XMEX:GS Goldman Sachs Group Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

or

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                             to

  

Commission File Number: 001-14965

The Goldman Sachs Group, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   13-4019460

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

200 West Street,

New York, N.Y.

 

10282

(Zip Code)

(Address of principal executive offices)  

(212) 902-1000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x Yes ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

  Large accelerated filer  x                     Accelerated filer  ¨
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)        Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨ Yes x No

APPLICABLE ONLY TO CORPORATE ISSUERS

As of April 27, 2012, there were 491,877,148 shares of the registrant’s common stock outstanding.


Table of Contents

THE GOLDMAN SACHS GROUP, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2012

 

INDEX

 

Form 10-Q Item Number    Page No.  
PART I  

FINANCIAL INFORMATION

     2   
Item 1  

Financial Statements (Unaudited)

     2   
   

Condensed Consolidated Statements of Earnings for the three months ended March 31, 2012 and March 31, 2011

     2   
   

Condensed Consolidated Statements of Comprehensive Income for the three months ended March 31, 2012 and March 31, 2011

     3   
   

Condensed Consolidated Statements of Financial Condition as of March 31, 2012 and December 31, 2011

     4   
   

Condensed Consolidated Statements of Changes in Shareholders’ Equity for the three months ended March 31, 2012 and year ended December 31, 2011

     5   
   

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2012 and March 31, 2011

     6   
   

Notes to Condensed Consolidated Financial Statements

     7   
   

Note 1.       Description of Business

     7   
   

Note 2.       Basis of Presentation

     7   
   

Note 3.       Significant Accounting Policies

     8   
   

Note 4.       Financial Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased,
at Fair Value

     12   
   

Note 5.       Fair Value Measurements

     13   
   

Note 6.       Cash Instruments

     15   
   

Note 7.       Derivatives and Hedging Activities

     23   
   

Note 8.       Fair Value Option

     37   
   

Note 9.       Collateralized Agreements and Financings

     45   
   

Note 10.     Securitization Activities

     48   
   

Note 11.     Variable Interest Entities

     51   
   

Note 12.    Other Assets

     56   
   

Note 13.     Goodwill and Identifiable Intangible Assets

     57   
   

Note 14.    Deposits

     59   
   

Note 15.     Short-Term Borrowings

     60   
   

Note 16.     Long-Term Borrowings

     61   
   

Note 17.     Other Liabilities and Accrued Expenses

     65   
   

Note 18.     Commitments, Contingencies and Guarantees

     66   
   

Note 19.     Shareholders’ Equity

     72   
   

Note 20.     Regulation and Capital Adequacy

     75   
   

Note 21.     Earnings Per Common Share

     79   
   

Note 22.     Transactions with Affiliated Funds

     80   
   

Note 23.     Interest Income and Interest Expense

     81   
   

Note 24.    Income Taxes

     81   
   

Note 25.     Business Segments

     82   
   

Note 26.     Credit Concentrations

     86   
   

Note 27.     Legal Proceedings

     87   
   

Report of Independent Registered Public Accounting Firm

     101   
   

Statistical Disclosures

     102   
Item 2  

Management's Discussion and Analysis of Financial Condition and Results of Operations

     105   
Item 3  

Quantitative and Qualitative Disclosures About Market Risk

     169   
Item 4  

Controls and Procedures

     169   
PART II  

OTHER INFORMATION

     169   
Item 1  

Legal Proceedings

     169   
Item 2  

Unregistered Sales of Equity Securities and Use of Proceeds

     170   
Item 6  

Exhibits

     171   
SIGNATURES      172   

 

1


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements (Unaudited)

 

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Earnings

(Unaudited)

 

   

Three Months

Ended March

 
in millions, except per share amounts       2012         2011  

Revenues

   

Investment banking

    $1,160        $  1,269   

Investment management

    1,105        1,174   

Commissions and fees

    860        1,019   

Market making

    3,905        4,462   

Other principal transactions

    1,938        2,612   

Total non-interest revenues

    8,968        10,536   

Interest income

    2,833        3,107   

Interest expense

    1,852        1,749   

Net interest income

    981        1,358   

Net revenues, including net interest income

    9,949        11,894   

Operating expenses

   

Compensation and benefits

    4,378        5,233   

Brokerage, clearing, exchange and distribution fees

    567        620   

Market development

    117        179   

Communications and technology

    196        198   

Depreciation and amortization

    433        590   

Occupancy

    212        267   

Professional fees

    234        233   

Insurance reserves

    157        88   

Other expenses

    474        446   

Total non-compensation expenses

    2,390        2,621   

Total operating expenses

    6,768        7,854   

Pre-tax earnings

    3,181        4,040   

Provision for taxes

    1,072        1,305   

Net earnings

    2,109        2,735   

Preferred stock dividends

    35        1,827   

Net earnings applicable to common shareholders

    $2,074        $     908   

Earnings per common share

   

Basic

    $  4.05        $    1.66   

Diluted

    3.92        1.56   

Dividends declared per common share

    $  0.35        $    0.35   

Average common shares outstanding

   

Basic

    510.8        540.6   

Diluted

    529.2        583.0   

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

    Three Months
Ended March
 
in millions       2012              2011  

Net earnings

    $2,109         $2,735   

Other comprehensive income/(loss), net of tax:

    

Currency translation adjustment, net of tax

    (28      (22

Pension and postretirement liability adjustments, net of tax

    7         1   

Net unrealized gains/(losses) on available-for-sale securities, net of tax

    30         (23

Other comprehensive income/(loss)

    9         (44

Comprehensive income

    $2,118         $2,691   

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Financial Condition

(Unaudited)

 

    As of
in millions, except share and per share amounts   March
2012
   

December

2011

Assets

   

Cash and cash equivalents

  $ 57,138      $ 56,008 

Cash and securities segregated for regulatory and other purposes (includes $33,679 and $42,014 at fair value as of
March 2012 and December 2011, respectively)

    53,099      64,264 

Collateralized agreements:

   

Securities purchased under agreements to resell and federal funds sold (includes $181,050 and $187,789 at fair value as of March 2012 and December 2011, respectively)

    181,050      187,789 

Securities borrowed (includes $57,062 and $47,621 at fair value as of March 2012 and December 2011, respectively)

    169,092      153,341 

Receivables from brokers, dealers and clearing organizations

    16,886      14,204 

Receivables from customers and counterparties (includes $8,328 and $9,682 at fair value as of March 2012 and December 2011, respectively)

    65,211      60,261 

Financial instruments owned, at fair value (includes $67,404 and $53,989 pledged as collateral as of March 2012 and
December 2011, respectively)

    385,506      364,206 

Other assets

    22,950      23,152 

Total assets

  $ 950,932      $923,225 

Liabilities and shareholders’ equity

   

Deposits (includes $5,524 and $4,526 at fair value as of March 2012 and December 2011, respectively)

  $ 50,874      $  46,109 

Collateralized financings:

   

Securities sold under agreements to repurchase, at fair value

    173,092      164,502 

Securities loaned (includes $550 and $107 at fair value as of March 2012 and December 2011, respectively)

    8,121      7,182 

Other secured financings (includes $28,367 and $30,019 at fair value as of March 2012 and December 2011, respectively)

    33,139      37,364 

Payables to brokers, dealers and clearing organizations

    3,678      3,667 

Payables to customers and counterparties

    206,627      194,625 

Financial instruments sold, but not yet purchased, at fair value

    151,251      145,013 

Unsecured short-term borrowings, including the current portion of unsecured long-term borrowings (includes $17,772 and $17,854 at fair value as of March 2012 and December 2011, respectively)

    48,721      49,038 

Unsecured long-term borrowings (includes $17,509 and $17,162 at fair value as of March 2012 and December 2011, respectively)

    171,592      173,545 

Other liabilities and accrued expenses (includes $9,451 and $9,486 at fair value as of March 2012 and December 2011, respectively)

    32,181      31,801 

Total liabilities

    879,276      852,846 

Commitments, contingencies and guarantees

   

Shareholders’ equity

   

Preferred stock, par value $0.01 per share; aggregate liquidation preference of $3,100 as of both March 2012 and December 2011

    3,100      3,100 

Common stock, par value $0.01 per share; 4,000,000,000 shares authorized, 808,213,029 and 795,555,310 shares issued as of March 2012 and December 2011, respectively, and 495,210,854 and 485,467,565 shares outstanding as of
March 2012 and December 2011, respectively

    8     

Restricted stock units and employee stock options

    3,889      5,681 

Nonvoting common stock, par value $0.01 per share; 200,000,000 shares authorized, no shares issued and outstanding

         — 

Additional paid-in capital

    47,035      45,553 

Retained earnings

    60,723      58,834 

Accumulated other comprehensive loss

    (507   (516)

Stock held in treasury, at cost, par value $0.01 per share; 313,002,177 and 310,087,747 shares as of March 2012 and
December 2011, respectively

    (42,592   (42,281)

Total shareholders’ equity

    71,656      70,379 

Total liabilities and shareholders’ equity

  $ 950,932      $923,225 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

 

    Three Months Ended         Year Ended  
in millions  

March

2012

        

December

2011

 

Preferred stock

Balance, beginning of year

    $   3,100            $   6,957   

Repurchased

               (3,857

Balance, end of period

    3,100            3,100   

Common stock

Balance, beginning of year

    8            8   

Issued

                 

Balance, end of period

    8            8   

Restricted stock units and employee stock options

Balance, beginning of year

    5,681            7,706   

Issuance and amortization of restricted stock units and employee stock options

    640            2,863   

Delivery of common stock underlying restricted stock units

    (2,415         (4,791

Forfeiture of restricted stock units and employee stock options

    (16         (93

Exercise of employee stock options

    (1         (4

Balance, end of period

    3,889            5,681   

Additional paid-in capital

Balance, beginning of year

    45,553            42,103   

Issuance of common stock

               103   

Delivery of common stock underlying share-based awards

    2,419            5,160   

Cancellation of restricted stock units in satisfaction of withholding tax requirements

    (872         (1,911

Excess net tax benefit/(provision) related to share-based awards

    (64         138   

Cash settlement of share-based compensation

    (1         (40

Balance, end of period

    47,035            45,553   

Retained earnings

Balance, beginning of year

    58,834            57,163   

Net earnings

    2,109            4,442   

Dividends and dividend equivalents declared on common stock and restricted stock units

    (185         (769

Dividends on preferred stock

    (35         (2,002

Balance, end of period

    60,723            58,834   

Accumulated other comprehensive income/(loss)

Balance, beginning of year

    (516         (286

Other comprehensive income/(loss)

    9            (230

Balance, end of period

    (507         (516

Stock held in treasury, at cost

Balance, beginning of year

    (42,281         (36,295

Repurchased

    (368         (6,051

Reissued

    57            65   

Balance, end of period

    (42,592         (42,281

Total shareholders’ equity

    $ 71,656            $ 70,379   

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

        Three Months
    Ended March
in millions   2012     2011 

Cash flows from operating activities

   

Net earnings

  $ 2,109      $  2,735 

Non-cash items included in net earnings

   

Depreciation and amortization

    433      594 

Share-based compensation

    643      1,512 

Changes in operating assets and liabilities

   

Cash and securities segregated for regulatory and other purposes

    11,165      219 

Net receivables from brokers, dealers and clearing organizations

    (2,671   568 

Net payables to customers and counterparties

    7,052      (9,671)

Securities borrowed, net of securities loaned

    (14,813   (16,901)

Securities sold under agreements to repurchase, net of securities purchased under agreements to resell
and federal funds sold

    15,328      29,391 

Financial instruments owned, at fair value

    (22,023   (14,701)

Financial instruments sold, but not yet purchased, at fair value

    6,304      10,278 

Other, net

    11      (2,124)

Net cash provided by operating activities

    3,538      1,900 

Cash flows from investing activities

   

Purchase of property, leasehold improvements and equipment

    (390   (277)

Proceeds from sales of property, leasehold improvements and equipment

    13     

Business acquisitions, net of cash acquired

    (39   (5)

Proceeds from sales of investments

    130      216 

Purchase of available-for-sale securities

    (653   (761)

Proceeds from sales of available-for-sale securities

    699      930 

Net cash provided by/(used for) investing activities

    (240   112 

Cash flows from financing activities

   

Unsecured short-term borrowings, net

    (869   1,501 

Other secured financings (short-term), net

    (483   1,340 

Proceeds from issuance of other secured financings (long-term)

    798      1,291 

Repayment of other secured financings (long-term), including the current portion

    (4,334   (3,580)

Proceeds from issuance of unsecured long-term borrowings

    9,358      8,805 

Repayment of unsecured long-term borrowings, including the current portion

    (11,134   (7,364)

Derivative contracts with a financing element, net

    208      210 

Deposits, net

    4,765      158 

Common stock repurchased

    (365   (1,481)

Dividends and dividend equivalents paid on common stock, preferred stock and restricted stock units

    (220   (358)

Proceeds from issuance of common stock, including stock option exercises

    39      63 

Excess tax benefit related to share-based compensation

    70      333 

Cash settlement of share-based compensation

    (1   (35)

Net cash provided by/(used for) financing activities

    (2,168   883 

Net increase in cash and cash equivalents

    1,130      2,895 

Cash and cash equivalents, beginning of year

    56,008      39,788 

Cash and cash equivalents, end of period

  $ 57,138      $  42,683 

SUPPLEMENTAL DISCLOSURES:

Cash payments for interest, net of capitalized interest, were $4.04 billion and $2.71 billion during the three months ended March 2012 and March 2011, respectively.

Income tax refunds, net of cash payments, were $29 million during the three months ended March 2012. Cash payments for income taxes, net of refunds, were $296 million during the three months ended March 2011.

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Note 1. Description of Business

Note 1.

Description of Business

The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, together with its consolidated subsidiaries (collectively, the firm), is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in all major financial centers around the world.

The firm reports its activities in the following four business segments:

Investment Banking

The firm provides a broad range of investment banking services to a diverse group of corporations, financial institutions, investment funds and governments. Services include advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, risk management, restructurings and spin-offs, and debt and equity underwriting of public offerings and private placements, as well as derivative transactions directly related to these activities.

Institutional Client Services

The firm facilitates client transactions and makes markets in fixed income, equity, currency and commodity products, primarily with institutional clients such as corporations, financial institutions, investment funds and governments. The firm also makes markets and clears client transactions on major stock, options and futures exchanges worldwide and provides financing, securities lending and prime brokerage services to institutional clients.

Investing & Lending

The firm invests in and originates loans to provide financing to clients. These investments and loans are typically longer-term in nature. The firm makes investments, directly and indirectly through funds that the firm manages, in debt securities, loans, public and private equity securities, real estate, consolidated investment entities and power generation facilities.

Investment Management

The firm provides investment management services and offers investment products (primarily through separately managed accounts and commingled vehicles, such as mutual funds and private investment funds) across all major asset classes to a diverse set of institutional and individual clients. The firm also offers wealth advisory services, including portfolio management and financial counseling, and brokerage and other transaction services to high-net-worth individuals and families.

 

 

Note 2. Basis of Presentation

Note 2.

Basis of Presentation

These condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP) and include the accounts of Group Inc. and all other entities in which the firm has a controlling financial interest. Intercompany transactions and balances have been eliminated.

These condensed consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements included in the firm’s Annual Report on Form 10-K for the year ended December 31, 2011. References to “the firm’s Annual Report on Form 10-K” are to the firm’s Annual Report on Form 10-K for the year ended December 31, 2011. The condensed consolidated financial information as of December 31, 2011 has been derived from audited consolidated financial statements not included herein.

These unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. These adjustments are of a normal, recurring nature. Interim period operating results may not be indicative of the operating results for a full year.

All references to March 2012 and March 2011 refer to the firm’s periods ended, or the dates, as the context requires, March 31, 2012 and March 31, 2011, respectively. All references to December 2011 refer to the date December 31, 2011. Any reference to a future year refers to a year ending on December 31 of that year. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

Note 3. Significant Accounting Policies

Note 3.

Significant Accounting Policies

 

The firm’s significant accounting policies include when and how to measure the fair value of assets and liabilities, accounting for goodwill and identifiable intangible assets, and when to consolidate an entity. See Notes 5 through 8 for policies on fair value measurements, Note 13 for policies on goodwill and identifiable intangible assets, and below and Note 11 for policies on consolidation accounting. All other significant accounting policies are either discussed below or included in the following footnotes:

 

Financial Instruments Owned, at Fair Value

and Financial Instruments Sold, But Not Yet

Purchased, at Fair Value

     Note 4   

Fair Value Measurements

     Note 5   

Cash Instruments

     Note 6   

Derivatives and Hedging Activities

     Note 7   

Fair Value Option

     Note 8   

Collateralized Agreements and Financings

     Note 9   

Securitization Activities

     Note 10   

Variable Interest Entities

     Note 11   

Other Assets

     Note 12   

Goodwill and Identifiable Intangible Assets

     Note 13   

Deposits

     Note 14   

Short-Term Borrowings

     Note 15   

Long-Term Borrowings

     Note 16   

Other Liabilities and Accrued Expenses

     Note 17   

Commitments, Contingencies and Guarantees

     Note 18   

Shareholders’ Equity

     Note 19   

Regulation and Capital Adequacy

     Note 20   

Earnings Per Common Share

     Note 21   

Transactions with Affiliated Funds

     Note 22   

Interest Income and Interest Expense

     Note 23   

Income Taxes

     Note 24   

Business Segments

     Note 25   

Credit Concentrations

     Note 26   

Legal Proceedings

     Note 27   

Consolidation

The firm consolidates entities in which the firm has a controlling financial interest. The firm determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity (VIE).

Voting Interest Entities. Voting interest entities are entities in which (i) the total equity investment at risk is sufficient to enable the entity to finance its activities independently and (ii) the equity holders have the power to direct the activities of the entity that most significantly impact its economic performance, the obligation to absorb the losses of the entity and the right to receive the residual returns of the entity. The usual condition for a controlling financial interest in a voting interest entity is ownership of a majority voting interest. If the firm has a majority voting interest in a voting interest entity, the entity is consolidated.

Variable Interest Entities. A VIE is an entity that lacks one or more of the characteristics of a voting interest entity. The firm has a controlling financial interest in a VIE when the firm has a variable interest or interests that provide it with (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. See Note 11 for further information about VIEs.

Equity-Method Investments. When the firm does not have a controlling financial interest in an entity but can exert significant influence over the entity’s operating and financial policies, the investment is accounted for either (i) under the equity method of accounting or (ii) at fair value by electing the fair value option available under U.S. GAAP. Significant influence generally exists when the firm owns 20% to 50% of the entity’s common stock or in-substance common stock.

 

 

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Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In general, the firm accounts for investments acquired subsequent to November 24, 2006, when the fair value option became available, at fair value. In certain cases, the firm applies the equity method of accounting to new investments that are strategic in nature or closely related to the firm’s principal business activities, when the firm has a significant degree of involvement in the cash flows or operations of the investee or when cost-benefit considerations are less significant. See Note 12 for further information about equity-method investments.

Investment Funds. The firm has formed numerous investment funds with third-party investors. These funds are typically organized as limited partnerships or limited liability companies for which the firm acts as general partner or manager. Generally, the firm does not hold a majority of the economic interests in these funds. These funds are usually voting interest entities and generally are not consolidated because third-party investors typically have rights to terminate the funds or to remove the firm as general partner or manager. Investments in these funds are included in “Financial instruments owned, at fair value.” See Notes 6, 18 and 22 for further information about investments in funds.

Use of Estimates

Preparation of these condensed consolidated financial statements requires management to make certain estimates and assumptions, the most important of which relate to fair value measurements, accounting for goodwill and identifiable intangible assets, discretionary compensation accruals and the provision for losses that may arise from litigation, regulatory proceedings and tax audits. These estimates and assumptions are based on the best available information but actual results could be materially different.

Revenue Recognition

Financial Assets and Financial Liabilities at Fair Value. Financial instruments owned, at fair value and Financial instruments sold, but not yet purchased, at fair value are recorded at fair value either under the fair value option or in accordance with other U.S. GAAP. In addition, the firm has elected to account for certain of its other financial assets and financial liabilities at fair value by electing the fair value option. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the measurement date. Financial assets are marked to bid prices and financial liabilities are marked to offer prices. Fair value measurements do not include transaction costs. Fair value gains or losses are generally included in “Market making” for positions in Institutional Client Services and “Other principal transactions” for positions in Investing & Lending. See Notes 5 through 8 for further information about fair value measurements.

Investment Banking. Fees from financial advisory assignments and underwriting revenues are recognized in earnings when the services related to the underlying transaction are completed under the terms of the assignment. Expenses associated with such transactions are deferred until the related revenue is recognized or the assignment is otherwise concluded. Expenses associated with financial advisory assignments are recorded as non-compensation expenses, net of client reimbursements. Underwriting revenues are presented net of related expenses.

Investment Management. The firm earns management fees and incentive fees for investment management services. Management fees are calculated as a percentage of net asset value, invested capital or commitments, and are recognized over the period that the related service is provided. Incentive fees are calculated as a percentage of a fund’s or separately managed account’s return, or excess return above a specified benchmark or other performance target. Incentive fees are generally based on investment performance over a 12-month period or over the life of a fund. Fees that are based on performance over a 12-month period are subject to adjustment prior to the end of the measurement period. For fees that are based on investment performance over the life of the fund, future investment underperformance may require fees previously distributed to the firm to be returned to the fund. Incentive fees are recognized only when all material contingencies have been resolved. Management and incentive fee revenues are included in “Investment management” revenues.

Commissions and Fees. The firm earns “Commissions and fees” from executing and clearing client transactions on stock, options and futures markets. Commissions and fees are recognized on the day the trade is executed.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Transfers of Assets

Transfers of assets are accounted for as sales when the firm has relinquished control over the assets transferred. For transfers of assets accounted for as sales, any related gains or losses are recognized in net revenues. Assets or liabilities that arise from the firm’s continuing involvement with transferred assets are measured at fair value. For transfers of assets that are not accounted for as sales, the assets remain in “Financial instruments owned, at fair value” and the transfer is accounted for as a collateralized financing, with the related interest expense recognized over the life of the transaction. See Note 9 for further information about transfers of assets accounted for as collateralized financings and Note 10 for further information about transfers of assets accounted for as sales.

Receivables from Customers and Counterparties

Receivables from customers and counterparties generally relate to collateralized transactions. Such receivables are primarily comprised of customer margin loans, transfers of assets accounted for as secured loans rather than purchases and collateral posted in connection with certain derivative transactions. Certain of the firm’s receivables from customers and counterparties are accounted for at fair value under the fair value option, with changes in fair value generally included in “Market making” revenues. See Note 8 for further information about the fair values of these receivables. Receivables from customers and counterparties not accounted for at fair value are accounted for at amortized cost net of estimated uncollectible amounts. Interest on receivables from customers and counterparties is recognized over the life of the transaction and included in “Interest income.”

Insurance Activities

Certain of the firm's insurance and reinsurance contracts are accounted for at fair value under the fair value option, with changes in fair value included in “Market making” revenues. See Note 8 for further information about the fair values of these insurance and reinsurance contracts.

Revenues from variable annuity and life insurance and reinsurance contracts not accounted for at fair value generally consist of fees assessed on contract holder account balances for mortality charges, policy administration fees and surrender charges. These revenues are recognized in earnings over the period that services are provided and are included in “Market making” revenues. Changes in reserves, including interest credited to policyholder account balances, are recognized in “Insurance reserves.”

Premiums earned for underwriting property catastrophe reinsurance are recognized in earnings over the coverage period, net of premiums ceded for the cost of reinsurance, and are included in “Market making” revenues. Expenses for liabilities related to property catastrophe reinsurance claims, including estimates of losses that have been incurred but not reported, are included in “Insurance reserves.”

Share-based Compensation

The cost of employee services received in exchange for a share-based award is generally measured based on the grant-date fair value of the award. Share-based awards that do not require future service (i.e., vested awards, including awards granted to retirement-eligible employees) are expensed immediately. Share-based awards that require future service are amortized over the relevant service period. Expected forfeitures are included in determining share-based employee compensation expense.

The firm pays cash dividend equivalents on outstanding restricted stock units (RSUs). Dividend equivalents paid on RSUs are generally charged to retained earnings. Dividend equivalents paid on RSUs expected to be forfeited are included in compensation expense. The firm accounts for the tax benefit related to dividend equivalents paid on RSUs as an increase to additional paid-in capital.

In certain cases, primarily related to conflicted employment (as outlined in the applicable award agreements), the firm may cash settle share-based compensation awards. For awards accounted for as equity instruments, additional paid-in capital is adjusted to the extent of the difference between the current value of the award and the grant-date value of the award.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Foreign Currency Translation

Assets and liabilities denominated in non-U.S. currencies are translated at rates of exchange prevailing on the date of the condensed consolidated statements of financial condition and revenues and expenses are translated at average rates of exchange for the period. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are recognized in earnings. Gains or losses on translation of the financial statements of a non-U.S. operation, when the functional currency is other than the U.S. dollar, are included, net of hedges and taxes, in the condensed consolidated statements of comprehensive income.

Cash and Cash Equivalents

The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business. As of March 2012 and December 2011, “Cash and cash equivalents” included $7.22 billion and $7.95 billion, respectively, of cash and due from banks, and $49.92 billion and $48.05 billion, respectively, of interest-bearing deposits with banks.

Recent Accounting Developments

Reconsideration of Effective Control for Repurchase Agreements (ASC 860). In April 2011, the FASB issued ASU No. 2011-03, “Transfers and Servicing (Topic 860) — Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 changes the assessment of effective control by removing (i) the criterion that requires the transferor to have the ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee, and (ii) the collateral maintenance implementation guidance related to that criterion. ASU No. 2011-03 is effective for periods beginning after December 15, 2011. The firm adopted the standard on January 1, 2012. Adoption of ASU No. 2011-03 did not affect the firm’s financial condition, results of operations or cash flows.

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (ASC 820). In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurements and Disclosures (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU No. 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain principles related to measuring fair value, and requires additional disclosures about fair value measurements. ASU No. 2011-04 is effective for periods beginning after December 15, 2011. The firm adopted the standard on January 1, 2012. Adoption of ASU No. 2011-04 did not materially affect the firm’s financial condition, results of operations or cash flows.

Derecognition of in Substance Real Estate (ASC 360). In December 2011, the FASB issued ASU No. 2011-10, “Property, Plant, and Equipment (Topic 360) — Derecognition of in Substance Real Estate — a Scope Clarification.” ASU No. 2011-10 clarifies that in order to deconsolidate a subsidiary (that is in substance real estate) as a result of a parent no longer controlling the subsidiary due to a default on the subsidiary’s nonrecourse debt, the parent also must satisfy the sale criteria in ASC 360-20, “Property, Plant, and Equipment — Real Estate Sales.” The ASU is effective for fiscal years beginning on or after June 15, 2012. The firm will apply the provisions of the ASU to such events occurring on or after January 1, 2013. Adoption is not expected to materially affect the firm’s financial condition, results of operations or cash flows.

Disclosures about Offsetting Assets and Liabilities (ASC 210). In December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210) — Disclosures about Offsetting Assets and Liabilities.” ASU No. 2011-11 will require disclosure of the effect or potential effect of offsetting arrangements on the firm’s financial position as well as enhanced disclosure of the rights of setoff associated with the firm’s recognized assets and recognized liabilities. ASU No. 2011-11 is effective for periods beginning on or after January 1, 2013. Since these amended principles require only additional disclosures concerning offsetting and related arrangements, adoption will not affect the firm’s financial condition, results of operations or cash flows.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

Note 4. Financial Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased, at Fair Value

Note 4.

Financial Instruments Owned, at Fair Value and Financial Instruments Sold, But Not Yet Purchased, at Fair Value

 

 

 

Financial instruments owned, at fair value and financial instruments sold, but not yet purchased, at fair value are accounted for at fair value either under the fair value option or in accordance with other U.S. GAAP. See Note 8 for further information about the fair value option. The table below presents the firm’s financial instruments owned, at fair value, including those pledged as collateral, and

financial instruments sold, but not yet purchased, at fair value. Financial instruments owned, at fair value included $4.69 billion and $4.86 billion as of March 2012 and December 2011, respectively, of securities accounted for as available-for-sale, substantially all of which are held in the firm’s insurance subsidiaries.

 

 

 

    As of March 2012         As of December 2011  
in millions   Financial
Instruments
Owned
     Financial
Instruments
Sold, But
Not Yet
Purchased
         Financial
Instruments
Owned
    Financial
Instruments
Sold, But
Not Yet
Purchased
 

Commercial paper, certificates of deposit, time deposits
and other money market instruments

    $  10,553         $          —            $  13,440        $           —   

U.S. government and federal agency obligations

    90,488         27,489            87,040        21,006   

Non-U.S. government obligations

    60,812         43,791            49,205        34,886   

Mortgage and other asset-backed loans and securities:
Loans and securities backed by commercial real estate

    6,724         1            6,699        27   

Loans and securities backed by residential real estate

    8,815         7            7,592        3   

Bank loans and bridge loans

    18,988         2,242  2          19,745        2,756  2 

Corporate debt securities

    24,370         6,841            22,131        6,553   

State and municipal obligations

    3,407         47            3,089        3   

Other debt obligations

    4,702                    4,362          

Equities and convertible debentures

    75,927         19,483            65,113        21,326   

Commodities

    9,462                    5,762          

Derivatives 1

    71,258         51,350            80,028        58,453   

Total

    $385,506         $151,251            $364,206        $145,013   

 

1.

Net of cash collateral received or posted under credit support agreements and reported on a net-by-counterparty basis when a legal right of setoff exists under an enforceable netting agreement.

 

2.

Includes the fair value of unfunded lending commitments for which the fair value option was elected.

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Gains and Losses from Market Making and Other Principal Transactions

The table below presents, by major product type, the firm’s “Market making” and “Other principal transactions” revenues. These gains/(losses) are primarily related to the firm’s financial instruments owned, at fair value and financial instruments sold, but not yet purchased, at fair value, including both derivative and non-derivative financial instruments. These gains/(losses) exclude related interest income and interest expense. See Note 23 for further information about interest income and interest expense.

The gains/(losses) in the table are not representative of the manner in which the firm manages its business activities because many of the firm’s market-making, client facilitation, and investing and lending strategies utilize financial instruments across various product types. Accordingly, gains or losses in one product type frequently offset gains or losses in other product types. For example, most of the firm’s longer-term derivatives are sensitive to changes in interest rates and may be economically hedged with interest rate swaps. Similarly, a significant portion of the firm’s cash instruments and derivatives has exposure to foreign currencies and may be economically hedged with foreign currency contracts.

 

 

    Three Months 
Ended March
in millions   2012     2011 

Interest rates

      $1,889          $ 2,406  

Credit

      1,710          2,051  

Currencies

      (724 )        (1,606 )

Equities

      1,973          2,850  

Commodities

      471          957  

Other

      524          416  

Total

      $5,843          $ 7,074  

 

Note 5. Fair Value Measurements

Note 5.

Fair Value Measurements

The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Financial assets are marked to bid prices and financial liabilities are marked to offer prices. Fair value measurements do not include transaction costs. The firm measures certain financial assets and financial liabilities as a portfolio (i.e., based on its net exposure to market and/or credit risks).

The best evidence of fair value is a quoted price in an active market. If quoted prices in active markets are not available, fair value is determined by reference to prices for similar instruments, quoted prices or recent transactions in less active markets, or internally developed models that primarily use market-based or independently sourced parameters as inputs including, but not limited to, interest rates, volatilities, equity or debt prices, foreign exchange rates, commodities prices, credit spreads and funding spreads.

U.S. GAAP has a three-level fair value hierarchy for disclosure of fair value measurements. The fair value hierarchy prioritizes inputs to the valuation techniques used to measure fair value, giving the highest priority to level 1 inputs and the lowest priority to level 3 inputs. A financial instrument’s level in the fair value hierarchy is based on the lowest level of input that is significant to its fair value measurement.

The fair value hierarchy is as follows:

Level 1. Inputs are unadjusted quoted prices in active markets to which the firm had access at the measurement date for identical, unrestricted assets or liabilities.

Level 2. Inputs to valuation techniques are observable, either directly or indirectly.

Level 3. One or more inputs to valuation techniques are significant and unobservable.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The fair values for substantially all of the firm’s financial assets and financial liabilities are based on observable prices and inputs and are classified in levels 1 and 2 of the hierarchy. Certain level 2 and level 3 financial assets and financial liabilities may require appropriate valuation adjustments that a market participant would require to arrive at fair value for factors such as counterparty and the firm’s credit quality, funding risk, transfer restrictions, liquidity and bid/offer spreads. Valuation adjustments are generally based on market evidence.

See Notes 6 and 7 for further information about fair value measurements of cash instruments and derivatives, respectively, included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” and Note 8 for further information about fair value measurements of other financial assets and financial liabilities accounted for at fair value under the fair value option.

Financial assets and financial liabilities accounted for at fair value under the fair value option or in accordance with other U.S. GAAP are summarized below.

 

 

    As of
$ in millions   March
2012
   

December   

2011   

Total level 1 financial assets

    $ 159,906      $ 136,780   

Total level 2 financial assets

    566,165      587,416   

Total level 3 financial assets

    48,015      47,937   

Netting and collateral 1

    (108,461   (120,821)  

Total financial assets at fair value

    $ 665,625      $ 651,312   

Total assets

    $ 950,932      $ 923,225   

Total level 3 financial assets as a percentage of Total assets

    5.0   5.2%

Total level 3 financial assets as a percentage of Total financial assets at fair value

    7.2   7.4%

 

Total level 3 financial liabilities at fair value

 

 

 

 

$   23,941

 

  

 

 

$   25,498   

Total financial liabilities at fair value

    $ 403,516      $ 388,669   

Total level 3 financial liabilities as a percentage of Total financial liabilities at fair value

    5.9   6.6%

 

1.

Represents the impact on derivatives of cash collateral and counterparty netting across levels of the fair value hierarchy. Netting among positions classified in the same level is included in that level.

 

Level 3 financial assets as of March 2012 were essentially unchanged compared with December 2011, primarily reflecting an increase in private equity investments, principally due to transfers to level 3 and purchases, offset by a decrease in derivative assets. The decrease in derivative assets primarily reflected settlements and net unrealized losses on credit and currency derivatives, partially offset by the impact of decreased counterparty netting and transfers to level 3 of certain credit derivatives.

See Notes 6, 7 and 8 for further information about level 3 cash instruments, derivatives and other financial assets and financial liabilities accounted for at fair value under the fair value option, respectively, including information about significant unrealized gains or losses and transfers in or out of level 3.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

Note 6. Cash Instruments

Note 6.

Cash Instruments

 

Cash instruments include U.S. government and federal agency obligations, non-U.S. government obligations, bank loans and bridge loans, corporate debt securities, equities and convertible debentures, and other non-derivative financial instruments owned and financial instruments sold, but not yet purchased. See below for the types of cash instruments included in each level of the fair value hierarchy and the valuation techniques and significant inputs used to determine their fair values. See Note 5 for an overview of the firm’s fair value measurement policies.

Level 1 Cash Instruments

Level 1 cash instruments include U.S. government obligations and most non-U.S. government obligations, actively traded listed equities and certain government agency obligations and money market instruments. These instruments are valued using quoted prices for identical unrestricted instruments in active markets.

The firm defines active markets for equity instruments based on the average daily trading volume both in absolute terms and relative to the market capitalization for the instrument. The firm defines active markets for debt instruments based on both the average daily trading volume and the number of days with trading activity.

Level 2 Cash Instruments

Level 2 cash instruments include commercial paper, certificates of deposit, time deposits, most government agency obligations, certain non-U.S. government obligations, most corporate debt securities, commodities, certain mortgage-backed loans and securities, certain bank loans and bridge loans, restricted or less liquid listed equities, most state and municipal obligations and certain lending commitments.

Valuations of level 2 cash instruments can be verified to quoted prices, recent trading activity for identical or similar instruments, broker or dealer quotations or alternative pricing sources with reasonable levels of price transparency. Consideration is given to the nature of the quotations (e.g., indicative or firm) and the relationship of recent market activity to the prices provided from alternative pricing sources.

Valuation adjustments are typically made to level 2 cash instruments (i) if the cash instrument is subject to transfer restrictions and/or (ii) for other premiums and liquidity discounts that a market participant would require to arrive at fair value. Valuation adjustments are generally based on market evidence.

Level 3 Cash Instruments

Level 3 cash instruments have one or more significant valuation inputs that are not observable. Absent evidence to the contrary, level 3 cash instruments are initially valued at transaction price, which is considered to be the best initial estimate of fair value. Subsequently, the firm uses other methodologies to determine fair value, which vary based on the type of instrument. Valuation inputs and assumptions are changed when corroborated by substantive observable evidence, including values realized on sales of level 3 financial assets.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents the valuation techniques and the nature of significant inputs generally used to determine

the fair values of each type of level 3 cash instrument.

 

 

Level 3 Cash Instrument    Valuation Techniques and Significant Inputs

 

Loans and securities backed by commercial real estate

 

Ÿ   Collateralized by a single commercial real estate property or a portfolio of properties

 

Ÿ   May include tranches of varying levels of subordination

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs for these valuations, which may be determined based on relative value analyses, include:

 

Ÿ   Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and changes in market indices such as the CMBX (an index that tracks the performance of commercial mortgage bonds)

 

Ÿ   Recovery rates implied by the value of the underlying collateral, which is mainly driven by current performance of the underlying collateral, capitalization rates and multiples

 

Ÿ   Timing of expected future cash flows (duration)

 

 

Loans and securities backed by residential real estate

 

Ÿ   Collateralized by portfolios of residential real estate

 

Ÿ   May include tranches of varying levels of subordination

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are determined based on relative value analyses, which incorporate comparisons to instruments with similar collateral and risk profiles, including relevant indices such as the ABX (an index that tracks the performance of subprime residential mortgage bonds). Significant inputs include:

 

Ÿ   Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral

 

Ÿ   Market yields implied by transactions of similar or related assets

 

Ÿ   Cumulative loss expectations, driven by default rates, home price projections, residential property liquidation timelines and related costs

 

Ÿ   Duration, driven by underlying loan prepayment speeds and residential property liquidation timelines

 

 

 

Bank loans and bridge loans

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are generally determined based on relative value analyses, which incorporate comparisons both to prices of credit default swaps that reference the same or similar underlying instrument or entity and to other debt instruments for the same issuer for which observable prices or broker quotations are available. Significant inputs include:

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and trends of market indices such as CDX and LCDX (indices that track the performance of corporate credit and loans, respectively)

 

Ÿ   Current performance and recovery assumptions and, where the firm uses credit default swaps to value the related cash instrument, the cost of borrowing the underlying reference obligation

 

Ÿ   Duration

 

 

Corporate debt securities

 

State and municipal obligations

 

Non-U.S. government obligations

 

Other debt obligations

  

 

Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques.

 

Significant inputs are generally determined based on relative value analyses, which incorporate comparisons both to prices of credit default swaps that reference the same or similar underlying instrument or entity and to other debt instruments for the same issuer for which observable prices or broker quotations are available. Significant inputs include:

 

Ÿ   Market yields implied by transactions of similar or related assets and/or current levels and trends of market indices such as CDX, LCDX and MCDX (an index that tracks the performance of municipal obligations)

 

Ÿ   Current performance and recovery assumptions and, where the firm uses credit default swaps to value the related cash instrument, the cost of borrowing the underlying reference obligation

 

Ÿ   Duration

 

 

Equities and convertible debentures

 

Ÿ   Private equity investments (including investments in real estate entities)

  

 

Recent third-party completed or pending transactions (e.g., merger proposals, tender offers, debt restructurings) are considered to be the best evidence for any change in fair value. When these are not available, the following valuation methodologies are used, as appropriate and available:

 

Ÿ   Industry multiples and public comparables

 

Ÿ   Transactions in similar instruments

 

Ÿ   Discounted cash flow techniques

 

Ÿ   Third-party appraisals

 

The firm also considers changes in the outlook for the relevant industry and financial performance of the issuer as compared to projected performance. Significant inputs include:

 

Ÿ   Market and transaction multiples

 

Ÿ   Discount rates, long-term growth rates, earnings compound annual growth rates and capitalization rates

 

Ÿ   For equity instruments with debt-like features: market yields implied by transactions of similar or related assets, current performance and recovery assumptions, and duration

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Significant Unobservable Inputs

The table below presents the ranges of significant unobservable inputs used to value the firm’s level 3 cash instruments. These ranges represent the significant unobservable inputs that were used in the valuation of each type of cash instrument. These inputs are not representative of the inputs that could have been used in the valuation of any one cash instrument. For example, the highest multiple

presented in the table for private equity investments is appropriate for valuing a specific private equity investment but may not be appropriate for valuing any other private equity investment. Accordingly, the ranges of inputs presented below do not represent uncertainty in, or possible ranges of, fair value measurements of the firm’s level 3 cash instruments.

 

 

Level 3 Cash Instrument    Significant Unobservable Inputs
by Valuation Technique
   Range of Significant Unobservable
Inputs as of March 2012

 

Loans and securities backed by commercial real estate

 

•     Collateralized by a single commercial real estate property or a portfolio of properties

 

•     May include tranches of varying levels of subordination  

 

  

 

Discounted cash flows:

 

•      Yield

 

•      Recovery rate 1

 

•      Duration (years) 2

  

 

 

3.3% to 27.7%

 

20.0% to 100.0%

 

0.6 to 7.4

 

Loans and securities backed by residential real estate

 

•     Collateralized by portfolios of residential real estate

 

•     May include tranches of varying levels of subordination  

 

  

 

Discounted cash flows:

 

•      Yield

 

•      Cumulative loss rate

 

•      Duration (years) 2

  

 

 

3.2% to 30.0%

 

0.0% to 79.0%

 

0.1 to 9.7

 

Bank loans and bridge loans

  

 

Discounted cash flows:

 

•      Yield

 

•      Recovery rate 1

 

•      Duration (years) 2

 

  

 

 

0.7% to 28.1%

 

15.0% to 100.0%

 

0.5 to 7.9

 

 

Corporate debt securities

 

State and municipal obligations

 

Non-U.S. government obligations

 

Other debt obligations

 

  

 

Discounted cash flows:

 

•      Yield

 

•      Recovery rate 1

 

•      Duration (years) 2

  

 

 

1.5% to 35.3%

 

0.0% to 100.0%

 

0.4 to 18.0

 

Equities and convertible debentures

 

•     Private equity investments (including investments in real estate entities)

  

 

Comparable multiples:

 

•      Multiples

 

Discounted cash flows:

 

•      Yield/discount rate

 

•      Long-term growth rate/compound annual
  growth rate    

 

•      Capitalization rate

 

•      Recovery rate 1

 

•      Duration (years) 2

 

  

 

 

0.8x to 20.0x

 

 

10.0% to 30.0%

 

 

(0.7)% to 55.9%

 

5.5% to 11.5%

 

45.0% to 100.0%

 

1.0 to 9.0

 

 

1.

A measure of expected future cash flows, expressed as a percentage of notional or face value of the instrument.

 

2.

Duration is an estimate of the timing of future cash flows and, in certain cases, may incorporate the impact of other unobservable inputs (e.g., prepayment speeds).

 

Increases in yield, discount rate, capitalization rate, duration or cumulative loss rate used in the valuation of the firm’s level 3 cash instruments would result in a lower fair value measurement; while increases in recovery rate, multiples, long-term growth rate or compound annual

growth rate would result in a higher fair value measurement. Due to the distinctive nature of each of the firm’s level 3 cash instruments, the interrelationship of inputs is not necessarily uniform within each product type.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Fair Value of Cash Instruments by Level

The tables below present, by level within the fair value hierarchy, cash instrument assets and liabilities, at fair value. Cash instrument assets and liabilities are included in

“Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” respectively.

 

 

   

Cash Instrument Assets at Fair Value as of March 2012

in millions   Level 1        Level 2        Level 3        Total

Commercial paper, certificates of deposit, time deposits
and other money market instruments

  $    1,985        $    8,560        $         8        $  10,553

U.S. government and federal agency obligations

 

37,228  

    

53,260  

    

—  

    

90,488

Non-U.S. government obligations

 

47,657  

    

13,050  

    

105  

    

60,812

Mortgage and other asset-backed loans and securities 1:

                

Loans and securities backed by commercial real estate

 

—  

    

3,568  

    

3,156  

    

6,724

Loans and securities backed by residential real estate

  —        7,205        1,610        8,815

Bank loans and bridge loans

 

—  

    

7,937  

    

11,051  

    

18,988

Corporate debt securities 2

 

90  

    

21,768  

    

2,512  

    

24,370

State and municipal obligations

 

—  

    

2,795  

    

612  

    

3,407

Other debt obligations 2

 

—  

    

3,153  

    

1,549  

    

4,702

Equities and convertible debentures

 

48,535 3

    

12,518 4

    

14,874 5

    

75,927

Commodities

  —        9,462        —        9,462

Total

  $135,495        $143,276        $35,477        $314,248
   

Cash Instrument Liabilities at Fair Value as of March 2012

in millions   Level 1        Level 2        Level 3        Total

U.S. government and federal agency obligations

  $  27,289        $       200        $        —        $  27,489

Non-U.S. government obligations

 

43,255  

    

536  

    

—  

    

43,791

Mortgage and other asset-backed loans and securities:

                

Loans and securities backed by commercial real estate

 

—  

    

1  

    

—  

    

1

Loans and securities backed by residential real estate

 

—  

    

7  

    

—  

    

7

Bank loans and bridge loans

  —        1,519        723        2,242

Corporate debt securities 6

  9        6,816        16        6,841

State and municipal obligations

  —        47        —        47

Equities and convertible debentures

  18,489 3      986 4      8        19,483

Total

  $  89,042        $  10,112        $     747        $  99,901

 

1.

Includes $437 million and $590 million of collateralized debt obligations (CDOs) backed by real estate in level 2 and level 3, respectively.

 

2.

Includes $404 million and $1.40 billion of CDOs and collateralized loan obligations (CLOs) backed by corporate obligations in level 2 and level 3, respectively.

 

3.

Consists of listed equity securities.

 

4.

Principally consists of restricted or less liquid listed securities.

 

5.

Includes $13.05 billion of private equity investments, $1.23 billion of real estate investments and $592 million of convertible debentures.

 

6.

Includes $7 million of CDOs and CLOs backed by corporate obligations in level 3.

 

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Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

    Cash Instrument Assets at Fair Value as of December  2011
in millions   Level 1        Level 2        Level 3        Total

Commercial paper, certificates of deposit, time deposits
and other money market instruments

    $    3,255           $  10,185           $       —         $  13,440

U.S. government and federal agency obligations

    29,263           57,777                  

87,040

Non-U.S. government obligations

    42,854           6,203           148        

49,205

Mortgage and other asset-backed loans and securities 1:
Loans and securities backed by commercial real estate

              3,353           3,346         6,699

Loans and securities backed by residential real estate

              5,883           1,709         7,592

Bank loans and bridge loans

              8,460           11,285        

19,745

Corporate debt securities 2

    133           19,518           2,480        

22,131

State and municipal obligations

              2,490           599        

3,089

Other debt obligations 2

              2,911           1,451        

4,362

Equities and convertible debentures

    39,955  3         11,491  4         13,667  5      

65,113

Commodities

              5,762                   5,762

Total

    $115,460           $134,033           $34,685         $284,178
    Cash Instrument Liabilities at Fair Value as of December  2011
in millions   Level 1        Level 2        Level 3        Total

U.S. government and federal agency obligations

    $  20,940           $         66           $       —         $  21,006

Non-U.S. government obligations

    34,339           547                  

34,886

Mortgage and other asset-backed loans and securities:
Loans and securities backed by commercial real estate

              27                   27

Loans and securities backed by residential real estate

              3                  

3

Bank loans and bridge loans

              1,891           865         2,756

Corporate debt securities 6

              6,522           31         6,553

State and municipal obligations

              3                   3

Equities and convertible debentures

    20,069  3         1,248  4         9         21,326

Total

    $  75,348           $  10,307           $     905         $  86,560

 

1.

Includes $213 million and $595 million of collateralized debt obligations (CDOs) backed by real estate in level 2 and level 3, respectively.

 

2.

Includes $403 million and $1.19 billion of CDOs and collateralized loan obligations (CLOs) backed by corporate obligations in level 2 and level 3, respectively.

 

3.

Consists of listed equity securities.

 

4.

Principally consists of restricted or less liquid listed securities.

 

5.

Includes $12.07 billion of private equity investments, $1.10 billion of real estate investments and $497 million of convertible debentures.

 

6.

Includes $27 million of CDOs and CLOs backed by corporate obligations in level 3.

Transfers Between Levels of the Fair Value Hierarchy

Transfers between levels of the fair value hierarchy are reported at the beginning of the reporting period in which they occur. Transfers of cash instruments between level 1 and level 2 were $728 million for the three months ended March 2012, consisting of transfers to level 2 of public

equity investments, primarily reflecting the impact of transfer restrictions. See level 3 rollforwards below for further information about transfers between level 2 and level 3.

 

 

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Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Rollforward

If a cash instrument asset or liability was transferred to level 3 during a reporting period, its entire gain or loss for the period is included in level 3.

Level 3 cash instruments are frequently economically hedged with level 1 and level 2 cash instruments and/or level 1, level 2 or level 3 derivatives. Accordingly, gains or losses that are reported in level 3 can be partially offset by gains or losses attributable to level 1 or level 2 cash

instruments and/or level 1, level 2 or level 3 derivatives. As a result, gains or losses included in the level 3 rollforward below do not necessarily represent the overall impact on the firm’s results of operations, liquidity or capital resources.

The tables below present changes in fair value for all cash instrument assets and liabilities categorized as level 3 as of the end of the period.

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Three Months Ended March 2012  
in millions   Balance,
beginning
of period
    Net
realized
gains/
(losses)
    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases 1     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
    Balance,
end of
period
 

Commercial paper, certificates of deposit, time deposits and other money market instruments

    $        —        $   —        $   —        $       8        $       —        $       —        $      —        $       —        $         8   

Non-U.S. government obligations

    148        (1     (59     7        (8            20        (2     105   

Mortgage and other asset-backed

  loans and securities:

Loans and securities backed by commercial real estate

    3,346        39        96        295        (276     (289     486        (541     3,156   

Loans and securities backed by residential real estate

    1,709        43        23        254        (181     (101     14        (151     1,610   

Bank loans and bridge loans

    11,285        150        206        1,188        (1,246     (792     960        (700     11,051   

Corporate debt securities

    2,480        92        158        295        (422     (128     260        (223     2,512   

State and municipal obligations

    599        2        8        20        (39     (2     25        (1     612   

Other debt obligations

    1,451        44        24        99        (120     (56     123        (16     1,549   

Equities and convertible debentures

    13,667        39        332        558        (150     (194     779        (157     14,874   

Total

    $34,685        $408  2      $788  2      $2,724        $(2,442     $(1,562     $2,667        $(1,791     $35,477   
    Level 3 Cash Instrument Liabilities at Fair Value for the Three Months Ended March 2012  
in millions   Balance,
beginning
of period
   

Net

realized
(gains)/
losses

    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Balance,
end of

period

 

Total

    $     905        $ (34     $ (68     $  (326     $      87        $    195        $   102        $   (114     $     747   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $167 million, $654 million and $375 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain on level 3 cash instruments of $856 million (reflecting $788 million on cash instrument assets and $68 million on cash instrument liabilities) for the three months ended March 2012 primarily consisted of gains on private equity investments, bank loans and bridge loans, and corporate debt securities, primarily reflecting an increase in global equity prices and tighter credit spreads.

Transfers into level 3 during the three months ended March 2012 primarily reflected transfers from level 2 of certain bank loans and bridge loans, private equity

investments, and loans and securities backed by commercial real estate, principally due to reduced transparency of market prices as a result of less market activity in these instruments.

Transfers out of level 3 during the three months ended March 2012 primarily reflected transfers to level 2 of certain bank and bridge loans, and loans and securities backed by commercial real estate, principally due to improved transparency of market prices as a result of market activity in these instruments.

 

 

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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

    Level 3 Cash Instrument Assets at Fair Value for the Three Months Ended March 2011  
in millions   Balance,
beginning
of period
     Net
realized
gains/
(losses)
   

Net unrealized
gains/(losses)
relating to
instruments
still held at

period-end

    Purchases  1     Sales     Settlements     Net
transfers
in and/or
(out) of
level 3
    Balance,
end of
period
 

Mortgage and other asset-backed loans
and securities:

Loans and securities backed by
commercial real estate

    $  3,976         $  58        $   162        $   389        $   (527     $   (323     $  (22     $  3,713   

Loans and securities backed by
residential real estate

    2,501         50        50        575        (230     (206     16        2,756   

Bank loans and bridge loans

    9,905         169        568        491        (274     (604     (326     9,929   

Corporate debt securities

    2,737         92        216        789        (459     (104     (133     3,138   

State and municipal obligations

    754         1        13        7        (3     (1     (29     742   

Other debt obligations

    1,274         24        20        297        (149     (53     70        1,483   

Equities and convertible debentures

    11,060         40        233        268        (302     (121     587        11,765   

Total

    $32,207         $434  2      $1,262  2      $2,816        $(1,944     $(1,412     $ 163        $33,526   
    Level 3 Cash Instrument Liabilities at Fair Value for the Three Months Ended March 2011  
in millions   Balance,
beginning
of period
     Net
realized
(gains)/
losses
    Net unrealized
(gains)/losses
relating to
instruments
still held at
period-end
    Purchases     Sales     Settlements    

Net
transfers
in and/or

(out) of
level 3

    Balance,
end of
period
 

Total

    $     446         $  (22     $     41        $    (59     $      90        $        8        $  (22     $     482   

 

1.

Includes both originations and secondary market purchases.

 

2.

The aggregate amounts include approximately $608 million, $656 million and $432 million reported in “Market making,” “Other principal transactions” and “Interest income,” respectively.

 

The net unrealized gain/(loss) on level 3 cash instruments of $1.22 billion (reflecting $1.26 billion on cash instrument assets and $(41) million on cash instrument liabilities) for the three months ended March 2011 primarily consisted of unrealized gains on bank loans and bridge loans, private equity investments and corporate debt securities, reflecting strengthening global credit markets and equity markets.

Significant transfers in or out of level 3 during the three months ended March 2011 included:

 

Ÿ  

Bank loans and bridge loans: net transfer out of level 3 of $326 million, principally due to transfers to level 2 of certain loans due to improved transparency of market

 

prices as a result of market transactions in these financial instruments, partially offset by transfers to level 3 of certain loans due to reduced transparency of market prices as a result of less market activity in these financial instruments.

 

Ÿ  

Equities and convertible debentures: net transfer into level 3 of $587 million, principally due to transfers to level 3 of certain private equity investments due to reduced transparency of market prices as a result of less market activity in these financial instruments, partially offset by transfers to level 2 of certain equity investments due to improved transparency of market prices as a result of initial public offerings.

 

 

21


Table of Contents

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Investments in Funds That Calculate Net Asset

Value Per Share

Cash instruments at fair value include investments in funds that are valued based on the net asset value per share (NAV) of the investment fund. The firm uses NAV as its measure of fair value for fund investments when (i) the fund investment does not have a readily determinable fair value and (ii) the NAV of the investment fund is calculated in a manner consistent with the measurement principles of investment company accounting, including measurement of the underlying investments at fair value.

The firm’s investments in funds that calculate NAV primarily consist of investments in firm-sponsored funds where the firm co-invests with third-party investors. The private equity, private debt and real estate funds are primarily closed-end funds in which the firm’s investments are not eligible for redemption. Distributions will be received from these funds as the underlying assets are liquidated and it is estimated that substantially all of the underlying assets of existing funds will be liquidated over

the next 10 years. The firm continues to manage its existing private equity funds taking into account the transition periods under the Volcker Rule of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), although the rules have not yet been finalized.

The firm’s investments in hedge funds are generally redeemable on a quarterly basis with 91 days’ notice, subject to a maximum redemption level of 25% of the firm’s initial investments at any quarter-end. The firm currently plans to comply with the Volcker Rule by redeeming certain of its interests in hedge funds. The firm redeemed approximately $250 million of these interests in hedge funds during the quarter ended March 2012.

The table below presents the fair value of the firm’s investments in, and unfunded commitments to, funds that calculate NAV.

 

 

    As of March 2012          As of December 2011  
in millions   Fair Value of
Investments
       Unfunded
Commitments
          Fair Value of
Investments
       Unfunded
Commitments
 

Private equity funds 1

    $  8,828           $3,066             $  8,074           $3,514   

Private debt funds 2

    3,744           3,244             3,596           3,568   

Hedge funds 3

    3,058                       3,165             

Real estate funds 4

    1,541           1,463             1,531           1,613   

Total

    $17,171           $7,773             $16,366           $8,695   

 

1.

These funds primarily invest in a broad range of industries worldwide in a variety of situations, including leveraged buyouts, recapitalizations and growth investments.

 

2.

These funds generally invest in loans and other fixed income instruments and are focused on providing private high-yield capital for mid- to large-sized leveraged and management buyout transactions, recapitalizations, financings, refinancings, acquisitions and restructurings for private equity firms, private family companies and corporate issuers.

 

3.

These funds are primarily multi-disciplinary hedge funds that employ a fundamental bottom-up investment approach across various asset classes and strategies including long/short equity, credit, convertibles, risk arbitrage, special situations and capital structure arbitrage.

 

4.

These funds invest globally, primarily in real estate companies, loan portfolios, debt recapitalizations and direct property.

 

22


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

Note 7. Derivatives and Hedging Activities

Note 7.

Derivatives and Hedging Activities

Derivative Activities

Derivatives are instruments that derive their value from underlying asset prices, indices, reference rates and other inputs, or a combination of these factors. Derivatives may be privately negotiated contracts, which are usually referred to as over-the-counter (OTC) derivatives, or they may be listed and traded on an exchange (exchange-traded).

Market-Making. As a market maker, the firm enters into derivative transactions with clients and other market participants to provide liquidity and to facilitate the transfer and hedging of risk. In this capacity, the firm typically acts as principal and is consequently required to commit capital to provide execution. As a market maker, it is essential to maintain an inventory of financial instruments sufficient to meet expected client and market demands.

Risk Management.    The firm also enters into derivatives to actively manage risk exposures that arise from market-making and investing and lending activities in derivative and cash instruments. The firm’s holdings and exposures are hedged, in many cases, on either a portfolio or risk-specific basis, as opposed to an instrument-by-instrument basis. The offsetting impact of this economic hedging is reflected in the same business segment as the related revenues. In addition, the firm may enter into derivatives designated as hedges under U.S. GAAP. These derivatives are used to manage foreign currency exposure on the net investment in certain non-U.S. operations and to manage interest rate exposure in certain fixed-rate unsecured long-term and short-term borrowings, and certificates of deposit.

The firm enters into various types of derivatives, including:

 

Ÿ  

Futures and Forwards. Contracts that commit counterparties to purchase or sell financial instruments, commodities or currencies in the future.

 

Ÿ  

Swaps. Contracts that require counterparties to exchange cash flows such as currency or interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, financial instruments, commodities, currencies or indices.

 

Ÿ  

Options. Contracts in which the option purchaser has the right, but not the obligation, to purchase from or sell to the option writer financial instruments, commodities or currencies within a defined time period for a specified price.

Derivatives are accounted for at fair value, net of cash collateral received or posted under credit support agreements. Derivatives are reported on a net-by-counterparty basis (i.e., the net payable or receivable for derivative assets and liabilities for a given counterparty) when a legal right of setoff exists under an enforceable netting agreement. Derivative assets and liabilities are included in “Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value,” respectively.

Substantially all gains and losses on derivatives not designated as hedges under ASC 815 are included in “Market making” and “Other principal transactions.”

 

 

23


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The table below presents the fair value of derivatives on a net-by-counterparty basis.

 

    As of March 2012          As of December 2011  
in millions   Derivative
Assets
     Derivative
Liabilities
          Derivative
Assets
       Derivative
Liabilities
 

Exchange-traded

  $  5,379        $  3,878             $  5,880           $  3,172   

Over-the-counter

  65,879        47,472             74,148           55,281   

Total

  $71,258        $51,350             $80,028           $58,453   

 

The table below presents the fair value and the number of derivative contracts by major product type on a gross basis. Gross fair values in the table below exclude the effects of both netting under enforceable netting agreements and

netting of cash collateral received or posted under credit support agreements, and therefore are not representative of the firm’s exposure.

 

 

    As of March 2012          As of December 2011  
in millions, except number of contracts  

Derivative

Assets

     Derivative
Liabilities
     Number of
Contracts
          Derivative
Assets
    

Derivative

Liabilities

    Number of
Contracts
 

Derivatives not accounted for as hedges

Interest rates

    $ 552,324         $ 512,372         304,937             $ 624,189         $ 582,608        287,351   

Credit

    115,065         97,845         363,617             150,816         130,659        362,407   

Currencies

    74,699         61,091         242,500             88,654         71,736        203,205   

Commodities

    36,058         36,959         85,787             35,966         38,050        93,755   

Equities

    59,623         51,704         299,762             64,135         51,928        332,273   

Subtotal

    837,769         759,971         1,296,603             963,760         874,981        1,278,991   

Derivatives accounted for as hedges

Interest rates

    22,238         68         1,308             21,981         13        1,125   

Currencies

    64         48         75             124         21        71   

Subtotal

    22,302         116         1,383             22,105         34        1,196   

Gross fair value of derivatives

    $ 860,071         $ 760,087         1,297,986             $ 985,865         $ 875,015        1,280,187   

Counterparty netting1

    (682,726      (682,726                   (787,733      (787,733        

Cash collateral netting2

    (106,087      (26,011                   (118,104      (28,829        

Fair value included in financial instruments owned

    $   71,258                               $   80,028                    

Fair value included in financial instruments sold,
but not yet purchased

             $   51,350                               $   58,453           

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

24


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THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Valuation Techniques for Derivatives

Price transparency of derivatives can generally be characterized by product type.

Interest Rate. In general, the prices and other inputs used to value interest rate derivatives are transparent, even for long-dated contracts. Interest rate swaps and options denominated in the currencies of leading industrialized nations are characterized by high trading volumes and tight bid/offer spreads. Interest rate derivatives that reference indices, such as an inflation index, or the shape of the yield curve (e.g., 10-year swap rate vs. 2-year swap rate), are more complex and are therefore less transparent, but the prices and other inputs are generally observable.

Credit. Price transparency for credit default swaps, including both single names and baskets of credits, varies by market and underlying reference entity or obligation. Credit default swaps that reference indices, large corporates and major sovereigns generally exhibit the most price transparency. For credit default swaps with other underliers, price transparency varies based on credit rating, the cost of borrowing the underlying reference obligations, and the availability of the underlying reference obligations for delivery upon the default of the issuer. Credit default swaps that reference loans, asset-backed securities and emerging market debt instruments tend to be less transparent than those that reference corporate bonds. In addition, more complex credit derivatives, such as those sensitive to the correlation between two or more underlying reference obligations, generally have less price transparency.

Currency. Prices for currency derivatives based on the exchange rates of leading industrialized nations, including those with longer tenors, are generally transparent. The primary difference between the transparency of developed and emerging market currency derivatives is that emerging markets tend to be observable for contracts with shorter tenors.

Commodity. Commodity derivatives include transactions referenced to energy (e.g., oil and natural gas), metals (e.g., precious and base) and soft commodities (e.g., agricultural). Price transparency varies based on the underlying commodity, delivery location, tenor and product quality (e.g., diesel fuel compared to unleaded gasoline). In general, price transparency for commodity derivatives is greater for contracts with shorter tenors and contracts that are more closely aligned with major and/or benchmark commodity indices.

Equity. Price transparency for equity derivatives varies by market and underlier. Options on indices and the common stock of corporates included in major equity indices exhibit the most price transparency. Equity derivatives generally have observable market prices, except for contracts with long tenors or reference prices that differ significantly from current market prices. More complex equity derivatives, such as those sensitive to the correlation between two or more individual stocks, generally have less price transparency.

Liquidity is essential to observability of all product types. If transaction volumes decline, previously transparent prices and other inputs may become unobservable. Conversely, even highly structured products may at times have trading volumes large enough to provide observability of prices and other inputs. See Note 5 for an overview of the firm’s fair value measurement policies.

Level 1 Derivatives

Level 1 derivatives include short-term contracts for future delivery of securities when the underlying security is a level 1 instrument, and exchange-traded derivatives if they are actively traded and are valued at their quoted market price.

Level 2 Derivatives

Level 2 derivatives include exchange-traded derivatives that are not actively traded and OTC derivatives for which all significant valuation inputs are corroborated by market evidence.

Level 2 exchange-traded derivatives are valued using models that calibrate to market-clearing levels of OTC derivatives. Inputs to the valuations of level 2 OTC derivatives can be verified to market transactions, broker or dealer quotations or other alternative pricing sources with reasonable levels of price transparency. Consideration is given to the nature of the quotations (e.g., indicative or firm) and the relationship of recent market activity to the prices provided from alternative pricing sources.

Where models are used, the selection of a particular model to value an OTC derivative depends on the contractual terms of and specific risks inherent in the instrument, as well as the availability of pricing information in the market. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, loss severity rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, model selection does not involve significant management judgment because outputs of models can be calibrated to market-clearing levels.

 

 

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Derivatives

Level 3 OTC derivatives are valued using models which utilize observable level 1 and/or level 2 inputs, as well as unobservable level 3 inputs.

 

Ÿ  

For the majority of the firm’s interest rate and currency derivatives classified within level 3, the significant unobservable inputs are correlations of certain currencies and interest rates (e.g., the correlation between Euro inflation and Euro interest rates) and specific interest rate volatilities.

 

Ÿ  

For level 3 credit derivatives, significant level 3 inputs include illiquid credit spreads, which are unique to specific reference obligations and reference entities, certain correlations required to value credit and mortgage derivatives (e.g., the likelihood of default of the underlying reference obligation relative to one another) and the basis, or price difference, of certain reference obligations to benchmark indices.

 

Ÿ  

For level 3 equity derivatives, significant level 3 inputs generally include equity volatility inputs for options that are very long-dated and/or have strike prices that differ significantly from current market prices. In addition, the valuation of certain structured trades requires the use of level 3 inputs for the correlation of the price performance of two or more individual stocks or the correlation of the price performance for a basket of stocks to another asset class such as commodities.

 

Ÿ  

For level 3 commodity derivatives, significant level 3 inputs include volatilities for options with strike prices that differ significantly from current market prices and prices or spreads for certain products for which the product quality or physical location of the commodity is not aligned with benchmark indices.

Subsequent to the initial valuation of a level 3 OTC derivative, the firm updates the level 1 and level 2 inputs to reflect observable market changes and any resulting gains and losses are recorded in level 3. Level 3 inputs are changed when corroborated by evidence such as similar market transactions, third-party pricing services and/or broker or dealer quotations or other empirical market data. In circumstances where the firm cannot verify the model value by reference to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value. See below for further information about unobservable inputs used in the valuation of level 3 derivatives.

Valuation Adjustments

Valuation adjustments are integral to determining the fair value of derivatives and are used to adjust the mid-market valuations, produced by derivative pricing models, to the appropriate exit price valuation. These adjustments incorporate bid/offer spreads, the cost of liquidity, credit valuation adjustments (CVA) and funding valuation adjustments, which account for the credit and funding risk inherent in derivative portfolios. Market-based inputs are generally used when calibrating valuation adjustments to market-clearing levels.

In addition, for derivatives that include significant unobservable inputs, the firm makes model or exit price adjustments to account for the valuation uncertainty present in the transaction.

 

 

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Significant Unobservable Inputs

The table below presents the ranges of significant unobservable inputs used to value the firm’s level 3 derivatives. These ranges represent the significant unobservable inputs that were used in the valuation of each type of derivative. These inputs are not representative of the inputs that could have been used in the valuation of any one derivative. For example, the highest correlation presented

in the table for interest rate derivatives is appropriate for valuing a specific interest rate derivative but may not be appropriate for valuing any other interest rate derivative. Accordingly, the ranges of inputs presented below do not represent uncertainty in, or possible ranges of, fair value measurements of the firm’s level 3 derivatives.

 

 

Significant

Unobservable Inputs

 

Derivative

Product Type

 

Range of Significant

Unobservable Inputs

as of March 2012

 

Sensitivity of Fair Value Measurement to Changes in Significant

Unobservable Inputs 1

Correlation

 

Interest rates

 

Credit

 

Currencies

 

Equities

 

Various 2

 

14% to 70%

 

5% to 91%

 

66% to 87%

 

46% to 91%

 

(51)% to 83%

 

For contracts where the holder benefits from the convergence of the underlying asset or index prices (e.g., interest rates, credit spreads, foreign exchange rates, inflation rates and equity prices), an increase in correlation generally results in a higher fair value measurement.

Volatility

 

Interest rates

 

Commodities

 

Equities

 

36% to 91%

 

4% to 80%

 

12% to 56%

 

 

In general, for purchased options an increase in volatility results in a higher fair value measurement.

Credit spreads

 

 

 

Recovery rates

 

 

Basis

 

Credit

 

 

 

Credit

 

 

Credit

 

88 basis points (bps) to 2,250 bps

 

 

0% to 85%

 

 

1 point to 10 points

 

 

In general, the fair value of purchased credit protection increases as credit spreads increase, recovery rates decrease or basis widens.

 

Credit spreads, recovery rates and basis are strongly related to distinctive risk factors of the underlying reference obligations, which include reference entity-specific factors such as leverage, volatility and industry, market-based risk factors, such as borrowing costs or liquidity of the underlying reference obligation and macro-economic conditions.

Spread per million British Thermal units (MMBTU)

of natural gas

 

  Commodities   $(0.82) to $3.91  

For contracts where the holder is receiving a commodity, an increase in the spread (price difference from a benchmark index due to differences in quality or delivery location) generally results in a higher fair value measurement.

 

1.

Represents the directional sensitivity of the firm’s level 3 fair value measurements to changes in significant unobservable inputs, in isolation. Due to the distinctive nature of each of the firm’s level 3 derivatives, the interrelationship of inputs is not necessarily uniform within each product type.

 

2.

Represents correlation across derivative product types.

 

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Fair Value of Derivatives by Level

The tables below present the fair value of derivatives on a gross basis by level and major product type. Gross fair values in the tables below exclude the effects of both netting under enforceable netting agreements and netting of cash

received or posted under credit support agreements both in and across levels of the fair value hierarchy, and therefore are not representative of the firm’s exposure.

 

 

    Derivative Assets at Fair Value as of March 2012  
in millions   Level 1     Level 2     Level 3     Cross-Level
Netting
    Total  

Interest rates

    $149        $ 574,153        $     260        $       —        $ 574,562   

Credit

           103,453        11,612               115,065   

Currencies

           73,384        1,379               74,763   

Commodities

           35,198        860               36,058   

Equities

    31        58,180        1,412               59,623   

Gross fair value of derivative assets

    180        844,368        15,523               860,071   

Counterparty netting 1

           (675,980     (4,372     (2,374 3      (682,726

Subtotal

    $180        $ 168,388        $11,151        $(2,374     $ 177,345   

Cash collateral netting 2

                                    (106,087

Fair value included in financial instruments owned

                                    $   71,258   
    Derivative Liabilities at Fair Value as of March 2012  
in millions   Level 1     Level 2     Level 3     Cross-Level
Netting
    Total  

Interest rates

    $139        $ 511,801        $     500        $       —        $ 512,440   

Credit

           92,735        5,110               97,845   

Currencies

           60,150        989               61,139   

Commodities

           36,000        959               36,959   

Equities

    33        49,739        1,932               51,704   

Gross fair value of derivative liabilities

    172        750,425        9,490               760,087   

Counterparty netting 1

           (675,980     (4,372     (2,374 3      (682,726

Subtotal

    $172        $   74,445        $  5,118        $(2,374     $   77,361   

Cash collateral netting 2

                                    (26,011

Fair value included in financial instruments sold,
but not yet purchased

                                    $   51,350   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

3.

Represents the netting of receivable balances with payable balances for the same counterparty across levels of the fair value hierarchy under enforceable netting agreements.

 

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

$172 $172 $172 $172 $172
    Derivative Assets at Fair Value as of December 2011  
in millions   Level 1     Level 2     Level 3     Cross-Level
Netting
    Total  

Interest rates

    $33        $ 645,923        $     214        $       —        $ 646,170   

Credit

           137,110        13,706               150,816   

Currencies

           86,752        2,026               88,778   

Commodities

           35,062        904               35,966   

Equities

    24        62,684        1,427               64,135   

Gross fair value of derivative assets

    57        967,531        18,277               985,865   

Counterparty netting 1

           (778,639     (6,377     (2,717 3      (787,733

Subtotal

    $57        $ 188,892        $11,900        $(2,717     $ 198,132   

Cash collateral netting 2

                                    (118,104

Fair value included in financial instruments owned

                                    $   80,028   

 

    Derivative Liabilities at Fair Value as of December 2011  
in millions   Level 1     Level 2     Level 3     Cross-Level
Netting
    Total  

Interest rates

    $  24        $ 582,012        $     585        $       —        $ 582,621   

Credit

           123,253        7,406               130,659   

Currencies

           70,573        1,184               71,757   

Commodities

           36,541        1,509               38,050   

Equities

    185        49,884        1,859               51,928   

Gross fair value of derivative liabilities

    209        862,263        12,543               875,015   

Counterparty netting 1

           (778,639     (6,377     (2,717 3      (787,733

Subtotal

    $209        $   83,624        $6,166        $(2,717     $   87,282   

Cash collateral netting 2

                                    (28,829

Fair value included in financial instruments sold,
but not yet purchased

                                    $   58,453   

 

1.

Represents the netting of receivable balances with payable balances for the same counterparty under enforceable netting agreements.

 

2.

Represents the netting of cash collateral received and posted on a counterparty basis under credit support agreements.

 

3.

Represents the netting of receivable balances with payable balances for the same counterparty across levels of the fair value hierarchy under enforceable netting agreements.

 

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Level 3 Rollforward

If a derivative was transferred to level 3 during a reporting period, its entire gain or loss for the period is included in level 3. Transfers between levels are reported at the beginning of the reporting period in which they occur.

Gains and losses on level 3 derivatives should be considered in the context of the following:

 

Ÿ  

A derivative with level 1 and/or level 2 inputs is classified in level 3 in its entirety if it has at least one significant level 3 input.

 

Ÿ  

If there is one significant level 3 input, the entire gain or loss from adjusting only observable inputs (i.e., level 1 and level 2 inputs) is classified as level 3.

Ÿ  

Gains or losses that have been reported in level 3 resulting from changes in level 1 or level 2 inputs are frequently offset by gains or losses attributable to level 1 or level 2 derivatives and/or level 1, level 2 and level 3 cash instruments. As a result, gains/(losses) included in the level 3 rollforward below do not necessarily represent the overall impact on the firm’s results of operations, liquidity or capital resources.

The tables below present changes in fair value for all derivatives categorized as level 3 as of the end of the period.

 

 

    Level 3 Derivative Assets and Liabilities at Fair Value for the Three Months Ended March 2012  
in millions  

Asset/

(liability)
balance,
beginning
of period

    Net
realized
gains/
(losses)
    Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
    Purchases     Sales     Settlements     Transfers
into
level 3
    Transfers
out of
level 3
   

Asset/

(liability)

balance,
end of

period

 

Interest rates — net

    $  (371     $(63     $   32        $    3        $    (1     $ 164        $       8        $  (12     $  (240

Credit — net

    6,300        10        (308     75        (73     (553     1,332        (281     6,502   

Currencies — net

    842        (6     (266     1        (7     (234     2        58  3      390   

Commodities — net

    (605     40        206        99        (99     41        100        119  3      (99

Equities — net

    (432     (25     (277     73        (100     306        15        (80     (520

Total derivatives — net

    $5,734        $(44 ) 1      $(613 ) 1,2      $251        $(280     $(276     $1,457        $(196     $6,033   

 

1.

The aggregate amounts include approximately $(444) million and $(213) million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

3.

Reflects a net transfer to level 2 of derivative liabilities.

 

The net unrealized loss on level 3 derivatives of $613 million for the three months ended March 2012 was primarily attributable to the impact of tighter credit spreads, increases in equity prices and changes in foreign exchange rates on the underlying derivatives, partially offset by the impact of changes in commodity prices.

Transfers into level 3 derivatives during the three months ended March 2012 primarily reflected transfers of certain credit derivative assets from level 2, primarily due to unobservable inputs becoming more significant to the valuation of these derivatives.

Transfers out of level 3 derivatives during the three months ended March 2012 primarily reflected transfers to level 2 of certain credit derivative assets, principally due to unobservable inputs no longer being significant to the valuation of these derivatives.

 

 

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     Level 3 Derivative Assets and Liabilities at Fair Value for the Three Months Ended March 2011
in millions    Asset/
(liability)
balance,
beginning
of period
   Net
realized
gains/
(losses)
  Net unrealized
gains/(losses)
relating to
instruments
still held at
period-end
  Purchases    Sales    Settlements    Net
transfers
in and/or
(out) of
level 3
  

Asset/

(liability)

balance,
end of

period

Interest rates — net

       $   194          $ (26 )       $  (58 )   $    1    $    —        $   13          $(221 )        $     (97 )

Credit — net

       7,040          3         (104 )   70    (81)        (722 )        385          6,591  

Currencies — net

       1,098          (1 )       (194 )   25    (6)        (31 )        241          1,132  

Commodities — net

       220          (78 )       90     241    (233)        115          (162 )        193  

Equities — net

       (990 )        176         (294 )   459    (625)        58          200          (1,016 )

Total derivatives — net

       $7,562          $  74  1       $(560 1, 2   $796    $(945)        $(567 )        $443          $ 6,803  

 

1.

The aggregate amounts include approximately $(501) million and $15 million reported in “Market making” and “Other principal transactions,” respectively.

 

2.

Principally resulted from changes in level 2 inputs.

 

The net unrealized loss on level 3 derivatives of $560 million for the three months ended March 2011 was primarily attributable to increases in equity index prices, tighter credit spreads and changes in foreign exchange rates on the underlying instruments.

Significant transfers in or out of level 3 derivatives during the three months ended March 2011 included:

 

Ÿ  

Credit — net: net transfer to level 3 of $385 million, principally due to reduced transparency of the correlation inputs used to value certain mortgage derivatives.

Impact of Credit Spreads on Derivatives

On an ongoing basis, the firm realizes gains or losses relating to changes in credit risk through the unwind of derivative contracts and changes in credit mitigants.

The net loss, including hedges, attributable to the impact of changes in credit exposure and credit spreads (counterparty and the firm’s) on derivatives was $179 million and $25 million for the three months ended March 2012 and March 2011, respectively.

Bifurcated Embedded Derivatives

The table below presents derivatives, primarily equity and interest rate products, that have been bifurcated from their related borrowings. These derivatives are recorded at fair value and included in “Unsecured short-term borrowings” and “Unsecured long-term borrowings.” See Note 8 for further information.

 

   

As of

in millions, except number of contracts   March
2012
  

December

2011

Fair value of assets

  $387    $422

Fair value of liabilities

  310    304

Net

  $  77    $118

Number of contracts

  357    333
 

 

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OTC Derivatives

The tables below present the fair values of OTC derivative assets and liabilities by tenor and by product type. Tenor is based on expected duration for mortgage-related credit

derivatives and generally on remaining contractual maturity for other derivatives.

 

 

in millions      OTC Derivatives as of March 2012  

Assets

 

Product Type

     0 - 12
Months
       1 - 5
Years
       5 Years or
Greater
       Total  

Interest rates

       $  9,356           $31,554           $  74,244           $ 115,154   

Credit

       2,705           13,987           10,976           27,668   

Currencies

       9,877           9,280           12,990           32,147   

Commodities

       5,768           4,837           124           10,729   

Equities

       4,306           7,620           7,370           19,296   

Netting across product types 1

       (1,960        (6,135        (5,092        (13,187

Subtotal

       $30,052           $61,143           $100,612           191,807   

Cross maturity netting 2

                                        (19,841

Cash collateral netting 3

                                        (106,087

Total

                                        $   65,879   

Liabilities

 

Product Type

     0 - 12
Months
       1 - 5
Years
       5 Years or
Greater
       Total  

Interest rates

       $  6,541           $17,077           $29,390           $ 53,008   

Credit

       1,222           5,826           3,400           10,448   

Currencies

       7,685           4,853           5,965           18,503   

Commodities

       5,235           4,747           2,556           12,538   

Equities

       3,626           4,544           3,844           12,014   

Netting across product types 1

       (1,960        (6,135        (5,092        (13,187

Subtotal

       $22,349           $30,912           $40,063           93,324   

Cross maturity netting 2

                                        (19,841

Cash collateral netting 3