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

Q1 2010 Earnings Call

April 20, 2010 11:00 am ET

Executives

Dane Holmes – Director Investor Relations

David Viniar – Chief Financial Officer

Gregory Palm – Executive Vice President, General Counsel

Analysts

Glenn Schorr - UBS

Guy Moszkowski - BAS-ML

Howard Chen - Credit Suisse

Michael Carrier - Deutsche Bank

Roger Freeman - Barclays Capital

Michael Mayo – CLSA

Edward Najarian – ISI

Meredith Whitney - Meredith Whitney Advisory Group

Jeff Harte – Sandler O’Neill

Kien Abouhossein – JP Morgan

Matt Burnell - Wells Fargo Securities

David Trone – Macquarie Securities

Ron Mandel – GIC

Richard Staite – Atlantic Equities

Operator

Welcome everyone to the Goldman Sachs first quarter 2010 earnings conference call. (Operator Instructions) This call is being recorded today, Tuesday, April 20, 2010. 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 first 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 those forward-looking statements. For a discussion of some of the risks and factors that 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 December 2009.

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 website 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

Thanks Dane, I would like to thank all of you for listening today. I will give an overview of our fourth quarter and full year results and then ask Gregory Palm, our General Counsel, to discuss the SEC complaint against Goldman Sachs. We will take your questions at the end.

I am pleased to report strong first quarter results for Goldman Sachs. Net revenues were $12.8 billion. Net earnings were $3.5 billion and earnings per diluted share were $5.59. Our annualized return on common equity was 20%. During the quarter book value per share was up over 4% to $122.52. Faced with a still difficult although improving macroeconomic operating environment our performance in the first quarter of 2010 continues to demonstrate the benefits of our diversified business model and deep client relationships. While certain businesses including FICC and equities produced sequentially higher revenues they were partially offset by the impact of lower levels of [continued] investment banking transactions and lower revenues from asset management and security services businesses.

While individual businesses will have different performance based on the operating environment in any given quarter, economic growth around the world remains the single most significant long-term driver of our firm’s opportunity stack. Our constant focus on clients despite the challenging environment of the past two years continued to bolster our performance via elevated market share and strong demand for our services.

We entered 2010 with robust liquidity and risk adjusted capital levels. In keeping with the firm’s longstanding policy of repurchasing shares to offset increases in share count over time resulting from employee share based compensation the firm repurchased 13.2 million shares for approximately $2.3 billion. Despite these share repurchases our common shareholder’s equity still increased by $2.2 billion to $66 billion. We remain committed to maintaining a conservative financial profile and appropriately managing our capitalization. Our Basel 1 Tier 1 ratio of 15% and a global core excess pool of liquidity which averaged $162 billion during the quarter reflect that commitment.

I will now review each of our businesses. Investment banking produced net revenues of $1.2 billion, down 28% from the fourth quarter. First quarter advisory revenues were $464 million, down 31% from the fourth quarter. Goldman Sachs ranked first in announced and completed M&A globally year-to-date and advised on a number of important transactions that were announced during the first quarter. These include Novartis’ $39.3 billion acquisition of the remaining stake in Alcon; American Life Insurance Company’s $15.5 billion sale to MetLife and Schlumberger’s $12.2 billion acquisition of Smith International.

We were also advisor on a number of significant closed transactions including Burlington Northern Santa Fe’s $35.9 billion sale to Berkshire Hathaway; Cadbury’s $22.4 billion sale to Kraft Foods and Liberty Global’s $5.2 billion acquisition of Liberty Media.

First quarter underwriting net revenues were $720 million. Equity underwriting revenues were $371 million, down 41% from the fourth quarter as the market for new issue activity was less robust. Debt underwriting was up 3% to $349 million with strength across leveraged finance and investment grade markets. During the first quarter we participated in many noteworthy underwriting transactions including; Sumitomo Mitsui’s $11.1 billion follow-on offering; IMS Health’s $2 billion term loan and $1 billion high yield note issuance and Hartford Financial’s $1.7 billion follow-on offering and $575 million convertible stock offering. Our investment banking backlog was essentially flat from year-end levels.

Let me now turn to trading and financial investments which are comprised of FICC, equities and principle investments. Net revenues were $10.3 billion in the first quarter. FICC net revenues were $7.4 billion in the quarter representing a significant increase from the fourth quarter as every major business including credit, interest rate, currency, commodities and mortgages generated higher revenues. This quarter’s FICC rev results are also more balanced with broad contribution across products and regions. Our FICC performance reflects solid market share and generally strong levels of client activity despite lower levels of volatility.

Turning to equities, net revenues for the first quarter were $2.4 billion, up 22% sequentially. Equities trading net revenues were $1.5 billion, up 45% versus the fourth quarter largely driven by a sequential improvement in derivative activity. Net revenues from our principle strategies business were positive but not a significant revenue driver in the quarter. Equities commissions were down 4% sequentially to $881 million due to generally lower market volumes during the quarter. Turning to risk, average daily value at risk in the first quarter was $161 million, down 11% from the fourth quarter.

Let me now review principle investments which produced net revenues of $510 million in the first quarter. Our corporate principle investment portfolio generated net gains of $760 million largely in corporate debt and public equity investments. This was partially offset by our investment in ICBC which generated net losses of $222 million during the quarter. Our real estate principle investment portfolio was not a meaningful contributor during the quarter.

In asset management and security services we reported first quarter net revenues of $1.3 billion, down 14% from the fourth quarter. Asset management produced revenues of $946 million which were down from the fourth quarter largely due to seasonally lower incentive fees. Assets under management declined 4% sequentially to $840 billion driven by money market outflows consistent with industry trends, partially offset by net inflows in fixed income assets and market appreciation primarily in equity assets. Security services produced net revenues of $395 million, down 11% from the fourth quarter due to a less favorable mix of customer balances.

Now let me turn to expenses. Compensation and benefits expense which includes salaries, bonuses, amortization of prior year equity awards and other items such as payroll taxes and benefits was accrued at a compensation to net revenues ratio of 43%. The first quarter 2010 compensation ratio is our lowest ever first quarter ratio, 650 basis points lower than our historical reported first quarter average compensation to net revenue ratio of 49.5%. The significant reduction in first quarter compensation accrual reflects the current strength of our revenues and relative competitive position and recognition of the broader environment in which we operate. Going forward the compensation ratio will continue to be impacted by these and other factors.

First quarter non-compensation expenses were $2.1 billion, 23% lower than the fourth quarter which included approximately $620 million in charitable contributions. Total staff at the end of the first quarter was approximately 33,100, up 2% from the fourth quarter. Our effective tax rate was 33% for the first quarter. As I mentioned earlier, based on our long standing policy of offsetting the diluting impact of employee based compensation we repurchased 13.2 million shares for approximately $2.3 billion during the quarter.

The broader economic environment remains fragile and the future status of operating regulatory guidelines remains in flux. However, we believe our long-term success hinges on a core set of principles. First and foremost we are focused on serving our client’s needs on a global basis with a diversified product portfolio. Second, given the importance of human capital to our success in meeting client needs we must recruit and retain the most talented people in our firm. Third, we will continue to foster a culture of communication, long-term thinking, collaboration, flexibility and risk management excellence. Finally, we will strive to provide industry leading returns by combining these principles with a compensation structure that pays for performance and aligns employee interests to those who are other long-term stakeholders.

As we stated last quarter we believe financial institutions have a significant and critical role to play in promoting economic growth, jobs and wealth creation for society. Our business model and culture is consistent with these significant responsibilities. As a major participant in the financial markets we remain committed to supporting initiatives that improve the long-term stability of the global financial system. Thus we will continue to work with governments, regulators and peers across the world to strengthen standards and processes.

With that I would like to pass the call to Gregory Palm, our General Counsel.

Gregory Palm

Thank you David. As you are aware last Friday the SEC filed a civil complaint against the firm and one of our employees. We are very disappointed the SEC would bring this action which relates to a single, synthetic CDO transaction involving two professional institutional investors in the face of an extensive record which we believes establishes the allegations are unfounded.

I should note that since this is actively engaged I will have to be somewhat constrained in my commentary.

To begin with I want to make very clear one important point. We do not in any way dispute the necessity and the importance of the SEC’s role in protecting investors and supporting fair, orderly and efficient markets. Our dispute is with regard to the respective views of the facts in this case and the applicable law.

The process which resulted in this action began in August 2008 when the SEC first asked for information on this transactions. Over the past 18 months we have provided the staff with an extensive amount of documents and testimony related to our activities in the mortgage space generally and this transaction in particular. The core of the SEC case appears to be based on the theory that one of our employees and thereby the firm misled two professional institutional investors, ACA and IKB in connection with a synthetic CDO transaction.

Specifically the SEC claims that we failed to ensure that the offering material disclosed the role of another market participant in the transaction, namely Paulson and Co. Before delving further into the facts of this case I want to make another point clear. We would never intentionally mislead anyone; certainly not our clients or a counter party. We have never condoned and would never condone inappropriate behavior by any of our people. On the contrary we would be the first to condemn it and to take all appropriate action. Our responsibility to the financial intermediary required and our commitment to our integrity and the firm’s business principles demand it.

As to the case, and by way of background there were only two professional institutional investors other than ABN Amro acting as counter-party credit intermediaries involved in this transaction. Both of these investors are institutions with significant resources and extensive experience in the CDO market. At year-end 2006 ACA, a specialty financial services company, managed 22 similar CDOs with $15.7 billion in assets. IKB, a large German bank, had a separate mortgage group and was an active participant in the CDO market. Indeed, as of January 2007 according to IKB, they had launched and managed more than $16.8 billion of [CFO] and CDOs and used securitization and CDO investments as an integral part of their business model.

From the outset the transaction enabled ACA, IKB and Paulson each to achieve certain desired exposures to [DAA] two rated sub-prime securities of the 2006 vintage. Our role as the financial intermediary and market maker is to bring together such market participants. ACA and IKB were positioned to benefit from an increase in the value of the referenced portfolio of securities and Paulson was positioned to benefit from a decline in the value of this portfolio. As professional investors they fully understood that a synthetic CDO transaction must have both a buyer and a seller; that is both a long and a short side. Each had the resources necessary to analyze the referenced portfolio of securities which was completed itemized for them.

In the process of selecting the referenced portfolio, ACA which was both the portfolio selection agent and overwhelmingly the largest investor evaluated every proposed security. Although ACA received input from both Paulson and IKB, ACA had sole responsibility for determining and did determine the final portfolio and was paid a fee for performing that role. ACA used proprietary models and methods of analysis to develop its own independent view of the relative riskiness in each security. To that point ACA rejected more than half of the securities suggested by Paulson.

All of that being said, the particular securities in the referenced portfolio were not ultimately a key factor in the performance of this transaction. The entire pool of DAA rated securities from the 2006 vintage performed similarly amidst an unprecedented market collapse. The SEC complaint also alleges that ACA was led to believe that Paulson would be buying an equity position rather than taking a contrary position against the portfolio which skewed ACA’s approach to dealing with Paulson. We simply do not believe that the evidence cited by the SEC demonstrates that ACA was misled into believing Paulson was going to be buying an equity position and the term sheets and offering circular did not reflect an equity trench.

Finally, a significant point missing from the SEC’s complaint was the fact that Goldman Sachs retained a significant residual long position in the transaction. Our overall losses in connection with the transaction exceeded $100 million including $83 million with respect to the retained long position. We certainly had no incentive to structure a transaction that was designed to lose money.

In summary, there are four key points to consider. First, this was a transaction between institutional counter parties who well understood the risks they were taking. Moreover, ACA and IKB knew the transaction must have a short position opposite their long position.

Second, ACA was portfolio selection agent was solely responsible for and in fact did select the securities in this portfolio.

Third, there was never any representation that Paulson was to be a long equity investor in the transaction.

Fourth, GS had no economic motivation for this transaction to fail. In fact, our incentives were aligned with ACA and IKB.

Finally, we want to emphasize again that we do not in any way dispute the importance of the SEC’s role in protecting investors and supporting fair and efficient markets. Our dispute is with regard to our respective views as to the facts in this case and the applicable laws. With that we would like to thank you again for listening today and we are now happy to answer your questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Glenn Schorr – UBS.

Glenn Schorr - UBS

A follow-up on the case, I am curious on one thing. If there was no misrepresentation about Paulson being a long, how were they introduced into the process? In other words they were obviously making suggestions into what securities ACA should include but under what capacity were they introduced if it wasn’t a long or a short? What were they doing?

Gregory Palm

My first comment would be and I think you probably know this very well. In this market there has to be a long and a short. That is perfectly clear. Other point I would really emphasize is in order to have a transaction in this market you have to have some reference portfolio of securities which is satisfactory to both the longs who are looking at the portfolio; they are not really looking at really anything else and the short who are looking at the same portfolio and deciding that. As you know, whether the shorts are us or anyone else.

Paulson entered the process here with ACA and at least based on the record we have we actually have no idea where ACA got, assuming they did because that is alleged here the impression that Paulson was a “equity investor.”

Glenn Schorr - UBS

How did they know there was a transaction going on? Meaning, I know Paulson approached you and wanted certain exposure. How did ACA get introduced to Paulson?

Gregory Palm

I am sure we would have put them in contact with each other. Do I recall precisely what date that occurred on? There is no evidence introduced to us exactly what their involvement. The question is what was ACA thinking. I don’t know for sure what they were thinking simply because as I have described we are part of this case and the only evidence we have been given as to what they were “thinking” is the SEC statements as to what they were thinking and as to how we influenced that thinking as to what they were thinking you would see it in the complaint. I have no knowledge beyond that.

Glenn Schorr - UBS

How about a more straight forward one, the risk factors in the perspective that I have been shown seem pretty clear of what you are not representing at the time. They seem from a non-lawyer person like me to cover any misrepresentations because you are not making any representations at the time. So I am curious to know how that factors in if any because like I said the risk factors seemed to say you are not representing anyone’s role in this and there might be nonpublic information, blah, blah, blah. How much does…what kind of role does a prospectus play in a case like this?

Gregory Palm

The case itself is about the offering circular in terms of risks. Let’s back up and not be too legalistic. These investments relative to the investor is referenced securities. Although this isn’t a registered U.S. offering there is a particular SEC regulation called an AB which specifies the types of information about the securities you have to put into a prospectus of this type. Unlike a Ford Motor Company where you put in a description of Ford Motor Company and certain required disclosures mostly describing the company in a variety of ways.

Here unlike that is providing to the potential “investor” a list of all the particular assets he or she is investing in. In this case since it is a CDO, the financial institution’s investments. The reason for the risk factors of which as you can see there are many, we are making no representation other than the fact that yes these are the securities referenced in the portfolio because after all the performance of those securities had nothing to do with anything but the future; i.e. how was the mortgage or housing market going to perform in the future. So that is the role we played.

Glenn Schorr - UBS

Are there other Wells outstanding on this sort of or other issues?

Gregory Palm

What I would say about that is our policy has always been to disclose to our investors everything we consider to be material. That would include investigations, obviously lawsuits, regulatory matters, anything. Whether there is a Wells or not a Wells if we consider it to be material we go ahead and disclose it and that is our policy. To get to your question we do not disclose every Wells we get simply because that wouldn’t make sense. Therefore we just disclose it if we consider it to be material.

Glenn Schorr - UBS

Obviously at the K you didn’t think this was material. Believe it or not I have a question on the quarter. Risk weighted assets up 6% but your leverage is still way low and you kind of [bridged]. I am just curious where those risk weighted assets are showing up?

David Viniar

One of the things we told you over the course of last year is we were transitioning from Basel 1 being regulated by the SEC to Basel 1 being regulated by the Fed and doing so we had to get some models approved and other items that would change the way in which assets were calculated. I think that increase in risk weighted assets was largely due to transitioning to the Fed model. We are now fully on all of the Fed models.

Glenn Schorr - UBS

Did anybody have to approve the buyback even though you have the best capital ratios in bank land?

David Viniar

I would say it like this. We don’t do anything without our capital without the knowledge and approval of our regulators.

Operator

The next question comes from the line of Guy Moszkowski - BAS-ML.

Guy Moszkowski - BAS-ML

Let me start with a question on the quarter and then we will transition back to the case. On the quarter as Glenn noted the risk weighted assets grew a bit but the VAR fell. I was curious whether the decline in VAR was a conscious de-risking choice or the result of declining volatility and swapping out a high VOL quarter for a lower VOL quarter?

David Viniar

It was a combination of two things I would say. It was lower vol which definitely reflected it and then a continuation of the opportunities there being high velocity on the balance sheet, off the balance sheet, very liquid stuff. It was a combination of those two things which drove the VAR lower. It was not a conscious decision of opportunities we saw and how it impacted the VAR.

Guy Moszkowski - BAS-ML

The decision to repurchase some shares obviously we haven’t really seen that much elsewhere in the industry to date with most people saying as you have until now the uncertainty with the capital regime is such one prefers to retain capital. What was the thought process there as you chose to go ahead and repurchase some capital even though as you made clear your capital nonetheless grew?

David Viniar

I think it is a question of balance. I think all of the statements you made are still applicable to Goldman Sachs as well. There is still a lot of uncertainty out there. We still want to maintain high capital ratios but even with the buyback we did grow our equity by over $2 billion. Our capital ratios are quite high and remain quite high and I think we are committed to continuing to maintain very conservative, high capital ratios and we will make decisions on buybacks within the context of that commitment.

Guy Moszkowski - BAS-ML

If I can follow-up on the comp ratio at 43% obviously given the operating leverage inherent in your business and very strong top line results, it makes a certain amount of sense. Yet from a policy perspective you never really have waivered from the idea of a very high 40’s to 50% early in the year ratio and then you true up as we go on. I would like to explore the thought process there just a little bit more if I might.

David Viniar

What I would say is our compensation ratio was based on our performance, our competitive positioning and the external environment. Any of those could change in the future but that was the balance we struck right now.

Guy Moszkowski - BAS-ML

If I could ask a question or two about the SEC case, you said that you had an $83 million principle loss on the retained long position and some other losses that aggregated up to over $100 million which was a little bit more than what you said in the earlier press release which I think was about $90 million. What is the difference between the $83 million and the total loss?

Gregory Palm

The first point I would make is I think our first release we talked about it being over 90.

David Viniar

Over 100 is still over 90. We thought 100 was a round number and that would make it read better. There were several other aspects of the transaction that included positive fees and bid offer spreads but then there were also collateral securities we managed in which we lost money and other aspects of the transaction. When we added them all up the net losses to Goldman Sachs were over $100 million.

Guy Moszkowski - BAS-ML

As a follow-up to that was the fact that you had the position essentially that it was an underwriting position that you were unable to distribute? If that was the case how routine would it have been in this type of a synthetic mortgage CDO for you to have a holding of that type?

Gregory Palm

Two things. One, on the generality of how often or whatever I must admit I have never done a frequency analysis so I can’t tell you for us. It is not that relevant to the investor on the other side. The investor on the other side is told in the prospectus that in fact we are selling it and from their perspective we are the short. From their perspective it is irrelevant. The only other point I think I would make here is when the transaction was effectuated, as it were, the final transaction was settled and we obviously didn’t have to do a transaction if we weren’t willing to sit here and hold this long position which is what we did. Whether or not we were going to sell it in the future or try to sell it or whatever else, all of that could be true. When we did the transaction we obviously held the position and we kept holding the position.

Operator

The next question comes from the line of Howard Chen - Credit Suisse.

Howard Chen - Credit Suisse

I will start with one on the complaint. Are there any client businesses that cannot be conducted in normal course or impaired due to the filing of the SEC complaint or formal enforcement investigation by the FSA?

Gregory Palm

By the FSA? The short answer is I am not aware of any at all. Full stop. All corners of our industry are investigated all the time about everything. It doesn’t cause anything.

Howard Chen - Credit Suisse

Second, it is clear you strongly disagree with the complaint but how do you think about the timeline and impact of resolution from here?

Gregory Palm

Obviously we were somewhat surprised on Friday morning that this was a filed complaint since no one had told us about it in advance. We are certainly in the early stages of this case so in terms of resolution there all sorts of mechanical things involved in cases which I am sure you would like for me to speak a long time about but everyone in this room would probably get bored. We have not yet been served. There is a process in the court where you have to “answer” within 20 days once you are served except there are extensions to do that. Litigation would play out over time. Whether it is resolved quickly over time, takes a long time or not I really couldn’t say.

Howard Chen - Credit Suisse

Switching over to the business, very strong sales and trading results continue. Can you speak qualitatively to where you think we are in that hand off of improving client volumes and normalizing good asset spreads?

David Viniar

It is a very tough question. There is no data to support things. I would say bid offer spreads have tightened somewhat. They are certainly not as robust as they were early in 2009. They are still healthy and there is still very good client activity. Yet, as we have said repeatedly if GDP growth around the world picks up we would expect client activity to pick up as well. So good client activity but hopefully it will get better and bid offer spreads tighter than they were but still healthy.

Howard Chen - Credit Suisse

I know we are just a few weeks into it but post the end of the Fed impact on the mortgage purchase program what are you hearing in terms of business heads and seeing in terms of client activity as we see the extraction of some of these quantitative [easing] measures on the core business?

David Viniar

I think the Fed has done a terrific job at that. One of the things the Fed made very clear was they signaled way in advance what they were going to do. They signaled and they told the market and they told the market again and they told them again and then when the day came they were going to stop purchasing mortgage securities it was hard to find any market participant who didn’t know on that day they were going to stop shouldn’t be a [market system]. I think the market was completely ready and I think there hasn’t been much effect because of that. I think they have done a terrific job. It is too early to say in 2 weeks into the quarter what is going to happen.

Howard Chen - Credit Suisse

A clean-up question. What was the impact of DBA and some other smaller puts and takes within this quarter’s trading results?

David Viniar

It was very small. DBA was about $100 million positive.

Operator

The next question comes from the line of Michael Carrier - Deutsche Bank.

Michael Carrier - Deutsche Bank

When we look at the SEC process this is very unusual relative to how they usually operate. I am just trying to understand and someone was asking about the timeline but maybe what are the options? What happens? Is it trial is one stance or settlement? I am just trying to understand more what we should be looking out for over the next 3-6 months.

Gregory Palm

I obviously have hit the options. You got to trial which is what we are doing. You always have the option if there is an agreeable settlement to both sides settling at any point in time too. The timeline as stated before is actually totally unknown at this time. It could take a lot of time or a little time but we just don’ t know.

Michael Carrier - Deutsche Bank

On the client side dealing with these headlines whether it is employees, management team, you had some of the Greece headlines and these headlines. What are you telling the clients? Is there a heightened level of concern or is it more one-offs?

Gregory Palm

I think what I would say is we are out talking to our clients. I think you can see from our results last quarter our clients still support us. Our view is our clients will support us as long as we provide very good service to our clients. That has been the key to our success. It has been the key to our success for a very, very long time. Our people through the entire financial practice are out talking with clients. We are out providing service to their clients. We are out driving prices and liquidity to their clients and we are still doing that.

I think as long as we continue to perform for our clients they will be happy with us. If we stop performing for them then they won’t.

Michael Carrier - Deutsche Bank

On some of the regulation or where regulators are focused it seems like it is a lot down the food chain so whether it is derivatives, certain trading areas, on your conversations with all of the regulators is anyone focused with the underwriting standards or the beginning of these transactions versus what goes on over time? On the trading side in terms of recent derivative regulation some firms have pointed out what the potential impact would be from clearing over the counter transactions. Any way to size up how significant derivatives are for you and any potential impact? Clearly we are still early in the process but any clarity there?

Gregory Palm

It is very hard to quantify what effect any of the legislation could have because it is very uncertain in how it affects all of the different markets which are uncertain. As far as some of the derivatives legislation we have said this before, we support greater standardization in the derivatives market. We support the increased use of central clearing houses. We think it will make the market safer and frankly given we are very conservative in our credit terms we think it will make us more competitive. We are supportive of much of the derivatives legislation that is out there.

As far as underwriting standards, I think that all of the regulators always are and always have been focused on underwriting standards. That is one of the most important things in driving a safe and efficient market is having good underwriting standards. I am not sure there is any new legislation on it. It is a big focus of every regulator and a big focus of ours and always has been.

Operator

The next question comes from the line of Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

One on the case, how many of your CDO transactions I think the data I has says you did 39 in 2006 and 34 in 2007. How many of those has the SEC reviewed and concluded reviews of so far?

Gregory Palm

The concept of, I think as I indicted in my remarks, the SEC for the past 18 months has been looking generally at the mortgage market; our mortgage deals and in particular focused on what we are talking about here. That is basically all I can say on it right now.

Roger Freeman - Barclays Capital

Are there others where there is repeated back and forth dialogue that they are asking a lot of questions that you think could result in charges?

Gregory Palm

There is one case that has been brought. That is all we know.

Roger Freeman - Barclays Capital

Moving onto the business, can you help us a bit with any particular areas of strength on the client flow side? Most of the indicators we have looked at as you [got to the close of it] are mediocre and definitely not 75% up from the fourth quarter and bid asks from what we can tell are pretty much at their tight but it sounds like you don’t agree with that. Any color you can give there on this particular product area of spreading from the flows?

David Viniar

I think what it shows is how broad and deep our client franchise is. It was strength across every one of the business units, across every one of the regions. It wasn’t dominated by one particular product, one particular trade or one particular region. It was really just broad strength across our entire franchise. I think that is what really, as I said, is very balanced. That is really what drove the performance in the quarter. Very good as opposed to great, very good performance in all of the products.

Roger Freeman - Barclays Capital

So you ended up with a great outcome right on the revenue. Was positioning material or no?

David Viniar

It is really because we don’t expect necessarily every one of the businesses to have very good performance at the same time. We talked about hand offs between micro and macro and this was really very good across all of them.

Roger Freeman - Barclays Capital

Anything in commodities worth pointing out in terms of trends?

David Viniar

Good performance.

Roger Freeman - Barclays Capital

What percentage of that business would you say is swaps related as opposed to securities trading and futures?

David Viniar

I’m not sure. I am not even sure how to quantify that.

Roger Freeman - Barclays Capital

My question I guess following on that with the Lincoln legislation what are your thoughts on or read on the swaps language basically is calling for the business to be completely spun out of the dealers or lose access to Fed borrowing?

David Viniar

All I would say is I think derivatives serve an important role in the world’s financial markets. My guess is they will continue to in some form. We will just see how the legislation turns out.

Roger Freeman - Barclays Capital

In equities you said the sequential increase was mostly derivatives. So I guess it is fair to say that derivatives as a percent of your equities trading revenue is probably at least 50% if not 2/3 of that business now?

David Viniar

That is where I want to be very careful. It drove the delta. It didn’t necessarily drive the [inaudible].

Roger Freeman - Barclays Capital

But your delta was $400 million so that would at least get you to 1/3 and then some portion of the $1 billion in the fourth quarter was derivatives right?

David Viniar

I think it is fair to say our equities business is relatively balanced between cash and derivatives.

Operator

The next question comes from the line of Michael Mayo – CLSA.

Michael Mayo – CLSA

I am not a lawyer either but it seems like a lot of the SEC’s case relates to page 12 of the SEC’s complaint where they say “investors were assured that the parties collecting the portfolio had an alignment of economic interest with investors.” I guess that relates to two points. One, Paulson helped to select the portfolio and two, Paulson was going short. So in very simple terms why would the SEC be wrong?

Gregory Palm

In very simple terms the portfolio here was not selected by John Paulson. The portfolio here was selected by ACA. ACA had the responsibility to do that. They were paid to do it. They did do it and they were the largest investor in this transaction overwhelmingly. They certainly had every incentive to do it. As I indicated in the prepared remarks way more than half of the portfolio are things they suggested and I use the word “suggested.” These transactions get suggestions from all sorts of people typically. That is why I would say there is nothing to what is in there.

Michael Mayo – CLSA

At what point does materiality kick in? If John Paulson had suggested all of the securities in the portfolio and ACA selected them all would that then be material? If he selected one and they selected one that wouldn’t be material. If he selected all maybe that would be material. At what point do you cross the threshold?

Gregory Palm

Number one, as you know I believe it didn’t matter what was selected here. If you bought in the 2006 vintage you got crushed when the market collapsed which no one could predict. This was basically just taking a view on what was happening in the housing market so it really didn’t matter at all. Secondly, think about the fact that ACA was the economic purchaser of more than 85% of the deal. So they selected the portfolio. They were paid to select the portfolio and they invested totally in the portfolio. Once again I have to end up at the same conclusion. We just disagree with the legal theory here as well as the way the facts are characterized.

Michael Mayo – CLSA

On this point, even if morally you are absolutely correct. It was three parties. Everybody knew what was going on but under the law perhaps there is a required disclosure even if the ACA knows what is going on there is required disclosure in the offering circular to simply say who was involved in the process. Why is that argument wrong?

Gregory Palm

You started out with “if the law requires” and why is the argument wrong. We don’t believe the law requires it. We certainly don’t believe it is material in this context at all.

Michael Mayo – CLSA

How typical would it be for hedge funds to meet with a third party for selection of securities in a CDO? How does that market work?

Gregory Palm

Commenting on your description is somewhat challenging. One point I would make is that the advocates transaction as you can see from reading the SEC complaint stands out on unique facts including the “allegation” that somehow one of our employees misled or negligently misled ACA into thinking Paulson was something other than he turned out to be. The facts here are incredibly, I would say, narrow in that sense.

Michael Mayo – CLSA

Let’s assume everything you did here was legal for the moment, which I know you believe, let’s assume this doesn’t go away soon. Why not just work with the SEC? When you fight City Hall some bad things can happen. At what point do you say let’s just put this behind us. The SEC has a point of view. We disagree. Let’s just find some middle ground and settle and disclose more and kind of see?

David Viniar

I would leave this to what Gregory said. We don’t know how this case is going to unfold at this point. It is very early on and we will see how it unfolds.

Operator

The next question comes from the line of Edward Najarian – ISI.

Edward Najarian – ISI

I would be interested, as you read the SEC’s complaint what in your opinion are they trying to extract from Goldman Sachs? Are they after a punitive damage of some sort? Assuming the SEC is successful, where will they attempt to go with this in terms of how they deal with Goldman Sachs? Will it be punitive damages? Will it be restricting Goldman from sort of business practices? Will it be both? How do you think about your downside risk even though you believe you are right regarding where the SEC is trying to take this?

Gregory Palm

First of all I have no idea how the SEC is approaching this obviously because the case came as quite a surprise. Secondly, when the SEC makes cases like this they typically want some type of a fine and other types of things. Unless they have given the nature of the allegations which is whether or not the individual or firm misled someone about something that is a pretty narrow set of facts. We certainly agree there should be prohibitions from people misleading people and we would never permit it if we knew about it. I have no idea what the SEC would think about and so forth so I can’t really comment beyond that.

Edward Najarian – ISI

They have made no indication to you of now they have filed this complaint and they have made no indication to you of where they would like to take this or what sort of is their next step in the process is?

Gregory Palm

No indication whatsoever.

Operator

The next question comes from the line of Meredith Whitney - Meredith Whitney Advisory Group.

Meredith Whitney - Meredith Whitney Advisory Group

You had pretty significant outflows this quarter and the results have been choppy for the last six quarter. I know you have had some personnel changes. Can you comment on that and can you comment on what you are doing to address what looks to be some disruption in that business?

David Viniar

I would say the results this quarter the outflows this quarter were basically all in money markets. That is pretty consistent with what we have seen going on around the world. Basically what is happening is the world is re-risking so they are taking money out of money markets and putting it elsewhere. We don’t control all of the dollars so we don’t keep all of them. We did have inflows into fixed income which is pretty consistent again with what has been happening in the world. We don’t view that as having been choppy. The changes we have made really had nothing to do with performance. It was people deciding it was time to retire and we moved some people around. We are still pretty pleased with how that business is going and the growth we have had over time and the mix of the assets.

Operator

The next question comes from the line of Jeff Harte – Sandler O’Neill.

Jeff Harte – Sandler O’Neill

This has kind of been touched on but when it comes to the fixed income trading environment we kept hearing how competitors were gone and there was very little competition and only a few people actively committing capital. With spreads not really coming back in all the way yet what are you seeing as far as competitors coming back into some of the fixed income businesses? Are they back?

David Viniar

I think you just saw it from the results from our competitors that a bunch of them are certainly more involved in the market than they have been over the last 18 months or so. There is definitely more competition than there was last year and as I have told you a bunch of times we expected that was going to happen and in fact we assumed it was going to happen sooner than it did. Our client franchise and our market shares remain extremely strong. I think what we have done in being there for our clients throughout has helped us and hopefully will continue to help us. The breadth and depth of the product portfolio we offer and our willingness to provide liquidity and make markets for our clients when they need it I think has helped us a lot. Our market share has stayed very strong but there is definitely more competition.

Jeff Harte – Sandler O’Neill

Covering as many products and geographies as you do are there specific products where the competition really hasn’t come back as much?

David Viniar

I think it is pretty much starting to come back in most places.

Jeff Harte – Sandler O’Neill

On sec lending you mentioned the year-over-year change in the composition of securities lending customer balances and stuff. Any changes sequentially?

David Viniar

I would say same thing. I think people are more nervous to short with harder to borrow securities given how robust the markets have been I think that is really what has been driving it.

Jeff Harte – Sandler O’Neill

One thing on the case, at this point we are talking about an SEC civil complaint. Has there been any conversations with the Department of Justice or anything beyond civil?

Gregory Palm

There have been no conversations whatsoever.

Operator

The next question comes from the line of Kien Abouhossein – JP Morgan.

Kien Abouhossein – JP Morgan

The first question is regarding litigation reserves. Have you taken any reserves regarding this SEC complaint? What are your outstanding litigation reserves currently?

David Viniar

We take litigation reserves for anything that is estimable and probable as we are supposed to do. We don’t disclose anything for individual cases because that wouldn’t be prudent for us to do.

Kien Abouhossein – JP Morgan

In respect to the financial regulatory bill is it possible to get into a little bit more quantification considering the bill is now relatively detailed both in respect to the Volcker Rule, the end user clearing and the trading on the [NASEF] platform?

David Viniar

We actually find it very difficult to quantify exactly what the effects would be because it is very hard to know how the markets will unfold, very hard to know how competitive positioning would unfold. We continue as we have said many times our support for the efforts of the Administration and Congress that improves the safety and soundness of the financial system. We think it would be very important for any reform to move forward on a global basis and not to be fragmented in different parts of the world but very hard to quantify. We think as long as regulation is consistent around the world and for all competitors we will do just fine.

Kien Abouhossein – JP Morgan

Regarding the Basel consultation paper for Basel 3, I assume you have replied to the consultation paper at this point. I was wondering what are the key issues that you would like to see changed in Basel 3?

David Viniar

We have responded to the qualitative comments because that is what we do lastly. The quantitative impact isn’t due until the end of the month so that is not done yet. Without getting into specifics we just want to make sure regulators in Basel who are looking to make the system safer which we support don’t go too far and do things that will [inaudible] against Basel 1. We want to make sure those unintended consequences don’t happen.

Kien Abouhossein – JP Morgan

Are there any specific issues, leverage or derivatives and minority holdings kind of thing, are there any issues you think should really be changed that are high on your list?

David Viniar

We are not going to get specific with our commentary.

Kien Abouhossein – JP Morgan

Lastly on FICC revenues I remember awhile ago you said you have a very high market share in FICC revenues and although you expect the pie to be relatively big and continue to be very big your continued size of your pie could shrink. If I look at these revenues I don’t see that. Can you explain in what areas you have significant performance and what business segments of FICC?

David Viniar

I actually think I said the opposite. I said if you think about what ought to happen when our market shares were so high last year is that if you think of what should happen as the world got better and competitors got healthier they would come into the market and our market share would probably decrease but that ought to be tied with the world getting better with greater activity levels and therefore the pie increases. My expectation was our market share would decrease and the pie would increase. But it was pretty certain those things would not happen at exactly the same time. That was the extent of the backdrop. As far as specific areas you asked about one of the things I mentioned was it was not a specific area that drove this. It was very good performance across all of the products really that drove this. Good balance, product mix and levels.

Kien Abouhossein – JP Morgan

Within regions?

David Viniar

Good product mix both across products and across regions. Very good balance.

Operator

The next question comes from the line of Matt Burnell - Wells Fargo Securities.

Matt Burnell - Wells Fargo Securities

A couple of questions on the quarter. You mentioned the backlog this quarter was flat from the prior quarter. That sounds a little bit less strong than we have heard from some of your competitors. Can you put some color around where there might be strength or weakness around that?

David Viniar

I think you always have to be a little careful of backlog because as you know a lot of deals, certainly financing deals, will quite often get done that don’t get into the backlog at all. I would say the mix shifted a little bit and so you probably had a small increase in advisory backlog, a small decrease in underwriting backlog but I wouldn’t read that much into it. Directionally it is usually pretty good but absolutely it is not. We are still seeing really good dialogue and I think if the world continues to improve, the economic world continues to improve I think we will see more activity. If it doesn’t then we are wrong.

Matt Burnell - Wells Fargo Securities

You mentioned in terms of FICC that the geographic breakdown was pretty solid. Would you characterize the equity performance as basically being the same internationally versus the U.S. or are there pockets of strength within the equities business geographically?

David Viniar

What I would say is really across the firm pretty consistent with what we have seen, but again it is always hard to measure because we are a global business but legal did over 50% of our revenues in the U.S. and a little bit under outside the U.S. I think that mix will probably shift in the other direction. Outside the U.S. probably 2/3 or so Europe and 1/3 Asia. That is pretty much what we saw.

Matt Burnell - Wells Fargo Securities

One regulatory question. You mentioned in the fourth quarter conference call Goldman had no intention of changing its charters in terms of having a bank charter. Can you confirm that is still the case? More to the point, with all the pending regulation in your view would it even matter if you were a bank or not a bank? Wouldn’t the regulation basically apply to you regardless of your status?

David Viniar

I think I mentioned that. We have no intention to change anything as we sit here now. I think at least from what we see it is pretty clear that in the regulation where [audio break] seems to be systemically important firms that we will be one and we are going to be covered by those same regulations. I don’t expect anything different than that.

Operator

The next question comes from the line of David Trone – Macquarie Securities.

David Trone – Macquarie Securities

I am still not 100% clear on something. The synthetic needed a short. Presumably ACA knew that construct. Did they know that Paulson was that side of the trade?

Gregory Palm

I have no idea what ACA knew. I read what I read in the complaint and I read what they say was caused by us negligently or otherwise.

David Trone – Macquarie Securities

It strikes me that if there is a synthetic and if ACA was as experienced as you say they must have known there was a short so it comes to the question of when Paulson was making recommendations did they; A. Solely think they were long. B. Did they think they were the short side of the trade? C. Did they think they were going to be the short and maybe hedge it with the equity trench? I guess that is really the crux of the matter.

Gregory Palm

I think you did a pretty good job of coming up with the variations. I have no idea. I really can’t help you out there. As I said somewhere in the prepared remarks this all seems to be, as I said, at root about whether or not someone intentionally misled someone and I have also said that is something we certainly wouldn’t approve of or sanction. Beyond that I have no idea. I can’t really speculate.

David Trone – Macquarie Securities

You mean you as a person or Goldman Sachs itself has no idea? You were the broker right? You kind of brought the parties together?

Gregory Palm

Me as a person? I am speaking on behalf of Goldman Sachs right now. What I am saying is…

David Trone – Macquarie Securities

Right so how could you now know. You brought the parties together.

Gregory Palm

Based on the facts as we know them the view is we have no basis for knowing why ACA concluded what it concluded. The SEC obviously alleges it was a negligent or whatever intentionally, there are all sorts of alternatives to this and it is a very technical document, by an employee of ours and it cites these emails which are sitting in the complaint for that proposition.

I think if you read the complaint it certainly provides no basis for representation by us or anything else. Again, we are at the beginning of this litigation and as I said at the beginning our view of the facts is different from the SEC’s view of the facts and the case will proceed.

David Trone – Macquarie Securities

Let me ask you customarily forgetting about this transaction but just generally in a synthetic where there has to be a long and short, wouldn’t it be totally legitimate for the short side of the trade to negotiate with the long side of the trade what they were going to include? Kind of no different than if I am going to bet on a basketball game with a friend he and I have to negotiate the spread?

Gregory Palm

Yes I would agree with you entirely and if you think about it you can’t do a synthetic trade unless both sides are amenable to whatever you are talking about. Whether or not a financial institution such as ourselves who sits in the middle of the mark and tries to bring people together talking to both sides all the time, then comes up with the [inaudible] going back and forth or otherwise. Of course that is the case.

David Trone – Macquarie Securities

If it was synthetic and didn’t need the equity trench and full capital structure I am not 100% clear on why Goldman had a position.

Gregory Palm

Our position wasn’t in the equity trench. Our position was a slice of the super senior. We had a slice there which was similar to the same slice ACA would have had on the swap they did using ABN Amro was the credit provider in the middle. It was part of the super senior.

David Trone – Macquarie Securities

Why did you take that? You didn’t have to right?

Gregory Palm

We didn’t have to take that position. Obviously I have been asked the question would we have wanted to redistribute it or whatever else which is somewhat irrelevant to the proposition and when we closed the transaction we took on the position. If you look at the proposed regulatory changes which David alluded to the concept of having skin in the game, the 5% rule or whatever he has talked about if that is adopted in some way you could say that underwriting we had is skin in the game. We held the position. Whether or not we decided to distribute it or wanted to distribute it later is somewhat quite irrelevant because we didn’t have to do the transaction. If we weren’t willing to take on the risk we wouldn’t have taken on the risk. If we believed there was something wrong with this transaction we obviously wouldn’t have put our skin in the game in that way as it were.

David Trone – Macquarie Securities

Let me take that a step further. Could the transaction have been consummated without you taking a position?

Gregory Palm

I have no idea. You would have to have a different transaction because right now you have to have a long and a short.

David Trone – Macquarie Securities

But you already had them without you.

David Viniar

We didn’t have matching positions. So we don’t know if it could have been consummated without us. It wasn’t consummated without us. We don’t know if it could have been.

David Trone – Macquarie Securities

So in essence, it sounds like you needed to take the position to make it happen?

David Viniar

We took a position and the deal got done. It is hard to say what would have happened if we didn’t.

David Trone – Macquarie Securities

Lastly, did you hedge that position?

Gregory Palm

The reason you see the loss that has been described is because we held the long position and it deteriorated in value substantially as did all the securities in this market are interested in this and that is why we had the loss.

David Trone – Macquarie Securities

So when you are giving us that number you are not just giving us a gross?

Gregory Palm

No that is the net loss to the firm. That is our so-called P&L on that, mostly L.

Operator

The next question comes from the line of Ron Mandel – GIC.

Ron Mandel – GIC

There is one aspect of the legal issue I am not sure I completely understand and that is as you say ACA involved ABN Amro in the deal. So it is not clear to me ACA ever had or actually when the deal closed that ACA had that significant an economic interest in the deal. I was wondering if you could elaborate on that point?

Gregory Palm

They had a full economic interest in how the deal performed. ABN Amro’s only role was in essence to stand between ACA and us simply because there was a credit question meaning ABN had collateral posting questions. ABN Amro was willing to take on the possibility that now ACA would have financial difficulties had nothing to do with this particular transaction whether it went up or down. They were there basically as a credit protector and so we faced ABN Amro with a [normatively] same type of swap arrangements going over to ACA. As the deals fluctuated in economic value ABN Amro really had no care or interest in that. Ultimately the only real question was at the end of the day would there be any kind of overall credit problem with ACA because it’s total business or whatever it is they happened to be doing. ABN Amro was there for that reason. As you know all the major financial institutions, never say all, but financial institutions like ABN Amro or Goldman Sachs we are willing to post collateral one way or the other depending on how the positions are moving between each other.

Ron Mandel – GIC

So in the end ABN Amro did suffer a loss from this deal because ACA had losses overall? Not just on this deal.

Gregory Palm

Entirely correct.

Ron Mandel – GIC

In regard to the asset management business you mentioned the outflows from the money market funds but the equity has been weak, slightly negative this quarter and haven’t been that strong in the recent past whereas they had been more robust earlier. Is there a bigger story there you can elaborate on?

David Viniar

No. Again I would say that is pretty consistent with industry trends as well. If you look at what happened really through the course of 2009 in the asset management world [forgive me] I call them factors in the industry, you saw outflows in money markets and inflows into fixed income funds. Very, very little, in fact I think gross in the industry and I may be off a little but I think there were still outflows in equities although pretty close to flat. It is really only recently that you started to see small inflows into equity funds.

Ron Mandel – GIC

So you are happy with your performance in the funds and there is no issue in that regard?

David Viniar

We are never happy with our performance. We always think we can do better. So we are always striving to make it better and asset management as well but we think relatively we are doing okay.

Operator

The next question comes from the line of Richard Staite – Atlantic Equities.

Richard Staite – Atlantic Equities

Getting back to the compensation ratio you said it was 43% reflecting the strength of your business and the current environment. If for the remainder of the year revenues remain strong and the environment doesn’t change should we be looking at 43% for the next three quarters and then a dip into the fourth quarter?

David Viniar

I guess what I would say is I mentioned three factors; our performance, the competitive environment and the external environment. The only thing I can be sure of is all three won’t stay exactly the same as they are today. So we are just going to have to see how that unfolds and that will be the basis of deciding what compensation should be over the course of the year.

Richard Staite – Atlantic Equities

What should we think about the U.K. bonus tax in that?

David Viniar

The U.K. bonus tax is not considered in those numbers. The U.K. bonus tax is a separate, one-time item.

Richard Staite – Atlantic Equities

A very separate question, on your overall revenues can you give some guidance around how much is generated from governments as a client? The obvious question being if certain governments decide they didn’t want to deal with you anymore would that have much of an impact?

David Viniar

As you know, I have answered this question many times before. It is a very, very hard question to answer because we have a very integrated sales and trading model but the very, very vast majority, in fact almost all of what we do, starts with our clients and starts with trades that our clients want to do and we are providing some type of service of liquidity for our clients. There is a small, walled off proprietary business like GSP which we have talked about but the great majority of what we do is based on our client franchise.

Operator

I will now turn the call back to management for any closing remarks.

Dane Holmes

Once again I would like to thank everyone for joining our first quarter 2010 conference call. If you have any additional questions please feel free to contact me at the Investor Relations department to have those answered. Otherwise, please enjoy the rest of your day.

Operator

Ladies and gentlemen this does conclude today’s Goldman Sach’s first quarter 2010 conference call. You may now disconnect.

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Source: The Goldman Sachs Group, Inc. Q1 2010 Earnings Call Transcript
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