part of
March 16, 1999
GOLDMAN SACHS GROUP INC (GS)
S-1 Filing (SEC form S1)
TRADING AND PRINCIPAL INVESTMENTS
Trading and Principal Investments represented 28% of fiscal 1998 net revenues and 39% of fiscal 1997 net revenues. We make markets in equity and fixed income products, currencies and commodities; enter into swaps and other derivative transactions; engage in proprietary trading and arbitrage; and make principal investments. In trading, we focus on building lasting relationships with our most active clients while maintaining leadership positions in our key markets. We believe our research, market-making and proprietary activities enhance our understanding of markets and ability to serve our clients.
OUR BUSINESS PRINCIPLES 1. Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow. 2. Our assets are our people, capital and reputation. If any of these is ever diminished, the last is the most difficult to restore. We are dedicated to complying fully with the letter and spirit of the laws, rules and ethical principles that govern us. Our continued success depends upon unswerving adherence to this standard. 3. Our goal is to provide superior returns to our shareholders. Profitabilityis critical to achieving superior returns, building our capital and attractingand keeping our best people. Significant employee stock ownership aligns theinterests of our employees and our shareholders. 4. We take great pride in the professional quality of our work. We have an uncompromising determination to achieve excellence in everything we undertake. Though we may be involved in a wide variety and heavy volume of activity, we would, if it came to a choice, rather be best than biggest. 5. We stress creativity and imagination in everything we do. While recognizingthat the old way may still be the best way, we constantly strive to find a better solution to a client's problems. We pride ourselves on having pioneeredmany of the practices and techniques that have become standard in the industry. 6. We make an unusual effort to identify and recruit the very best person forevery job. Although our activities are measured in billions of dollars, weselect our people one by one. In a service business, we know that without thebest people, we cannot be the best firm. 7. We offer our people the opportunity to move ahead more rapidly than ispossible at most other places. We have yet to find the limits to the responsibility that our best people are able to assume. Advancement depends solely on ability, performance and contribution to the Firm's success, without regard to race, color, religion, sex, age, national origin, disability, sexual orientation, or any other impermissible criterion or circumstance. 8. We stress teamwork in everything we do. While individual creativity isalways encouraged, we have found that team effort often produces the bestresults. We have no room for those who put their personal interests ahead of theinterests of the Firm and its clients. 9. The dedication of our people to the Firm and the intense effort they give their jobs are greater than one finds in most other organizations. We think that this is an important part of our success. 10. We consider our size an asset that we try hard to preserve. We want to be big enough to undertake the largest project that any of our clients could contemplate, yet small enough to maintain the loyalty, the intimacy and the esprit de corps that we all treasure and that contribute greatly to our success. 11. We constantly strive to anticipate the rapidly changing needs of ourclients and to develop new services to meet those needs. We know that the worldof finance will not stand still and that complacency can lead to extinction. 12. We regularly receive confidential information as part of our normal client relationships. To breach a confidence or to use confidential information improperly or carelessly would be unthinkable. 13. Our business is highly competitive, and we aggressively seek to expand our client relationships. However, we must always be fair competitors and must never denigrate other firms. 14. Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the Firm and in their personal lives.
TRADING AND PRINCIPAL INVESTMENTS Trading and Principal Investments represented 28% of fiscal 1998 net revenues and 39% of fiscal 1997 net revenues. We make markets in equity and fixed income products, currencies and commodities; enter into swaps and other derivative transactions; engage in proprietary trading and arbitrage; and make principal investments. In trading, we focus on building lasting relationships with our most active clients while maintaining leadership positions in our key markets. We believe our research, market-making and proprietary activities enhance our understanding of markets and ability to serve our clients.
($ in millions)
Long-term borrowings.......................... 14,418 13,358 12,376 15,667 19,906
We generally maintain large trading and investment positions in the fixed income, currency, commodity and equity markets. To the extent that we own assets, i.e., have long positions, in any of those markets, a downturn in thosemarkets could result in losses from a decline in the value of those long positions. Conversely, to the extent that we have sold assets we do not own,i.e., have short positions, in any of those markets, an upturn in those markets could expose us to potentially unlimited losses as we attempt to cover our short positions by acquiring assets in a rising market. We may from time to time have a trading strategy consisting of holding a long position in one asset and a short position in another, from which we expect to earn revenues based on changes in the relative value of the two assets. If, however, the relative value of the two assets changes in a direction or manner that we did not anticipate oragainst which we are not hedged, we might realize a loss in those pairedpositions. We incurred significant losses in our Trading and Principal Investments business in the second half of fiscal 1998 from this type of "relative value" trade.
For example, the market movements of the late third and early fourth quarters of fiscal 1998 were larger and involved greater divergences in relative asset values than we anticipated. This caused us to experience trading losses that were greater and recurred more frequently than some of our risk measures indicated were likely to occur.
We are exposed to the risk that third parties that owe us money, securities or other assets will not perform their obligations. These parties include our trading counterparties, customers, clearing agents, exchanges, clearing houses and other financial intermediaries as well as issuers whose securities we hold.These parties may default on their obligations to us due to bankruptcy, lack ofliquidity, operational failure or other reasons. This risk may arise, for example, from holding securities of third parties; entering into swap or other derivative contracts under which counterparties have long-term obligations to make payments to us; executing securities, futures, currency or commodity trades that fail to settle at the required time due to non-delivery by the counterparty or systems failure by clearing agents, exchanges, clearing houses or other financial intermediaries; and extending credit to our clients through bridge or margin loans or other arrangements.
. INVESTORS IN THE NOTES FACE ADDITIONAL RISK BECAUSE THE GOLDMAN SACHS GROUP, INC. IS A HOLDING COMPANY
Because The Goldman Sachs Group, Inc. is a holding company, it depends on dividends, distributions and other payments from its subsidiaries to fund all payments on its debt obligations, including its obligations to make payments onthe notes.
". EMPLOYEE MISCONDUCT IS DIFFICULT TO DETECT AND DETER AND COULD HARM GOLDMAN SACHS AND REDUCE THE VALUE OF THE NOTES
There have been a number of highly publicized cases involving fraud orother misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct could occur. Misconduct by employees could include binding Goldman Sachs to transactions that exceedauthorized limits or present unacceptable risks, or hiding from Goldman Sachs unauthorized or unsuccessful activities, which, in either case, may result inunknown and unmanaged risks or losses. Employee misconduct could also involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter employee misconduct and the precautions we take to prevent and detect this activity may not be effective in all cases.
Later in the fourth quarter of 1998, market conditions improved as the U.S.Federal Reserve cut interest rates, the International Monetary Fund finalized a credit agreement with Brazil and a consortium of 14 financial institutions,including Goldman Sachs, recapitalized Long-Term Capital Portfolio, L.P. For a further discussion of Long-Term Capital Portfolio, L.P., see"-- Liquidity -- The Balance Sheet" below.
52
In September 1998, a consortium of 14 banks and brokerage firms, including Goldman Sachs, made an equity investment in Long-Term Capital Portfolio, L.P., a major market participant. The objectives of this investment were to provide sufficient capital to permit Long-Term Capital Portfolio, L.P. to continue active management of its positions and, over time, to reduce risk exposures and leverage, to return capital to the participants in the consortium and ultimately to realize the potential value of the portfolio. We invested $300 million in Long-Term Capital Portfolio, L.P.
TRADING AND PRINCIPAL INVESTMENTS Our Trading and Principal Investments business facilitates customertransactions and takes proprietary positions through market-making in andtrading of fixed income and equity products, currencies, commodities, and swapsand other derivatives. In order to meet the needs of our clients, our Trading and Principal Investments business is diversified across a wide range of products. For example, we make markets in traditional investment grade debt securities, structure complex derivatives and securitize mortgages and insurancerisk. A fundamental tenet of our approach is that we believe our willingness and ability to take risk distinguishes us and substantially enhances our client relationships.
Our Trading and Principal Investments business includes the following: - FIXED INCOME, CURRENCY AND COMMODITIES. Goldman Sachs makes markets in and trades fixed income products, currencies and commodities, structures and enters into a wide variety of derivative transactions and engages in proprietary trading and arbitrage activities;
Major investors worldwide recognize Goldman Sachs for its value-added research products, which are highly rated in client polls across the Americas, Europe and Asia. Our Research Department is the only one to rank in the topthree in each of the last 15 calendar years in Institutional Investor's "All- America Research Team" survey. In December 1998, the Research Department alsoachieved top honors for global investment research from Institutional Investor.In Europe, based on the Institutional Investor "1999 All-Europe Research Team"survey, the Research Department ranked number one for coverage of pan-Europeansectors and number three in European Strategy and Economics. Global Investment Research employs a team approach that provides equityresearch coverage of approximately 2,300 companies worldwide, 53 economies and26 stock markets. This is accomplished through four groups: - the Economic Research group, which formulates macroeconomic forecasts for economic activity, foreign exchange, and interest rates based on the globally coordinated views of its regional economists;
- the Portfolio Strategy group, which forecasts equity market returns and provides recommendations on both asset allocation and industry representation;
- the Company/Industry group, which provides fundamental analysis, forecasts and investment recommendations for companies and industries worldwide. Equity research analysts are organized regionally by sector and globally into more than 20 industry teams, which allows for extensive collaboration and knowledge sharing on important investment themes; and
84
- the Commodities Research group, which provides research on the global commodity markets.
ASSETS:
------------------------AS OF NOVEMBER -------------------- 1997 1998 ----
(in millions)
Derivative contracts...................................... 13,788 21,299 Physical commodities...................................... 1,092 481
LIABILITIES AND NET WORTH:
Derivative contracts...................................... 15,964 24,722 Physical commodities...................................... 78 966
MARKET RISK. The Firmwide Risk Committee, which reports to senior management and meets weekly, is responsible for managing and monitoring all of the Firm's risk exposures. In addition, the Firm maintains segregation ofduties, with credit review and risk-monitoring functions performed by groupsthat are independent from revenue-producing departments. The potential for changes in the market value of the Firm's tradingpositions is referred to as "market risk". The Firm's trading positions resultfrom underwriting, market-making and proprietary trading activities. The broadly defined categories of market risk include exposures to interestrates, currency rates, equity prices and commodity prices. - Interest rate risks primarily result from exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates, mortgage prepayment speeds and credit spreads. - Currency rate risks result from exposures to changes in spot prices, forward prices and volatilities of currency rates. F-12 THE GOLDMAN SACHS GROUP, L.P. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - Equity price risks result from exposures to changes in prices and volatilities of individual equities, equity baskets and equity indices. - Commodity price risks result from exposures to changes in spot prices, forward prices and volatilities of commodities, such as electricity, natural gas, crude oil, petroleum products and precious and base metals. These risk exposures are managed through diversification, by controlling position sizes and by establishing off setting hedges in related securities or derivatives. For example, the Firm may hedge a portfolio of common stock by taking an offsetting position in a related equity-index futures contract. The ability to manage these exposures may, however, be limited by adverse changes in the liquidity of the security or the related hedge instrument and in the correlation of price movements between the security and the related hedge instrument.
The broadly defined categories of market risk include exposures to interestrates, currency rates, equity prices and commodity prices.
- Interest rate risks primarily result from exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates, mortgage prepayment speeds and credit spreads.
- Currency rate risks result from exposures to changes in spot prices, forward prices and volatilities of currency rates.
THE GOLDMAN SACHS GROUP, L.P. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
AS OF NOVEMBER
---------------------- 1997 1998 ---- ----
(in millions)
CURRENCY AND COMMODITY PRICE RISK:
Financial futures and forward settlement contracts......... 355,882 420,138
Swap agreements............................................ 32,355 51,502
Written option contracts................................... 179,481 183,929
25
THE GOLDMAN SACHS GROUP, L.P. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF FINANCIAL CONDITION AS OF FEBRUARY 1999 ------------- (unaudited) (in millions)
ASSETS:
Derivative contracts...................................... 20,441
Physical commodities...................................... 688
LIABILITIES AND NET WORTH:
Derivative contracts...................................... 22,677
Physical commodities...................................... 267
DERIVATIVE ACTIVITIES Most of the Firm's derivative transactions are entered into for trading purposes. The Firm uses derivatives in its trading activities to facilitate customer transactions, to take proprietary positions and as a means of riskmanagement. The Firm also enters into non-trading derivative contracts to manage the interest rate and currency exposure on its long-term borrowings. Derivative contracts are financial instruments, such as futures, forwards,swaps or option contracts, that derive their value from underlying assets,indices, reference rates or a combination of these factors. Derivatives may involve future commitments to purchase or sell financial instruments or commodities, or to exchange currency or interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, securities, commodities or indices. Derivative contracts exclude certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations andindexed debt instruments, that derive their values or contractually required cash flows from the price of some other security or index. Derivatives also exclude option features that are embedded in cash instruments, such as theconversion features and call provisions embedded in bonds. The Firm has elected to include commodity-related contracts in its derivative disclosure, although not required to do so, as these contracts may be settled in cash or are readily convertible into cash. Derivatives used for trading purposes are reported at fair value and are included in "Derivative contracts" on the consolidated statement of financial condition. Gains and losses on derivatives used for trading purposes are included in "Trading and Principal Investments" on the consolidated statements of earnings. The Firm utilizes replacement cost as its measure of derivative creditrisk. Replacement cost, as reported in financial instruments owned, at fairvalue on the consolidated statement of financial condition, represents amounts receivable from various counterparties, net of any unrealized losses owed wheremanagement believes a legal right of set off exists under an enforceable masternetting agreement. Replacement cost for purchased option contracts is the marketvalue of the contract. The Firm controls its credit risk through an established credit approval process, by monitoring counterparty limits, obtaining collateral where appropriate and, in some cases, using legally enforceable master netting agreements. The fair value of derivative financial instruments used for trading purposes, computed in accordance with the Firm's netting policy, is set forth below: AS OF FEBRUARY 1999 ---------------------- ASSETS LIABILITIES ------ -----------
(in millions)
Forward settlement contracts................................ $ 3,991 $ 3,725
Swap agreements............................................. 9,233 10,460 Option contracts............................................ 7,140 8,484 ------- -------
Total....................................................... $20,364 $22,669 |
