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Business Context and Reporting Period

This Form 10-Q covers The Goldman Sachs Group, Inc. for the quarterly period ended August 30, 2002, and the nine months ended on that date. The firm operates as a global investment banking, securities, and investment management organization divided into three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services. The reporting period was characterized by a slow global economic recovery, weak investor confidence, and significantly reduced activity in mergers and acquisitions and equity underwriting.

Key Financial Metrics

Liquidity and Leverage: The firm maintained a liquidity cushion averaging $30.15 billion during the quarter. The leverage ratio (total assets to equity) was 18.5x, and the adjusted leverage ratio was 14.3x. The annualized return on tangible shareholders' equity was 15.1% for the quarter and 15.6% for the nine-month period.

Material Changes vs. Prior Period

• Revenue Trends: Net revenues for the three months ended August 2002 were flat compared to the prior year ($3,649 million vs. $3,661 million). However, for the nine-month period, revenues declined 10% to $11.1 billion from $12.4 billion.
• Profitability: Net earnings increased 12% for the quarter ($522 million vs. $468 million) but decreased 11% for the nine-month period ($1.61 billion vs. $1.81 billion).
• Segment Performance:
  • Investment Banking: Revenues dropped 41% for the quarter and 24% for the nine months due to a sharp decline in M&A and underwriting activity.
  • Trading and Principal Investments: Revenues rose 21% for the quarter, driven by Fixed Income, Currency, and Commodities (FICC), though Principal Investments recorded negative revenues due to valuation declines in tech and telecom sectors.
  • Asset Management and Securities Services: Revenues increased 14% for the quarter, supported by higher commissions and asset management fees.
• Expenses: Total operating expenses decreased slightly for the quarter (1%) and by 9% for the nine-month period, aided by expense reduction initiatives and the elimination of goodwill amortization under new accounting standards (SFAS No. 142).

Outlook, Risks, and Contingencies

Management Commentary: Management noted that the business environment remained challenging with slow global growth. The firm continues to target compensation and benefits expenses at approximately 50% of net revenues. A new fee-based pricing structure for Nasdaq trading was implemented in January 2002, shifting revenue recognition from Trading to Commissions.

Risks and Contingencies:

• Legal Proceedings: The firm is involved in various litigation matters, including IPO process disputes, research independence class actions, and bondholder litigation related to Enron, WorldCom, and Exodus Communications. Management believes these proceedings will not have a material adverse effect on financial condition but could impact operating results in specific periods.
• Credit Ratings: Credit ratings remain critical for funding costs. Fitch revised its outlook to "negative" in May 2002, while Moody's upgraded the long-term rating in August 2002. Standard & Poor's placed the short-term rating on CreditWatch with negative implications.
• Market Risk: The firm's Value at Risk (VaR) for trading positions averaged $47 million for the quarter. Nontrading portfolio sensitivity to a 10% equity market decline was estimated at $86 million.

Investor Verification Checklist

• Revenue Composition: Verify the sustainability of the Trading segment's revenue growth given the volatility in FICC markets and the negative impact of Principal Investments.
• Expense Ratios: Monitor the compensation-to-revenue ratio, which remained at 50%, to ensure cost discipline holds if revenue pressures persist.
• Legal Exposure: Track the status of the IPO underpricing and research independence lawsuits, as these represent significant contingent liabilities.
• Liquidity Position: Confirm the stability of the $30 billion liquidity cushion and the firm's ability to refinance short-term borrowings ($40 billion) in a tightening credit environment.
• Accounting Changes: Review the impact of the transition to SFAS No. 142 (goodwill impairment testing) on future earnings volatility.