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
financial markets, the unprecedented events of the past few
weeks have clearly shaken both investors and casual observers
of the financial markets. At the beginning of 2007, risks to the
economy appeared minimal; the prices of insuring against
default on corporate debt, high quality mortgages, and even
lower-quality subprime mortgages were all at historically low
levels. Since that time, however, we have seen a dramatic
increase in the perceived risks to the US and global economies.
As the economy and markets lurched from one crisis to the
next, some measures of economic and financial risk reached
their highest levels in decades. Currently, risk aversion is so
high that the credit markets have seized up: lenders now
require huge spreads (by historical standards) to extend credit,
with some intermediaries unable to borrow or lend at all
because they can’t assess their liquidity positions due to the
lack of bids for their mortgage-backed securities (MBS)
portfolios.1 In an effort to calm markets, Congress and the
Administration are working on a proposal to create a new
government authority which could buy up to $700 billion in
distressed securities, essentially providing a backstop bid that
would allow lenders to assess their liquidity levels and resume
their normal business of providing credit to the economy. In
addition, Goldman Sachs and Morgan Stanley, the last two
remaining bulge-bracket investment banks, applied to become
bank holdings companies, placing themselves under the
regulatory supervision of the Federal Reserve.
In this paper, we discuss how the economy and markets have
reached this precarious point. We begin with an abbreviated
chronology of selected events over the past several months.
Next, we examine how various market prices have reacted to
these events. We also discuss how economic theory can help us
understand what’s happened and the implications for financial
markets and the broader economy. Finally, we examine the
predictive power and implications of financial disruption with
respect to our macro and equity strategies, and also our efforts
to manage portfolio risk in this environment.

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

 Anatomy of a Crisis 쐍 September 30, 2008

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
Annualized volatility (%)

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!

Goldman Sachs Asset Management | 3


III. Evolution of the current crisis
In January 2007, market prices were indicating steady
economic growth with few risks. Spreads on corporate debt,
commercial and residential mortgage-backed securities, and
even subprime mortgage-backed securities were close to all-
time lows. The VIX was just above 10%, close to the all-time
low of 9.31% set in 1993, and well below the previous highs
of 44–45% seen in September 1998 and September 2001 (see
Exhibit 2). The Federal Reserve was more concerned about
inflation than recession. Accordingly, the Fed Funds target rate
had been raised to 5.25% on June 29, 2006, and would not
move again for another 14 months.
Exhibit 2: Volatility increased sharply in 2008
Daily VIX level, Jan. 2, 1990 – Sep. 29, 2008
50
40
Annualized volatility (%)
30
20
10
0
1990 1992 1994 1996 1998
Source: Yahoo!
Within a few months, the first clear indications of the current
financial crisis began to emerge. Concerns about decreasing
home values and increasing mortgage delinquency rates caused
the spreads on subprime mortgages to rise in a dramatic
fashion. Exhibit 3 plots the implied ABX BBB- spread. On
January 2, 2007, the spread stood at 411 bps, meaning that
investors who sold protection on these securities were willing
to accept 4.11% of the loan value per year as an insurance
premium. However, by February 27, 2007, the premium
demanded had jumped almost four-fold, peaking at a level of
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
13.32% per year. By August 2007, the spread had jumped to
approximately 45% per year, a full ten-fold increase, and
prices on BBB- MBS had fallen by 40%. By mid-September
2008, these prices had fallen by another 85% to under 9 cents
on the dollar. Essentially, the market was implicitly forecasting
that the vast majority of subprime mortgages would default,
and that lenders would recover little value for the
underlying property.
Exhibit 3: The sharp increase on the ABX BBB- spread illustrates
investors deepening concerns about default risk
ABX BBB- spread, Jul. 19, 2006 – Aug. 15, 2007
5000
4000
ABX spread (bps)
3000
2000
1000
0
Aug 06 Oct 06 Dec 06 Feb 07 Apr 07 Jun 07 Aug 07
Source: Morgan Markets, JPMorgan Chase
2000 2002 2004 2006 2008 Mortgage-backed securities
In order to understand the current financial situation, we must
first discuss the securitization of mortgages. Mortgage
securitization can provide many economic benefits: it promotes
sharing of mortgage risk across broad segments of the
population, allows more investors to earn some of the
premium associated with bearing this risk, and lowers the cost
of borrowing to home owners. However, in the mortgage
securitization process there is an asymmetric information
problem. In other words, the loan originators (i.e., the banks
actually making loans to homeowners) understand default risks
better than the firm or individual purchasing the mortgages or,
ultimately, the MBS that are backed by the loans.
Goldman Sachs Asset Management | 4

For many years, the mortgage-backed securities market was
primarily based on conforming mortgage loans, which were
generally issued by Fannie Mae and Freddie Mac, who also
guaranteed these mortgage-backed securities against default. In
fact, most MBS investors – which include pension funds,
insurance companies, hedge funds, mutual funds, foreign central
banks, and individuals – assumed these securities were implicitly
guaranteed by the federal government as well, since it had
sponsored both organizations. However, this implicit backing,
coupled with the asymmetric information problem, created a
moral hazard issue. More specifically, it could be argued that
Fannie and Freddie (and the ultimate investor) didn’t need to
worry too much about the quality of the underlying mortgages
because the government would bear most of the risk of a
mortgage default.
This issue became even more pronounced as the subprime
mortgage market developed. Subprime mortgage-backed
securities do not carry a guarantee against default, as do those
on conforming mortgages. In hindsight, we believe this should
have led investors in subprime MBS to insist on tighter loan
standards and better monitoring. However, perhaps because of
the long, steady increase in housing prices leading up to 2007,
there was little fear in early 2007 that subprime MBS would
experience major losses – or rather, investors felt that a small
interest rate premium was enough to compensate for the
modest risk of default in a diversified subprime mortgage pool.
Another factor that may have contributed to the lax loan
standards was that Fannie and Freddie were purchasing large
quantities of subprime securities. In particular, Freddie
purchased $158 billion worth of subprime and Alt-A securities
in 2006-07, which was 13% of the total amount issued over
this period.2
In early 2008, as the price of subprime mortgage debt
continued to fall, investors began to more fully appreciate the
extent and quality of Fannie and Freddie’s subprime holdings.
As a result, Fannie and Freddie found it extremely difficult to
secure additional debt or equity financing. On September 7,
2008, because of the concern that a bankruptcy of one or both
of these firms would lock up the home mortgage market and
potentially exacerbate the decline in home values, the Treasury
stepped in to assume the risk, as well as the control, of Fannie
and Freddie – essentially making good on the implicit guarantee.
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.
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
The crisis spreads to other markets
At first glance, it is tempting to conclude that the string of
events detailed in Exhibit 1 arose solely as a consequence of
declining real estate prices and the resulting losses in subprime
mortgages. While there are commonalities between the
widening default and credit spreads witnessed over the last few
months, it would be wrong to ascribe them entirely to falling
home prices.
Indeed, prior to July 2007, the market perceived that the fall in
the value of subprime mortgages was an isolated event which
would not adversely affect the rest of the economy. This is seen
in Exhibit 4 which plots the spread from March 6, 2006
through August 15, 2007 on three portfolios representing
different levels of credit risk in investment-grade corporate debt
and commercial mortgages, the CDX, the AAA CMBX and the
super-senior tranche of the CDX.3
Until June 2007, the market did not perceive that the sharp fall
in the value of subprime MBS would result in an increased
probability of default for either high-grade commercial
mortgage-backed securities (CMBS) or investment-grade
corporate debt. However, beginning in late July 2007, spreads
in these instruments spiked dramatically: the CDX spread
jumped from 40 to 80 bps, the AAA CMBX from 10 to over
40 bps, and the spread on the super-senior tranche of the CDX
by a factor of 10: from 1.6 bps on June 29 to 16.2 bps on
August 1. At this time, concerns about a contagion effect
arising from the subprime mortgage debacle surfaced.
Exhibit 4: Spreads spiked significantly in July of 2007 as sentiment shifted
Credit derivative spreads, Mar. 6, 2006 – Aug. 15, 2007
100
CDX spread
AAA CMBX spread
CDX super-senior tranche spread
80
Spread (bps)
60
40
20
0
Apr 06 Jun 06 Aug 06 Oct 06 Dec 06 Feb 07 Apr 07 Jun 07 Aug 07
Source: Morgan Markets, JPMorgan Chase
Goldman Sachs Asset Management | 5
 Anatomy of a Crisis 쐍 September 30, 2008

Additionally, evidence from money markets also revealed
increased concern about the broader economy. Exhibit 5 plots
3-month T-bill rates, Eurodollar rates (LIBOR), and the TED
spread (the difference between LIBOR and T-bills) since
January 2006. As LIBOR is an inter-bank lending rate and the
T-bill rate is effectively the risk-free rate, the spread between
the two is an indicator of credit risk in inter-bank loans. The
TED spread increases when the perceived risk of bank default
rises. As shown in Exhibit 5, the TED spread increased slightly
in mid-June 2007 as a result of declining T-bill rates, and then
jumped dramatically in early August.4
Exhibit 5: Investor fear drove rates down, borrowing premium hit record highs
Treasury, LIBOR, and TED spread, Jan. 1, 2006 – Sep. 29, 2008
6
5 and the Federal Reserve jointly injected roughly $150 and
4
Rate (% per year)
documented in our “Quant Liquidity Crunch” paper from last
year.5 The deleveraging began in the US, then quickly became
severe and spread to non-US regions. This deleveraging
resulted in unprecedented negative returns to all standard
quant factors in the US and overseas during the first two weeks
of August. In the process, it became clear that many popular
quantitative signals had become over-crowded, resulting in
either reduced effectiveness and/or increased risk. After a
harrowing week for quant strategies, Goldman Sachs and a
number of other institutional investors announced significant
investments in quantitative portfolios. Coincident with these
investments, many quantitative factors flipped directions on
August 10, 2007 and moderated to more normal levels.
Around the same time, as a result of an increased demand for
liquidity in the financial system, the European Central Bank
$100 billion of credit into the financial system on August 9
and 10, respectively.6 In the US, the increased liquidity drove

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
0
Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08
Source: Bloomberg
The large moves in July and August 2007 were likely related
to two factors: new information about financial institutions’
exposures to credit instruments, and a broader demand
for liquidity.
On July 30, 2007, Deutsche Industriebank (IKB), a German
bank, warned that it faced losses as a result of holding US
subprime mortgage-related instruments in a structured vehicle
and was subsequently bailed out by a consortium of German
banks. This was the first major bank failure that resulted from
mortgage-related distress.
Also in early August 2007, the equity markets saw a dramatic
deleveraging of quant trades, something we previously
The crisis widens
Since August of last year, the shock of increased capital costs
has propagated through multiple markets in a way that few
could have predicted. Exhibit 6 extends the time period of the
credit spread plot in Exhibit 4 up through September 29, 2008.
To facilitate comparison, the blue area in Exhibit 6’s plot is
that previously shown in Exhibit 4. Note that the seemingly
large spread of 80 bps for the CDX in early August 2007
widened to over 200 bps per year in March 2008. The 45 bps
CMBX spread increased to over 250 bps in early March as
Bear Stearns collapsed following a massive decline in the values
of its mortgage-related securities; it was subsequently acquired
by JPMorgan Chase.
Both the CDX spread and the CDX super-senior tranche
spread indicate that the implied probability of major defaults
on corporate debt reached extraordinary levels in March 2008,
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.
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 | 6

Exhibit 6: Derivative spreads indicate increased probability for default
Credit derivative spreads, Mar. 6, 2006 – Sep. 29, 2008
300
CDX spread
AAA CMBX spread
250
CDX super-senior tranche spread
200
Spread (bps)
150
100
50
0
Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08
Source: Morgan Markets, JPMorgan Chase
levels far higher than those experienced during the Great
Depression. In our view, these levels were the result of investor
fear and panic – i.e., market inefficiency – rather than a
rational assessment of default probabilities. Similarly, the
“too thin” spreads in early 2007 were probably based on
overly optimistic (i.e., irrational) expectations.
The magnitudes of these spreads are remarkable. If an investor
had sold protection on a dollar’s worth of the 5-year
investment-grade CDX on September 18, he would receive
10% over the coming five years, and would pay any losses due
to defaults on the debt. However, the worst loss rate ever on a
basket of debt of this quality was only about 140 bps per year
(during 1932-1936).7 So even if losses on bonds over the next
five years turn out to be as bad as the worst five years of the
Great Depression, an investor will still clear 3% over five
years. If losses are not that bad, the investor will earn more.
An alternative trade at this point would have been to sell the
CDX super-senior tranche. On this trade, an investor would
have received 75 bps per dollar of loss insured on September
18. And with this security, investors only had to cover losses
that exceeded 30% over the 5-year period – that is, if losses
were more than four times as bad as they were during the
Great Depression. While it is not hard to argue, with the
benefit of hindsight, that the spread of 1.3 bps per year on the
super-senior tranche in January 2007 was “too low,” it is
certainly also the case that the spread is remarkably high now.
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.
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
Of course, if these CDX and CDX-tranche prices are so high
right now, why aren’t more investors selling protection, or
otherwise jumping in to earn this extra premium? There are
several plausible answers. One possibility is that investors
really believe that the economy will move into a downturn
much worse than the Great Depression of the 1930s. In our
discussions with investors, however, no one admits to being
this pessimistic.
Another possibility is that these high premia are the result of a
“credit crunch.” A credit crunch is described by the popular
press as a situation where “there isn’t enough capital to go
around.” This interpretation of a crunch is a bit too simplistic.
There is clearly still capital available for investment today – in
fact, a number of investors are currently tying up their capital
in T-bills which currently yield almost zero – but the marginal
investor is unwilling to take on seemingly small risks even
when the rewards are large, as current credit prices suggest.
One interpretation of this is that, among the investors who still
have capital, there are relatively few who have both (1) gone
through an analysis to try to determine the “correct” prices for
these credit instruments, and (2) set up the infrastructure to
allow them to trade these instruments. This further limits the
amount of investment capital available to take advantage of
these dislocations.
The government’s asset purchase plan is a direct response to
these mortgage-related asset dislocations. By proposing to buy
these distressed assets, we believe the government is arguing
that the true values of these securities are misunderstood, and,
consequently, that they are trading at prices that are “too low.”
Moreover, if the government is willing to invest taxpayer
capital in these undervalued securities, we believe they should
be able to acquire them at a favorable price.
Finally note that, compared to August 2007, the recent crisis
was not confined to quant strategies and factors. In fact, quant
strategies saw less volatility and dislocation than many other
investments, including corporate bonds and commercial paper.
As with quant strategies in 2007, however, it is difficult to
explain the dislocation in these other markets via a direct link
to mortgages – most corporations have limited exposure to
mortgages or real property markets. Rather, the heightened
implied risk of default seems more driven by broad deleveraging
and panic than by a rational assessment of default risk.
Goldman Sachs Asset Management | 7

Investment banking firms and bank runs
In the latest manifestation of the recent financial crisis, a
number of investment banks (including Goldman Sachs) have
seen their stock prices fall precipitously. Lehman Brothers filed
for Chapter 11 in the largest bankruptcy ever on September 15
(Lehman had $600 billion in assets and 25,000 employees).
Two others have been acquired or are due to be acquired: Bear
Stearns by JPMorgan Chase and Merrill Lynch by Bank of
America. Most recently the last two remaining large investment
banks – Goldman Sachs and Morgan Stanley – have filed to
become commercial banks. This occurred after a fall in their
equity prices of 66% and 84%, respectively, from their all-time
highs, indicating investor concerns that Goldman Sachs and
Morgan Stanley would not be able to continue to fund their
investing and financing activities.
One striking aspect of these events is that they resulted more
from a positive feedback loop in asset pricing than from a
dramatic change in expected cash flows from the underlying
investments. That is, as some firms got into liquidity problems
and were forced to sell illiquid assets to raise cash, healthier
firms were forced to write down their own holdings in these
same assets to reflect the fire-sale prices that less healthy firms
were obliged to accept. This produced new liquidity problems
for the originally healthy firms, forcing them to raise capital by
selling assets, and the process snow-balled. The point is that
the decline in values for financial firms were driven more by a
forced fire-sale in illiquid assets than by a true decline in the
expected cash flows from those investments.
Some economists have interpreted this latest episode as a
classical bank run, with some modifications. Bank runs were
relatively common in the United States up until 1933, when the
Federal Deposit Insurance Corporation (FDIC) and Federal
Savings and Loan Insurance Corporation (FSLIC) were
established in response to a string of bank failures in the early
1930’s. Now, the deposits of individuals in commercial banks
are insured up to $100,000. Economists generally believe that,
prior to the establishment of deposit insurance, a number of
otherwise solvent banks were taken under by bank runs.
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
A very simplistic explanation of the way a commercial bank
operates is that it takes in demand deposits and makes loans or
investments in illiquid assets, for example home or business
loans, or investments in real estate. Unfortunately, the assets in
which the bank invests may be hard to value; therefore,
investors and depositors will very rarely know exactly what the
bank’s assets are worth.
A run on a commercial bank occurs when a significant fraction
of the bank’s depositors fear that the bank’s asset values may
have fallen to very low levels, and they subsequently rush to
withdraw their deposits. The bank has a certain amount of
reserves, which means that the first depositors to withdraw
their money will get paid in full. However, if enough depositors
attempt to withdraw their money at the same time, the bank
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
its investments. Since the bank has to do this quickly, the prices
that it will obtain for these assets will likely be less than the
true value of the underlying assets. This means that the bank
may not be able to pay off all of its depositors in full. The FDIC
and FSLIC have substantially reduced bank runs in the past 70
years because depositors know they will be able to get their
savings out (up to the insured amount) quickly if a bank fails.
Modern investment banks are like commercial banks in that a
lot of their activities rely on raising liquid, short-term capital
from investors. In turn, they use this short-term capital to
make investments in longer-term, illiquid investments. The
investment bank, as long as it is viewed as having a strong
capital base, will be able to continue to roll over short-term
financing and continue to fund its investment activities.
It is this short-term financing that makes modern investment
banks look much like the commercial banks of old. Once
investors begin to fear that the bank may not be able to pay
them off in full, they may be unwilling to extend credit to the
bank. Thus, like commercial banks in the early 1930’s,
investment banks today may be forced to liquidate some of
their longer-term assets at fire-sale prices. Moreover, as this
short-term financing dries up, customers of other divisions
Goldman Sachs Asset Management | 8
 Anatomy of a Crisis 쐍 September 30, 2008

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

Annualized volatility (%)

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.
Goldman Sachs Asset Management | 9

IV: How market disruption affects our
investment process
As discussed earlier, financial markets have been characterized
by a period of unusually high uncertainty. In the QIS group, we
believe that measures of financial disruption may be helpful in
forecasting the efficacy of our risk, return and liquidity models.
Factors in our equity and macro models are inspired by
economic intuition and supported by empirical evidence over
long periods of time. Unfortunately, during periods of extreme
uncertainty, the motivation for trading often shifts from
fundamental information to short-term liquidity considerations.
For example, the crisis that affected many quantitative
managers in the summer of 2007 was sparked by concerns in
credit markets, but quickly led to heavy deleveraging of a wide
variety of investment strategies due to the immediate need for
liquidity. In the short term, the main driver behind most price
movements became the need to liquidate positions, regardless
of fundamental information.
With this in mind, late in the summer of 2007 we created an
index which seeks to quantify the level of disruption in
financial markets. This index, which we call the Financial
Disruption Indicator (FDI, see Exhibit 8), is a composite of
metrics that gauges the level of overall turbulence in financial
markets – including measures of yield spreads, volatility, return
and correlation. We combine the various measures of disruption
into a single index and then scale those measures so that the
index has an expected mean of zero and a volatility of one. If
observations of the index were drawn from a (standardized)
normal distribution, we should expect 68% of the index values
to fall between 1 and -1, and 95% of the index values to fall
between 2 and -2. Although we do not believe that a normal
distribution is a realistic way of describing the behavior of
most financial data, the bounds described above still provide a
useful way of identifying unusual events.
The history of the FDI reveals that the Index spikes during
periods of obvious turmoil, such as: the Asian crisis of 1997;
the Long Term Capital Management collapse and the Russian
financial crisis in the summer of 1998; the September 11 attack
in 2001; the accounting scandals in the late summer of 2002;
and the most recent credit crisis associated with broad
deleveraging in the summer of 2007.
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
Exhibit 8: The FDI can warn us about changes in risk
FDI, Jan. 1, 1995 – Sep. 29, 2008
4
Subprime crisis &
broad deleveraging
LTCM collapse &
3
Level of disruption in financial markets
Russian default
Asian crisis
2 September 11th
Accounting scandals
1
0
-1
In sample
Out of sample
-2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: GSAM
The Financial Disruption Indicator, which starts in January 1995, is a proprietary composite of
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
normalized (this means that we subtracted the average return from the realized return and then
divided by the standard deviation).
The very high levels of the FDI in recent months provide a
good perspective on the extreme nature of the current financial
crisis relative to other disruptive events in the past 15 years.
Because we originally created the FDI at the end of August
2007, in Exhibit 8 we use different colors to display the values
of the FDI before and after we completed our research. We
recognize that the index was built to fit historical data and,
therefore, may not fully capture future disruptive events. As
quant managers, we are always conscious of this type of
potential bias in our models.
Clearly, the FDI has been fluctuating at a high level over the
past twelve months. In Exhibit 9, we provide a magnified
version of the fluctuations of the FDI since January 2008. The
evidence suggests that the FDI has reached several peaks during
this period.
The values of the FDI during 2008 indicate that most of this
year has been characterized by high disruption, with the FDI at
levels greater than 1.0. Early in the year, the FDI reached levels
close to 3.0 during the heated debate over the methods used by
credit rating agencies. After a brief decline, the FDI spiked
again surrounding the collapse of Bear Stearns. After these
events, financial markets appeared to revert to a less turbulent
Goldman Sachs Asset Management | 10
 Anatomy of a Crisis 쐍 September 30, 2008

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,
Level of disruption in financial markets

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
Level of disruption in financial markets

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.

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 | 11

For a more general perspective on forecasting power and
market disruption, in Exhibit 11, we plot the monthly returns
from our selected macro strategy against the values of the FDI
that would have been observable at the beginning of the
month. This allows us to assess whether the FDI has any
forecasting power on future performance.
It is hard to interpret the relationship between future
performance and current values of the FDI by simply looking
at the points in the graph. For this reason, we also show the
fitted linear relationship. As expected, the evidence suggests
that periods of financial disruption are associated, on average,
with future periods of poor performance, at least on a relative
basis. On the other hand, another implication of the fitted line
is that when the disruption subsides, performance tends to be
better than average. This is consistent with the intuition that
extreme disruption can be costly in the short run, but can also
create good fundamental investment opportunities for the long
run. As frustrating as disruptions may be, it is important to be
well-positioned for the return to normalcy.
Implications of financial disruption for our portfolios
Having documented a negative relationship between financial
disruption and expected performance, the next question to ask
is: What should an investor do to mitigate the effects of
disruption and crowding on expected portfolio performance?
Our response has been to focus our effort on two goals: (1)
search for new factors that are less likely to be crowded; and
(2) evaluate the potential benefits of modulating the risk target
of our factors and portfolios based on the overall level of
turbulence in financial markets.
To achieve the first goal, we have invested in new data that are
hard to access and, therefore, have not been extensively studied
by others. As one should expect, the most potentially profitable
strategies are likely also the hardest ones to uncover.
For the second goal, we have performed a thorough empirical
analysis to evaluate the expected benefits and the costs of
modulating risk over time. Clearly, if performance does vary
with the level of market disruption, then in the absence of
transaction costs, one would immediately adjust the risk target
of the portfolio to reflect different levels of market disruption.
Once transaction costs come into play, however, the answer
may not always be so simple. In fact, the cost of reducing
active position sizes may be too high to justify unwinding
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
Exhibit 11: Periods of disruption can create investment opportunities
Normalized macro strategy returns against FDI
4
3
Normalized simulated selected
2
macro strategy returns
1
-2 -1 -1 1 2 3 4
-2
-3
-4
Risk timing signal
Source: GSAM
The risk timing signal is a composite of various indicators of market uncertainty, including equity
market returns, implied volatility measures, etc. Normalization means that we subtracted the
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
implementation of the FDI. The figures used in the above analysis are sourced from the
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
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
reflect the deduction of investment advisory fees, which will reduce returns.
positions during periods of high disruption, especially when we
expect we will have to reinstate them again after a short time.
So far, the evidence for our strategies suggests that introducing
an opportunistic component to our risk targets is beneficial in
many of our macro strategies, but less successful for our equity
strategies. There are two reasons for this difference: first, while
the profitability of many of our macro strategies’ varies
measurably with the FDI, the profitability of individual equity
strategies is less predictable. Second, individual equities are far
more expensive to trade than the very liquid futures and forward
contracts that we use in most of our macro strategies. Given
the limited predictability and higher trading costs, our current
research indicates that we are better off maintaining steady
exposures to our equity return factors than to modulate them.
Our approach for equity strategies has been to focus our
efforts on developing more proprietary investment factors that
we believe are less crowded and therefore less vulnerable to
disruption. By adding these factors, which are also
uncorrelated to existing factors in the model, we increase
diversification and improve our ability to manage portfolio
risk, without incurring excessive transaction costs.
Goldman Sachs Asset Management | 12
 Anatomy of a Crisis 쐍 September 30, 2008

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.

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 | 13
 Anatomy of a Crisis 쐍 September 30, 2008

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

Annualized volatility (%)

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.
Annualized volatility (%)

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
Annualized volatility (%)

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.
Goldman Sachs Asset Management | 14

two of our control factors: firm leverage and firm-specific
volatility. While both have exhibited large increases over the
last month, the volatility of our leverage factor in particular
has increased dramatically since the onset of the crisis, rising
447% since July 1, 2007.
For comparison, Exhibit 16 shows the volatility of our
“optimal tilt portfolio” (or OTP), which has “optimal”
exposure to our return factors, but almost no exposure to
industries or control factors. This plot shows that, although we
did see a large increase in return factor volatility during the
quant liquidity crunch of August 2007 – especially for more
popular/common factors – the increase since that time has been
minimal in comparison to the volatility increases observed in
the industry and control factors.
These volatility shifts have implications for our portfolios. In
particular, the cost (in terms of risk) of incidental exposure to
industry and control factors has gone up; therefore, it now
makes sense to forego some expected alpha and/or pay additional
transaction costs to further minimize exposure to these factors.
In addition, while overall exposure to our return factors has
remained stable, recent changes in the relative risks within our
return factors has resulted in changes in our relative exposures
to factors. In general, our exposures to common/popular
factors have gone down as their relative risks have gone up,
while our exposures to newer proprietary factors have gone up
as their relative risks have declined. The one exception is value
– although its risk has gone up, its expected return has also
increased due to further widening of valuation spreads. On a
net basis, our exposure to this popular factor has remained
fairly stable.
The overall effect of the recent market disruption on the
composition of our equity portfolios has been a modest but
intentional shift in risk away from uncompensated risks that
have risen significantly into newer, less crowded and higher
expected payoff sources of return.
Conclusion
Recent events have produced a crisis of confidence in financial
markets, resulting in many dislocations that could potentially
derail the economy for many years to come. In particular, many
investors are consumed with fear and uncertainty about the
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.
Anatomy of a Crisis 쐍 September 30, 2008
value of their illiquid assets, and have become unwilling to
extend credit or take much risk despite record-high risk
premiums. This extreme risk aversion has the potential to
paralyze the economy as companies are unable to efficiently
finance their operations or fund additional investments. It has
also forced many financial institutions, which rely extensively
on short-term credit, into dire circumstances, including
bankruptcy (Lehman Brothers and Washington Mutual), loss of
control (Wachovia, Merrill Lynch and Bear Stearns), or outright
takeover by the federal government (Fannie Mae, Freddie Mac
and AIG).
We believe the roots of our current crisis can be traced to
issues of moral hazard. That is, everyone from homeowners to
issuers of mortgage-backed securities faced asymmetric risks
and payoffs in the mortgage market. As long as housing values
kept climbing, they would make money. When the music
stopped (i.e., home prices declined), they could forfeit their
leveraged investments back to the bank (homeowners) or the
federal government (MBS issuers). Thus, they took risks
without adequate appreciation of the consequences of default.
As a result, relative capital costs were distorted and capital was
misallocated, resulting in excess capital flowing into housing
and inflating real estate prices.
Currently, however, the problem has come full circle. Instead of
demanding down payments and interest rates that are too low
for marginal homeowners (thereby discouraging them from
buying), investors are now demanding excessive risk premiums
for even low-risk AAA corporate bonds – essentially estimating
their risk of default at multiples of what it was during the
Great Depression. In response, the government has proposed a
plan to backstop the price of distressed assets at levels closer to
those justified by the actual risks and expected cash flows.
As investors, however, our job is to be prepared for disruption,
while also being ready to take advantage of the opportunities
that such disruption provides. We believe that recent market
movements have been driven more by short-term liquidity
considerations than by long-term economic fundamentals. This
has produced opportunities for above-average returns when
normal conditions return – which we hope will be soon.
Accordingly, we have been focusing our efforts on identifying
less crowded strategies that can withstand a liquidity crisis and
also provide consistent alpha under normal market conditions.
Goldman Sachs Asset Management | 15

Glossary
AAA CMBX spread: The CMBX spread is analogous to the
annualized cost of insuring against losses due to defaults and
interest writedowns on a basket of CMBS. The index is
constituted of CDS on the AAA tranches of 25 different
CMBS deals.
ABX BBB- spread: This spread represents the annual cost of
insuring a basket of subprime (BBB- rated) MBS against losses
in case of default.
ALT-A: A type of US mortgage that, for various reasons is
considered riskier than “prime” but less risky than
“subprime,” the riskiest category. A mortgage may be classified
as Alt-A for reasons including limited documentation or
because the loan is subordinated such as a home equity line of
credit. Alt-A interest rates, which are determined by credit risk,
tend to be between that of prime and subprime home loans.
Carry trade: A strategy where an investor sells (i.e., borrow in)
a currency with a relatively low interest rate and uses the funds
to buy a different currency yielding a higher interest rate.
CDX spread: The CDX spread is effectively the annualized cost
of insuring against losses from defaults in a basket of
investment-grade corporate bonds. The index contains 125
investment-grade corporations and is rebalanced every six months.
CDX super-senior tranche spread: This is the annualized cost
of providing insurance against the most severe losses on
investments grade credit – specifically, no protection is
provided until losses on the CDX basket exceed 30% over the
specified period. This tranche can effectively be thought of as
the “safest” class of CDX debt.
Conforming mortgage: A residential mortgage that conforms to
the loan purchasing guidelines set forth by the Government
Sponsored Enterprises (GSE), e.g., FNMA/FHLMC. Criteria
include debt-to-income ratio limits and documentation
requirements. There is also a maximum loan amount, which
changes based on the mean home price (above which a
mortgage is considered a “jumbo loan”).
Source: GSAM
Anatomy of a Crisis 쐍 September 30, 2008
Commercial mortgage-backed security (CMBS): A type of
mortgage-backed security that is secured by pools of mortgages
on commercial property. These loans are typically secured by
such commercial property as apartment buildings, shopping
malls, warehouse facilities, hotels and office buildings.
Credit default swaps (CDS): A financial instrument designed to
transfer the credit exposure of fixed income securities between
parties. It is essentially an insurance contract that enables a
seller to protect against the risk of default on debt obligations
for a specific issuer.
LIBOR (London Interbank Offered Rate): Daily reference rate
based on the interest rate at which banks offer to lend unsecured
funds to other banks in the London Interbank market.
Moral hazard: Moral hazard is the prospect that an individual
insulated from risk may behave differently from the way she
would behave if she were fully exposed to the risk. Moral
hazard arises because an individual does not bear the entire
consequences of her actions, and therefore has a tendency to
act less carefully, leaving another party to bear some
responsibility for the consequences of those actions.
Mortgage-backed security (MBS): A security created by pooling
a group of individual mortgage loans with similar characteristics.
Monthly payments from the mortgage pool are then passed
through to investors in the mortgage-backed security.
Subprime: Borrowers who generally exhibit lower credit scores
and higher leverage (i.e., higher debt-to-income ratio).
TED spread: Measures the premium high quality firms and
banks have to pay for short-term borrowing above
government rates. It is measured by the difference between
LIBOR and T-bills.
VIX: The Chicago Board Options Exchange’s (CBOE)
Volatility index (ticker VIX), which is a key measure of market
expectations of near-term volatility conveyed by S&P 500
stock index option prices.
Goldman Sachs Asset Management | 16
 Anatomy of a Crisis 쐍 September 30, 2008

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.

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