've seen in the past that that's something that takes a long time to build up and you have to get it right and you have to do it well. And otherwise you get in trouble by making commitments.

Douglas Sipkin - Pali Research

I know you don't always provide, but any guidance around your hiring outlook, given maybe we're seeing some stabilization in markets? I know you saw a jump this quarter, which I know some seasonal elements to that, but maybe through 2010?

David Viniar

Don't know yet. I think we're still kind of looking through what we want to do for 2010.

Operator

Your next question comes from Kian Abouhossein - JP Morgan.

Kian Abouhossein - JP Morgan

In respect to capital at risk and capital allocation, I see you are coming down, mainly in interest rates. Is this a trend that we should expect to see that VaR is maybe scaled down or is this just a methodological impact? And how do you see capital moving between different businesses and regions?

David Viniar

It really is going to depend on the opportunities we see. I think if you look back in our history you will see—take VaR as an example, you will see both the VaR and the absolute number go up or down, but you will see even more movement within the categories virtually every quarter. You will see differences. You will see some up, you'll see some down. And we don't walk into a period of time and say, okay, let's take risks here or let's allocate capital here. Because we know we're not smart enough to know. We know the world is going to unfold differently than we think it's going to.

What is important for us is that we're nimble enough to move our resources where we see the opportunity, whether that's capital, whether that's people, balance sheet, whatever we see, we move it to where we see the opportunities. And I think you'll see that continuously. So you'll see it moving around.

Kian Abouhossein - JP Morgan

And do you see, considering that the consensus is to move more capital into a lot of the fixed income businesses, do you feel uncomfortable about that at this point or there is no uneasiness about any of the movement that you're seeing by peers?

David Viniar

No, we're not uncomfortable. Again, we think that the key to being able operate in the fixed income trading business is, and especially to do things on behalf of our clients, is our risk management. And as long as we continue to be as focused on that as we are and have the quality of people involved in our risk management and have the most senior people of this firm involved in it, we are comfortable with where we are.

Kian Abouhossein - JP Morgan

Just [inaudible] risk-weighted assets, your Basel II SEC risk-weighted assets increased by about $20.0 billion, $19.0 billion. Can you explain why?

David Viniar

I'm not sure what number you're looking at because I think our risk-weighted assets in the third quarter stayed almost flat.

Kian Abouhossein - JP Morgan

I think I'm looking at Basel II, risk-weighted assets, SEC.

David Viniar

I'm not sure what period you're looking at. You're looking at first quarter to second quarter?

Kian Abouhossein - JP Morgan

I'm looking at year-on-year. It was $380.0 billion and they're about $400.0 billion. I'm just trying to understand if it's procyclicality or what is the driver of the change.

David Viniar

So you're looking at the Basel II risk-weighted assets?

Kian Abouhossein - JP Morgan

Yes.

David Viniar

Okay. So, part of that was just a mix issue, part of that is in Basel II as we transition from the SEC Basel II to the Fed Basel II. There are some changes in methodology that are pretty small. And because you see while it $20.0 billion, it was $380.0 billion to $400.0 billion so on a percentage basis it wasn't that high. But you are seeing some methodology changes that have caused an increase in risk-weighted assets.

Kian Abouhossein - JP Morgan

And your market risk, about 170—your market risk rated assets, if I compare them to peers, you're clearly significantly bigger and today the Basel committee came with a statement, a quantitative statement that you've probably seen, on trading book risk rated assets to double to triple, on an average. And I'm just wondering what does it mean for you as a group and how much of your market risk rated assets are trading book related?

David Viniar

I think it's too early to tell how all this is going to unfold and I would tell you that I think our calculation is extremely conservative. I think when everything is put on an equal footing, I think that the effect on us is going to be the same as the effect on most of our major counterparties.

Kian Abouhossein - JP Morgan

Can you say, in terms of trading book versus market risk, is it maybe one third or half? Is that kind of both parts?

David Viniar

I think those are not numbers that we want to discuss.

Operator

Your next question comes from Matt Burnell - Wells Fargo Securities.

Matt Burnell - Wells Fargo Securities

In terms of underwriting fees, across the debt and equity platform, from some of the information we've gotten from third-party sources, it appears those fees, particularly in the U.S., for debt and equity products, are actually relatively higher than they were a year ago and have actually been trending upward over the last couple of quarters. Is that characterization correct and how what can you tell us about what fee trends might occur in some of those products, particularly outside the U.S.?

David Viniar

It feels, and you might have more statistics than I, I would actually say that the fees are pretty stable. That you the fees on equity products, while they had been trending down, they've probably more stabilized. Same thing with fixed income products. But I don't think they're really trending up very much. I think they're pretty stable. I think you might just be seeing a different mix, more highly leveraged deals than not, therefore the fees would be a little bit higher. Not as many really, really big deals. You tend to charge smaller fees on a percentage basis the bigger the deal, even though the dollars are bigger, and you haven't seen as many really large transactions as you had seen in 2006, 2007. So that might be what you're seeing. I think it's probably a mix question more than anything.

Kian Abouhossein - JP Morgan

The charitable donation expense, that runs through other expenses, correct?

David Viniar

That's correct.

Operator

Your next question comes from Michael Hecht - JMP Securities.

Michael Hecht - JMP Securities

I just wanted to follow-up on the strength in equities trading. I know you pointed to the strength in derivatives and it sounded like GSPS wasn't a real big driver this quarter. Any other color you can give us on what drove the strength there?

David Viniar

No. I mean, it was really just, with both shares and derivatives much more than our principal strategies business, and it was just kind of, as I said, every day blocking and tacking, dealing with our clients, doing things for them, helping them re-position, things such as that. No big item.

Michael Hecht - JMP Securities

Can you talk a little more about the seasonality you saw in the trading business, maybe through the quarter? Just trying to get a sense of whether the revenues were kind of evenly distributed over the three months of the quarter or whether you saw any pick up in September?

David Viniar

It was much more even. I would not say we saw a big pick up in September.

Michael Hecht - JMP Securities

So it wasn't a normal summer then?

David Viniar

Well, it was a more normal summer than the prior two summers, I would say that. But it was pretty stable throughout the quarter.

Michael Hecht - JMP Securities

Can you talk a little more about your outlook on the regulatory environment and the impact of have you seen more derivative shift and from the over-the-counter markets to exchanges and through centralized clearing houses? I mean, I guess on top of the cyclical forces and the competitive forces you talked about that may drive trading spreads and now over time, do you see that as more of a secular driver with tighter spreads over time?

David Viniar

My first answer is we don't know. It's too early to tell. I think there are some themes that are almost certainly going to happen. You mentioned some of them, we've talked about some of them. There are probably going to be higher capital requirements. We think there will be more centralized clearing of derivatives than we've seen before. There will be more things on exchanges. And we actually think that that's a good thing. We think it's a good thing for the world; we think if it's done correctly it will be risk-reducing and we think that is good. And so most of the things that, at least at the high level, have been talked about, we're pretty much in favor of.

Michael Hecht - JMP Securities

Diluted share count was up about 5%, basic shares a little bit more modestly. What's the driver there?

David Viniar

A lot of it was just the passage of time and the increase in our share price. Those two things helped drive share count because of accounting for RSUs and options on treasury stock method.

Operator

Your final question is a follow-up from Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

What's the illiquidity discount on ICBC at this point? We think it's like $1.0 billion to $2.0 billion. Is that right?

David Viniar

We don't disclose exactly what that discount is. But you could probably get pretty close to calculating it.

Roger Freeman - Barclays Capital

Yes, because the gain on it was definitely less than the share price was at the close of this quarter. That would suggest that discount. But I guess the bigger question is the lock up there expires April of next year, so at some point is that going to be a point-in-time P&L event?

David Viniar

First of all, no, the discount would be amortized in over time as we get closer to that point in time but if you remember what happened last April, we extended the discount on the lock up on a very large portion of the shares so we don't know what will happen in April.

Roger Freeman - Barclays Capital

In some of the illiquid investments, opportunities, what are you seeing on the whole on front and REPIA. It's not like there's a sort of trickle of activity. It sounds like at least some hedge funds. I'm wondering if you're doing this as well. Kind of going to banks and offering to buy portfolios that they can now absorb to sell at a loss with better than expected operating earnings. Is that something you're doing too?

David Viniar

I think a trickle is a good way to describe what's going on there. As I mentioned to you, the buyers and sellers, there is a very wide divergence in price expectations. I think that divergence has narrowed pretty dramatically but I still think for the most part, buyers and sellers are still not in the same place, although getting closer and in some cases I think you will see some sales. But I think it's going to be a while before it's a very large amount.

Roger Freeman - Barclays Capital

Within sort of prime brokerage leverage for hedge funds, it sounds like we're creeping up a bit. It sounds like there is a fairly robust repo market again for a number of assets. I'm wondering where haircuts are on sort of a lot of key, whether it's mortgage-backed or other are today versus where they were maybe going into the crisis.

David Viniar

First of all, on leverage, as I said, we saw the beginnings of it starting to trickle up, but I don't want to overstate that. It's a little bit. And I don't think haircuts on repos have changed very much at all, on most securities. I think they're pretty much the same as where they've been.

Roger Freeman - Barclays Capital

In the mortgage securities trading area, or MBS program, do you think that with the Fed having been so aggressive in buying MBC securities here, that that's actually kept some of the traditional players on the sideline and that's where that incremental demand comes from?

David Viniar

This is a chicken-and-egg question. Did their buying keep the traditional players on the sideline or did they buy because they were on the sideline? And I think it's a little bit of both and I think that hopefully what you'll see is that they will stop buying so much as these traditional buyers become healthier and more willing to take risks and come back in and that's why you'll see the flows stay. I think they are trying to time their withdrawal that way.

Operator

This concludes the question and answer session.

Dane Holmes

Thanks once again for joining the call. Obviously if you have any other follow-up questions, please feel free to reach out to me in the Investor Relations department.

Operator

This concludes today’s conference call.

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