Goldman Sachs 2007 Annual Report Download - page 75

Management’s Discussion and Analysis
(3% of total assets) and $23.64 billion (3% of total assets),
respectively, of other sovereign obligations, principally consisting
of securities issued by the governments of Japan and the
United Kingdom. In addition, as of November 2007 and
November 2006, $144.92 billion and $104.76 billion of our
financial instruments purchased under agreements to resell
and securities borrowed, respectively, were collateralized by
U.S. government and federal agency obligations. As of
November 2007 and 2006, $41.26 billion and $38.22 billion
of our financial instruments purchased under agreements to
resell and securities borrowed, respectively, were collateralized
by other sovereign obligations. As of November 2007 and
November 2006, we did not have credit exposure to any other
counterparty that exceeded 2% of our total assets. However,
over the past several years, the amount and duration of our
credit exposures have been increasing, due to, among other
factors, the growth of our lending and OTC derivative activities
and market evolution toward longer dated transactions. A further
discussion of our derivative activities follows below.
Derivatives
Derivative contracts are 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. Derivative instruments may be privately negotiated
contracts, which are often referred to as OTC derivatives, or
they may be listed and traded on an exchange.
Substantially all of our derivative transactions are entered into
to facilitate client transactions, to take proprietary positions
or as a means of risk management. In addition to derivative
transactions entered into for trading purposes, we enter into
derivative contracts to manage currency exposure on our net
investment in non-U.S. operations and to manage the interest
rate and currency exposure on our long-term borrowings and
certain short-term borrowings.
Derivatives are used in many of our businesses, and we believe
that the associated market risk can only be understood relative
to all of the underlying assets or risks being hedged, or as
part of a broader trading strategy. Accordingly, the market
risk of derivative positions is managed together with our
nonderivative positions.
The fair value of our derivative contracts is reflected net of cash
paid or received pursuant to credit support agreements and is
reported on a net-by-counterparty basis in our consolidated
statements of financial condition when management believes a
legal right of setoff exists under an enforceable netting agreement.
For an OTC derivative, our credit exposure is directly with our
counterparty and continues until the maturity or termination
of such contract.
Credit Risk
Credit risk represents the loss that we would incur if a counter-
party or an issuer of securities or other instruments we hold
fails to perform under its contractual obligations to us, or upon
a deterioration in the credit quality of third parties whose
securities or other instruments, including OTC derivatives, we
hold. Our exposure to credit risk principally arises through our
trading, investing and financing activities. To reduce our credit
exposures, we seek to enter into netting agreements with
counterparties that permit us to offset receivables and payables
with such counterparties. In addition, we attempt to further
reduce credit risk with certain counterparties by (i) entering
into agreements that enable us to obtain collateral from a
counterparty on an upfront or contingent basis, (ii) seeking
third-party guarantees of the counterparty’s obligations, and/or
(iii) transferring our credit risk to third parties using credit
derivatives and/or other structures and techniques.
To measure and manage our credit exposures, we use a variety
of tools, including credit limits referenced to both current
exposure and potential exposure. Potential exposure is generally
based on projected worst-case market movements over the
life of a transaction. In addition, as part of our market risk
management process, for positions measured by changes in
credit spreads, we use VaR and other sensitivity measures. To
supplement our primary credit exposure measures, we also use
scenario analyses, such as credit spread widening scenarios,
stress tests and other quantitative tools.
Our global credit management systems monitor credit exposure
to individual counterparties and on an aggregate basis to
counterparties and their affiliates. These systems also provide
management, including the Firmwide Risk and Credit Policy
Committees, with information regarding credit risk by product,
industry sector, country and region.
While our activities expose us to many different industries
and counterparties, we routinely execute a high volume of
transactions with counterparties in the financial services industry,
including brokers and dealers, commercial banks, investment
funds and other institutional clients, resulting in significant
credit concentration with respect to this industry. In the ordinary
course of business, we may also be subject to a concentration
of credit risk to a particular counterparty, borrower or issuer.
As of November 2007 and November 2006, we held
$45.75 billion (4% of total assets) and $46.20 billion (6% of
total assets), respectively, of U.S. government and federal
agency obligations (including securities guaranteed by the
Federal National Mortgage Association and the Federal
Home Loan Mortgage Corporation) included in “Financial
instruments owned, at fair value” and “Cash and securities
segregated for regulatory and other purposes” in the
consolidated statements of financial condition. As of
November 2007 and November 2006, we held $31.65 billion
73Goldman Sachs 2007 Annual Report