Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

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

Q3 2008 Earnings Call

September 16, 2008 11:00 am ET

Executives

Dane Holmes – IR

David Viniar - CFO

Analysts

Prashant Bhatia - Citigroup

Guy Moszkowski - Merrill Lynch

Glen Schorr – UBS

Meredith Whitney – Oppenheimer

Analyst – Morgan Stanley

Mike Mayo – Deutsche Bank

Roger Freeman - Lehman Brothers

Doug Sipkin – Wachovia

James Mitchell – Buckingham Research

Michael Lipper – Lipper Advisory Services

Operator

Good morning and welcome everyone to the Goldman Sachs third quarter 2008 earnings conference call. (Operator Instructions) Mr. Holmes you may begin your conference.

Dane Holmes

Good morning everyone this is Dane Holmes, Head of Investor Relations and 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 those forward-looking statements. For a discussion of some of the risks and factors that could affect the firm’s future results, please see the description of risk factors in our current Annual Report on Form 10-K for our fiscal year ended November, 2007.

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.

Let me now ask David Viniar, our Chief Financial Officer to review the firm’s third quarter results.

David Viniar

Thanks Dane, good morning and I’d like to thank all of you for listening. Before discussing our results for the third quarter, I want to briefly address events surrounding the financial services industry and some of the things that have been said and written about Goldman, Sachs and our business model.

First the issues in the mortgage and credit markets have affected all financial institutions including investment banks, commercial banks, regional banks, mortgage companies, and insurers. These issues are in no way isolated to the broker dealer sector.

Some of the key issues facing the financial service industry have included concentrated sources of revenue generation and outside risk exposure to certain asset classes. Declining market values across these products translated into meaningful investment losses that in many cases resulted in dilutive capital raises.

Given our position within the global financial services industry we have not emerged completely unscathed during this process and I can assure you that we have made our share of mistakes. That being said our priority has always been to protect the firm’s financial position and franchise at all costs.

First and foremost, since going public we have executed on our goal of building a global diversified business model. This goal was not solely a business decision but also reflected a fundamental risk management strategy. Through our financial performance as a public company, we have repeatedly demonstrated the benefits of having a deep and broad franchise.

It is this business model and franchise which despite the challenging environment generated a return on equity of nearly 19% over the past four quarters. Second, a key component of our firm wide risk management process is a disciplined approach to marking our assets to market.

Our commitment to daily marking allows us to appropriately measure risk, see problems early, and thus be more proactive in managing our exposures. Our process is dedicated to marking each individual asset at a market clearing level.

For example, in the third quarter we sold approximately $4 billion of non-agency residential mortgages and virtually every trade was at or above our marks. You will never hear from us that we won’t sell and asset because we are reluctant to take a loss since our positions are marked where they can be sold.

We recognized early the risks associated with concentrated exposures and aggressively moved to reduce them. As we’ve discussed before we have $52 billion in leveraged loans just over a year ago. Now we have $8 billion of these legacy loans; an 85% reduction in our exposure.

This risk reduction came at a substantial economic cost as we incurred losses of over $3 billion but it was the realization of those losses on a daily basis that strengthened our resolve to continue to reduce our exposures.

Let me be clear, many times over the past year we have sold assets that we believed would ultimately be worth more then where we sold them. The reality was they were too large or too concentrated and therefore needed to be sold. When we have a problem we try to deal with it.

As you’ve heard me say numerous times, the first loss is often the best loss. Furthermore, as opposed to diluting our shareholders during this cycle, we’ve actually strengthened our capitalization through the core earnings power of our franchise and business model.

Despite the difficult environment we’ve grown book value per share by over 17% in the past four quarters. In addition we continue to have significant financial flexibility given the fact that 93% of our total shareholders equity is comprised of common equity.

Finally, you’ve heard me talk about the importance of liquidity. We’ve always approached our liquidity risk management framework with extreme conservatism. Throughout these trying times we’ve become even more cautious in our approach.

We continue to focus on maintaining the appropriate size, term structure and diversification of our counterparties. Our global core access averaged $102 billion during the third quarter; 17% higher then during the second quarter.

In addition the average life of our secured funding book is well in excess of 100 days with the more difficult to fund assets having the longest term. For example, the average life for our bank loan funding is well in excess of six months.

It costs a lot of money to manage our liquidity in this conservative fashion but at Goldman, Sachs this expense has been up for debate. In addition to this conservative liquidity risk framework, the Federal Reserves announcement on Sunday, has introduced policies that go even further in mitigating our liquidity risk.

The Fed has agreed to accept in the PDCF a broad range of collateral that closely matches the assets eligible for tri party repo including non-investment grade debt securities, whole loans and domestic and international equities.

So while our access to funding continues to be quite robust the Fed’s actions have greatly diminished the liquidity risk associated with our secured funding book. There is broad based fear in the markets today, but we believe individual financial institutions that have global diversified business models, and that have outperformed through the crisis will be positively differentiated and that goes for commercial banks, insurers, investment banks or any other type of financial institution.

It is not the business model. It is the performance that matters. While I cannot predict the near-term macro environment, I can assure you that Goldman, Sachs has never been closer to our clients or better positioned to face tough markets and take advantage of profitable opportunities.

We’ll continue to manage this firm with our focus utmost on protecting this valuable franchise. Now I’m going to turn to reviewing our third quarter results.

Net revenues were $6 billion, net earnings were $845 million and earnings per diluted share were $1.81, annualized return on common equity was 7.7%.

Third quarter market environment presented significant challenges. We experienced meaningful volume declines in many of our businesses and pricing pressure across both equity and credit assets. Despite this difficult backdrop we remain committed to helping our clients at a time when sound advice and dependable execution were of the utmost importance.

And although this quarter was likely the most challenging operating environment we’ve experienced as a public company, the strength of our franchise and effectiveness of our business model have never been more evident.

Let me now review each of our major businesses, investment banking produced net revenues of $1.3 billion this quarter, down 23% from the second quarter. Third quarter advisory revenues were $619 million, down 23% sequentially. We ranked first in announced global and completed mergers and acquisitions for the calendar year-to-date.

We advised on a number of important transactions that closed during the quarter including [Andessa Italia’s] $9.1 billion euro sale of a majority stake to [Eon], Ingersoll Rand’s $11.5 billion acquisition of Trane, and Novartis’ $10.5 billion acquisition of a minority stake in Alcon.

We’re also advisor on a number of significant announced transactions including Anheuser-Busch’s $59.6 billion sale to InBev, Alltel’s $28.1 billion sale to Verizon Wireless and APP Pharmaceuticals’ $5.6 billion sale.

Underwriting revenues were $675 million, down 24% sequentially. Equity underwriting revenues of $292 million were down 53% from a strong second quarter that included our participation in a number of financial institution capital raises.

Significant declines in global equity markets during the third quarter also meaningfully reduced new [issue] volumes. IPO activity was particularly weak with industry volumes down more than 50% sequentially. Debt underwriting revenues were up 42% from a weak second quarter to $383 million.

Bank loan activity increased while investment grade and high yield underwriting levels continued to be soft. During the quarter we participated in a number of significant underwriting transactions including Wrigley’s $4.9 billion debt offering, State Street’s $2.9 billion common stock offering and AngloGold Ashanti’s $1.8 billion rights offering.

Our investment banking backlog increased during the quarter. Let me turn to trading and principal investments which includes FICC, equities and principal investments.

Net revenues in this segment were $2.7 billion, down 52% from the second quarter. FICC net revenues were $1.6 billion, down 33% sequentially. Rates, currencies and commodities all produced solid revenues that were up from the second quarter showing the continued strength of our macro franchise.

Credit revenues declined sequentially due to lower client activity, weak investment performance, largely outside the United States and approximately $275 million of losses associated with our leverage lending business.

Mortgage revenues also declined from the second quarter due to residential and commercial real estate net losses of $500 million and $325 million respectively. Turning now to equities, net revenues for the third quarter were $1.6 billion, down 37% on a sequential basis.

Equities trading net revenues were $354 million, down 72% from the second quarter. Significant declines in global equity markets and higher volatility levels combined to form a challenging environment for this business. In addition client deleveraging and lower activity levels drove fewer opportunities across various businesses, particularly in August.

Principal strategies results were also very weak. Equities commissions of $1.2 billion in the quarter were strong, down approximately 2% on a sequential basis. Turning to risk, average daily value at risk in the third quarter was $181 million compared to $184 million for the second quarter.

Our equity category VAR declined during the quarter due to lower position sizes while our currency category VAR declined due to lower exposures.

Let me now review principal investments, we recorded $581 million in losses from other corporate principal and real estate investments largely outside of the US. This was offset by $106 million gain on our ICBC investment for a net loss of $453 million in the third quarter.

Our investment in ICBC produced a gain during the quarter despite a decline in their stock price due to the amortization of our liquidity valuation adjustment as we approach the April, 2009 initial lock up expiration.

We produced very strong results in asset management and security services with net revenues of $2 billion, down 5% from the second quarter. Asset management produced net revenues of $1.1 billion which were down 3% sequentially. Assets under management decreased to $863 billion at the end of the third quarter. During the quarter assets under management decreased $32 billion reflecting $7 billion of outflows and $25 billion of market depreciation largely in equity assets.

Security services produced its second best quarterly net revenues of $916 million, down 7% from a seasonally strong second quarter. Now let me turn to expenses.

Compensation and benefits expense in the third quarter was $2.9 billion, accrued at 48% of net revenues. Third quarter non-compensation expenses were $2.2 billion, a 6% increase from the second quarter.

Excluding non-compensation expenses related to consolidated investments costs were up 2% sequentially largely in other expenses and primarily related to our reinsurance business.

Although non-compensation expense fluctuates from quarter to quarter we are vigilant about controlling costs especially in light of the more challenging environment. Headcount at the end of the third quarter was approximately 32,600, up 3% from the second quarter reflecting the normal seasonal pattern of college and business school hires starting in our analyst and associate programs during the summer.

Our year-to-date effective tax rate was 25.1%, which resulted in a tax rate of 12% for the third quarter. The decrease in the effective tax rate was largely due to the geographic mix of earnings and an increase in permanent benefits as a percentage of lower earnings.

During the quarter the firm repurchased 1.5 million shares for approximately $270 million. We currently have approximately 61 million shares remaining under the firm’s existing stock repurchase authorization.

As I mentioned earlier our liquidity and capital positions are strong. As of the end of the quarter our Tier 1 ratio was 11.6%. In addition our global core access pool of liquidity averaged $102 billion during the third quarter.

Given the current challenging operating environment we are maintaining higher then normal levels of capital and liquidity. The global capital markets have experienced significant turmoil over the past year. Extreme volatility and asset value reductions across both credit and equity markets, have presented numerous challenges for Goldman, Sachs and our peers.

Throughout this period we’ve remained focused on protecting the firm and limiting the impact of a dislocated environment. But with challenges come opportunities and the risk management decisions we’ve made over time allow us to approach this market from a position of strength.

We continue to be outward-looking and know that in times of market stress our clients come to Goldman, Sachs even more often for our guidance and execution. We will remain focused on our core strategies and be opportunistic about committing capital.

While you know me well enough to know that I won’t predict when this extended credit crisis will end, I can promise you that it will end. The continued hard work of the people of Goldman, Sachs and our unrelenting focus on our clients will leave us well positioned to pursue our goal of long-term value creation for our shareholders.

With that I’d like to thank you again for listening today, and I’m now happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Prashant Bhatia – Citigroup

Prashant Bhatia – Citigroup

There seems to be a perception that having bank deposits is in some way a cure-all. Even if you were to merge with a commercial bank again, just theoretically, would you even be allowed to use those deposits in the trading businesses?

David Viniar

You made a very good point; you can answer the question for me. Our banking competitors also need to fund the capital markets, bank deposits can basically be used to fund the business of the bank; what a bank does, largely not the capital markets businesses that we are in. And so I think the answer is there would be some small portion of our business that would probably be able to be funded by bank deposits, but most of the business that we’re in could not be funded by banks.

Its one of the reasons why if you look at—take five big financial, four of the biggest, best banks in the world—Citi, JP Morgan, UBS, Banc America, and add Goldman, Sachs to that list and which one do you think has the lowest amount of long-term unsecured debt sourced in the capital markets? It’s Goldman, Sachs because while we have big non-bank businesses to fund, so do our competitors. They’re very good competitors. They’re very good companies. They can access the capital markets as can we.

Prashant Bhatia – Citigroup

Also from a risk management perspective you’ve talked about liquidity and so on, but what we’re seeing in the marketplace right now in some ways is a run on certain stock. How do you from a risk management perspective deal with that situation? Is there a way to deal with that situation?

David Viniar

I count on you to do that for us. There is very little we can do about that. We can’t stop rumors and we can’t stop fear. I have believed for a very long time that if we perform well, our stock price will follow. It may not follow each individual day and rumors and fear in the market might affect our stock price for a period of time, but if we continue to perform well in all environments, and of course we’re not going to perform as well in an environment like this as we will in an environment of good global growth, but if we continue to perform well and perform at or near the market, I believe that our stock price will ultimately follow that.

Prashant Bhatia – Citigroup

I know you don’t normally comment on individual clients and so on, but just in terms of Lehman and AIG, could you help investors understand what kind of exposures you have with each of those entities?

David Viniar

Let me without giving exact numbers, let me just tell you how we think about this. AIG and Lehman, big important financial institution counterparties to Goldman, Sachs. We did and we do a lot of business with both of them as we do with all other major financial institutions. The way we do business with financial institutions is by having appropriate daily margin terms. That’s how we’re able to do the volume of business with each other that we do.

And that goes for AIG, Lehman and also Morgan, Stanley and JP Morgan and Citi and UBS and Credit Suisse. That’s how we manage our risk. In addition to the margin terms we augment our risk management with appropriate hedging strategies. You heard at the beginning of my remarks that we believe one of the biggest challenges we have is to avoid large concentrated exposures and we took that very much into account in managing our credit exposures to Lehman and to AIG as well as we do with any other financial institution and given that what I would tell you is, given the outcome at Lehman and whatever the outcome at AIG I would expect the direct impact of our credit exposure to both of them to be immaterial to our results.

Operator

Your next question comes from the line of Guy Moszkowski - Merrill Lynch

Guy Moszkowski - Merrill Lynch

To your point about long-term funding, or actually just focusing on current portion of it, you have about $29 billion of long-term debt and short-term coming due and $21 billion of hybrid instruments, so it looks like about $50 billion out of your total $300 billion debt load or 16% that’s in the next 12 months, at least looking at the last 10-Q obviously changed in the quarter, can you describe to us how you’re finding conditions in the debt markets and how you trade off your funding options going forward versus the returns on assets available to you? In other words, does the Lehman bankruptcy mean that your access to funding is going to be more complicated and potentially limit your asset growth and financial leverage over the next 12 to 18 months?

David Viniar

I think time will tell the answer to that question. I’m not going to say that you don’t know. The debt markets have clearly been more challenging in the last few months then they were in the months before that. We’ve continued to access funding. We’ve done less long-term debt issuance in the last quarter then we did in the quarters before, that’s one of the reasons why we accessed the markets significantly more then we need when they’re open. We did a tremendous amount of long-term debt financing in the first half of this year so that in the second half if the markets weren’t as welcoming we wouldn’t have as much to do.

We’ve done more longer secured financing then we had done in the past because that’s been more available and I think we recognize the fact that the financing costs have gone up, frankly yields on assets have gone up also. The one thing we do when we do longer term financing, we swap everything back basically at overnight, so or most things back to overnight.

So as yield on asset goes up, they tend to match funding costs so the carry doesn’t make that big a difference to us but it’s a more challenging environment. In the more challenging environment you saw that we did kind of constrain the growth of our balance sheet for the last two quarters. We’ve reduced our concentrated exposures. We’ve taken less risk because it’s a more challenging environment and so we will be prudent first. We will play defense first in this opportunity and then we will look for opportunities as well.

Operator

Your next question comes from the line of Glen Schorr - UBS

Glen Schorr – UBS

Back to something related to counterparty, given the events that no one was able to think about what’s gone on in the last week or so, how has your thoughts changed on the risk management side related to counterparty exposure, thoughts in over the counter derivatives repo market, how you manage your book and then how you think the system could change towards a more clearing base mentality if you will?

David Viniar

To say we’re not affected by what’s happening would be disingenuous. Clearly we’re going to be more cautious in our counterparty risk however we have to do that. Whether it’s through different margin terms, through more hedging ourselves which is likely what we’ll do. But we’re still going to be doing business in the markets and we still think there are a lot of good counterparties out there.

We’ve been concerned about large concentrated exposures no matter how good the counterparty is and so that’s why we do things with margin triggers. We’ll take some exposure. We’ll try and limit the amount. We’ll hedge where we have exposures that we think are too big.

It’s something that we’ve always done and of course we’re focused even more on now. As far as clear, I think we’ve talked in the past, I think it is likely that there will be an industry wide solution and some industry wide utility over the coming months. I can’t tell you if its going to be three or six but people are working really hard on it and everybody knows that will be a good thing.

Glen Schorr – UBS

I’m pretty sure that any liquidation of a portfolio or a company doesn’t necessarily create a mark to market, but does something like what seemed to be reasonably aggressive third quarter mark on Lehman’s residential assets? Does that create a mark and as companies get a little squeeze here this close on collateral and certain portfolios get liquidated, what are you expecting the follow-on impact into the credit markets to be?

David Viniar

We mark things based on where we believe we can sell them at the time. Quite often based on where things have actually been sold regardless of where other people mark their assets. So that’s how we mark our books. I think, sure Lehman announced filing over the weekend and the credit markets declined, spreads widened, mortgage assets went down in values, if we own an asset, it goes down in value, we’ll lower our mark.

But other then the initial reaction and I actually think it was pretty well signaled that Lehman was trying to sell their assets so that overhang was very largely in the market. I don’t think its going to be a surprise to anyone. I know from reading what you guys in the press have written more than anything else how many people they had talked to. So I think that overhang was pretty in the market. I think in some ways it might be the case that after a couple of months if that asset gets sold, you actually take some overhang out and things actually improve.

So I don’t think its going to have any meaningful other then initial impact on values of assets.

Glen Schorr – UBS

If you think about it, there’s been some comments just recently after some hibernation that have really made a big impact on the fate of certain companies, I know you haven’t relied on individual securities, you’ve always done your own work, your own models, but on the counterparty side how much does the public rating matter to your counterparty exposure, is it self fulfilling and is there any work around to that at this extreme point?

David Viniar

Its one data point we use, we look at what the rating agencies say. We think that they are a data point we can use. They are a resource we can use, an important resource that we in the markets use but it’s not the only one we use. We do our own credit work as well. We look at whatever information we can get including what the rating agencies say.

Operator

Your next question comes from the line of Meredith Whitney - Oppenheimer

Meredith Whitney – Oppenheimer

Just a clarification, its unclear to me that you wouldn’t get any advantage from deposits, obviously you can’t fund capital markets activity with deposits but your overall credit ratings as seen by the rating agencies would improve because of diversification so there would be a benefit, right?

David Viniar

I didn’t say we wouldn’t get any benefit, I said that most of the assets that we have can’t be funded by a bank. Some could be. I think there are not many banks that are rated higher then we are at this point so I think its really, again even with the rating agency, I think there is some benefit to being a bank but I think more importantly is a question of performance and there are several banks that are quite good and quite strong and deserve a strong rating but I think its based on their performance more than anything else.

Meredith Whitney – Oppenheimer

So given these extreme market conditions, if the industry was forced to adopt bank holding company structures, what conceptually you would imagine that would cost you in terms of profitability, so negative and positive there when you look through that? Is it a possibility albeit distant possibility?

David Viniar

That’s an extremely complicated question to answer because it depends on exactly what the rules were. It depends—there are parts of the bank holding company regulations that include things like how many of your assets, what percentage you have to lend into your local community so if it totally changed our business model then it might change things a lot. If it didn’t and it was just a question of having deposits using some of it to do certain things but largely operating the business the way we operate it today, I don’t think it would change things very much.

I should just say but I can’t tell you for sure because we’ve never been regulated. We’ve never operated a bank and it’s not something we’re an expert at.

Meredith Whitney – Oppenheimer

With respect to what’s gone on with Lehman and what is going on with AIG with respect to sales in the marketplace and real capitulation sales which you—I know you’ve been expecting capitulation sales I can’t imagine your risk management is good enough to expect the capitulation shares of those two, right, who knew, but can you walk through the liquidity discounts that you have embedded in your asset values on a very generic basis to anticipate what happens to your portfolio when you see a market capitulation sale of unprecedented proportions?

David Viniar

First of all while you said we can’t anticipate, we certainly did not anticipate exactly what happened to Lehman but as I said, we anticipated that they were trying to sell a very large portion of their troubled assets for awhile.

Meredith Whitney – Oppenheimer

But all of their assets?

David Viniar

Just talking about the troubled ones. That’s been well known for a fairly long time. That’s actually not only been in what we thought, it’s been in the prices of assets so as we’ve sold things, that’s been taken into account and as we’ve bought things as well. And so generically what we do is we look at what assets we have and as I said first of all, most of the marks are not based on where we think we can sell them, most are based on where we sold them and where we’ve actually seen trading in the markets.

There is a lot of activity in the markets even for less liquid assets. They may not be exactly the same assets you have, they may be slightly different. You might have seven tranches of a commercial real estate loan and two of them may trade and the other five don’t but that gives you a pretty good sense where the other five are going to be and we mark things where we think we can sell our assets in the size we have them.

We don’t market where we think we could sell every dollar tomorrow. We market where we think we can sell over a reasonable timeframe of whether it’s 30 or 60 days and that’s how we think about things. Sure I think that the Lehman filing over the weekend probably caused assets values to decline yesterday. There was no question about it. Credit spreads widened, mortgage [inaudible] widened dramatically, those assets went down in value but I think that was a shock reaction more then anything.

Its been well signaled to the market that most of those troubled assets are going to be sold and I think that at some point getting the overhang out will be a good thing for asset value.

Meredith Whitney – Oppenheimer

When you look at company’s ability to raise capital in the equity market significantly diminished and now more assets being put on the market to raise capital, does that change what you had anticipated in terms of capitulation sales?

David Viniar

Not really. I think they’ve still been slower then we thought. We thought that we would have seen more troubled assets for sale then we have seen. So no, I don’t think anything has changed there.

Meredith Whitney – Oppenheimer

Will you remind me things are never as bad as they seem or never as good as they seem?

David Viniar

I was actually on the phone with someone earlier and I said that and we believe it. When things are bad it appears that they will never get better. When things are good it appears that they will never get worse. They both happen. When they’re good they get worse, when they’re bad they get better and you never see either one coming and afterwards it was obvious it was going to happen. And so I’m not unrealistic about this. We’re in a very, very difficult time but things will get better. I don’t know when but they will get better.

Operator

Your next question is a follow-up from the line of Guy Moszkowski - Merrill Lynch

Guy Moszkowski - Merrill Lynch

I wanted to ask about CMBS exposure update, how that evolved in the quarter, obviously that’s not that enormous a deal for you but I’d just be interested in knowing what the numbers were and to the extent that they came down, how much versus sales versus just marks and principal reduction?

David Viniar

Our total commercial real estate exposure was $16.6 billion at the end of the second quarter, $14.7 billion at the end of the third quarter. If you take out CMBS which are more trading assets, you were $15.2 at the end of the second quarter and $12.4 at the end of the third quarter and the great majority of those reductions were sales. You heard what the losses were; now those were net, there were some gains on some of the hedges but the majority of those reductions were sales.

Guy Moszkowski - Merrill Lynch

There was a comment in the press release about how in credit products you had weak negative investment results, what was that exactly and if it’s something that was not captured then in the $453 million loss on principal investments?

David Viniar

It was not in the principal investments, its really within credit and we’ve talked about this before, within our credit businesses, we will do a variety of things including sometimes you buy distressed debt that for which you get equity when companies recover. Sometimes we’ll actually make small equity investments because given the size of companies you’ll invest all across a capital structure but quite often sometimes these distressed investments or these small investments will turn into equity and then its still within our credit business because that’s how its managed given the size of the companies and sometimes whether they’re private or public, sometimes they’ll go public after you make that investment and you get equity and then we just mark it to market and sometimes even in private form we mark them to market.

So really it’s those investments within the credit business that start off smaller and sometimes get big and that’s a good thing that didn’t do well as asset values declined and it’s all within the credit business.

Guy Moszkowski - Merrill Lynch

Could you walk us through the roll forward on the Tier 1 ratio in the third quarter, was it principally just the increase in retained earnings, was there also a reduction in risk weighted assets as you changed around the portfolio and then BIS is proposing a greater weighting for market risk assets, any comment on their proposal and any estimate of the impact on your Tier 1 ratio?

David Viniar

I believe but we will confirm to you that most of the increase was from the increase in capital although our risk weighted assets did come down as well but more would be weighted towards the increase in capital and on the proposal and what it would affect, we’re just going to have to do more work on that to come back to you.

Guy Moszkowski - Merrill Lynch

The level three assets, I think you commented came down by $9 or $10 billion depending on which particular measure you used, I assume that most of that is just a reduction in leverage finance?

David Viniar

That was part of it and it was other types of leverage—level three assets as well but the leverage finance assets were the biggest driver of that.

Operator

Your next question comes from the line of Analyst – Morgan Stanley

Analyst – Morgan Stanley

While I understand the limitations on using the deposit base here in the US to help fund the broker, what about in Europe, potentially are there some opportunities there to grow the deposits to help with some long-term funding for the broker?

David Viniar

Yes, there are different rules in Europe then there are in the United States. We have a bank in the United States, it has mid-$20 billion type of deposits which by the way makes it like the 50th largest bank in the United States. We have a bank in Ireland that has about $10-ish billion of deposit we use. So we have them and we use them, it’s just now our basic business model. So there are some advantages, we have some of them, we use them where we can but it doesn’t fit with most of our business model.

Analyst – Morgan Stanley

So even if the Fed’s action on Sunday night, temporary suspending Section 23A of the Federal Reserve Act, even if that were made permanent, would you see any benefit to boosting your bank deposits here in the US?

David Viniar

I don’t actually think they suspended it, I think they changed it somewhat. But there are a lot of things—I don’t mean to be not answering the question, but people are asking a lot of theoretical questions about what would happen if the world changes and if the world changes we would evaluate the world at the time and decide what we thought was in the best interest of the firm and our shareholders. We can really only operate where we are today. We’re always looking at what might happen and if different things unfold, if different rules happen, if things change, we might make different decisions.

But given the rule set that we have to operate under today, we think what we have works quite well.

Operator

Your next question comes from the line of Mike Mayo – Deutsche Bank

Mike Mayo – Deutsche Bank

You talked a lot about your BRIC expansion strategy but the BRIC stock market [inaudible] were down like about one-fifth last quarter, I have then down 16% so far this month, so the question is I know that’s your long-term strategy, its not a straight line, but are you changing your capital allocation to BRIC or non-US countries, changing staffing, any other changes there?

David Viniar

It is something that we clearly are looking at quite closely in this environment. We have not changed our long-term strategy at all. We continue to believe that that is where we will see very good, in fact probably the best growth opportunities looking out into the medium to long-term. Everything you said about the decline in those markets is correct. They have been more dramatic then the decline in other markets. We’ve talked in the past about the fact that we know this is not going to be a straight line up and its going to be bumps and the bumps are going to be bigger.

On a tactical basis, we’ll probably take less risk there for some period of time but I don’t think it’ll be a long period of time and it’s a tactic not a strategy and as things start to pick up it will continue to be our strategy to concentrate growth in assets in people and in capital in the BRIC.

Mike Mayo – Deutsche Bank

And in terms of staffing in those economies, overall staffing for Goldman, Sachs, you increased headcount 3% this quarter any changes in overall staffing?

David Viniar

We increased it by about 3% in the quarter. I think we will be up on the year if you exclude the acquisition of Litton, very low single-digits, a couple of percent and as far as next year, we’re literally going through the budgeting process right now and trying to figure out what we should do.

Mike Mayo – Deutsche Bank

And as far as principal investment losses, you said most were outside the US, and then you have the stock indices, I’m not sure how good we can use that to model the principal investment losses, what are the principal investment losses so far this quarter or your marks this quarter?

David Viniar

Its two weeks in and we obviously don’t talk about where we are until [we’re] into a quarter.

Mike Mayo – Deutsche Bank

And then you said it’s never as bad as it seems, if you believe that, how are you capitalizing off the current dislocations or how can you capitalize further?

David Viniar

We will continue to look for opportunities to buy assets at what we think are good prices. The distressed investing business for Goldman, Sachs over the years has been a very, very good business. Part of me says I wish it wasn’t. I’d rather there were no distressed assets anywhere and the world was growing at a great pace everywhere in the world. Unfortunately that’s not the case. There have not been as many sales of distressed assets then we thought there would be up to now. We think that there will be opportunities to do this in the future, in the near future, and so as we see them taking into consideration that times are tough and we’re going to be prudent about how we commit our capital and liquidity we would like to take advantage of some of those opportunities.

Mike Mayo – Deutsche Bank

The discussion about you joining up with a bank at some point, given the roles the way they stand today, would it be extremely unlikely that you would join up with a bank?

David Viniar

Within the context of the fact that never is a really long time, and I try not to think in those timeframes. We think that the business model that we have right now is working quite well and that our performance is good and you heard what I said at the beginning that we think it is not about the model, it is about the performance of the company and the model that we are in has helped us and allowed us to perform as well as we have and we’d like to continue that.

Operator

Your next question comes from the line of Roger Freeman - Lehman Brothers

Roger Freeman - Lehman Brothers

I want to come back to the funding question, so you’re saying a large part of your business don’t fit well into a bank framework in terms of funding, you’ve got the Fed now essentially as a repo counterparty, now at some point those facilities are going to go away, presumably in better times, how do you think the asset backed financing market will shape up, do you think there’ll be permanent higher discounts to asset prices, will there be fewer assets, will be repo-able, will that be a limiting factor in funding going forward?

David Viniar

First of all, you said permanent, permanent is a long time. Our business is a very cyclical business and every time we go through a cycle like this with this part maybe being one of the worst we’ve every seen, people think no one’s going to take risk again, there’s going to be no securitizations again, all the things and never is a long time and people ultimately come back and take risk. There’s a lot of liquidity in the market right now. There’s just a lot of fear that’s overwhelming peoples’ willingness to use that liquidity so when things get better it could get better pretty quickly.

So no I don’t think there’s going to be a permanent decline. I don’t think that there’s going to be a permanent change in the assets that can be financed. I think it’s a tough funding market today but no I don’t think it’s permanent.

Roger Freeman - Lehman Brothers

Can you tell us what the structured debt marks were in the quarter in terms of I presume those were gains?

David Viniar

Yes, they were gains and they were less then $200 million, somewhere in the range of $175 million, something like that.

Roger Freeman - Lehman Brothers

Mostly in fixed?

David Viniar

Yes.

Roger Freeman - Lehman Brothers

In terms of remaining exposures, we’re got commercial and leveraged loans, I think; you have Alt-A subprime and prime exposures?

David Viniar

I do. Within resi prime was about, round numbers, $7 billion, but within that about $5 billion were agencies. Alt-A about $3.6 and subprime $1.7, $12.7 total.

Roger Freeman - Lehman Brothers

What was—can you give us average marks on Alt-A and commercial? Leveraged loans while you’re at it.

David Viniar

I think I can. On Alt-A, I think the weighted average mark at the end of the quarter was around 50.

Roger Freeman - Lehman Brothers

Commercial mortgage and securities, however you look at that combined?

David Viniar

Commercial is a lot harder because there are so many tranches and securities are all over the place. To put it in context, on the loans on some of the—I’m not going to be able to give you everything because there’s so many different parts of it, but I would tell you that most of the loans were in the low 80s, and the securities are all over the place. It depends on what they are.

Roger Freeman - Lehman Brothers

What if you looked at the range of property types backed by the loans and securities, can you put those in any bucket for us, how much is office versus multi family, commercial--

David Viniar

I don’t have that level of detail with me. We have it, I just don’t have it.

Roger Freeman - Lehman Brothers

If you think about the $325 million and marks you’re taking across commercial securities and loans, I don’t think you’ve disclosed any specific marks in the past presumably they’ve been bundled in there but definitely a 2% mark, right, I’m just trying to bridge that to where you’re saying low 80s in loans for example? It looks like you’ve only got a 2% total net mark because this is the first quarter we’re seeing any commercial marks.

David Viniar

You have to look at where it was last quarter versus where it is this quarter; remember we also had hedges in there which as you know the CMBS indices widened a lot over the course of the quarter. This quarter the hedges were pretty effective. There will be quarters where they won’t be and we know that.

Operator

Your next question comes from the line of Doug Sipkin - Wachovia

Doug Sipkin – Wachovia

Obviously a lot of questions on big picture stuff, I just wanted to drill down a couple of the revenue lines, security services second best ever, I know it’s a very challenging environment for hedge funds, a lot of deleveraging slowdown in activity so I’m surprised by the strength, is it more a function of some of the capacity coming out affording you a little bit more pricing power or was there just more activity then I think we though?

David Viniar

I think it was more of the former then the latter.

Doug Sipkin – Wachovia

Can you talk about that, I mean obviously its an incredibly challenging environment, like nothing we’ve ever seen, but moving along to other pieces of the business do you get the sense that that’s going to start to show up with all this capacity coming out all the way down to even underwriting where there’s going to start to be more pricing power with the remaining firms?

David Viniar

Hard to say. We’re not happy with how capacity has come out of the market, we feel for the people. We have a lot of compassion for them. We wish it never happened. I’d rather we had more good strong competitors then we have right now but yes, it is likely that certainly when things start getting better and there’s more—if there are more opportunities and fewer competitors that will help our market shares and our pricing power. It should give us opportunities going forward. I wish we didn’t have them.

Doug Sipkin – Wachovia

Obviously you’ve done a very good job of managing through this situation and I know your views on gross leverage, you view them as misleading, but it just feels like right now the market has the potential to make things happen. Maybe that doesn’t necessarily need to happen. So have you given any thought to more sources of permanent capital, not so much that you need them, but maybe the markets would be relieved by you getting them and it would probably improve the debt spreads and make cost of funding easier.

David Viniar

I think I was talking to someone before who used a line which I really liked, he said that you should do things before you have to and I completely agree with it and I think we’ve been doing some of that. The fact that we’ve had basically rounding to zero buybacks in the last two quarters is one of the things that with our earnings have allowed us to grow our capital more than we would have. I would love to have been able to buyback shares and have a higher ROE but we thought it was more prudent to grow capital.

Having over $100 billion of excess cash over the quarter has cost us money. I’d love to have—not do that and fund everything secured and have lower interest costs and have higher EPS but we thought in this quarter it was better to do things before we had to and so this quarter and last quarter and for the last several, so we’ve been growing our capital, we’ve been increasing our liquidity and we’ve been doing things to make sure that we were appropriately risk managed so that when there are opportunities we can take advantage of them.

But in this environment, it was and it is defense first.

Doug Sipkin – Wachovia

Just commenting in the press release about the investment banking backlog being up, I guess you don’t probability weight that stuff or can you just talk a bit more about the details behind that?

David Viniar

We actually do, our investment banking backlog is probability weighted and so it is. That’s how we calculate it.

Doug Sipkin - Wachovia

So can you talk about what areas are stronger versus last quarter?

David Viniar

It was largely in the merger area.

Doug Sipkin – Wachovia

Is this stuff that is announced but not closed or like pre-announced?

David Viniar

It could be either but it has a high enough probability that we think it should be backlogged. We actually scrub that quite well. We go through it deal by deal to make sure we are confident it will become revenues. It is probability weighted but that doesn’t mean that everything in backlog always closes. Because things do come out of there and of course things—we get revenues investment banking that never get into the backlog.

Operator

Your next question comes from the line of James Mitchell – Buckingham Research

James Mitchell – Buckingham Research

I know you haven’t really talked about this before but with the Fed opening up the window to even more assets, can you give us a sense of how much in unencumbered assets you have to pledge, I would think it’s a pretty large amount?

David Viniar

First of all, most of our assets are funded so as I said, we don’t need any of the Fed facilities to fund now and we’re funding all of our assets without using the Fed facilities. One of the things we did and we said this in the release that came out on Sunday, all of the various financial firms went and used the PDCF this week and I think we might all continue to do that in various times because we want to take away the stigma of using it. We don’t want people to say, oh my goodness they used it that’s terrible, so we just said, you know what? Let’s all use it for some amount and that way everyone will know it’s just there, it’s just another source of funding.

Its not like we have assets sitting there that we need to take to the Fed but I think the Fed being there is really a big statement about liquidity risk and I’ve seen reports, I’ve seen articles about tri party repo is too risky, its going away, I’ve never given any of them any weight but with the Fed doing that, it kind of takes away most of that risk if you thought it was there.

James Mitchell – Buckingham Research

To the business line on the asset management business, you had the equity outflow is not too surprising in this environment offset by some fixed income asset inflows and [alternate] investments, but within equities was it mostly in the []quant] side or where has that been concentrated or is it across the board?

David Viniar

Yes, to the first part of your question. It was, the majority was [quant] side but there was other stuff too.

James Mitchell – Buckingham Research

Are you seeing any kind of slowdown in the deleveraging process of the clients?

David Viniar

No we’re not. I think there is more fear then anything out there which is what is leading to deleveraging and again if you want the glass is half full side of it, it just means that there is a lot of liquidity there, a real lot, so that when you start to see things tick up there is the opportunity for them to tick up pretty quickly.

Operator

Your final question comes from the line of Michael Lipper – Lipper Advisory Services

Michael Lipper – Lipper Advisory Services

Often the press is not specific about potential investments in the sense that they speak of Goldman, Sachs without identifying whether it’s a proprietary investment or an investment for the funds under management. For example, assume for the moment that it was real that you looked at the commercial real estate at Lehman, was that something that was primarily a proprietary investment or was that primarily for funds under management?

David Viniar

In all cases the answer is it depends. To a large extent it is size driven. We have agreements with our funds in the asset classes that they are specialized in and we have a real estate equity fund, we have a corporate equity fund, we have mezzanine funds, and if investments are over a certain size then they go to the funds. And we’ve done that because the funds are big enough that it makes sense. We’ve also done it because we want to manage the concentrations of our risk. We will with certain large investments we might put part of it in the fund, part of it on our balance sheet and go raise capital from partners to do even more.

So it’s really size driven where it goes. Larger investments will tend to be in the fund or partner with the fund or partner with other funds and smaller investments on the balance sheet.

Michael Lipper – Lipper Advisory Services

It would be useful when these things happen if they can be identified as to the source of the investment.

David Viniar

We will try.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Dane Holmes

Thank you everyone for dialing in. If you have any additional questions, feel free to contact us at the Investor Relations department and we once again appreciate your participation on the call. Have a nice day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: The Goldman Sachs Group, Inc. F3Q08 (Qtr End 08/29/08) Earnings Call Transcript
This Transcript
All Transcripts