Balance Sheet and Liquidity In 2003, our balance sheet grew, reflecting the higher activity levels in our trading and investing businesses and our willingness to deploy our capital to serve clients. While we face risks across every aspect of our business, access to liquidity remains the single most important issue for any financial services firm. There are many events that can create problems for a financial institution—macro events, trading losses, reputational damages, to name a few—but the most serious is a lack of liquidity. As a result, we place major emphasis on assuring our access to liquidity. The cornerstone of our approach is a “cushion” we maintain in the form of cash and highly liquid securities that averaged some $38 billion in 2003. We think of this cushion as liquidity support in the event of unexpected dislocations in financial markets. Derivatives The use of derivatives, a key part of our trading activity, has been the subject of increased debate recently. Derivatives span a wide range—from a simple interest rate swap that allows a company to convert its fixed rate borrowing into a floating rate exposure, to more complex instruments like credit derivatives that allow investors to hedge risk associated with credit exposures in their portfolios. While derivatives can be misused, they are a vital tool for risk management and risk dispersion. Over the last few years, we have witnessed seven of the ten largest corporate bankruptcies ever with surprisingly little dislocation in global credit markets. The dispersion of risk permitted by derivatives appears to have contributed very significantly to this outcome. Moreover, those financial institutions that have had some of the greatest problems in recent years were hurt in many cases by large unhedged exposures to equity markets. Of course, the use of derivatives, like other financial instruments, requires a rigorous, hands-on approach to risk management and control. These features were notably absent in some companies whose troubles have been widely publicized. At Goldman Sachs, we maintain an independent control function that monitors all of our trading positions and independently verifies their fair value. Principal Investments After two disappointing years, Principal Investments produced positive results in 2003. Net revenues increased to $566 million, up from negative $35 million in 2002. The increase was attributable to gains and overrides from real estate and corporate investments, including a $293 million unrealized gain on our investment in Sumitomo Mitsui Financial Group (SMFG). We expect the results from this business to be uneven, as there is a time lag between investing and harvesting. In 2003, we were fortunate to make a number of significant investments and we are optimistic about their return potential. We believe we have improved the quality of the portfolio in the last few years and have made some substantial investments that can drive the performance of this business over the cycle. We also sold some successful investments during 2003, including part of our holding in Kookmin Bank in South Korea. This deal highlights some of the characteristics of our business that we believe stand us in good stead for the future: our global reach and relationships, our willingness to deploy significant capital swiftly and our ability to take a long view. Our investment in convertible preferred stock of SMFG carries with it significant volatility. We hold the investment at fair value, which is derived primarily from SMFG's common share price. Since our investment in February 2003, SMFG's share price has closed as low as ¥164,000 and as high as ¥665,000. Significant changes in SMFG's share price produce significant changes in the fair value of our investment, which we report as net revenues each quarter. Our decision to invest in SMFG was based on our long-term confidence in Japan and the opportunity to strengthen our relationship with one of the most important financial institutions in Japan. Short-term fluctuations in the value of SMFG are not cause for particular concern to us, as long as the fundamentals of SMFG are steady and improving, which we believe to be the case. 4 / 6 4 / 6 © Copyright 2007, The Goldman Sachs Group, Inc. All rights reserved.