Anatomy of A Crisis

Quantitative Investment Strategies
September 30, 2008
Anatomy of a Crisis
Causes and implications of the current financial disruption
Executive Summary
• After a long period of stable economic growth and rising financial prices, the market has
entered a period of extreme disruption that has shaken investor confidence to its foundation.
Uncertainty about the future is in turn driving a pronounced reduction in risk taking by
individual investors, institutional investors and financial intermediaries.
• We believe a key ingredient of this disruption is moral hazard in the housing market. That is,
both home buyers and mortgage lenders were encouraged to undertake risky investments
without adequate appreciation of the consequences, since they could easily walk away from the
investment if things didn’t work out – homeowners, by defaulting; lenders, by securitizing the
loans in pools with an implied federal guarantee.
• This resulted in too much money flowing into housing, which became overvalued relative to
income and alternative investment opportunities.
• When housing prices declined, and mortgage default rates rose, creditors were left holding
assets (mortgage-backed and related securities) that were illiquid and hard to value, thereby
limiting their ability to make loans or raise additional capital.
• As uncertainty and paralysis spread, many assets, including higher-quality corporate bonds and
commercial mortgages, began to sell at extremely distressed levels, putting further pressure on
intermediaries’ ability to lend and invest.
• Faced with a budding financial meltdown that could send the whole economy into a
severe recession, the Treasury has proposed a distressed asset purchase plan that would
provide a backstop to pricing for certain illiquid assets, freeing up liquidity to be used in the
broader economy.
• We believe the Treasury proposal, however, does create a potential new moral hazard issue.
Some of the questions you may ask are: if the government will always be there to bail out
investors when risks don’t work out, why should investors have any reason to assess risk
carefully or to assure that they earn adequate compensation for taking risk? If capital costs
don’t accurately reflect risks, how can markets efficiently allocate capital to the best risk-
adjusted opportunities?
• We believe this new moral hazard risk is smaller and less certain than the real economic
risks associated with a financial crisis. We also believe increased disclosure and modest
regulatory improvements can offset these new moral hazards. Clearly, the market believes that
some type of backstop plan is necessary as illustrated by the events seen on Monday,
September 29, 2008.
• From an investment standpoint, periods of disruption often provide extraordinary
opportunities. We are pursuing these opportunities by positioning our portfolios to hedge
against further disruption while being ready for a return to normalcy. From a research
standpoint, we are also using disruption indicators to modify our risk targets over time and
incorporating additional proprietary factors that are less susceptible to disruption.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and
should not be construed as research or investment advice. Please see additional disclosures.
Anatomy of a Crisis 쐍 September 30, 2008
I. Introduction
After many years of a booming world economy and calm government authority which could buy up to $700 billion in
financial markets, the unprecedented events of the past few distressed securities, essentially providing a backstop bid that
weeks have clearly shaken both investors and casual observers would allow lenders to assess their liquidity levels and resume
of the financial markets. At the beginning of 2007, risks to the their normal business of providing credit to the economy. In
economy appeared minimal; the prices of insuring against addition, Goldman Sachs and Morgan Stanley, the last two
default on corporate debt, high quality mortgages, and even remaining bulge-bracket investment banks, applied to become
lower-quality subprime mortgages were all at historically low bank holdings companies, placing themselves under the
levels. Since that time, however, we have seen a dramatic regulatory supervision of the Federal Reserve.
increase in the perceived risks to the US and global economies.
In this paper, we discuss how the economy and markets have
As the economy and markets lurched from one crisis to the
reached this precarious point. We begin with an abbreviated
next, some measures of economic and financial risk reached
chronology of selected events over the past several months.
their highest levels in decades. Currently, risk aversion is so
Next, we examine how various market prices have reacted to
high that the credit markets have seized up: lenders now
these events. We also discuss how economic theory can help us
require huge spreads (by historical standards) to extend credit,
understand what’s happened and the implications for financial
with some intermediaries unable to borrow or lend at all
markets and the broader economy. Finally, we examine the
because they can’t assess their liquidity positions due to the
predictive power and implications of financial disruption with
lack of bids for their mortgage-backed securities (MBS)
respect to our macro and equity strategies, and also our efforts
portfolios.1 In an effort to calm markets, Congress and the
to manage portfolio risk in this environment.
Administration are working on a proposal to create a new
1Complete definitions of select terms used in this paper are given in the Glossary (see page 16).
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice.
Please see additional disclosures.
Goldman Sachs Asset Management | 2

II. Chronology of Selected Events

Exhibit 1: S&P 500 Implied Volatility Index (VIX), Jan. 2, 2007 – Sep. 29, 2008 I-P See below
September 08
50
P
F. Establishment of Fed’s lending facility;

Corporate Credit Crunch II; Bear
Stearns collapse; JPMorgan Chase
D. Bank write-downs due to subprime announces plans to acquire Bear
40
mortgages (over $15 billion) Stearns (March, 2008)
(November, 2007)
C. Quant Liquidity Crunch
(August, 2007) O
N
F
B. Investment-grade corporate D E M
C K
spreads widen; SEC G. CMBX spreads widen
Annualized volatility (%)
L
30 eliminates uptick rule H
(June-July, 2008) J
(July, 2007)
I
A. Subprime mortgage spreads widen G
(February-March, 2007)
A
20 B
E. Fed cuts rates by 3/4 of a point,

the biggest cut in nearly 24 years H. Concerns over Fannie Mae/Freddie
(January, 2008) Mac collapsing; SEC bans naked
shorting of 19 financial companies
10
(July, 2008)
0
Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08
I. Fannie Mae/Freddie Mac placed into a conservatorship run by the Federal

Housing Finance Agency (FHFA) (September 7, 2008)
50
J. Bank of America announces plans to acquire Merrill Lynch (September, 14, 2008)
P K. Lehman Brothers files for Chapter 11 protection, marking the largest bankruptcy
in US history (September 15, 2008)
L. American International Group (AIG) share price falls due to news of valuation of
subprime MBS
Federal Reserve announces creation of credit facility of up to $85 billion
40
(September 16, 2008)
M. Bush administration requests Congress to authorize the Treasury Department to
buy up to $700 billion of mortgage-related assets, requests raising the national
N O debt ceiling to $11.3 trillion
K M In the US & UK, the SEC and FSA apply short selling restrictions
Intraday prices of Morgan Stanley and Goldman Sachs fall to 84% and 66%,
30 J L respectively, below their all time highs (September 18, 2008)
N. Goldman Sachs and Morgan Stanley become bank holding companies
NY Fed immediately provides access of bank’s broker dealer arms to Fed’s
I Primary Dealer Credit facility (September 21, 2008)
O. JPMorgan Chase announces plans to acquire Washington Mutual (September 25, 2008)
20
2 3 4 5 8 9 10 11 12 15 16 17 18 19 22 23 24 25 26 29 P. House of Representatives fails to pass the asset purchase legislation
September 2008 Citigroup announces plans to acquire Wachovia’s banking operations
VIX hits an all-time high (September 29, 2008)
Source: Yahoo!

III. Evolution of the current crisis 13.32% per year. By August 2007, the spread had jumped to
approximately 45% per year, a full ten-fold increase, and
In January 2007, market prices were indicating steady prices on BBB- MBS had fallen by 40%. By mid-September
economic growth with few risks. Spreads on corporate debt, 2008, these prices had fallen by another 85% to under 9 cents
commercial and residential mortgage-backed securities, and on the dollar. Essentially, the market was implicitly forecasting
even subprime mortgage-backed securities were close to all- that the vast majority of subprime mortgages would default,
time lows. The VIX was just above 10%, close to the all-time and that lenders would recover little value for the
low of 9.31% set in 1993, and well below the previous highs underlying property.
of 44–45% seen in September 1998 and September 2001 (see
Exhibit 2). The Federal Reserve was more concerned about Exhibit 3: The sharp increase on the ABX BBB- spread illustrates
inflation than recession. Accordingly, the Fed Funds target rate investors deepening concerns about default risk
had been raised to 5.25% on June 29, 2006, and would not
ABX BBB- spread, Jul. 19, 2006 – Aug. 15, 2007
move again for another 14 months.
5000
Exhibit 2: Volatility increased sharply in 2008

4000
Daily VIX level, Jan. 2, 1990 – Sep. 29, 2008
50 ABX spread (bps)
3000
40
2000
30 1000
20 0
Aug 06 Oct 06 Dec 06 Feb 07 Apr 07 Jun 07 Aug 07
10
Source: Morgan Markets, JPMorgan Chase
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Mortgage-backed securities
Source: Yahoo! In order to understand the current financial situation, we must
first discuss the securitization of mortgages. Mortgage
Within a few months, the first clear indications of the current securitization can provide many economic benefits: it promotes
financial crisis began to emerge. Concerns about decreasing sharing of mortgage risk across broad segments of the
home values and increasing mortgage delinquency rates caused population, allows more investors to earn some of the
the spreads on subprime mortgages to rise in a dramatic premium associated with bearing this risk, and lowers the cost
fashion. Exhibit 3 plots the implied ABX BBB- spread. On of borrowing to home owners. However, in the mortgage
January 2, 2007, the spread stood at 411 bps, meaning that securitization process there is an asymmetric information
investors who sold protection on these securities were willing problem. In other words, the loan originators (i.e., the banks
to accept 4.11% of the loan value per year as an insurance actually making loans to homeowners) understand default risks
premium. However, by February 27, 2007, the premium better than the firm or individual purchasing the mortgages or,
demanded had jumped almost four-fold, peaking at a level of ultimately, the MBS that are backed by the loans.

For many years, the mortgage-backed securities market was The crisis spreads to other markets
primarily based on conforming mortgage loans, which were
At first glance, it is tempting to conclude that the string of
generally issued by Fannie Mae and Freddie Mac, who also
events detailed in Exhibit 1 arose solely as a consequence of
guaranteed these mortgage-backed securities against default. In
declining real estate prices and the resulting losses in subprime
fact, most MBS investors – which include pension funds,
mortgages. While there are commonalities between the
insurance companies, hedge funds, mutual funds, foreign central
widening default and credit spreads witnessed over the last few
banks, and individuals – assumed these securities were implicitly
months, it would be wrong to ascribe them entirely to falling
guaranteed by the federal government as well, since it had
home prices.
sponsored both organizations. However, this implicit backing,
coupled with the asymmetric information problem, created a Indeed, prior to July 2007, the market perceived that the fall in
moral hazard issue. More specifically, it could be argued that the value of subprime mortgages was an isolated event which
Fannie and Freddie (and the ultimate investor) didn’t need to would not adversely affect the rest of the economy. This is seen
worry too much about the quality of the underlying mortgages in Exhibit 4 which plots the spread from March 6, 2006
because the government would bear most of the risk of a through August 15, 2007 on three portfolios representing
mortgage default. different levels of credit risk in investment-grade corporate debt
and commercial mortgages, the CDX, the AAA CMBX and the
This issue became even more pronounced as the subprime
super-senior tranche of the CDX.3
mortgage market developed. Subprime mortgage-backed
securities do not carry a guarantee against default, as do those Until June 2007, the market did not perceive that the sharp fall
on conforming mortgages. In hindsight, we believe this should in the value of subprime MBS would result in an increased
have led investors in subprime MBS to insist on tighter loan probability of default for either high-grade commercial
standards and better monitoring. However, perhaps because of mortgage-backed securities (CMBS) or investment-grade
the long, steady increase in housing prices leading up to 2007, corporate debt. However, beginning in late July 2007, spreads
there was little fear in early 2007 that subprime MBS would in these instruments spiked dramatically: the CDX spread
experience major losses – or rather, investors felt that a small jumped from 40 to 80 bps, the AAA CMBX from 10 to over
interest rate premium was enough to compensate for the 40 bps, and the spread on the super-senior tranche of the CDX
modest risk of default in a diversified subprime mortgage pool. by a factor of 10: from 1.6 bps on June 29 to 16.2 bps on
Another factor that may have contributed to the lax loan August 1. At this time, concerns about a contagion effect
standards was that Fannie and Freddie were purchasing large arising from the subprime mortgage debacle surfaced.
quantities of subprime securities. In particular, Freddie
purchased $158 billion worth of subprime and Alt-A securities Exhibit 4: Spreads spiked significantly in July of 2007 as sentiment shifted
in 2006-07, which was 13% of the total amount issued over Credit derivative spreads, Mar. 6, 2006 – Aug. 15, 2007
this period.2
100
CDX spread
In early 2008, as the price of subprime mortgage debt AAA CMBX spread
CDX super-senior tranche spread
continued to fall, investors began to more fully appreciate the 80
extent and quality of Fannie and Freddie’s subprime holdings.
Spread (bps)
As a result, Fannie and Freddie found it extremely difficult to 60

secure additional debt or equity financing. On September 7,
2008, because of the concern that a bankruptcy of one or both 40
of these firms would lock up the home mortgage market and
potentially exacerbate the decline in home values, the Treasury 20
stepped in to assume the risk, as well as the control, of Fannie
and Freddie – essentially making good on the implicit guarantee. 0
Apr 06 Jun 06 Aug 06 Oct 06 Dec 06 Feb 07 Apr 07 Jun 07 Aug 07
Source: Morgan Markets, JPMorgan Chase
2 From “Fannie, Freddie subprime spree may add to bailout.” By Jody Shenn, Bloomberg.com, September 23, 2008.
3 We refer to the five-year maturity instruments for all three indices.

Additionally, evidence from money markets also revealed documented in our “Quant Liquidity Crunch” paper from last
increased concern about the broader economy. Exhibit 5 plots year.5 The deleveraging began in the US, then quickly became
3-month T-bill rates, Eurodollar rates (LIBOR), and the TED severe and spread to non-US regions. This deleveraging
spread (the difference between LIBOR and T-bills) since resulted in unprecedented negative returns to all standard
January 2006. As LIBOR is an inter-bank lending rate and the quant factors in the US and overseas during the first two weeks
T-bill rate is effectively the risk-free rate, the spread between of August. In the process, it became clear that many popular
the two is an indicator of credit risk in inter-bank loans. The quantitative signals had become over-crowded, resulting in
TED spread increases when the perceived risk of bank default either reduced effectiveness and/or increased risk. After a
rises. As shown in Exhibit 5, the TED spread increased slightly harrowing week for quant strategies, Goldman Sachs and a
in mid-June 2007 as a result of declining T-bill rates, and then number of other institutional investors announced significant
jumped dramatically in early August.4 investments in quantitative portfolios. Coincident with these
investments, many quantitative factors flipped directions on
Exhibit 5: Investor fear drove rates down, borrowing premium hit record highs
August 10, 2007 and moderated to more normal levels.
Treasury, LIBOR, and TED spread, Jan. 1, 2006 – Sep. 29, 2008
Around the same time, as a result of an increased demand for
6
liquidity in the financial system, the European Central Bank
5 and the Federal Reserve jointly injected roughly $150 and
$100 billion of credit into the financial system on August 9
4
and 10, respectively.6 In the US, the increased liquidity drove
Rate (% per year)
3
3-Month T-bills down Treasury rates, but the increased demand for investment
3-Month LIBOR
TED spread capital and increased concerns about risk drove up LIBOR,
2 resulting in a strong jump in the TED spread.
1
The crisis widens
0
Since August of last year, the shock of increased capital costs
Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08
has propagated through multiple markets in a way that few
Source: Bloomberg could have predicted. Exhibit 6 extends the time period of the
credit spread plot in Exhibit 4 up through September 29, 2008.
The large moves in July and August 2007 were likely related To facilitate comparison, the blue area in Exhibit 6’s plot is
to two factors: new information about financial institutions’ that previously shown in Exhibit 4. Note that the seemingly
exposures to credit instruments, and a broader demand large spread of 80 bps for the CDX in early August 2007
for liquidity. widened to over 200 bps per year in March 2008. The 45 bps
On July 30, 2007, Deutsche Industriebank (IKB), a German CMBX spread increased to over 250 bps in early March as
bank, warned that it faced losses as a result of holding US Bear Stearns collapsed following a massive decline in the values
subprime mortgage-related instruments in a structured vehicle of its mortgage-related securities; it was subsequently acquired
and was subsequently bailed out by a consortium of German by JPMorgan Chase.
banks. This was the first major bank failure that resulted from Both the CDX spread and the CDX super-senior tranche
mortgage-related distress. spread indicate that the implied probability of major defaults
Also in early August 2007, the equity markets saw a dramatic on corporate debt reached extraordinary levels in March 2008,
deleveraging of quant trades, something we previously and again over the week of September 15 – in both cases to
4 The 3-month TED spread widened to 354 bps on September 29, 2008, the highest level since September 18, 2008, when it stood at 313 bps. The September 18, 2008 spread broke the previous
record, which was set after the “Black Monday” crash of 1987 (300 bps on October 20, 1987).
5 Please see GSAM papers “The Quant Liquidity Crunch” and “Quantcentration,” released in August 2007 and March 2008, respectively.
6 On August 9 and 10, the Federal Reserve pumped $24 and $38 billion, respectively, into the financial system. This move was presumably in response to a perceived lack of liquidity in the financial
system and, more specifically, to a (somewhat more remarkable) increase in overnight rates early Friday morning to more than 6% – well above the Fed target rate of 5.25%. At the same time, the
European central bank took even stronger action, injecting $130.6 and $83.6 billion on August 9 and 10. As a result, the Fed Funds rate dropped to below 1% on Friday afternoon, also coinciding
with the sharp positive move in US quant factors on Friday afternoon.
Exhibit 6: Derivative spreads indicate increased probability for default Of course, if these CDX and CDX-tranche prices are so high
Credit derivative spreads, Mar. 6, 2006 – Sep. 29, 2008 right now, why aren’t more investors selling protection, or
300
otherwise jumping in to earn this extra premium? There are
CDX spread several plausible answers. One possibility is that investors
AAA CMBX spread
250
CDX super-senior tranche spread
really believe that the economy will move into a downturn
much worse than the Great Depression of the 1930s. In our
200
discussions with investors, however, no one admits to being
Spread (bps)
150
this pessimistic.
Another possibility is that these high premia are the result of a

100
“credit crunch.” A credit crunch is described by the popular
50 press as a situation where “there isn’t enough capital to go
around.” This interpretation of a crunch is a bit too simplistic.
0
Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08
There is clearly still capital available for investment today – in
fact, a number of investors are currently tying up their capital
Source: Morgan Markets, JPMorgan Chase in T-bills which currently yield almost zero – but the marginal
investor is unwilling to take on seemingly small risks even
levels far higher than those experienced during the Great
when the rewards are large, as current credit prices suggest.
Depression. In our view, these levels were the result of investor
fear and panic – i.e., market inefficiency – rather than a One interpretation of this is that, among the investors who still
rational assessment of default probabilities. Similarly, the have capital, there are relatively few who have both (1) gone
“too thin” spreads in early 2007 were probably based on through an analysis to try to determine the “correct” prices for
overly optimistic (i.e., irrational) expectations. these credit instruments, and (2) set up the infrastructure to
allow them to trade these instruments. This further limits the
The magnitudes of these spreads are remarkable. If an investor
amount of investment capital available to take advantage of
had sold protection on a dollar’s worth of the 5-year
these dislocations.
investment-grade CDX on September 18, he would receive
10% over the coming five years, and would pay any losses due The government’s asset purchase plan is a direct response to
to defaults on the debt. However, the worst loss rate ever on a these mortgage-related asset dislocations. By proposing to buy
basket of debt of this quality was only about 140 bps per year these distressed assets, we believe the government is arguing
(during 1932-1936).7 So even if losses on bonds over the next that the true values of these securities are misunderstood, and,
five years turn out to be as bad as the worst five years of the consequently, that they are trading at prices that are “too low.”
Great Depression, an investor will still clear 3% over five Moreover, if the government is willing to invest taxpayer
years. If losses are not that bad, the investor will earn more. capital in these undervalued securities, we believe they should
be able to acquire them at a favorable price.
An alternative trade at this point would have been to sell the
CDX super-senior tranche. On this trade, an investor would Finally note that, compared to August 2007, the recent crisis
have received 75 bps per dollar of loss insured on September was not confined to quant strategies and factors. In fact, quant
18. And with this security, investors only had to cover losses strategies saw less volatility and dislocation than many other
that exceeded 30% over the 5-year period – that is, if losses investments, including corporate bonds and commercial paper.
were more than four times as bad as they were during the As with quant strategies in 2007, however, it is difficult to
Great Depression. While it is not hard to argue, with the explain the dislocation in these other markets via a direct link
benefit of hindsight, that the spread of 1.3 bps per year on the to mortgages – most corporations have limited exposure to
super-senior tranche in January 2007 was “too low,” it is mortgages or real property markets. Rather, the heightened
certainly also the case that the spread is remarkably high now. implied risk of default seems more driven by broad deleveraging
and panic than by a rational assessment of default risk.
7 Historically, the worst 5-year period for investment-grade corporate defaults was 1932-1936, when the default rate on a comparable basket was 13.5%. However, the recovery rate given default
was almost certainly above 50% for these bonds, giving a cumulative 5-year loss of 6.75%, and a loss rate of 135 bps/year.
Investment banking firms and bank runs A very simplistic explanation of the way a commercial bank
operates is that it takes in demand deposits and makes loans or
In the latest manifestation of the recent financial crisis, a
investments in illiquid assets, for example home or business
number of investment banks (including Goldman Sachs) have
loans, or investments in real estate. Unfortunately, the assets in
seen their stock prices fall precipitously. Lehman Brothers filed
which the bank invests may be hard to value; therefore,
for Chapter 11 in the largest bankruptcy ever on September 15
investors and depositors will very rarely know exactly what the
(Lehman had $600 billion in assets and 25,000 employees).
bank’s assets are worth.
Two others have been acquired or are due to be acquired: Bear
Stearns by JPMorgan Chase and Merrill Lynch by Bank of A run on a commercial bank occurs when a significant fraction
America. Most recently the last two remaining large investment of the bank’s depositors fear that the bank’s asset values may
banks – Goldman Sachs and Morgan Stanley – have filed to have fallen to very low levels, and they subsequently rush to
become commercial banks. This occurred after a fall in their withdraw their deposits. The bank has a certain amount of
equity prices of 66% and 84%, respectively, from their all-time reserves, which means that the first depositors to withdraw
highs, indicating investor concerns that Goldman Sachs and their money will get paid in full. However, if enough depositors
Morgan Stanley would not be able to continue to fund their attempt to withdraw their money at the same time, the bank
investing and financing activities. may not have sufficient reserves to pay them all. At this point,
for the bank to remain open, it will have to liquidate some of
One striking aspect of these events is that they resulted more
its investments. Since the bank has to do this quickly, the prices
from a positive feedback loop in asset pricing than from a
that it will obtain for these assets will likely be less than the
dramatic change in expected cash flows from the underlying
true value of the underlying assets. This means that the bank
investments. That is, as some firms got into liquidity problems
may not be able to pay off all of its depositors in full. The FDIC
and were forced to sell illiquid assets to raise cash, healthier
and FSLIC have substantially reduced bank runs in the past 70
firms were forced to write down their own holdings in these
years because depositors know they will be able to get their
same assets to reflect the fire-sale prices that less healthy firms
savings out (up to the insured amount) quickly if a bank fails.
were obliged to accept. This produced new liquidity problems
for the originally healthy firms, forcing them to raise capital by Modern investment banks are like commercial banks in that a
selling assets, and the process snow-balled. The point is that lot of their activities rely on raising liquid, short-term capital
the decline in values for financial firms were driven more by a from investors. In turn, they use this short-term capital to
forced fire-sale in illiquid assets than by a true decline in the make investments in longer-term, illiquid investments. The
expected cash flows from those investments. investment bank, as long as it is viewed as having a strong
capital base, will be able to continue to roll over short-term
Some economists have interpreted this latest episode as a
financing and continue to fund its investment activities.
classical bank run, with some modifications. Bank runs were
relatively common in the United States up until 1933, when the It is this short-term financing that makes modern investment
Federal Deposit Insurance Corporation (FDIC) and Federal banks look much like the commercial banks of old. Once
Savings and Loan Insurance Corporation (FSLIC) were investors begin to fear that the bank may not be able to pay
established in response to a string of bank failures in the early them off in full, they may be unwilling to extend credit to the
1930’s. Now, the deposits of individuals in commercial banks bank. Thus, like commercial banks in the early 1930’s,
are insured up to $100,000. Economists generally believe that, investment banks today may be forced to liquidate some of
prior to the establishment of deposit insurance, a number of their longer-term assets at fire-sale prices. Moreover, as this
otherwise solvent banks were taken under by bank runs. short-term financing dries up, customers of other divisions
within the bank, including their brokerage and investment Exhibit 7: Volatility on September 18, 2008 was driven by investor concern
banking groups, may pull away from doing business with these over Goldman Sachs and Morgan Stanley
investment banks. However, for investment banks, the Cumulative intraday changes, Sep. 18, 2008
insurance and orderly liquidation process does not exist, as it 0.3 0.25
does with commercial banks through the FDIC. VIX
0.2 Goldman Sachs
Morgan Stanley 0.20
Market prices over this recent period suggest that investors
Cumulative return (normalized)

0.1

0.15
feared there could be major consequences associated with
0.0
failures of investment banks and the financial sector more 0.10
broadly. This makes sense, as investment banks are key -0.1
0.05
intermediaries between the holders of capital and the users of -0.2
capital. This was particularly apparent on the day of -0.3
-0.00
September 18, when Morgan Stanley and Goldman Sachs saw
-0.4 -0.05
their largest declines.
-0.5 -0.10
The price behavior of Goldman Sachs and Morgan Stanley, and 9:40 10:19 11:31 12:43 13:55 15:07 16:00
the behavior of the VIX equity volatility index on September

Source: Yahoo!
18 were strongly reminiscent of a bank run. By mid-day
Thursday, September 18 the VIX had achieved its highest level
closely the three series moved over this day. The correlations of
since 2002 at 42.4%, as the share prices of Morgan Stanley
the 15-minute changes in the VIX with Goldman Sachs and
and Goldman Sachs fell dramatically following the announced
Morgan Stanley returns were -71% and -72%, respectively.
acquisition of Merrill Lynch by Bank of America, Lehman’s
The market apparently believed that a default by Morgan
filing for bankruptcy and the near-collapse of American
Stanley or Goldman Sachs would lead to dramatically higher
International Group (AIG) over the prior four days.
market volatility, and by extension, significant disruption in the
Exhibit 7 plots cumulative intraday changes in the VIX and in proper functioning of markets globally.
share prices of Goldman Sachs and Morgan Stanley over the
In the week since the events of September 18, Goldman Sachs
September 18 trading day. Shortly after 10AM the share prices
and Morgan Stanley have filed to become commercial banks,
of Morgan Stanley and Goldman Sachs began to fall, and at
both to secure financing and to avoid “runs” like that
12:55PM hit levels 45% and 23% below the previous day’s
experienced on September 18. Goldman Sachs has secured $10
close. As the prices of the largest two remaining US investment
billion, and Morgan Stanley $9 billion, of new long-term
banks fell, implied volatilities for the overall market soared,
financing with this same goal. Additionally, Congress is
pushing the VIX from 34.7% at the open, to 42.2% midday.
evaluating a proposal to set aside up to $700 billion to purchase
The yield on the 3-month T-bills fell to 1 bp (0.01%), as
distressed securities. Of course, with all of this activity, financial
investors fled to safety.
market volatility has remained high.
Later, as the Treasury plan began to take shape, market panic
While we in QIS are students of history, over the past year we
abated, and the prices of Goldman Sachs and Morgan Stanley
have increased our focus on measures of unusual market
recovered. The VIX also recovered, falling back to a level of
disruption as well as on strategies for reacting to these types of
33.1% at the close. Exhibit 7 clearly illustrates just how
infrequent events. In the next section, we describe our efforts in
this area and the implications for our portfolios.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions. It also refers to specific securities which pertains to past
performance or is the basis for previously made discretionary investment decisions. It should not be construed as research or investment advice, or recommendation to buy or sell investments in the
strategy or any other investments mentioned in this report or to follow any investment strategy. Please see additional disclosures.
IV: How market disruption affects our Exhibit 8: The FDI can warn us about changes in risk
investment process FDI, Jan. 1, 1995 – Sep. 29, 2008

4
Subprime crisis &
As discussed earlier, financial markets have been characterized broad deleveraging
LTCM collapse &
by a period of unusually high uncertainty. In the QIS group, we 3
Level of disruption in financial markets

Russian default
Asian crisis
believe that measures of financial disruption may be helpful in
2 September 11th
forecasting the efficacy of our risk, return and liquidity models.
Accounting scandals
Factors in our equity and macro models are inspired by 1
economic intuition and supported by empirical evidence over
long periods of time. Unfortunately, during periods of extreme 0
uncertainty, the motivation for trading often shifts from

-1
fundamental information to short-term liquidity considerations. In sample
Out of sample
For example, the crisis that affected many quantitative -2
managers in the summer of 2007 was sparked by concerns in 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
credit markets, but quickly led to heavy deleveraging of a wide
Source: GSAM
variety of investment strategies due to the immediate need for The Financial Disruption Indicator, which starts in January 1995, is a proprietary composite of
liquidity. In the short term, the main driver behind most price various indicators of financial disruption, including volatility measures, credit spreads and other
signals. In an effort to make the underlying data sets comparable, each component was first
movements became the need to liquidate positions, regardless normalized (this means that we subtracted the average return from the realized return and then
of fundamental information. divided by the standard deviation).
With this in mind, late in the summer of 2007 we created an The very high levels of the FDI in recent months provide a
index which seeks to quantify the level of disruption in good perspective on the extreme nature of the current financial
financial markets. This index, which we call the Financial crisis relative to other disruptive events in the past 15 years.
Disruption Indicator (FDI, see Exhibit 8), is a composite of
metrics that gauges the level of overall turbulence in financial Because we originally created the FDI at the end of August
markets – including measures of yield spreads, volatility, return 2007, in Exhibit 8 we use different colors to display the values
and correlation. We combine the various measures of disruption of the FDI before and after we completed our research. We
into a single index and then scale those measures so that the recognize that the index was built to fit historical data and,
index has an expected mean of zero and a volatility of one. If therefore, may not fully capture future disruptive events. As
observations of the index were drawn from a (standardized) quant managers, we are always conscious of this type of
normal distribution, we should expect 68% of the index values potential bias in our models.
to fall between 1 and -1, and 95% of the index values to fall Clearly, the FDI has been fluctuating at a high level over the
between 2 and -2. Although we do not believe that a normal past twelve months. In Exhibit 9, we provide a magnified
distribution is a realistic way of describing the behavior of version of the fluctuations of the FDI since January 2008. The
most financial data, the bounds described above still provide a evidence suggests that the FDI has reached several peaks during
useful way of identifying unusual events. this period.
The history of the FDI reveals that the Index spikes during The values of the FDI during 2008 indicate that most of this
periods of obvious turmoil, such as: the Asian crisis of 1997; year has been characterized by high disruption, with the FDI at
the Long Term Capital Management collapse and the Russian levels greater than 1.0. Early in the year, the FDI reached levels
financial crisis in the summer of 1998; the September 11 attack close to 3.0 during the heated debate over the methods used by
in 2001; the accounting scandals in the late summer of 2002; credit rating agencies. After a brief decline, the FDI spiked
and the most recent credit crisis associated with broad again surrounding the collapse of Bear Stearns. After these
deleveraging in the summer of 2007. events, financial markets appeared to revert to a less turbulent
Exhibit 9: There have been significant fluctuations in the FDI since the The “carry trade” in currency markets is a textbook example
beginning of the year of a well known (and often crowded) trade. In the carry trade,
FDI, Jan. 1, 2008 – Sep. 29, 2008 investors borrow in low-yielding (funding) currencies to invest
4 in high-yielding (investment) currencies. As long as spot
Rating Agencies Bear Stearns
in the news collapse Government steps in to save exchange rates are relatively stable, investors expect to gain
3 Fannie Mae & Freddie Mac,
Lehman Bros. bankruptcy, from the interest rate differential between the two currencies.
Federal loan to AIG
2
Given its popularity, the financial press focuses on the appetite
for the carry trade as an indicator of market sentiment
1 concerning the expected levels of relative stability.
0 In Exhibit 10, we overlay the chart of the FDI from Exhibit 9

with the cumulative performance of a currency portfolio
-1
that implements the carry trade. The carry portfolio is
-2
updated daily based on the relative yield of a basket of ten
Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08 developed currencies.
Source: GSAM As we can see, the two lines display a negative correlation.
The carry trade appears to gain popularity (and performance)
equilibrium, but not for long. In late August, concerns about
every time the FDI moves to lower values, but once disruption
the financial stability of Fannie Mae and Freddie Mac sparked
picks up, the carry portfolio suffers significant losses rather
the most recent increase in the FDI, which has stayed near 2.0
quickly thereafter.
as the market was inundated with additional news concerning
Lehman Brothers, Merrill Lynch, Bank of America, AIG,
Exhibit 10: There is a negative correlation between the FDI and the returns
Morgan Stanley, Goldman Sachs and Washington Mutual. of the currency carry trade
FDI and predictive power of our models FDI vs. cumulative returns on currency carry trade, Jan. 1, 2008 – Sep. 29, 2008
4.0 1.2
Given that the FDI seems to accurately capture the level of FDI
Carry trade cumulative return
disruption in financial markets, can this information be used to
Cumulative return on carry trade (%)

anticipate periods when our models might have weaker 3.0 1.0
predictive power or more uncertainty?

2.0 0.8
There are at least two reasons to suspect that strategies
inspired by economic intuition and fundamental information
may suffer from deterioration in expected alpha during periods 1.0 0.6
of financial disruption. First, during times of disruption, rising
volatility in the markets tends to swamp much of the
0.0 0.4
underlying fundamental information from our forecasts. This is
Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08
especially true for factors driven by medium- to long-term
economic considerations. Second, some of the most well- Source: GSAM
known factors tend to result in correlated positions among For the carry trade return illustrated in the chart above, after ranking each currency based on
its three month yield, we created a portfolio by going long the top third currencies, those with
investors. During financial crises, the need for immediate high yields, and short the bottom third currencies, those with low yields. We then calculated
liquidity often leads to quick and aggressive deleveraging of the return to the portfolio and repeated the process on a daily frequency. Disruptions in the
subprime mortgage market, widening of credit spreads and broad de-levering may have led to
those positions. As a consequence, strategies exposed to the unwinding of the worldwide carry trade and a general flight to quality over this period.
crowded signals are likely to suffer considerable losses when
the level of uncertainty increases.
For a more general perspective on forecasting power and Exhibit 11: Periods of disruption can create investment opportunities
market disruption, in Exhibit 11, we plot the monthly returns Normalized macro strategy returns against FDI
from our selected macro strategy against the values of the FDI
that would have been observable at the beginning of the 4
month. This allows us to assess whether the FDI has any 3
Normalized simulated selected

forecasting power on future performance. 2
macro strategy returns

It is hard to interpret the relationship between future 1
performance and current values of the FDI by simply looking
-2 -1 -1 1 2 3 4
at the points in the graph. For this reason, we also show the
fitted linear relationship. As expected, the evidence suggests -2
that periods of financial disruption are associated, on average, -3

with future periods of poor performance, at least on a relative
-4
basis. On the other hand, another implication of the fitted line Risk timing signal
is that when the disruption subsides, performance tends to be
better than average. This is consistent with the intuition that Source: GSAM
The risk timing signal is a composite of various indicators of market uncertainty, including equity
extreme disruption can be costly in the short run, but can also market returns, implied volatility measures, etc. Normalization means that we subtracted the
create good fundamental investment opportunities for the long average return from the realized return and then divided by the standard deviation. In the above
analysis, we use historical figures and there are sub-periods of the analysis prior to the
run. As frustrating as disruptions may be, it is important to be implementation of the FDI. The figures used in the above analysis are sourced from the
well-positioned for the return to normalcy. Quantitative Investment Strategies Group (the manager of the Fund) and not the Risk Management
& Analytics Group (the keeper of official performance numbers). The performance published here
is estimated, unaudited, and subject to subsequent adjustments. Simulated performance results
Implications of financial disruption for our portfolios do not reflect actual trading and have inherent limitations. Please see additional disclosures. Past
performance is not indicative of future results, which may vary. The returns are gross and do not
Having documented a negative relationship between financial reflect the deduction of investment advisory fees, which will reduce returns.
disruption and expected performance, the next question to ask
is: What should an investor do to mitigate the effects of positions during periods of high disruption, especially when we
disruption and crowding on expected portfolio performance? expect we will have to reinstate them again after a short time.
Our response has been to focus our effort on two goals: (1) So far, the evidence for our strategies suggests that introducing
search for new factors that are less likely to be crowded; and an opportunistic component to our risk targets is beneficial in
(2) evaluate the potential benefits of modulating the risk target many of our macro strategies, but less successful for our equity
of our factors and portfolios based on the overall level of strategies. There are two reasons for this difference: first, while
turbulence in financial markets. the profitability of many of our macro strategies’ varies
measurably with the FDI, the profitability of individual equity
To achieve the first goal, we have invested in new data that are strategies is less predictable. Second, individual equities are far
hard to access and, therefore, have not been extensively studied more expensive to trade than the very liquid futures and forward
by others. As one should expect, the most potentially profitable contracts that we use in most of our macro strategies. Given
strategies are likely also the hardest ones to uncover. the limited predictability and higher trading costs, our current
For the second goal, we have performed a thorough empirical research indicates that we are better off maintaining steady
analysis to evaluate the expected benefits and the costs of exposures to our equity return factors than to modulate them.
modulating risk over time. Clearly, if performance does vary Our approach for equity strategies has been to focus our
with the level of market disruption, then in the absence of efforts on developing more proprietary investment factors that
transaction costs, one would immediately adjust the risk target we believe are less crowded and therefore less vulnerable to
of the portfolio to reflect different levels of market disruption. disruption. By adding these factors, which are also
Once transaction costs come into play, however, the answer uncorrelated to existing factors in the model, we increase
may not always be so simple. In fact, the cost of reducing diversification and improve our ability to manage portfolio
active position sizes may be too high to justify unwinding risk, without incurring excessive transaction costs.
In the recent period of heightened disruption, our newer, Exhibit 13: Valuation spreads are nearing the peaks reached during the
proprietary factors have fared much better than our older ones. internet bubble
In Exhibit 12, we illustrate the cumulative return to our new A. Value spreads in the US, Dec. 31, 1976 – Sep. 29, 2008
and old factors in the US, since February 2008. It is clear that 1.0
our new factors have fared better than our old factors over this 0.9
Percentile rank of the interquartile

time period. It is also interesting to see how these factor 0.8
groupings performed during the recent crisis period. Not
range of value signal

0.7
surprisingly, our older factors were hit relatively hard when 0.6
disruption peaked on September 18. This is also true in our 0.5
models outside the US. 0.4
0.3
Exhibit 12: Our new factors have contributed more to our returns than 0.2
our old factors
0.1
Cumulative return to investment factors in the US, Feb. 15, 2008 – Sep. 29, 2008 0.0
1977 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
2.5
New Factors
Old Factors B. Value spreads in Japan, Jul. 31, 1987 – Sep. 29, 2008
2.0
1.0
Cumulative return (%)
1.5 0.9
Percentile rank of the interquartile
0.8
1.0
range of value signal
0.7
0.5 0.6
0.5
0.0 0.4
0.3
-0.5
Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08 0.2
0.1
Source: GSAM
0.0
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
While we have been successful in finding and incorporating new
factors in our models, we continue to hold exposure to many Source: PACE and Compustat.
of our older factors. Although in this particular crisis many of We arrive at the interquartile range by taking the difference between the 25th percentile and
75th percentile book-to-price values. The above uses Global Industry Classification Standard
our older factors have not performed well, in general we believe (GICS) industries. The returns above represent cumulative performance of the value factor on a
that some market inefficiency remains in many of the better rolling one-year basis. These performance results are backtested based on an analysis of past
market data with the benefit of hindsight, do not reflect the performance of any GSAM product
known factors. For example, we continue to include valuation and are being shown for informational purposes only. Please see additional disclosures.
measures in our models because we believe that securities will
continue to become over- and under-valued over time. The
degree of mispricing can vary, however, as investors become
more and less optimistic. Moreover, we believe that the recent
underperformance of value has resulted in unusual opportunities
today. As Exhibits 13 (A & B) show, in both the US and Japan,
the spread between the cheapest and most expensive stocks are
near the peaks reached during the Internet bubble.
Equity Risk Management Exhibit 14: Volatility has increased since mid-2007
Predicted volatility across industries, Jan. 2, 1998 – Sept. 29, 2008

Our equity risk model is a key input to our portfolio
50
construction process. We use a factor risk model, with factors Industry average
Commercial banks
categorized into return, industry and control factors. Our
40
process attempts to take risks in return factors, while

neutralizing risk from industry and control factors.
30
Return factors represent risks that we expect will earn a
premium going forward. For example, factors related to 20
Valuation, Sentiment or Momentum are all return factors. Our
portfolio construction process strives to achieve exposures to 10
return factors that are roughly commensurate with the risk-
adjusted expected returns offered by these factors. 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Industry and control factors represent risks that generally offer
Source: GSAM
no expected premium. We include them in our risk models to
make sure we measure their risks adequately, and so we can Exhibit 15: The risk of certain factors has increased dramatically
assess the risk impact from incidental exposures. Firm leverage Predicted volatilities within leverage and volatility, Jan. 2, 1998 – Sep. 29, 2008
is an example of a control factor: being significantly over- or 14
underweight firms that are all highly levered is risky because Volatility
12 Leverage
these highly-levered firms tend to move together in response to
variations in financing costs and expected economic activity.
10
Our goal in portfolio construction is generally to minimize
8
exposures to both control factors and industries. However,
because our portfolios are optimized taking into account 6
transaction costs, penalties and constraints, zero exposure to
4
each of these factors is not always optimal.
2
The recent crisis has differentially impacted these various
sources of risk. We have seen modest increases in the volatility 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
of some of our less proprietary return factors (e.g., price
Source: GSAM
momentum), but only minimal increases in the volatility of our
newer, proprietary factors. In contrast, the volatility associated Exhibit 16: Volatility within our return factors has not risen significantly
with industry and control factors has increased substantially;
Predicted volatility within the optimal tilt portfolio, Jan. 2, 1998 – Sep. 29, 2008
for some of these factors, risk has spiked in a truly dramatic
1.4
fashion. Exhibit 14 plots predicted volatilities for the average
industry and for the commercial banking industry over the 1.2
period from January 1995 through September 29, 2008. The 1.0
plot clearly shows the recent sharp increase in industry risk.
0.8
Over the period from July 1, 2007 through September 29,
2008, average industry volatility increased by 81%, while the 0.6
volatility of the commercial banking industry increased by a 0.4
whopping 221%. Exhibit 15 plots estimated volatilities for
0.2
The OTP is an optimized, unconstrained long-short portfolio which does not take transactions
costs into account. It is not meant to reflect performance achieved in any realized accounts, but 0.0
rather to measure the success of the model's predictions. The returns presented herein are 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
gross and do not reflect the deduction of investment advisory fees, which will reduce returns.
Source: GSAM
These performance results for optimal tilt portfolios are backtested based on an analysis of
past market data with the benefit of hindsight, do not reflect the performance of any GSAM With regard to our simulation methodology, we generate risk and return estimates for all
product and are being shown for informational purposes only. Please see additional disclosures. assets in our research database using our proprietary model. Simulated performance results do
not reflect actual trading and have inherent limitations. Please see additional disclosures.
This information discusses general market activity, industry or sector trends, or other broad-based
economic, market or political conditions and should not be construed as research or investment
advice. Please see additional disclosures.
two of our control factors: firm leverage and firm-specific value of their illiquid assets, and have become unwilling to
volatility. While both have exhibited large increases over the extend credit or take much risk despite record-high risk
last month, the volatility of our leverage factor in particular premiums. This extreme risk aversion has the potential to
has increased dramatically since the onset of the crisis, rising paralyze the economy as companies are unable to efficiently
447% since July 1, 2007. finance their operations or fund additional investments. It has
also forced many financial institutions, which rely extensively
For comparison, Exhibit 16 shows the volatility of our
on short-term credit, into dire circumstances, including
“optimal tilt portfolio” (or OTP), which has “optimal”
bankruptcy (Lehman Brothers and Washington Mutual), loss of
exposure to our return factors, but almost no exposure to
control (Wachovia, Merrill Lynch and Bear Stearns), or outright
industries or control factors. This plot shows that, although we
takeover by the federal government (Fannie Mae, Freddie Mac
did see a large increase in return factor volatility during the
and AIG).
quant liquidity crunch of August 2007 – especially for more
popular/common factors – the increase since that time has been We believe the roots of our current crisis can be traced to
minimal in comparison to the volatility increases observed in issues of moral hazard. That is, everyone from homeowners to
the industry and control factors. issuers of mortgage-backed securities faced asymmetric risks
and payoffs in the mortgage market. As long as housing values
These volatility shifts have implications for our portfolios. In
kept climbing, they would make money. When the music
particular, the cost (in terms of risk) of incidental exposure to
stopped (i.e., home prices declined), they could forfeit their
industry and control factors has gone up; therefore, it now
leveraged investments back to the bank (homeowners) or the
makes sense to forego some expected alpha and/or pay additional
federal government (MBS issuers). Thus, they took risks
transaction costs to further minimize exposure to these factors.
without adequate appreciation of the consequences of default.
In addition, while overall exposure to our return factors has
As a result, relative capital costs were distorted and capital was
remained stable, recent changes in the relative risks within our
misallocated, resulting in excess capital flowing into housing
return factors has resulted in changes in our relative exposures
and inflating real estate prices.
to factors. In general, our exposures to common/popular
factors have gone down as their relative risks have gone up, Currently, however, the problem has come full circle. Instead of
while our exposures to newer proprietary factors have gone up demanding down payments and interest rates that are too low
as their relative risks have declined. The one exception is value for marginal homeowners (thereby discouraging them from
– although its risk has gone up, its expected return has also buying), investors are now demanding excessive risk premiums
increased due to further widening of valuation spreads. On a for even low-risk AAA corporate bonds – essentially estimating
net basis, our exposure to this popular factor has remained their risk of default at multiples of what it was during the
fairly stable. Great Depression. In response, the government has proposed a
plan to backstop the price of distressed assets at levels closer to
The overall effect of the recent market disruption on the
those justified by the actual risks and expected cash flows.
composition of our equity portfolios has been a modest but
intentional shift in risk away from uncompensated risks that As investors, however, our job is to be prepared for disruption,
have risen significantly into newer, less crowded and higher while also being ready to take advantage of the opportunities
expected payoff sources of return. that such disruption provides. We believe that recent market
movements have been driven more by short-term liquidity
Conclusion considerations than by long-term economic fundamentals. This
has produced opportunities for above-average returns when
Recent events have produced a crisis of confidence in financial normal conditions return – which we hope will be soon.
markets, resulting in many dislocations that could potentially Accordingly, we have been focusing our efforts on identifying
derail the economy for many years to come. In particular, many less crowded strategies that can withstand a liquidity crisis and
investors are consumed with fear and uncertainty about the also provide consistent alpha under normal market conditions.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions. It also refers to specific securities which pertains to past
performance or is the basis for previously made discretionary investment decisions. It should not be construed as research or investment advice, or recommendation to buy or sell investments in the
strategy or any other investments mentioned in this report or to follow any investment strategy. Please see additional disclosures.

Glossary
AAA CMBX spread: The CMBX spread is analogous to the Commercial mortgage-backed security (CMBS): A type of
annualized cost of insuring against losses due to defaults and mortgage-backed security that is secured by pools of mortgages
interest writedowns on a basket of CMBS. The index is on commercial property. These loans are typically secured by
constituted of CDS on the AAA tranches of 25 different such commercial property as apartment buildings, shopping
CMBS deals. malls, warehouse facilities, hotels and office buildings.
ABX BBB- spread: This spread represents the annual cost of Credit default swaps (CDS): A financial instrument designed to
insuring a basket of subprime (BBB- rated) MBS against losses transfer the credit exposure of fixed income securities between
in case of default. parties. It is essentially an insurance contract that enables a
seller to protect against the risk of default on debt obligations
ALT-A: A type of US mortgage that, for various reasons is for a specific issuer.
considered riskier than “prime” but less risky than
“subprime,” the riskiest category. A mortgage may be classified LIBOR (London Interbank Offered Rate): Daily reference rate
as Alt-A for reasons including limited documentation or based on the interest rate at which banks offer to lend unsecured
because the loan is subordinated such as a home equity line of funds to other banks in the London Interbank market.
credit. Alt-A interest rates, which are determined by credit risk,
Moral hazard: Moral hazard is the prospect that an individual
tend to be between that of prime and subprime home loans.
insulated from risk may behave differently from the way she
Carry trade: A strategy where an investor sells (i.e., borrow in) would behave if she were fully exposed to the risk. Moral
a currency with a relatively low interest rate and uses the funds hazard arises because an individual does not bear the entire
to buy a different currency yielding a higher interest rate. consequences of her actions, and therefore has a tendency to
act less carefully, leaving another party to bear some
CDX spread: The CDX spread is effectively the annualized cost responsibility for the consequences of those actions.
of insuring against losses from defaults in a basket of
investment-grade corporate bonds. The index contains 125 Mortgage-backed security (MBS): A security created by pooling
investment-grade corporations and is rebalanced every six months. a group of individual mortgage loans with similar characteristics.
Monthly payments from the mortgage pool are then passed
CDX super-senior tranche spread: This is the annualized cost through to investors in the mortgage-backed security.
of providing insurance against the most severe losses on
investments grade credit – specifically, no protection is Subprime: Borrowers who generally exhibit lower credit scores
provided until losses on the CDX basket exceed 30% over the and higher leverage (i.e., higher debt-to-income ratio).
specified period. This tranche can effectively be thought of as
TED spread: Measures the premium high quality firms and
the “safest” class of CDX debt.
banks have to pay for short-term borrowing above
Conforming mortgage: A residential mortgage that conforms to government rates. It is measured by the difference between
the loan purchasing guidelines set forth by the Government LIBOR and T-bills.
Sponsored Enterprises (GSE), e.g., FNMA/FHLMC. Criteria
VIX: The Chicago Board Options Exchange’s (CBOE)
include debt-to-income ratio limits and documentation
Volatility index (ticker VIX), which is a key measure of market
requirements. There is also a maximum loan amount, which
expectations of near-term volatility conveyed by S&P 500
changes based on the mean home price (above which a
stock index option prices.
mortgage is considered a “jumbo loan”).
Source: GSAM

Additional Disclosures
These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.
Backtested performance results do not represent the results of actual trading using client assets. They do not reflect the reinvestment of dividends, the deduction of any fees, commissions or any other expenses a
client would have to pay. If GSAM had managed your account during the period, it is highly improbable that your account would have been managed in a similar fashion due to differences in economic and market
conditions.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.
Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by
any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may differ from the views and opinions
expressed by the GIR Department or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This
information should not be relied upon in making an investment decision. GSAM has no obligation to provide any updates or changes.
Holdings may change by the time you receive this report. The securities discussed do not represent all of the portfolio's holdings and may represent only a small percentage of the strategy’s portfolio holdings. A
complete list of holdings is available upon request. Future portfolio holdings may not be profitable. The information should not be deemed representative of future characteristics for the strategy.
Effect of Fees:
The following table provides a simplified example of the effect of management fees on portfolio returns. Assume a portfolio has a steady investment return, gross of fees, of 0.5% per month and total management
fees of 0.05% per month of the market value of the portfolio on the last day of the month. Management fees are deducted from the market value of the portfolio on that day. There are no cash flows during the
period. The table shows that, assuming all other factors remain constant, the difference increases due to the compounding effect over time. Of course, the magnitude of the difference between gross-of-fee and
net-of-fee returns will depend on a variety of factors, and this example is purposely simplified.
Period Gross Return Net Return Differential
1 year 6.17% 5.54% 0.63%
2 years 12.72 11.38 1.34
10 years 81.94 71.39 10.55
CORESM is a registered service mark of Goldman, Sachs & Co.
Indices are unmanaged and reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses, which would reduce returns. Investors cannot invest directly in indices.
This presentation has been communicated in Canada by GSAM LP, which is registered as a non-resident adviser under securities legislation in certain provinces of Canada and as a non-resident commodity trading
manager under the commodity futures legislation of Ontario. In other provinces, GSAM LP conducts its activities under exemptions from the adviser registration requirements. In certain provinces GSAM LP is not
registered to provide investment advisory or portfolio management services in respect of exchange-traded futures or options contracts and is not offering to provide such investment advisory or portfolio management
services in such provinces by delivery of this material.
This presentation has been communicated in the United Kingdom by Goldman Sachs Asset Management International which is authorised and regulated by the Financial Services Authority (FSA). This presentation
has been issued or approved for use in or from Hong Kong by Goldman Sachs (Asia) L.L.C. This presentation has been issued or approved for use in or from Singapore by Goldman Sachs (Singapore) Pte. (Company
Number: 198602165W). With specific regard to the distribution of this document in Asia ex-Japan, please note that this material can only be provided to GSAM’s third party distributors (on the basis they will not
distribute it to third parties), prospects in Hong Kong and Singapore and existing clients in the referenced strategy in the Asia ex-Japan region.
This material is distributed in Australia and New Zealand by Goldman Sachs JBWere Investment Management Pty Ltd ABN 41 006 099 681, AFSL 228948 trading as Goldman Sachs JBWere Asset Management
(GSJBWAM). Investment in any herein mentioned capability is only open to wholesale clients for the purposes of section 761G of the Corporations Act 2001 (Cth) and to investors in New Zealand to who fall within
the category of investors set out in sub-sections 3(2)(a) and 5(2cc) of the Securities Act 1978 (NZ) by private arrangement with GSJBWAM and this document is intended for viewing only by such clients.
Tracking Error (TE) is one possible measurement of the dispersion of a portfolio’s returns from its stated benchmark. More specifically, it is the standard deviation of such excess returns. TE exhibits are
representations of statistical expectations falling within “normal” distributions of return patterns. Normal statistical distributions of returns suggests that approximately two thirds of the time the annual gross
returns of the accounts will lie in a range equal to the benchmark return plus or minus the TE if the market behaves in a manner suggested by historical returns. Targeted TE therefore applies statistical probabilities
(and the language of uncertainty) and so cannot be predictive of actual results. In addition, past tracking error is not indicative of future TE and there can be no assurance that the TE actually reflected in your
accounts will be at levels either specified in the investment objectives or suggested by our forecasts.
Simulated performance is hypothetical and may not take into account material economic and market factors that would impact the adviser’s decision-making. Simulated results are achieved by retroactively applying
a model with the benefit of hindsight. The results reflect the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs, and other expenses, which would reduce returns. Actual results
will vary. These performance results are backtested based on an analysis of past market data with the benefit of hindsight, do not reflect the performance of any GSAM product and are being shown for informational
purposes only.
Copyright © 2008, Goldman, Sachs & Co. All rights reserved. (13959.OTHER) QECrisis/09-08

Anatomy of A Crisis

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Anatomy of A Crisis

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Anatomy of A Crisis

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What caused the financial crisis?

What caused the financial crisis?

How did the crisis spread?

How did the crisis spread?

Quantitative Investment Strategies

September 30, 2008

Goldman Sachs Asset Management | 2

II. Chronology of Selected Events

F. Establishment of Fed’s lending facility;

E. Fed cuts rates by 3/4 of a point,

I. Fannie Mae/Freddie Mac placed into a conservatorship run by the Federal

Goldman Sachs Asset Management | 3

Exhibit 2: Volatility increased sharply in 2008

Goldman Sachs Asset Management | 4

As a result, Fannie and Freddie found it extremely difficult to 60

Source: Morgan Markets, JPMorgan Chase

Goldman Sachs Asset Management | 5

Another possibility is that these high premia are the result of a

Cumulative return (normalized)

Annualized volatility (%)

the behavior of the VIX equity volatility index on September

investment process FDI, Jan. 1, 1995 – Sep. 29, 2008

Level of disruption in financial markets

uncertainty, the motivation for trading often shifts from

0 In Exhibit 10, we overlay the chart of the FDI from Exhibit 9

Cumulative return on carry trade (%)

predictive power or more uncertainty?

month. This allows us to assess whether the FDI has any 3

Normalized simulated selected

macro strategy returns

that periods of financial disruption are associated, on average, -3

Percentile rank of the interquartile

range of value signal

Predicted volatility across industries, Jan. 2, 1998 – Sept. 29, 2008

Annualized volatility (%)

Goldman Sachs Asset Management | 15

Goldman Sachs Asset Management | 16

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